How to deal with mass short-selling in a mature way

Spain has recently banned the short selling of its debt (government bonds). This move has been greatly critized by many analysts as shooting the messenger instead of solving the problem. But isn't shortselling part of the problem? That's what I will discuss in this post (hint: things are always more complex here..)

Short selling, or shorting, is the process of selling an asset that you don't posses.  This wikipedia page explains it all quite well. The short version: When you short you sell an asset that you have borrowed. Later you buy that same asset and return it to the borrower. With this proces you're actually betting on a decrease in value. A more devious business is naked shorting where you do not borrow the asset but sell it anyway. After the asset has decreased in price you quickly buy it and complete the previous selling transaction

Interestingly shorting is a neutral action, since there is both a selling and a buying transaction. This also holds true for naked shorting. It is because of this that traditional economics expects no long term effects from these practices. Actually shorting increases the value of the asset for two reasons. The first is that the buying and selling transactions create more liquidity in the market, giving other players the opportunity to easily buy and sell that asset. The other enhancing value is that it allows players to lend their assets to these speculators and thereby increasing the return of it.

So if shorting is good for the value of the underlying stock, why ban it? First massive shorting creates a surge of assets on sale thus depressing the price. This is later compensated, but it will depress the price for some time. In the case of naked shorting the number of assets on sale can actually be larger than the total number of assets, leading to a very unstable market.  There is also a psychological issue: massive shorting signals a distrust in the asset, and issuers of the asset (e.g. the Spanish government) generally do not like that.

Thus it seems that banning shorting is in fact shooting the messenger, but it is not the whole story. The financial markets have another unnamed aspect: uncertainty. Most players, mainly conservative ones, rely on other players to gain information on an asset. When an asset is massively shorted, many long term players will also leave the market out of fear that there is unknown information. Even if the players don't leave immediately the strong variations in price, due to massive buying and selling, will create a distrust by themselves. Therefore massive shorting does actually bring down the value of an asset.

There are many ways to deal with shorting: the most mature way is to accept shorting as an inevitable side effect of trading in your asset. For most cases shoring does not affect the price of the asset in a great matter itself. However there are cases were action needs to be taken.

This is when a massive shorting campaign on your asset is taking place. Simply banning the shorting of your asset will drive out most long term holders, since they can't rely on the liquidity and the extra income provided by shorting. This will then result in a non-neutral action on your asset driving prices further down. Even worse, since long term holders do not like to be in your asset anymore the price will remain depressed.

The only other way is to keep the price from your asset up, since shorting and especially naked shorting is often only for a small period of time. It is only necessarily to keep the price up for some time. This can be done by buying up the asset under covert plans. By doing so you actually reward the holders of your asset while you punish those that doubt you. Precisely what you'd want to achieve. Therefore don't ban the shorting of the stock but strongly discourage massive shorting.      

The real problem with economics

Abstract: I believe that economics should focus more external validation of models. It's refusal leads to an economic religion. With implementation of economic theories local factors and alternatives should be more prominent. If you want to know why, please read the rest of the article. 

For some time now, the attack on economics as a science has been made by the media, the politicians and even economists themselves. The main focus here is on mainstream macro-economics (aka neoclassical economics).  People criticize the simplistic nature of the science and mainly the weird assumptions that are being made. Now it is true that perfect rationality, homo economus, perfect competition perfect information and such do not actually exist. In fact they don't exist anywhere in the real world. But in my opinion and that, this is not the real problem

To assess the actual problem it is useful to compare economics to the science it wants to be: physics. In physics some very weird assumptions are also made: the existence of holes with negative mass in electric currents is but one example. Also extreme simplifications of reality are present: no gravity, no friction, no air, infinite time to relax a system and many others. Yet physics is not in any distress at the moment. Weird underlying simplifications and assumptions could not possibly be the only explanation then.

In fact economists are not that protective of their assumptions either. When I discuss with a more traditional economist, I find that challenging assumptions and replacing them with more realistic ones can often be achieved quite simply. This often happens when I introduce evolutionary models to them. Assumptions and simplicity are simply not the main culprit here.
Also the mathematical way of structuring the models, another thing critiqued by some, seems to work out reasonably well.  After all what better tools do we have that can provide such internal validity to any science?

The validation of the science is touching a critical part here. The external validation is where economics and physics diverge. In physics anything that can not be proven will remain a good theory, but not an absolute one, until proof is found. This is why we spend billions of euros on the CERN complex with a primary goal of proving the existence of the Higgs boson. Regardless of the field of physics this almost always holds true (fields in which this doesn't hold are often ridiculed by other for providing mathematical fantasies).

Economics is rather different. It is true that there are a lot of people, some of which great economists, working on external validation. This is not the problem. However, the main divide in economics seems to be occurring not between economists of different traditions (Classical, Keynesian, Austrian, Evolutionary etc.) but between those that make models and those that look at the real world. This leads to a situation in which great models are made but are never tested thoroughly. And great discoveries that are made in economic data and also within other sciences are not seriously being taken into economic models.  Rather they are added as outside features. This leads to so called fads, Naim has a good paper on this from the asia crisis.

The sad thing what then happens, is that models that were introduced with a very good intent are being used in the wrong way. They are also never really validated or adapted to new insights. In fact they are even more simplified into one concept or idea. Some examples are 'the free market' (Neoliberals), 'stimulus' (Keynesians) and 'class warfare' (Marxists).  This then leads to an orthodoxy and dogma in the economics science that borders on religion. This is most visible and most painful in the economic experiments from the 20th century.

It is therefore not a coincidence that I chose a paper about developing economies when it comes to fads. This is usually where the dissonance between economic macro theories and reality is often the most visible. Also this is where economic religions cause the most harm. A good example of this is the free market paradigm that is presented by neo-liberals. Look at Russia and the former Warsaw pact after the fall of the iron curtain.  If you want to know how the 'stimulus' experiment is working out just look at the US or for more historic reference: Japan. Finally the Marxist experiment (communism) does not need further introduction. 

