Humiliation and Hubris

Just a quick take on Gillian Tett's article a while ago on the psychology of the eurozone crisis as it applies to distressed nations. It's obviously paramount to get a comprehensive historical understanding of the european political psyche post WWII to analyze how people and politicians have been reacting and why they do so but Tett makes an important, if not exact point. 

The background is that (as British sociologist Dennis Smith puts is) - the post-war european experience has been self-characterized and presented as a post-humiliation regime constructed to heal the wounds of the second world war and foster liberty, equality, (and more tellingly), fraternity. Post-crisis, it is humiliation that has returned, drawing stark, naked and divisive lines among nations in the union. 

Conventional psychologists differentiate between shame and humiliation through the source - one is internally driven while the other is external, characterized by "a loss of autonomy, demotion of status and finally exclusion of the group". 

What's important is the response, which Tett says can be short-term (flight, rebellion or disassociation) and long-term (acceptance, challenge etc.)

But such thinking is commonplace. Investors often attempt to get a sense of state when analyzing market sentiment or crises by looking at position on the cycle of denial-anger-bargaining-depression-acceptance. And it is here where the contrast is drawn between Ireland and Greece, with Spain open for debate. 

According to Smith, Ireland, having lived in British dominance has innate "cultural coping mechanisms" to deal with this and the response to crisis has been escape (emigration), pragmatic conciliation (reform) and defiant compliance. 

Naturally Greece looks nothing like this. Perhaps it is due to the high level of national pride and fervour - that during the prosperity years when millions were rescued by public sector expansion, the past was conveniently forgotten and the present (recent past) was embraced. This could explain the state of shock and reaction from Greece compared to Ireland, where "politicians are physically attacked in the streets...public buildings are set on fire...german politicians are caricatured as Nazis".

But what about Spain? 

I would presume that Spain has an added state of confusion, with a lot of each thrown in - enough denial, dollops of anger, attempts at bargaining, an uncertain sense of depression and perhaps a latent form of acceptance. 

Spain is not Greece, and to generalize sovereign nations under basic psychological reaction would be foolish but it seems the key here is pragmatic conciliation - something Greece has not and perhaps cannot adhere to. For all the pragmatism in the world will not ease the pain of conciliation and that is something Greece continues to learn in the worst of ways. 

Tett shifts the focus of Spanish pride in requesting assistance to the 'strong eurozone leaders' (cue: Merkel). It should serve as a plea: to be mindful of the state of national psyche when attempting to enforce a solution.

Rmb Musings

I don't understand the Renminbi. I don't understand how and when China plans to 'internationalize' the Rmb. I don't understand how much capital really moves in and out of the economy. I don't understand why the yuan has been hitting multiple highs against the dollar since July...but of course, I could always try and shed some light. Let me start with some facts, some old, some new:

1) At the turn of the century, the US accounted for a quarter of China's exports, now it accounts for just a  sixth. LatAm+SE Asia account for the same proportion.

2) In the past five years, the Rmb has appreciated by a fifth against the dollar but only a tenth on a trade-weighted basis. 

3) On two consecutive days last week, the Rmb almost hit the upper limit of its daily trading band against the dollar. 

4) Over the past 12 months, China's trade surplus is up nearly USD 200 billion and net foreign direct investment has been about USD 30 billion. 

Here's what has happened to the Real and Nominal trade weighted exchange rates over the same time period as well as the bilateral rate, which hit a 19 year high of 6.2530! (the NEER-REER is Left Scale, USDCNY is right)

Which obviously begs the question, what is the PBOC doing?

Ok, let me rewind. Essentially, an economy with a controlled exchange rate and the ability to set its own monetary policy should have a direct trade-off between its legal capital flows and its official reserves. If there's an imbalance between recorded and reported flows and the change in reserves, one immediately should smell hot money. In China's case, the status quo, loosely speaking - is ever increasing reserves above expectations, which suggests inward/onshore speculative flows. 

As it turns out, quite the opposite as happened. Look at 4) above - according to general estimates and basic calculations (factoring the returns on existing reserves plus currency changes) - you get another USD 50-100 billion which is a huge margin by all means. If you add all that up, there's a bandwidth of USD 280 - 330 billion, as Simon Rabinovitch estimates over at beyondbrics. 

But this is what happened to forex reserves (USD billion). 

Does that look like a few hundred billion? Nope, 88.32 to be precise and that's a USD 200-250 billion short fall there. Is it really possible that all that has been moved ashore? As it turns out, there's a more than partial explanation - the majority of which has to do with the central bank and the rest of the banks. 

