Friday 6 July 2012

This is how to examine students

This is from to the io9 webpage:
University exams are never anyone's idea of a rollicking time, particularly when your professor rambles on besotted for 23 hours, denies you sustenance and bathroom breaks, and covers topics not on the syllabus, such as her wardrobe and outside business interests.

And according to students at Russia's Kazan Federal University, this is exactly what precipitated on June 26, when an oral nuclear physics examination began at 10:00 AM and ended at 9:00 AM the following day. In an interview with the newspaper Moskovsky Komsomolets, one of the pupils noted, "Towards the end, everyone was just sitting there, totally exhausted [...] The lecturer would go into another room, drink, come back and start telling us about her business."

Oral exams are not uncommon in Russia, and even the instructor admitted that this one in particular ran long. But marathon examiner Landysh Zaripova responded to these allegations with a swipe at her fifteen students' academic aptitude. ("Do you think I am an idiot? [...] I was sober. The students just decided to get revenge on me because they couldn't pass the exam.")
Now that's what a real exam is like! And imagine what it would do for coffee sales.

Thanks to EC for the tip.

A bigger slice of a smaller pie

Institutions are a key determinant of economic development and indeed many developing institutions are deeply dysfunctional. A new column a presents a new model suggesting that those in power may prefer to keep bad institutions despite their anti-development effects since they alllow the elite to grab a bigger slice of a smaller pie.

Bernardo Guimaraes and Kevin D Sheedy look at Power sharing and institutional stability. Clearly if you are creating a smaller pie then your institutions are not right. This in turn raises the question, Why inefficient institutions persist,
Institutions determine the allocation of resources and power among the individuals in the model. However, institutional choices have to survive popular uprisings, coups d'états, and all types of insurrections against them. Hence the elite in power chooses the rules that maximise its members’ payoffs subject to avoiding challenges that would dislodge them from power. For instance, excessively large taxes on some groups would prompt the disaffected groups to fight to take power and change the institutions.

In many cases, rules necessary for economic efficiency require restrictions on the untrammelled exercise of the elite's power. Including the possibility of investment in the model immediately raises this issue: rules against expropriation are needed, because protection of private property is optimal for the elite ex-ante, but not ex-post. There needs to be a means of preventing the elite from using its power to sweep aside existing rules and reshaping institutions to conform to their ex-post interests. The problem is essentially the classic question of ‘who will guard the guardians?’.

The model provides an answer: there must be many guardians if institutions are to be safe. A larger group holding power emerges as a commitment mechanism that allows them to act as a government bound to a set of policies that would otherwise be time inconsistent. This large group in power could perhaps be interpreted as including armed forces, police, parliaments, judges, etc. This resonates with Montesquieu's doctrine of the separation of powers, now accepted and followed in well-functioning systems of government.

How does it work? Once sunk investment costs have been incurred, many groups will want to destroy the current institutions and replace them with new ones. That is the time inconsistency problem: a group taking power would have incentives to expropriate the fruits of investments previously made. But importantly, this group would also have some optimal degree of power sharing in mind. For instance, a large legislative body might be thought of as unnecessary when institutions are rebuilt. Now suppose that the current institutions share power among a wider group. If a coup d’état occurs, some of those in power will lose their privileged status. Anticipating that, they will be willing to ‘fight’ to defend the current institutions.
The key idea is that power has to be shared so that power is less concentrated than it would be if institutions were destroyed and the group that took power were to rebuild institutions from scratch. Interestingly, the mechanism through which this operates is not bringing in new types of individuals who represent or care about other citizens. All members of the elite care only about their own rents under the status quo, and that is what gives them incentives to fight against insurrections from both insiders and outsiders. But alas, that is also what precludes efficient institutions from arising.

Although it is possible to sustain protection against expropriation by sharing power among a sufficiently large group, in equilibrium there is too little power sharing and thus too little commitment to rules such as protection of property rights. The reason is that sharing power requires sharing rents – because were powerful individuals not to receive rents commensurate with their status, they would have incentives to join rebellions against the current institutions, and no incentive to defend them. Hence those in power might want to choose a small pie (inefficient institutions) in order to guarantee their slice will be larger (little power sharing).