The main issue with all of this is that the real world experiences are not used to update, alter or refine the existing theories. At the current time economists are still calling for free markets and stimulus, even though history has already shown that the economy does not behave according to these grand concepts.

In an additional note it is often astonishing how economic macro theory often fails to appreciate the different structures that are present in the economy. In a previous post I have addressed different institutions and their impact on economies. But not only institutions are different: culture and history are also of major influence of the economic workings in a country. Therefore a policy that succeeds in one country can fail completely in another even when economic factors (capital, labor etc.) are similar. I would still like to see a push into adapting global theories more into local contexts and also local experiences adapting the global theories.

In conclusion, the economic science needs to change. This change is not  better models or better data collection but a better communication between the two. This will actually lead to better models and better data to work with. Local contexts are important and are often missing completely from the theories. They should at least add to them that a given theory is only valid under a certain underlying structure of the economic system.

A final note: I don't think it is actually possible to find a grand unified economic theory as we can find it in physics. People are not electrons and at times behave unpredictably, also when in groups. Therefore be very wary when an economic solution is offered that can be summarized in one term. The world is just not that simple. This should not stop us from finding increasingly better ways to model economics as by doing so we can improve many lives.

The economics of the complaints book

We all know the feeling: you enter into a restaurant on a trip, things look well from the outside but when you enter things are quite different. The staff is rude; you are not being serviced; the food is cold/raw/burned/rotten and at the end you get a bill that is at least 50% more than the menu said. In most cases this is an exercise in bitter helplessness: you don't want to sue them because it is to small. Also you can't use your economic position, since you weren't really planning on coming back there in any case.

Enter the complaints book, a neat innovation from Portugal. The complaints book (livro do reclamações)  lets you file an official complaint against the business that has wronged you. This is how it works(the short version): you file a complaint in the book, the complaint is send to a smaller court. If you're complaint is deemed valid, the business is fined. Nothing to major for first offences, but in any case way more than they ever made of wronging you. For repeated offenders the fines get quite severe, up until forced closing. The system also has a safety in it: if you file a bogus complaint you will get fined.

So what does this mean from an economic perspective? Let's first assume that some people have been wronged enough for them to get a satisfaction out of writing it in the book. Even though it does not give them any direct benefits (like money or higher social status), psychologically it certainly does pay off.  I would call this  'revenge utility'.

Eventually these people complain enough for some businesses to get fines. This affects the selection environment leading to companies that will less frequently wrong customers. The higher the fines and the higher the propensity for customers to file a complaint, the faster this process will be. However this could lead to a situation where only non-risk seeking companies are left, therefore there needs to be some minimum level of wronging present (e.g. a minimum time waiting or a minimum threshold of bad food).

This can be instated by raising the difficulty of filing the complaint. This will mean that more wronging needs to be done for people to acquire enough 'revenge-utility' to make the complaint.  Or alternatively by simply instating minimum requirements. In practice both of these mechanisms are there. However the first one also reduces the frequency of complaining, thus reducing the speed evolutionary process.

But there is another thing that might happen: the customer might be bought of from filling his complaint. This can be done by giving him a free meal or just being very kind to him. In the case of actually providing services this creates a nice situation: the customer can replace 'revenge-utility' with real utility. This makes a nice two player game where the company needs to make sure it always outbids the revenge appetite of the customer and will therefore always overbid. In any case even if the book is not filled in the customer still gets refunded.

In conclusion: the complaints book reduces the number of bad experiences for customers by changing the system of companies through evolutionary systems. It gives customers the chance of being compensated properly for the wronging occurred. And if all else fails the book provides a 'revenge utility' to the angry customer. I think this is one of the better innovations of the last decade and I would like to see a European wide implementation of the system.

Racist statistics

In the western world outright racism and sexism (which I will group in this post under racism)  seems to be (mostly) eradicated; even though we should always be vigilant that it may return, sooner than we think. However, the fight against racism has not been won. In fact, the most difficult part of the fight against this despicable human practice has began: the fight against hidden racism. It is in this fight that statistics play an ambivalent role.

So what is hidden racism? For me, it is racism that is not bound by formal rules and strict practices, but something that is more under the surface. An example: suppose that every time you had to make a choice between a white guy and a black guy, and that all things being equal you choose the white guy 75% of the time. This is obviously a racist process, since you're making a clear difference between the white and black guy. It is however very hard to prove that you are being racist since every case (white or black guy) is not necessarily obviously racist (you can still choose the black guy). That is the problem with hidden racism.

The use of statistics can help identify these cases. In general we know that women are still being discriminated when it comes to jobs in our societies. All things being equal women often earn 10% less than their male coworkers. But this is hard to judge on a case by case basis, since the pay scale is often not constant, because many jobs pay more depending on experience; extra tasks and other factors. However if you have a larger group of cases then statistical analyses can show a severe distortion in the wage levels. Large companies are vulnerable to this use of statistics, reference the women vs Walmart case. If we can eradicate sexism from large companies we have already won a great battle in the fight against discrimination. I believe that smaller companies will eventually follow the big ones and will discriminate less as well.

Unfortunately, statistics can also be used to hide racism, or even worse: they can create racism. A good example of this is the statistical algorithms that banks use to decide whom they lend to. These algorithms use a variety of factors including zip-code. Since zip-code was apparently a good predictor of loan delinquency, entire zip-codes were excluded, 'red-lined',  from obtaining mortgages and other credit. The main groups that were living in these zip-codes (which were in the poorer neighborhoods in the larger American cities) where black and latino communities. This is a very racist policy because it is not easy to change your living space to a better and more expensive neighborhood, therefore these people were already discriminated against from birth. The redlining example shows that a process that did not start out as racist (I hope) became racist thanks to the use of statistical algorithms.

This leads to a problem: are statistics inherently good, bad or neutral? As with many technologies this is all related to the actual use of the statistics. It is clear that statistics in the first example provide a weapon against widespread sexism and are therefore very good. The second example is more ambiguous: even though the objective was not racist, the consequences were. I see this as a warning: we should always be vigilant that racism does not creep up to us, even when we operate with the best intentions.       