Essentially, if Chinese company X were to receive a payment in dollars for its goods, it could/would officially convert them into Rmb (at a fixed beneficial rate) and the dollars would end up in the central bank as official reserves. The company would use the Rmb to produce/manufacture/pay wages etc. This leads to the simple explanation that if company X stops doing this as much then the dollars end up in commercial banks rather than in the official reserves. So what's happened to foreign currency deposits at Chinese banks? They's increased by 60% yoy, a good USD 158 billion that gets offset with our initial 200-240 bandwidth. 

What about the remaining USD 40-80 billion?

An increase in Rmb payments to settle invoices and trades. This is where the 'internationalization' issue sets in. At least, for such kinds of settlements, there's not much doubt that China has been pushing for a more active Rmb role. Hong Kong, though an SAR, operates under a free capital, currency board framework thus being positioned as a prime offshore market. If the Rmb doesn't appreciate in line with expectations, a foreign company Y would send Rmb back to pay for a Chinese export. This is measurable stuff through the HKMA - Rmb deposits in Hong Kong have fallen by approx USD 9 billion (currency converted). 

That's still another USD 30-70 billion which is a far cry from the initial starting point, but it still merits enough thought and almost inevitable conclusions. China suffers from significant capital movement (significant could be a misnomer, because it's less than a percentage point of GDP) but that's Chinese output! 

Unleashed on smaller markets such as Hong Kong, Sydney, Singapore, Cyprus it could have significant impacts on asset prices. 

If there's a change in perception of Rmb appreciation, investors naturally start opting for dollars - but there comes a point when the PBOC has to say enough before a more dangerous trend is set. 

I think, but don't remember for sure, that I read an excerpt of a note somewhere from a Credit Agricole analyst that dwelled on the impact of US politics on China's Rmb policy but it's impossible for anyone to measure something like that. 

Over at Alphaville, David Keohane uses similar estimates concluding naturally that an estimate the size of the initial outflow runs opposite to the recent new found strength of the Rmb. It wasn't too long ago (May-July), that the Rmb depreciated sharply on the back of outflows and China's first BOP deficit in 14 years.

Josh Noble, at beyondbrics, points to the seemingly depressing macro-fundamentals that might be a bit too dooms-dayish, a reversal of outflows, Obama over Romney and QE3 leading to higher import costs. 

Meanwhile, BNY Mellon's Neil Mellor wrote about the long-term fortune of the euro and its role as a reserve currency, the logic being that USD accumulation (via sterilized intervention to check local currency appreciation) have led to a diversification into the euro as well as other currencies. Using China's reserves as a proxy, it means there is little doubt that fundamental support for the euro has weakened over the past year (less USD accumulation implies less reserves for euro-swaps). 

The WSJ has an interesting report on the draining of the Chinese money-basin, so to speak. It uses similar outflow estimates among stories of citizens finding ways to circumvent the capital restrictions. Moreover, it has a couple significant statements - one by Michael Pettis stating that if local businessmen take money offshore in such a fragile global environment, it can't be a good sign. The other is by the well-known Eswar Prasad who reiterates what everyone assumes and realizes, "The wealthy in China have always had an open capital account". 

The general consensus is obviously to wait a little longer for more data. But this is a really really interesting spell for the Rmb and China's policy makers. There's a lot going on.

What Am I Reading?

-   Raghuram Rajan has this refreshing piece on democracy and free enterprise.

-   Free exchange has an internally inconsistent but broad analysis on the Bush deficits.

-   Anne Lowrey has this piece in the NYT citing a study on inequality's effect on growth by Jonathan Ostry     and Andrew Berg among other ideas.

-   Mark Thoma has a response to James Kwak who had a response to Richard Posner's much debated post on the role of luck and hard work in...you guessed...making money.

-   Menzie Chinn has a compact analysis of gasoline prices and Romney's boasting and blaming. Don't miss the correlation between Brent in the US and Europe.

-  Noah Smith has an interesting read on the age-old math-in-economics debate in the wake of the Nobel awarded to Roth and Shapley.

-  And here's something for me, so I don't know why I'm posting this. Also from Noah Smith

AWOL

Sifting through the data coming out of the financial world, it's easy to feel like the calm has come and the sun is about to rise. Every chart that's depicted has something nice to say, every new number points to increased confidence. 

I've still felt like a sceptic more than once. And I've got Clive Crook in my corner! In a sort-of reality-check piece on Bloomberg, Crook says that, "The condition of the world economy, you might think, is serious but stable. Actually, it continues to deteriorate."

He's right. Look at the numbers all you want but just imagine how little has been done anywhere save monetary policy. Imagine what the global economic outlook would be without "reckless" QEs. It's not a great situation, to be stuck between the devil and the deep sea but that's where we are.