In many parts of the world, the threat of conflict has played and continues to play an important role in shaping institutions. Understanding that connection might teach us why some parts of the world are still so underdeveloped, and perhaps help us to devise better ways to address the problem.

Thursday 5 July 2012

Foreigners may just be good for your economy

Just don't tell Winston Peters! A new paper in the Journal of Economics and Management Strategy looks at Firm Productivity and the Foreign-Market Entry Decision. The abstract reads:
We use Japanese firm-level data to examine how a firm’s productivity affects its foreign-market entry strategy. The firm faces a choice between exporting and foreign direct investment (FDI). In the case of FDI, the firm has two options: greenfield investment or acquisition of an existing plant (M&A). If it selects greenfield investment, it has two ownership choices: whole ownership or a joint venture with a local company. Controlling for industry- and country-specific characteristics, we find that the more productive a firm is, the more likely it is to choose FDI rather than exporting and greenfield investment rather than M&A.
If these results hold for firms setting up in New Zealand they look like good news for New Zealand. If we see FDI, and in particular in areas of greenfields investment, in New Zealand then this tips the probability that the investing firm is a high productivity firm. But these are exactly the type of firms we want setting up shop in New Zealand. Given they are high productivity firms they will bring with them the industry best management, manufacturing and organisational practices which can flow onto New Zealand firms. Also given their productivity these firms will provide the most competition for local firms forcing the locals to lift their game and benefiting local consumers.

Of course if we make investment in New Zealand harder for foreign firms then this research suggests we could be loosing the benefits of having the best firms in our markets.

Wednesday 4 July 2012

Council asset sales

There is much heat and little light being generated over the funding of the Christchurch City Council's spending plans via increased debt or asset sales. I think part of the problem with the discussion is that there are in fact two issues here and not just one. The first is, for a given spending plan, should more debt be issued or should revenue be increased? And the second is, Should the council sell assets? These two question can being seen as related but they don't have to be. It is possible, for example, that the council could in increase revenue by, say, selling assets to another council. This would raise cash without privatisation. Or it could privatise assets by giving them away which would result in no revenue. Also even if the council had no problems with its budget it still would face the issue of asset sales.

Actually there is a third option, cut spending. No I don't see the council going for that option! But you do have to ask, do we really need a new rugby stadium or a new convention centre, for example.

One of the big issues to do with debt has been the discussion of the difference between the rate of return on the council assets and the cost of debt. But as Eric Crampton has noted its more really possible to compare the two given the way the rate of return on assets is worked out.
“It’s a bit of a shame that so much of the discourse around asset sales has focused on differences between dividend rates and the interest rate on Council borrowing. First, it’s harder to put a fair value on assets held by government because they’re not traded on the open market; the recent rather large reduction in the book value of KiwiRail points to some of these difficulties. Where we are less certain of the asset’s value, we have less confidence around the actual dividend rates. Further, where reported dividend payments include a lot of booked capital gain rather than actual cash payments, it’s not entirely a fair comparison with bond payments. But more fundamentally, ownership of assets comes both with risk and with ongoing maintenance liabilities; gaps between dividends paid by Council enterprises and interest on Council debt is largely explained by that the former is riskier.”
There is little point in keeping the "family silver" as a hedge against bad times if you're not willing to sell it when bad times hit.
As to the should the council privatise question, the answer is, it depends. Privatisation makes sense when the private sector is more efficient than the public sector. Incomplete contracts models show that even when the government sets out to maximise welfare there are still times when it makes sense to privatise (Klaus M. Schmidt (1996) 'The Costs and Benefits of Privatization: An Incomplete Contracts Approach', Journal of Law, Economics, & Organization, Vol. 12, No.1 (April), 1-24 and Klaus M. Schmidt (1996) 'Incomplete contracts and privatization', European Economic Review, vol. 40, 569-579.) . This is because there is a trade-off bwteen allocative efficiency - which the government is good at achieving - and productive efficiency - which the private sector is good at achieving. If the gain in productive efficiency is greater than the loss in allocative efficiency then privatisation makes sense.