Why there should not be a 'one-size-fits-all' approach in macro-economics

Within the macro-economic field there is this idea that essentially all economies are the same. This is because the abstraction in the field has led to ignore the underlying structures of economies. A good example of this is the classical Keynesian theory that deals only with macro variables (investment, consumption, government spending etc.). There is no mentioning of how these variables are related to essential economic structures (e.g. companies, markets, government policies etc.)in an economy. My fear is that this line of thought has persisted in mainstream macro-economics.

However, there is are alternative ways of looking at economies. One of these I will discuss shortly here: the theory of institutional complementarities (from Hall and Gingerich). According this theory institutions (laws, politics, taxes, unions, corporate structures, decision making structures etc. etc.) support each other and create a stable economical system. This means that, in theory, there are different well-functioning economical systems possible. In practise this is precisely what is observed; through different histories different countries have developed different systems.

Two distinct economical systems have developed in the western world: the Anglo-Saxon Liberal Market Economy (LME) and the North-European Coordinated Market Economy (CME). (There is also a Southern-European variant but I don't agree with the descriptions given to it so far) The reason for the divergence is quite simply put: history. Where the UK and the US championed liberty and individual responsibility, European countries opted for cooperation and the welfare state.

The LME and the CME are quite different, even though they are both definite forms of capitalism. Within the LME there is in general a lot of fluidity: liberal labor laws make that employees can get easily fired and easily rehired. The focus on shareholders makes that one can easily opt out of an agreement by selling stock. There is a lot more to describe, but in general the LME is focused on rapid change and individuality in most sectors.

The CME model is quite different: it focuses more on stability. More strict labor laws prevent employers from easily firing employees. The stake holder model gives more structural connections within the economy. This makes it hard to walk away from undesirable agreements and more incentives to improve them. Again this is a short description but the CME is generally focused more on  stability and cooperation.

What I am not arguing here is that one model is per definition better than the other. What I am arguing here is that a policy that may work in a LME could be disastrous in a CME and vice versa. Therefore a 'one size fits all aproach' should not be used when macro-economic policy is discussed.

Saving Portugal and Spain: My solution

In the previous post in this series I addressed the need for investment in the countries most affected by the current crisis. In this post I will explain what in my opinion would be the best investment in Portugal and Spain.

My proposal would be to invest in green energy production on the Iberian peninsula.
The reason for choosing the green energy sector in general is that this is producing something that Europe desperately needs: reliable unending clean energy (see also an earlier post in this series).

Solar power tower operating near Seville, Spain

The investment should be in the two most promising green energy technologies: wind and sun. I chose wind and sun because water technology is often either already taken or impossible (in the case of hydro dams) or it is in a very early stage (tidal energy), but that may change. I will return later to the biomass option. Wind and sun are two commodities that are very present in the south sides of the Iberian peninsula. They are also being used already. Therefore my proposal would merely expand an existing industry rather than creating an entirely new one.

My proposal would be for the EU/Eurozone to set up a fund that invests in turning relatively dry agricultural grounds into places where solar and wind energy plants can be tested and expanded. The removal of agriculture would probably lead to a drastic reduction in the use of water and therefore would help solve some of the water issues that these countries are facing. Since there are sever issues with water, biomass plants would not be a preferable option.

The installation of high technological equipment would also create a need for well trained engineers. Because it is taking place in the home country of the people who originally left it would be likely that they would return, also bringing the knowledge that they have acquired abroad.  This in turn could help alleviate the effects of the brain drain that is occurring right now.

Finally, putting the newly constructed energy valley in the Iberian peninsula has the advantage that it is in a reliable area. Portugal and Spain are stable democracies as opposed to the countries where the energy valley would be if the European Saharan energy plan would be implemented. 

There is however one maior issue with this investment plan and that concerns the people whose land would need to be taken. A good plan would need to be devised to convince farmers and other citizens to volunteer their land. In practice this means offering a premium on top of the price of the land so that farmers can relocate or find other occupations. This buying up of land would then help slightly with the housing crisis (by injecting money in the real estate sectors) that is now present on the Iberian peninsula.

In this post I have only outlined the what and why of investing in green energy. In the next post in this series I will outline a more detailed plan of the investment. If you agree or disagree with this post please use the comment section below for your arguments :-)



   

Saving Portugal and Spain: Solutions(2)

In this next post in the series on the Iberian peninsula, I will deal with economic solutions that can be taken by outside actors. By which I mainly mean the European Union but also some specific member states.

The first solution is in fact remarkably easy: create an higher inflation by some form of quantitative easing. If one looks at most member states in the EU, nominal debt (loans, mortgages, government debt etc.) is a serious issue. Here I say nominal because this debt is nominated in euros. Also certain prices such as those on houses and those of wages are incredibly hard to bring down. By instilling inflation this would be done automatically and most markets (mainly housing) could find better equilibriums.
The inflation that could be a solution here should be not incredibly high but somewhere in the range of 4-6%. This is because an inflation that is to high will have more stronger negative effects.  The disadvantage of this solution is that inflation often hits lower and middle classes very hard, since they don't own many non-monetary assets (houses) and their wages/entitlements won't go up. It could also create a dereciation in the euro because investors will trust the euro a little less.

The second solution is to spend more money in the northern states to fuel the economy in there. This strategy would not only be beneficial for the people in the north, who would get more spending power; it would be also good for the southern countries since these countries can export more goods if the north is booming. The effect would be much larger than an increase in the world economy because  the European economy is very connected. In my research on Portugal I found that all its main trading partners are within the EU (and are specifically Germany and Spain). Therefore the better the EU economy operates the better Portugal can get out of the debt crisis. I have no doubt that the same will hold for Spain.

Finally a solution that I would prefer the most: investing in these countries. Instead of lending hundreds of billions in bailouts, investing fewer billions would be better. This is because investing has a number of additional benefits.  It creates jobs and it stimulates the economy. It also raises tax revenue directly and it will provide a continuous money source for the investor.  Just plain borrowing of money to pay of government debt will not do this (except for the last effect). In the case of Portugal and Spain the investments could be used to reform and transform their economies so they can join a better Euro Zone. Naturally this should not be a simple bailout, through investments, because that would create moral hazard and it is necessary to avoid a to big to fail notion for countries.