Monetary policy is the domain of independent technocrats - distinguished academics (in most cases) - who function without the horrible burden of being answerable to voters. Fiscal policy is entirely the realm of people who are elected by us. Crook gets it spot on when he judiciously states that, "Compare this with fiscal policy, the realm of elected leaders. It’s in shambles both in the U.S. and Europe, albeit in different ways. What governments ought to do is conceptually simple: Maintain fiscal support for lower-than-normal economic activity in the short term, while announcing plans -- detailed, credible plans -- to strengthen public finances over the longer term. It hasn’t happened."

Europe's political structure is incapable but it's also predictable. After all, these are sovereign nations bound by a monetary union, not a fiscal one. What's been the most shocking to see over the past few years is the extreme polarization of the American polity. The divisiveness, derision and lack of respect shown by both parties has hurt the average citizen the most and will continue to do so in the future.

The patient may be showing signs of recovery but it's more likely that the internal sickness is worsening. As long as the politics is dysfunctional, nothing will ever get accomplished. Leaders are failing everywhere and I don't think the reaction to this void is strong enough. To be honest, it is a pretty bleak scenario after all. 

Mittthesmallbusinessguy

This is more of a scrap, but I think it is worthy of solitary mention. I push myself to steer clear of politics because it's sometimes too frustrating and furthermore, I'd never stop typing/talking. This, though, really does warrant its own mention.

From Romney's acceptance speech in Tampa, 

"I learned the real lessons about how America works from experience. When I was 37, I helped start a small company. My partners and I had been working for a company that was in the business of helping other businesses. So some of us had this idea that if we really believed our advice was helping companies, we should invest in companies. We should bet on ourselves and on our advice. So we started a new business called Bain Capital. The only problem was, while WE believed in ourselves, nobody else did. We were young ...That business we started with 10 people has now grown into a great American success story."

It's amazing what words can do - it really is. You could easily get the impression that Romney started a little corner-shop book store or a fence-painting service for his neighbourhood. Who would realize he started a private-equity spin-off from an elite management consulting firm! Krugman has a blurb today on "Itsy-Bitsy-Bain" too!

Poor Mitt, it's the only way a governor's son-harvard educated-multi-millionaire-million-times-over can try and connect with 'ordinary' voters - with the actual small business owners - a lot of whom, unfortunately actually think that he "came through small business". 

Of course this is all irrelevant if he doesn't win. But just saying...stranger things have happened. 

Noble Nobel

I don't quite understand how one predicts the Economics Nobel but I'm pretty sure it's easy to figure out who's not getting it. Just do the usual rounds of the internet during the lead up and you'll be able to cross out a few very well known names. 

So of course I was surprised when the announcement was made. Nash, Harsani and Selten got it in 1994, while Aumann and Schelling got it in 2005 and now Roth and Shapley. The official announcement states that it was for, "the theory of stable allocations and practice of market design" but it's a lot more than that. 

Shapley reminds me, in a way of Nash (they both overlapped at Princeton). I read somewhere that when informed of the decision, he stated that he had never taken an economics course in his lifetime. Pure mathematics, nothing more powerful and perceptive. 

Along with the Shapley value, the Bondareva-Shapley theorem , the Shapley–Shubik power index, the Gale–Shapley algorithm (for the stable marriage problem), the concept of a potential game, the Aumann–Shapley pricing, the Harsanyi–Shapley solution, and the Shapley–Folkman lemma & theorem bear his name

Aumann, in his 2005 lecture, considered Shapley to be "the greatest game theorist of all time". In 1995, Albert Tucker said that he felt Shapley was only second to Neumann in game theory research. 

Essentially, when I think of Shapley, I think of the Shapley value which is the foundation for determining gains in cooperative games. In a set of players (where some may have greater control over an outcome/gain or some may contribute more to the overall outcome), you can assign a unique distribution to each element. i.e: how important is each player in the game and what pay-off can he/she expect based on his/her contribution/power etc. 

Shapley offered decades of fascinating research in analyzing outcomes. The area in relevance due to the Nobel in fact, is the Gale-Shapley theorem or the Stable Marriage Problem. Simply put, it ensures pair-wise matching between a man and a woman such that no pairing is unstable (there are no two people of opposite sex who would rather have each other over their current partners). You can see how it works in practice here.

Think about the implication of such a system. You could match employees into departments based on the preferences of either side. You could match children choosing schools if you navigated or equalized the entry-process. What if you could match kidneys between donors and recipients?

That's where Alvin Roth comes in. Steven Levitt stated that, "When I talk about economists, one of the greatest compliments I give is to say that they changed the way people think about the world." 

Thanks to Roth, if John needs a kidney but his sister Jill is incompatible - they could find Molly, a willing donor who matches with John, and whose brother Mike is compatible with Jill. Which makes you immediately think about a three way swap, or a multi-swap, could you design this for n-participants?