As a general guide, Hart, Shleifer and Vishny ("The Proper Scope of Government: Theory and an Application to Prisons", Quarterly Journal of Economics, 112(4): 1127-61, November 1997) argue that the case for government provision of goods or services is generally stronger when non-contractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant and when corruption in government procurement is a severe problem. It has been argued that the case for government production is strong in such services as the conduct of foreign policy, police and armed forces. The case can also be made reasonably persuasively for the case of prisons. The case for private sector provision is stronger when quality reducing cost reduction can be controlled through contract or competition, when quality innovations are important and when patronage and powerful unions are a severe problem inside the government.

The Christchurch City Council ownership of assets is controlled by Christchurch City Holdings Ltd (CCHL) which is the commercial and investment arm of the council. CCHL manages the ratepayers' investment in these seven fully or partly-owned council-controlled trading organisations: Orion New Zealand Ltd – 89.3 per cent shareholding. Christchurch International Airport Ltd – 75 per cent. Lyttelton Port Company Ltd – 78.9 per cent. Christchurch City Networks Ltd (trading as Enable Networks) – 100 per cent. Red Bus Ltd – 100 per cent. City Care Ltd – 100 per cent. Selwyn Plantation Board Ltd – 39.3 per cent.

It's hard to see how any of these assets are in anyway like foreign policy, the police or the armed forces. It is difficult see how non-contractible cost reductions would have negative effects on quality and it seems likely that quality innovations are important in these areas, so (local) government ownership is not justified.

So if the council can not justify keeping assets in terms of it is the most efficient owner of them, then it could use the revenues gained from a sale to offset spending. Or it could buy another asset which it is the most efficient owner of and thus increase returns. But, on the other hand, if the council is the most efficient owner of an asset then selling it just to get money doesn't make sense.

So asset sales or increase debt? If some the assets the council controls are not those it can economical justify owning then increasing revenue by selling them should be on the table. If the council can justify owning these assets then increasing debt should be on the table. I would remind the council however there is option three: cut spending your spending plans.

Job search and employment

In these times of increased unemployment an interesting question is Does job search help with finding a job? And the answer appears to be the obvious, yes. That at least is the finding for a new working paper Job search methods in times of crisis: native and immigrant strategies in Spain by Javier Vázquez-Grenno. The abstract reads:
This paper uses Spanish Labor Force Survey data for the period 2005 to 2010 to examine the use of job search methods and the intensity of the job search strategies of unemployed natives and immigrants. We focus on the determinants of the job search methods and search effort. Additionally, we examine the impact of the methods selected and of the search intensity on the job-finding probabilities of native and immigrant groups in a period that covers the transition from economic growth to crisis. Our findings suggest that, irrespective of the job search methods adopted, the probability of employment is higher among immigrants than it is among natives. However, this gap is closed following the onset of the current crisis in 2008. We find that most job search methods have a positive impact on the probability of finding a job, with the exception of registration at a public employment office. Search effort (measured as the number of methods adopted) seems to matter in finding work. (Emphasis added)
But note the highlighted comment. The one thing that doesn't appear to help getting a job is registration at a public employment office! The government may be here to help, it just doesn't help you get a job.

Knock it down quick!

Eric Crampton writes over at Offsetting Behaviour
The National Business Review reports that the Heritage New Zealand Pouhere Taonga Bill will make it more difficult for owners of pre-1900 buildings to make any kind of alteration. In addition to requiring a building consent and, for buildings listed in district plans, a resource consent, you'll now also need an archaeological permit.