These are three proposals that I think should be implemented by the EU. In my next post in this series I will discuss the investment option in more detail.   

What to do if your country leaves the Euro

Recently there has been a lot of discussion on countries that may or should leave the euro. In a later post I will clarify my position further, but for now it is the following: It would be disastrous not only for the country but also for the Eurozone.

In this post however, I would like to describe what I think would happen if your country leaves the Euro. How to see the warning signs and what you should do when you see them. The technical scenario that I will describe has been partially borrowed from this site, which also describes other countries leaving a monetary zone.

First, the warning signs. in the case of Greece they´re already there: capital flight, unrest in the streets, default of the government en problems with banks. But it is mainly that a lot of people that are saying Greece will leave the Euro. The only thing that is missing is a firm official denial from the government (which would mean that they have given the idea some thought). In the case of Portugal the obvious sign is Greece leaving the Euro.

So what would happen if a country, for arguments sake Greece, would leave the Euro? The first thing is that it would happen overnight in a weekend without any official warning. Banks will close for a number of days to complete the transfer.  This is to prevent massive capital flight.

All euros will be marked in the following way: for the notes they would get a stamp without which the note will lose its value withing Greece (that means that the banks will not accept unmarked notes). For other euros like those on banks, they will be transferred to the currency under which laws they operate. So if you have a Greek account your euros would be transferred. The same will hold for contracts, loans and bonds under Greek law.  To make this all work, strict capital controls will be imposed: nobody will be allowed to transport money across the border. That means that you can´t travel with notes on your pocket and that you probably can´t transfer money.

Now for the more personal consequences. If this all happens it is certain that the new coin will drastically be devalued. That means that all goods from abroad (things like medicines, oil, other food and factory goods)  will be substantially more expensive. So if you need medicines (especially expensive ones) it may be prudent to keep a reserve in case that you can´t afford or won´t be able to buy them.

A lot of things will depend on how the owners from stores and other producers will accept the new coin. This in turn is very much dependent on the actual depreciation of the coin. If it depreciates little then life for Greeks will be more expensive but livable. If the depreciation is large then bad things will happen.

In the later case a following scenario could occur: banks will remain closed as people frantically try to get to their savings, while they are still worth something. That in turn will lead to the shutting down of the banking system of the whole country. A disaster since the majority of payments and wages is done using a bank.
Because of that shop owners will essentially not accept the new coin and all virtually monetary traffic breaks down (this happened in Argentina, where gold parts of necklaces became currency in some cases). Whatever the new currency will be a lot of people will not have enough of it to subsist. Therefore you can expect the looting of supermarkets and other stores if this situation lasts for more than a couple of days.

What should normal people do? If there are strong capital controls, getting your money from the bank early will only help a little (on a black market people will still accept the unmarked euros because they can smuggle them out). Also putting your money on a foreign account may not work if you're not allowed to import euros. More important is to have some reserves of essential food, water and medicine. If looting actually takes place, the streets will become more unsafe so the less you have to go outside the better. If you have friends or a job opportunity abroad this might be the time to move out.

When the chaos resides, your old job will most likely no longer be there. So it is time to rethink your career. A good example was given in this Dutch documentary of an Argentinian shoemaker who started a black market which now has a turnover of millions of euros per day. Also since many assets from companies (equipment, money, bonds etc.) and people (houses, cars) will be cheap, it may be the time to invest and hope for recovery.  

I don't think that in any European country this chaos will last long or will really occur at the first place. Therefore panicking and making rash decisions is unwarranted.  What I would recommend though is to have some reserves so that if bad things happen you can ride it out.

 

Defaults

Recently we have heard a lot on defaults and I have also written that default is a possible solution to a financial crisis for a country. But as Ryan commented on the previous post my description was quite short. In this post I will expand on the the principles of defaults.

As I described before, defaults can be divided up in two kinds orderly and disorderly: an orderly default is simply the country agreeing with the owners of its bonds not to pay them in full or on time or both. In contrast a disorderly default is a country unilaterally giving the finger to its bondholders and not paying its bonds at all.

Why can a state actually disorderly default? If it does, won't it violate its contracts? The answers to this problem is that if the bonds are hosted under the law from that same state, the state can alter the law so that it won't really violate its contracts. To default disorderly a state just declares the bond contracts void. In the case of an orderly default the country offers bondholders the ability to exchange their old bonds onto new ones(with less principal or more maturity or both) which are treated differently. It will then still declare the old bonds void. There are some entities (appropriately named vultures) which buy up these void bonds and try to get money out from the issuing state, some times that works, some times it doesn't (Cuba is the main case here)

As I described in the previous post, the state is usually more interested in the orderly default since that will still retain some credibility on the financial markets. Since the country is usually in a crisis when defaults occur it could be of a great value to retain the possibility to borrow money (be it against usually extortionate rates). The second reason is that orderly defaults prevent creditors from seizing the assets of the state that are abroad. Finally disorderly default usually create all kinds of chaos that will seriously harm what's left of the economy and society (see Argentina in 2001, another episode from the Dutch show tegenlicht deals with it).

You could wonder why bondholders would agree to an orderly default, after all they have a contract with the state to receive the full amount on the bonds. The reason for this is the possibility of the disorderly default.They agree to be paid less with more certainty, than being paid in full with almost no certainty. The increased certainty can come from another country/entity guaranteeing the payments (as happens in the Greek case, it is not the bond holders but that entity that is demanding the reforms) or by putting the bonds outside of the countries borders. Often countries with less credibility opt to host their binds in New York or London so that the bonds are hosted under the law from the USA/UK.

The situation that then appears is similar to that of the battle of the sexes ( a game similar to the prisoners dilemma). The real question in these games is the preparedness of one player to wreak havoc, the more likely you are to drive of the cliff, the more likely it is that the other party will settle with you on favorable terms. Therefore a state should negotiate with absolute disregard for the economic consequences of disorderly default. I know it sounds strange but that's the world we live in.