Anyway, there are A LOT of tributes, accolades and information on the both of them.

1)  Ben Walsh over at Counterparties has this short piece which is nicely titled "Economists who did good".

2)  Josh Keating at Foreign Policy further explores Roth's paper on Repugnance and why it could be a constraint on markets. Think of it this way, as Roth provides an example. In California, it's illegal to eat horses but it's not illegal to kill them - just not to eat them. Yet, some people in California are from societies where eating horse meat is normal...

3)  Matthew Yglesias at Slate has a more focused piece on the matching issues, and why the lack of money and prices is why it works. 

4)  Alex Tabarrok at Marginal Revolution has perhaps the most succinct yet informative piece on the two. He focuses on the stable marriage issue, it's weaknesses, how they can be overcome and why the future is open to more wonders. 

5)  Joshua Gans at Digitopoly says, "Here is an economic theorist who hasn’t just made things more efficient. He has actually saved lives. It is unclear whether it is the economics Nobel he deserved or the Nobel prize for medicine." Strong praise indeed. 

6)  Mark Thoma has an agglomeration of the above as well as a very brief summary of the two. He concludes by saying that, "Even though these two researchers worked independently of one another, the combination of Shapley's basic theory and Roth's empirical investigations, experiments and practical design has generated a flourishing field of research and improved the performance of many markets. This year's prize is awarded for an outstanding example of economic engineering."

7)  Dylan Matthews at EK's Wonkblog has more detail, especially on Shapley but also on Roth.

8)  Susan Adams had this well written piece on Roth back in 2010 that focuses more on the school-matching issue.

9)  Leon Neyfakh has a detailed story back in 2011 on how Roth fixed a breaking process of matching young doctors with hospitals (the NRMP program). 

I think I'd like to conclude with the fact that we get so caught up in terms of what is relevant with respect to the world we live in, what can or cannot be applied today and all those if-and-but questions that it's easy to forget the power of an intuitively brilliant theory and the impact that its practical application may have. 

To Shapley and Roth.

Easing on EMs

Bernanke's making tidal waves and garnering support as well as opposition for his defence against the Fed's easing policies on emerging market economies. 

On the surface, it seems genuine enough (the argument, that is!) - in a capital-mobile network of economies, the zero-boundedness and short/medium-term promise of zero rates in advanced economies tend to cause a "search-for-yield" thus possibly leading to hot money flows into EMs and in the process, creating all sorts of unwanted troubles such as currency appreciation, asset bubbles, volatility and stoking inflation fears at a sensitive time. 

Now firstly, this is a sensitive issue that needs  a good bit of further empirical study. A couple of weeks ago, Jose-Antonio Campo had a piece on this where he essentially went down the middle path. He gives the Fed credit for acting boldly given that the recovery was sluggish, there was no fiscal manoeuvre left and the gridlock in DC was too strong. Here's the problem though (and this comes back to Triffin once again) - The dollar is the international reserve currency of the world. And such expansionary monetary measures are bound to create significant externalities and imbalances in the rest of the world, effects that (as Campo says), "the Fed is clearly not taking into account". 

I'd summarize Bernanke's defence but Weisenthal at Business Insider has a short and sweet round-up of the rebuttal:

a) Interest rate differentials aren't the only determinant of private inflows, growth differentials for example, also play a role.

b) Data shows that since the advent of ultra-easy monetary policy, flows have actually eased. (I'll get some data on this)

c) Emerging Market economies aren't exactly powerless and helpless to do anything

d) Stronger currency = greater ability to buy imports, woohoo! to domestic demand (and to hell with all exporters!)

There's a dilemma when EM economies have to calm speculation and cool the economy. Raising rates to adopt even a strict anti-inflationary stance could end up attracting more short-term funds and hot, volatile money. The problem is the alternative. A US recession and inaction from the Fed could be extremely painful for the global economy, already facing a bleak and sluggish outlook. I don't think anyone denies this and desires this above all.

Andy Mukherjee over at BreakingViews mentions an IMF study (I haven't read it), that concludes a 3% reduction in probability of an EM surge for every 1% rise in US interest rates. Yet, he also agrees with the premise that the ups and downs of the EZ crisis over recent times have caused sometimes implausible shifts in investor sentiment. To him though, what Bernanke failed to mention is an economy without QE which might have led to lower oil and commodity prices, something of great importance to EM policy makers. 

But in a world without QE, to revisit the earlier point, the impact on the global economy of a US slowdown might be far worse. Bernanke raised valid points, some of which were indisputable, but he also left a few openings in his analysis which will undoubtedly be questioned in the very-near future.