NBR points to the Law Society's submission on the bill. They write:
The practical implications of this definitional change, however, are wide-ranging for New Zealand’s older settlements. In some of these (for example, Nelson and Dunedin) there is still a substantial housing and commercial building stock comprising pre-1900 structures. A literal application of the definition of “archaeological site”, together with its companion definition of “harm”, means that there will be many thousands of private dwellings around New Zealand that will require an archaeological authority to be obtained for the most minor maintenance work, such as the replacement of spouting or the hanging of new wallpaper. It is not clear whether this level of intervention with private ownership rights is intended by the Bill. If that is not intended, then revisiting the definition of “harm” or “archaeological site” is warranted. The Law Society does not believe that this difficulty can be addressed by Heritage New Zealand simply applying the legislation in a pragmatic way, since the failure to obtain an archaeological authority is a criminal offence of strict liability.
Who would want to own a heritage home if they had to seek archaeological approval if they wanted to change the wallpaper? If the value of heritage buildings is bid down because of the regulatory encumbrances, investments in maintenance and strengthening are attenuated too.
What is the rational reaction to this? If you own a pre-1900 building which you think will need work done to it in the future or that you may want to renovate, What do you do? With the costs imposed by a Bill like this why not knock you building down now, while you still can, and put up something new.

So we could see a  large reduction in the number of heritage buildings around in the future. This I'm sure is not the intention of the Bill but it may be its effect.

You can only imagine the effect on heritage buildings here in Christchurch if you face these additional costs for earthquake related repairs.

Tuesday 3 July 2012

Assumptions underlying the case for free trade

Don Boudreaux has been writing to the Washington Post about the assumptions underlying the economic case in support of free trade.
In fact, the critical assumptions on which the economic case for free trade rests are highly descriptive of reality: (1) the ultimate justification for economic activity is to improve living standards for consumers; (2) producers facing competition serve consumers better than do monopolists; (3) each party to a voluntary trade is generally made better off by such trades; and – most importantly – (4) the first three assumptions aren’t nullified merely by putting a national political border between consumers and producers.

Other subsidiary assumptions, when they hold, explain particular trade patterns and the size of trade’s benefits. But the proposition that trade between America and, say, India is beneficial for the people of both countries rests on assumptions no more unrealistic, tentative, or fragile than does the proposition that trade between Arizona and Indiana is beneficial for the people of both states.
So if people in the South Island are made better off by trading with people in the North Island (and vice versa) then people in the South Island are made just as well off trading with people in Iceland (and vice versa).

Testimony on fractional-reserve banking

Lawrence H. White, Professor of Economics, George Mason University, testified before the House Subcommittee on Domestic Monetary Policy and Technology, United States House of Representatives. His testimony is a good discussion of fractional-reserve banking.

One of the more interesting sections of the testimony has to do with advantages and disadvantages of fractional reserves.
The advantage to the bank from keeping fractional reserves is clear: it earns interest on the lent-out funds. A few commentators have declared that FRB [fractional-reserve banking] must be a fraud: the gain is all on the bank’s side, and no customer would agree to it if she realized what the bank was up to. But this claim assumes that there are no advantages to the bank’s customers. In fact there are clear advantages to the bank’s customers, at least under competition. To compete for customers, all experience shows, banks offering fractional-reserve accounts charge zero storage fees and even pay interest on deposits, up to point where the interest they pay falls short of the interest they earn only by just enough to cover the bank’s operating costs for safekeeping and payment services. In this way FRB creates a synergy between payments services (checkable deposits, banknotes) and intermediation (pooling savers’ funds for lending to selected borrowers). When the deposited funds that are not needed as reserves can be lent out, depositors enjoy lower (or zero) storage fees and interest on checking deposit balances.

By contrast to money warehousing, the savings of fractional-reserve banking do carry a disadvantage in the form of greater default risk. If the bank’s investments go sour, the depositor may not be repaid in full. The warehouse, by contrast, makes no investments. So the customer choosing between a bank account contract and a warehousing contract needs to consider: is the saving in storage fees and the interest paid on deposits high enough (relative to the increased risk of not being paid promptly)? Historically, in competitive systems where banks were free to diversify and capitalize themselves well, the answer was yes for most people. Thus well informed consumers who want economical payment services typically prefer a fractional-reserve bank to a warehouse. In sound banking systems historically, before deposit insurance, the risk of loss was a small fraction of one percent, while the interest was more than one percent, and the sum of interest and storage fee savings was even higher. Thus FRB can arise and survive without fraud. The economist George Selgin has examined the record of the London goldsmith bankers, and debunked the myth that they pulled a fraudulent switcheroo, promising 100% reserves but holding less, at the beginning of the practice of FRB. Goldsmith bank accounts became enormously popular in the mid-1600s because they offered interest on demand deposits. The offer of interest is a clear signal that the contract is not a warehousing contract.