Another problematic thing with defaults and negotiations to prevent them is the shear amount of actors involved in them. Here is a list of likely actors involved in any deal: The state, large social actors within that state (unions, employers, state companies etc.), the banks with bonds (most likely also within the country), other bond holders (pension funds, hedge funds etc.), foreign governments whose banks and funds hold bonds, trading partners, maybe courts that are abroad and of course the citizens of the the defaulting state. A Reuters blogger has a nice video on the main actors involved in Greece ( It has also a pirate boat :-)).

Finally, throughout history people and governments have made two big mistakes when it came to defaults. The first was that it doesn't happen to us/ the people we lend money to. And the second one was that a default means the destruction of a country. Both of which are almost always untrue: In the book this time it's different the authors describe how almost all countries (and yes that includes the US in the 1970s by some measures) have defaulted one way or another in the last 200 years. The second thing is that defaults even disorderly ones can be better on the long term than muttering along in a bad situation that is not going to improve with a large debt burden (see also my previous post). It seems that the Europeans have finally understood that with Greece.

Saving Portugal and Spain: Solutions (1)

After all the negative messages from this series, it is time to finally start working on the possible solutions. In this first post I will address the more financial solutions. Some have been discussed by European leaders, others should be.

The first solution is to lend a lot of money to these countries to help them cope with their deficit and debt payments. This policy can work to stem the problem of loss of trust on the side of the bondholders. It is quite simple to see why: if you know that you will get your money back one way or another, it is very safe to lend your money (in this case buy bonds). But in here there is the immediate problem: to give this trust to bond holders, one needs to be able to lend enough so that whatever happens, the country can pay its debt obligations. That means that you need to have very big reserves ready for lending (a job well suited for a central bank, which has virtually infinite reserves). But even if you're willing to do this you need to be sure that the treasure country is inherently sound (or force it to make policies to ensure this). If this is not the case you need to lend until the end of days and you're effectively subsidizing. In the Euro zone this is far from reality, and politicians more liked to pretend it was true rather than knowing it. This is why the policy has been branded: extend (the loans) and pretend (everything is OK) by some bloggers.

If the countries are in more than just a liquidity issues and I believe they are then it is time for more drastic measures. One of the proposed measures (and already kinda enforced on Greece) is the orderly default on its debts. An orderly default is simply the country agreeing with the owners of its bonds not to pay them in full or on time or both. In contrast a disorderly default is a country unilaterally giving the finger to its bondholders and not paying its bonds at all. The disadvantages of a default, either kind, is the loss of trust on the side of the bondholders and a disastrous rating from the rating agencies. Furthermore, since often a significant portion of the owners of sovereign bonds are domestic actors (banks, pensionfunds, etc.) the effects for the economy are likely to be bad as well. The main advantage is that the country is relieved of its debt burden and it can move forward, and if a country defaults orderly many of the bond holders will eventually return (be it that you borrow at higher rates). If a default is disorderly the country will be shunned from the financial markets and that is in this age very very bad. Therefore an orderly default is always better than a disorderly one.

However if the underlying economy is not sound, a default will not solve most problems (and could be even worse than a large debt burden). In fact the only way to move out of the mess is to get the economy running again. This can be by external factors such as, increased trade. But this is unlikely to happen since most of the world is still struck by the financial and euro-crisis. Structural reforms like cuts usually take too much time as I mentioned in a previous post. Therefore the only way forward is to invest in the country. Since this is usually impossible by the state, it needs to either borrow money using bonds with such a long maturity that it can use the money to grow or with foreign investment. If the money is well spend it could be the only way out of a debt and economic crisis that Portugal and Spain are now in.

Saving Portugal and Spain:The situation (3)

This post will be the final post about the situation of Portugal and Spain. In this post I will address some of broader the issues facing Europe as a whole and the Iberian peninsula in particular.

The first real problem is energy: Europe is increasingly dependent on increasingly unstable countries for its energy needs. Some examples: as a recurrent winter tradition Russia is threatening to cut gas to certain or all European states. Iran has just announced (or maybe announced, it is a bit unclear), that it will cut its oil deliveries to at leas 6 European countries. Other countries with substantial oil and gas reserves are in turmoil because of the Arab spring (Libya, Egypt, etc.) . In Europe we do not want more coal plants because of the CO2 and other environmental issues. Nuclear power is not a feasible political option since the disaster in Japan, even though Europe is a bit divided on this issue with France and Germany being on both sides of the debate. At this moment, so called green energy (in order of importance: water, wind, sun and .... biomass) does not seem to be able to cope with the ever increasing demand.

The other problem, which is a bit more local, is water. In the northern countries there is to much of it and in the southern countries there is to little. The too much part can be mitigated by building better structures to deal with water (levies, dikes, dams, preemptive flooding areas etc.). In the south the problems are harder to solve. Spain and Portugal have already entered an argument on the use of a Spanish dam on one of the larger rivers flowing into Portugal. Here the main culprit is the agricultural sector (even though some industries are also large water consumers). It just takes an extraordinary amount of water to use modern large scale agricultural techniques.

Finally there is the problem of indecisiveness. In Europe, and in specific European countries it seems harder and harder to make quick decisions. This is fueling the uncertainty over the crisis and more importantly it is delaying the plans for a way of getting Europe out of the crisis and back in the lead. The indecisiveness is caused by the incomplete patchwork that is the European Union. Fact of the matter is that in many cases nobody seems to know which actor is responsible for what (European commission, European council, European parliament, European central bank, the parliaments...). This then invokes lots of political games, which only make the situation worse. Therefore it is necessary to create a more clear structure, one way (decentralization) or another (Federalization).

In my next series of posts on this subject I will be discussing a more cheerfull subject of solutions to this situation. So if you want to discuss more on the situation of Portugal and Spain, please react below.

Saving Portugal and Spain: The situation (2)

This post is a continuation of the earlyer post on the situation of Spain and Portugal. There some of the unitil problems were discussed, the problems here are results of the earlyer problems. These non-the-less represent a serious threat to recovery on the Iberian Peninsula.

First there is the drain of young talented people: as i discussed before, the lack of innovative and growing companies means that there are no positions for young people. The continuous corruption on the high levels of society and the large bureaucracy are also responsible for demotivating youth. This means that young people will flee the country and will move to countries, in Europe but also outside. This is very bad for the home country since it is precisely these people that the country needs to start new companies, renew existing ones, reconstitute the governance structure, in short to construct the countries future.

Then there is the problem with trust, which is also one of the reasons young people are leaving. At this moment people do not trust the country to leave the crisis. This leads to less investments and lower credit ratings not just of the country but also of all organizations (banks, municipalities, companies etc.). The lower ratings and fewer investments in turn lead to less trust and less economic growth. What I mean to say here is that once a country has turned a certain corner it will fall down a cliff. The only way to fix a situation like this is either to go broke, wait a long time in misery and slowly rebuild your economy on the wreckage of the old one. Or, a more preferable option, make a grand gesture on something econmic and rebuild trust.

The unfortunate part is that countries that are already in distress are usually not able to make these gestures, since they are already in distress. The only way to make a good gesture yourself is to either present a workable way out of economic decline and insolvency (usually nearly impossible, since most plans only revolve around budget cuts and increased taxes. Most economists, even at the IMF know that that doesn't work) or the other way: embellish and lie. Show a suddenly growing GDP, show more investments, show a cleaner government, fire some important heads of institutions. It surely wont help your economy or your situation directly but if Portugal and Spain manage to inspire trust back in them. They might be able to turn the situation around as quickly as it emerged.

In the next part of this series I will talk about the more international aspects of the crisis.

Rating the agencies

Credit ratings have gone from an obscure financial term to a report card on the behavior of governments. But what are these ratings, where do they come from and why should we care about them?

Credit ratings are an indication of the likelyhood that an financial instrument (bonds, securities etc.) will pay the promised returns. It is best understood when talking about bonds(corporate and country loans): it is the likelyhood that a company will pay the principal and interests on its loans. The ratings can range from AAA (No question, they will pay) to D(they won't pay). In the globalized world we live in ratings on credit are a necessity: how else would you as a small investor be able to know if it is save to buy bonds from a company around the world. Interestingly it is mainly large actors (pensionfunds etc. ) who actually do have the resources to investigate these questions, that mainly rely on credit ratings: they often even have the ratings enshrined in their statutes..

There are three major credit rating agencies: Moody's, S&P and Fitch and they are all from the USA. That means that ratings are likely to be biased to USA values, like a preference to a certain law-system(see this chapter on Fitch). It is hard to precisely understand where a rating actually comes from. To make a rating these agencies use all kinds of quantitative (e.g. amount of external debt), qualitative (e.g. willingness to pay on debts) and institutional parameters (e.g. enforceability of contracts). And out comes a single rating, which actually always means a gross oversimplification of the situation a country or company is in.

To make matters more complex: it is not the investors that pay the agencies but the issuer of the instrument. This means that the interests of the rating agencies are not fully aligned with the investors. It is rumored that during the boom of MBS (Mortgage Backed Securities), large investment banks made rating agencies put incredibly high ratings on their products, even though the chances of default where substantial. Some might say that this is one of the main reasons why the crisis began, but i will come back to that in another post.

The reason why we should care about these ratings is because other people do. Even though it is incredibly unlikely that France will default on its bonds, some large investors might be forced by their statutes to sell of their French bonds now that they are rated lower. Because of these kinds of reactions from large financial actors the ratings have a significant impact on the price of the thing that they are rating. In the case of a country it means that a lower rated country needs to pay more interest in its bonds than a higher rated country.

For all Dutch speakers: there is a very good documentary from VPRO Tegenlicht on rating agencies(about half of it is in English, so non-Dutch speakers can also watch it). I believe that the Inside Job also deals with them in understandable way.

Saving Portugal and Spain:The situation

For any successful attempt of solving a situation, it is important to make an overview of the problems that are there. And this is what I want to do in this post. I have gathered quite some data about Portugal and I believe that a lot of the problems are similar to the ones of Spain. As always please correct me if I'm wrong.

First an assessment of the situation right now. The government debt of Portugal is increasing at an alarming rate: depending on who's measures one uses it has reached over 100% of GDP already. In 2011 the deficit was around 6% (note that it may change because Eurostat hasn't published the official data yet) as also agreed in the bailout package with the Troika (EU,ECB, IMF). In general a government debt like this is unsustainable unless there is an economic boom or an unexpected increase in income. Both of which are unlikely.

This brings us to the second point: the Portuguese economy. For the last decade there hasn't been any real growth in GDP of Portugal. The Spanish GDP did experience a growth rate of about 3.5% but this is probably biased upwards due to the real estate boom in there. I believe that the reason for the low growth rate, mainly in Portugal, is the lack of innovative activity. Factories are closing instead of opening, and there is no adequate work for university graduates. In Spain the same situation seems to exist (If I have to believe the Dutch news stories).

Finally there is the problem nobody really wants to talk about: corruption. From what I have seen in Portugal this is not on lower levels (e.g. never seen corrupt police and I doubt that it would be accepted by the population). Rather, it is at higher levels of society. There are controversies surrounding the takeover of the bank BPN, there is operation face occulta, even the president Cavaco Silva has been accused of accepting bribes. At some point there was even an add campain by the Portuguese Licor Beirão making fun about how corrupt the government really was. The main point is that if even half of these stories are true it means that the most powerfull politicians are more busy getting rich and covering themselves than leading the country.

In the next post I will discuss more details about the situation in Portugal and Spain.

Saving Portugal and Spain: Introduction

For a while i would like to devote my time and the space on this blog on the quest to save these countries from the economic turmoil they are in. I chose Portugal and Spain because I think that even though the problems that they are facing and their economic structures, language and culture are quite different; the problems are similar enough to at least consider some form of similar approach. This I do not think about the three other EU countries in trouble: Ireland, Italy and Greece. But even for them there might be something in this blog.