For payment by account transfer, FRB offers a more economic way of providing payment services. A money warehouse or 100% reserve institution could also offer payments by account transfer, but its services would be significantly more expensive. The other bank payment instrument, redeemable banknotes circulating in round denominations, simply cannot exist without fractional reserves. Banknotes are feasible for a fractional-reserve bank because the bank doesn’t need to assess storage fees to cover its costs. It can let the notes can circulate anonymously and at face value, unencumbered by fees, and cover its costs by interest income. An issuer of circulating 100% reserve notes would need to assess storage fees on someone, but would be unable to assess them on unknown note-holders. There are no known historical examples of circulating 100% reserve notes unemcumbered by storage fees.

Under a gold or silver standard, the introduction and public acceptance of fractionally backed demand deposits and banknotes means that the economy needs less gold or silver in its vaults to supply the quantity of money balances (commonly accepted media of exchange) that the public wants to hold. Thus money is supplied at a lower resource cost, that is, with less labor and capital devoted to mining or importing precious metals and fashioning them into coins or bars. Looking at the change in balance sheets from money warehouses to fractional reserve banks, the economy can now fund productive enterprises where before it only held metal. Gold can be exported, and productive machinery imported. This development in Scotland was praised by Adam Smith as a source of his country’s economic growth. As the economist Ludwig von Mises put it, “Fiduciary media [fractionally backed demand deposits and banknotes] … enrich both the person that issues them and the community that employs them."

Under a fiat money standard, as we have today with the Federal Reserve dollar, things are different. There are no mining or minting costs saved by holding fractional rather than 100% reserves in the form of fiat money. For commercial banks to hold 100% reserves in the form of fiat money issued by the federal government would, however, change drastically the function of the banks. Instead of funding productive enterprises, the banks would instead only fund the federal government. Fewer loanable funds would be available to the private economy, and more to the government. Private investment would be suppressed, and public spending enlarged.
White's conclusion is
The evidence shows that a fractional-reserve banking system is not unstable when the banking system is free of hobbling legal restrictions and free of privileges. The US banking system in the 19th century was weakened by legal restrictions. In response to that weakness, rather than let the banking system become robust by repealing its restrictions, Congress in the 20th century patched over the problem by creating the Federal Reserve system (to act a “lender of last resort”) and federal deposit insurance. As a result, the US banking system in the 21st century is chronically weakened by government privileges (especially taxpayer-backed deposit insurance and taxpayer-backed “too big to fail” bailouts) that generate moral hazard. Banks take advantage of these guarantees by holding asset portfolios too full of default risk and interest-rate risk. They finance their portfolios with excess leverage (too much debt, not enough equity). Rather than trying to come up with another patch, Congress should seek to dismantle the restrictions and the privileges that have left the American people saddled with an unhealthy banking system.

EconTalk this week

Luigi Zingales of the University of Chicago and author of A Capitalism for the People talks with EconTalk host Russ Roberts about the ideas in his book. Zingales argues that the financial sector has used its political power to enhance the size of the sector and the compensations executives receive. This is symptomatic of a larger problem where special interests steer resources and favors based on their political influence. Zingales argues for a capitalism for the people rather than a capitalism for cronies or the politically powerful. The conversation concludes with a plea by Zingales to his fellow economists to speak out against behavior that is legal but immoral--lobbying Congress for special treatment that exploits others to benefit one's own industry, for example.