This first post( in a long line) is about why it is important to care about the problems on the Iberian peninsula. For me it is quite simple, after living in Portugal for half a year: então parte da minha alma é português :-). Furthermore my girlfriend and here family as well as mine and her friends still live in Portugal. Also in Spain I have quite some friends, so I guess I'm quite biased here... But also for somebody that has no direct connection it is important that these countries do not sink further in economic crisis.

First there are the costs for the people in there themselves. A lot of people that are like us are facing a deep recession, unemployment (yes even more than we do), sharp increases in prices, sharp decreases in the services that you expect from a government in Europe and a lot more.

But also for other European countries there are problems. there is the economic perspective, a lot of the exports from northern Europe go to southern Europe. I might be mistaken but i think that the crisis is starting to hit German exports (e.g. cars) to these countries. Then there is the financial world: for a country to be seriously indebted there needed to be banks willing to lend it money, in the case of Greece those were French banks (which are now mysteriously at the brink of bankruptcy). In the case of Portugal and Spain i am quite sure that other North-European banks have the most exposure again.

Finally, I see this also as a test for Europe. If we can make it through this crisis together, Europe will be stronger regardless of the exact configuration of power. If we fail to make it trough we are back to where we started with the ECSC. So my message is that it is in the interest for all Europeans to solve this crisis.

Economics at a turning point(3)

After the previous 2 posts on my view on the economics science, it is time to present my view on propelling it forward. I will present a far more humble and empiric science of economy rather than the abstract science that it has become. My ideas are still in a very early stage so they may lack a full and thourough basis and therefore i would like to invite the readers of this blog to comment on the concept.

My general idea is to approach the economy as a set of different sectors (production consumption government etc.) as is common within economics. Here is where the twist is: instead of theorizing how the interaction between these blocks is and fitting the data to such an interaction, i would like to compute response functions between them. The response function, as borrowed from electrical enginering, does not need to be a neat mathematical sound function as all to often happens in classical economics. It would be a function that has probably lags and maybe even cases in which a system responds before the signal actually was given. This could happen with consumption when people, worry that a crisis might occur, adjust their spending accordingly.

This does not mean that the theory of economy would go to the trash, rather it could explain and smooth en the function. This will be very necessary because it is impossible to observe an economic impulse in abstraction, rather we will have to get it from observing the entire system. This means that there will be a lot of noise, that economic theory of all branches, be it classical evolutionary or something else, could help over come.

When the response functions of all important components from the economic system are know, we could use simulation (which we probably need because the system will be far to complex to analyze only analytically) to answer questions on all sorts of economic questions. Interestingly we could use a system like this also to test the robustness of our predictions by varying the initial conditions slightly (an approach commonly used in simulation). This means that we can predict the likelihood of major events like another financial crisis much better.

As I've said before, this idea is still in the early stages so i would like everybody to comment and expand on it.

Cuts and Crisis

As many of us are experiencing: Europe and other large economies are in a great economic crisis. One of the consequences of a crisis of this magnitude is the high deficits that many governments are now running, threatening their solvency. An obvious answer to this threat is reducing deficits by cutting costs, reducing benefits and increasing taxes.

In this post I will deal with the first method of cutting: cost reductions. In most government programs this is simply firing civil servants or 'reducing bureacracy'. This seems a good idea: reducing a deficit by getting rid of unproductive labor. Unfortunately things are (almost) never as easy as what they seem. What happens with cutting programs is that civil servants get fired, but because they can't find another job they need to be supported by the state. This means in effect that you, instead of paying a salary to a working person, pay a benefit to a not working person. This effect greatly reduces the effects of cutting programs even when they cut only unproductive civil servants.

But wait, it gets even worse: cost cutting programs take specialists to asses and implement the programs, especially when they involve larger scales. Many governments do not have these specialists amongst their own staff so they will need to hire them from the private sectors. These specialists (now called consultants) do not come cheap. An ironic situation now occurs: the government is paying high costs to get rid of low salaries. And this, of course, leads to even less cost reductions.

The final problem with cutting personell in time of crisis is that large reorganizations often reduce productivity temporarily(lets assume, contrary to reality, that it is not a permanent reduction). The reduction comes from the fact that people and therefore organizations learn to act within an organization. When that organization rapidly changes people need time to adjust to the new organization, leading to less productivity temporarily. This is bad, especially in a crisis. In crises people need to be able to trust the government and are relying on its stability. Therefore a reorganization of crucial sectors is precisely the opposite of what a government should do.

In conclusion: even though cutting civil servants seems to be a good idea to reduce the governments deficit, it probably is better to get money from somewhere else if you are in a crisis.

Polls and what to make of them

With the republican primaries going on in the USA and the always present polls for coalition governments in Europe, polls have become part of our daily lives. If polls are made properly, they are good for governments and the general public because they can tell us an indication on how the majority of people thinks about certain subjects. A government can use polls to see the effects of their policy on the population and might decide upon a change in it midterm, because their voters disapprove of it.

However polls are dangerous things, because all to often they are misinterpreted and taken more seriously than they should. One problem of polls is that people might not tell the the truth in a poll, because they are not anonymous. For instance: they might give the social acceptable answer of voting for a social party and then vote for an extreme right one (In Dutch: Links lullen, Rechts stemmen). Also people that are asked during a poll might not actually know what they would vote for and just give a random answer depending on what they have seen on that day on TV. And finally even if somebody truthfully answers he might not go voting because the weather is bad on voting day. And these are just some problems, there are many more...

Next to these inherent problems of polling there are also problems with to low sample sizes (that means that not enough people take part in the poll). To give an example (this involves some statistics 1.02): In the Dutch assembly there are 150 seats. So the question is: how many people do you need to ask before you can say up to 1 seat in uncertainty per party how the people would vote. To calculate the uncertainty you need to use a Poisson distribution and take roughly two times the standard deviation for the uncertainty. This amounts to roughly one over the square root of the number of people asked (it also depends on how much seats you expect, parties with less seats are predicted more accurately). Here we need an accuracy of 1/150, since there are 150 seats. So to get within 1 seat you need 150 square or 22500 voters asked. If you want an accuracy of 2 seats you need 22500/4 voters, if you need 3 seats 22500/9 etc. The average poll in the Netherlands has about a 1000 people in it, giving it an accuracy of 3% of the votes or 4.5 seats in the Dutch parliament. (please correct me if the math I did was wrong)

Now what does all of this math tell us? That any poll that we see in the Dutch news is probably inaccurate to about 4 seats per party. That makes questions like: so your party rose by one seat in today's poll, what do you think about that? Totally ridiculous. The same math also applies to other countries: If the number of people asked in CNN is the same, a lead of 3% in the polls for a US candidate does not really tell you anything.

In conclusion: most daily polls do not really tell much except for when they show major differences. What those polls can tell us is a trend: a political party which is falling by numerous polls over a long time(e.g. Dutch CDA) still needs to be worried and will probably need to adjust its policies. This is because with consequetive polls the uncertainty shrinks, simply because more people were asked. A political party which is bouncing up and down a bit in the polls should not worry, that is just statistical noise.

A final note: this post deals with acceptable polls with good techniques. I do not classify the polls from Maurice de Hond (most cited poll in the Netherlands) in here. As far as i am concerned his polls are of very little value to predict outcomes of elections.

Economics at a turning point (2)

Yesterday I made a post on the need for a new economics. In this post I will elaborate more on the possibilities of replacing the economic science of today with the complexity of tomorrow.

The main questions for me are: where do we go from here? How do we make a new economic reasoning? We can do this using some economics that is already here: Evolutionary economics. This kind of economics is more based changes in systems rather than the optimization and equilibrium that is more present in classical economics. In evolutionary economics it is thought that all sorts of things (products, companies, strategies etc.) follow the evolutionary algorithm that was found in biology by Darwin. This means that less fit things (products, etc.) will eventually give way to more fit things (other products, etc.).

Evolutionary economics also employs another interesting concept: bounded rationality. In short, bounded rationality means that actors in systems (you and me) do not make the most optimal decision, or make a completely random decision but rather something that is in between: we make a strategy which is OK. These strategies are then mainly chosen, not because they are the optimal strategy, but because we are satisfied with them. I think that this is far closer to human nature (and also that of companies and other larger actors) than an optimizing approach.

Unfortunately there is always something to complain about: in evolutionary economics the focus is solely on the evolutionary algorithm that obscures systems of our economy which do not have evolutionary properties. A good example of this is the behavior of consumers (again you and me), where there is not really a process where bad consumers get replaced by good consumers. But this can be solved by taking a broader perspective of economic systems and creating a theory of complex systems in which the evolutionary algorithm is just one component, be it a very important one.

However, there is a real problem with the state of evolutionary and other ways of describing the economic system. By my knowledge (please answer this post if I am wrong) there is not a single complex way of describing the entire economy. There is no answer to the question what is the increase in GDP the next year or over the next 5 years. Or: what will happen in X years to our government debt if we raise taxes on middle-incomes by 3 percentage points? All models of from complexity economics are just models: they are good at describing one behavior or give an understanding into dynamics of different systems but they cannot really be applied to real-world economic policy questions.

Classical economic theory offers answers to these questions. But we know that these answers are not only inaccurate but they are also skewed towards certain outcomes (something that I will come back to in a later post). Therefore I believe that we need to come up with an economic theory based on complexity that is general and that can be applied to answer economic policy questions.

Economics at a turning point

Economics is at a point where physics was some 100 years ago. We think we have solved all the mayor issues and that there is just some small details to be solved before we can complete this chapter of knowledge. This in fact is like physics 100 years ago not true, as the current crisis showed and keeps showing us. Therefore it is time for a new paradigm: complexity economics (my expertise)

First lets discuss some history of economics(the really short version): the foundation of our current thought of economics comes from Walras. His thought that economics are the result of general equilibria (e.g. between supply and demand) are still common good in economics. But that was not the only thing that he did, thanks to him (and others) also the mathematical description of economics was introduced. The main thought for this all was the description of economics as a kind of phyiscs. After him other economists have shown that economics is not only about equilibrium's (notably Keynes) but the two other points (mathematics and physics) have stayed.

What we see in the world now is that economics is actually quite far from physics: unlike physics, all parts of the economics system (that's you and me) are not the same. Also the different parts of the system think and plan strategic behavior, thus undermining general equilibria. These two small arguments make that economics cannot be simply seen as a physical system which can be described by nice differential equations and integrals but is rather a complex system in which modelling is more the way to go. Recently the economic science has kinda acknowledged this and introduced behavioral economics

I believe that this acknowledgement is not enough: economics needs to be transformed into a science that is based on complexity rather than just makes a complexity addition. With this new economics the results of classical economics are not waisted, nor untrue. They are stylist versions of the real complex system that hold true in limit situations. Just like classical physics is a limit situation of relativity and quantum theory.

Hello world!

Dear reader

As a first post i shall give you an idea into what i think this blog is all about. But first a small introduction: My name is Jurriën Bakker and I'm a Dutch student of Innovation Sciences at the university of Eindhoven (aka TU/e). Before that I did a bachelor of applied physics so some ideas from these studies will make it to this blog.

This blog is in general about the complexity of the world around us. I think that in the media and in most of our world view not enough attention is devoted to how complex most systems in the world actually are. This feeling also originates from the fact that I am a 'complexity' economist, and have dedicided to study complex economic systems. But describing the world alone is not enough for me, I want to improve it. And that is where you come in my dear reader: I want to discuss ways with you of changing some of the things that we have grown to accept. My strong believe is in discussion and i hope that you will engage on the subjects that i discuss over here.

Of course this blog is not the only nice place to read interesting things about the world. My good friend Ryan hosts this nice blog on science and technology: and if you like this blog i advise you to check it out.

Yours

Jurriën