Sunday 1 July 2012

The reality of the wartime economy

A common story told about the U.S. economy, and many other economies, is that World War II got the U.S. out of the Great Depression and thus a war like effort should act as a model for getting the U.S. out of the Great Recession. Economic historian Robert Higgs is one author who has for many years challenged this view. In a paper published in 1992 Higgs wrote
Relying on standard measures of macroeconomic performance, historians and economists believe that “war prosperity” prevailed in the United States during World War II. This belief is ill-founded, because it does not recognize that the United States had a command economy during the war. From 1942 to 1946 some macroeconomic performance measures are statistically inaccurate; others are conceptually inappropriate. A better grounded interpretation is that during the war the economy was a huge arsenal in which the well-being of consumers deteriorated. After the war genuine prosperity returned for the first time since 1929.
Higgs end his paper by saying
To sum up, World War II got the economy out of the Great Depression, but not in the manner described by the orthodox story. The war itself did not get the economy out of the Depression. The economy produced neither a “carnival of consumption” nor an investment boom, however successfully it overwhelmed the nation’s enemies with bombs, shells, and bullets. But certain events of the war years—the buildup of financial wealth and especially the transformation of expectations—justify an interpretation that views the war as an event that recreated the possibility of genuine economic recovery. As the war ended, real prosperity returned.
Now Steven Horwitz and Michael J. McPhillips join the club of those arguing against such a narrative. They have a paper forthcoming in the "Independent Review" on The Reality of the Wartime Economy: More Historical Evidence on Whether World War Il Ended the Great Depression The abstract reads,
In response to contemporary arguments that the expenditures associated with World War II were a major factor in ending the Great Depression and should therefore be imitated today, we offer historical evidence to suggest that the wartime economy was hardly a model of success in the eyes of most Americans. Expanding on Robert Higgs’ criticisms of the ability of conventional macroeconomic data to tell the real story, we examine newspapers, diaries, and other primary source material to reveal the retrogression in living standards in the US during the war. Our investigation suggests that wartime prosperity is largely a myth and hardly a model for recovery from the Great Recession.
What of New Zealand? Did war expenditure get us out of the depression? It appears not. This piece from Greasley and Oxley (2002) suggests that changes to New Zealand's monetary regime was behind the recovery from the depression here.
New Zealand's recovery from the Great Depression was unusually fast, and was associated with a fundamental shift in monetary regime. The new regime ended the conventional sterling standard, and diminished the influence of the trading banks on monetary conditions in New Zealand. Since the trading banks' operations spanned to Australia, the new monetary regime also decoupled the Dominion's monetary conditions from those across the Tasman. Devaluation and the formation of a reserve bank underpinned the new regime. This article shows that monetary growth in New Zealand was dramatically faster in the 1930s than it would have been had the old regime survived the Great Depression. New Zealand's nominal money stock, measured by M1, fell during the years 1923-9, but almost doubled between 1929 and 1939. The new monetary regime stimulated a recovery from New Zealand's long depression of the 1920s, as well as from the Great Depression. Had the old regime survived, New Zealand's GDP per caput in 1938 would have been around one-third lower.

New Zealand's recovery experience in the 1930s differed sharply from that of other export economies of the periphery, and was based on a new monetary regime that took effect in two stages. In contrast to what happened in Brazil, Mexico, and Australia, devaluation was chosen rather than forced, and eventually associated with a new inflationary regime. Initially, though, devaluation in New Zealand promoted recovery, in 1933, by redistributing income to the hard-pressed farm sector (the 'Copland effect'). Subsequently, during 1934-5, New Zealand's record to some extent mirrors that of the Argentine where the destruction of deflationary sentiments also ameliorated the depression (the 'Mundell effect'). However, New Zealand went much further, by more than doubling money supply between 1932 and 1937, which led to lower real interest rates (the 'Keynes effect').

New Zealand's experience also differed from that of the US, where monetary growth woe initially rapid but was curtailed in 1936 by the Federal Reserve increasing reserve requirements to counter possible inflation. Moreover, the strategy for redistributing income towards farmers in New Zealand did not rest, as it did in the US, on output restrictions, but on monetary manipulation. In concert, the three mutually reinforcing monetary transmission mechanisms, the 'Copland', 'Keynes', and 'Mundell' effects, stimulated powerfully real economic recovery. The growth potential of New Zealand's economy was strong in the 1920s but constrained by a deflationary regime. The Great Depression destroyed the Dominion's old monetary regime, and the new regime promoted a remarkable recovery.
  • David Greasley and Les Oxley, "Regime shift and fast recovery on the periphery: New Zealand in the 1930s", Economic History Review, LV, 4 (2002), pp. 697-720.