Saturday, March 14, 2015

Who is winning in Ukraine?

Russia has accomplished two things over the past year:  The annexation of Crimea, and the establishment of a small section of Ukraine with still unspecified powers of autonomy.  The cost of these accomplishments has been the alienation from Russia of the rest of Ukraine, a new Cold War with the West, and direct costs of military action.

What have been the benefits to Russia?  Russian people have enjoyed the pleasures of nationalist fervor, and President Putin has seen his popularity rise.  But if real gains do not result, these good feelings will disappear quickly.

Economically, the invasions have been a disaster for Russia.  The new regions under Russian control are net economic drains. The resulting economic sanctions from the West have made the adventure even more costly.

Strategically, invading Crimea had little value for Russia.  It already had a lease on a naval base there, and it was constructing another base on the Russian coast of the Black Sea.  The Donbass region provides a small buffer protecting Russian possessions in the Caucasus region, but if the rest of Ukraine becomes more pro-West than it was and holds onto the Sloboda region of northeast Ukraine the strategic losses will outweigh the gains.  On the other hand, if Ukraine falls apart and Russia moves in to take control, and if the West cannot respond effectively, then Russia will at least have gained a buffer state against the West.

Russians and Germans are similar - they are both clever, ambitious people living in regions that are impossible to defend.  The solution to their security problems has been to conquer neighbors to create empires with defensible borders.  Germany had to be destroyed, humiliated and shamed in order to stop it from doing what came naturally.  The same may be true of Russia.  It will feel insecure until it controls everything between the Baltic Sea, Carpathian Mountains, Black Sea, and Caucasus Mountains.  Then it will focus on gaps between these natural features, such as Poland.

If Russia ever gets to the point where it feels secure, it will be too powerful for the rest of the world to be comfortable.  The empire Russia creates will require massive repression of nationalities under its control, which will mean constant instability.

To avoid wars, revolutions, and economic waste, the Russian empire (known now as the Russian Federation) might eventually be dismantled, and Russia will become a normal country dependent on the goodwill of its neighbors for security.  Western countries know this, and are slowly chipping away at Russia's buffer zones.  Ukraine, with or without the Donbass, would be a great prize - it would open up a new invasion route into the Russian heartland, and it would put pressure on Belarus.

I am not endorsing the campaign against Russia, only observing and predicting it.  Whether it is a good idea is related to a constant dilemma in international affairs; whether to manage problems or seek a permanent solution.  I don't know enough to say whether the risks outweigh the benefits of either approach.  But I think there is a reasonable chance that we will see the end of the Russian empire as we know it sometime in the next few decades, and maybe sooner.

Friday, March 6, 2015

The Fed's Fault?

This is a chart that ought to get more attention.  It shows the Federal Funds Rate increasing dramatically right before the 2008 crash and recession. 

Conventional wisdom holds that an irrational housing bubble that was bound to burst caused the crash of 2008 and subsequent recession.  But what if the Federal Reserve had kept rates low instead of quintupling them over 24 months?  Houses were affordable even at the height of the bubble - the ratio of mortgage payments to income was lower in 2006 than at any time during the 1970s or 1980s, and was comparable to levels seen during the 1990s.  In other words, house prices were not at levels that were unheard of given incomes and interest rates.  Perhaps interest rate hikes weakened the economy, weakening house prices, instead of the reverse story; weakening house prices bringing down the economy as a whole.

Today we had great economic news, a nearly 300,000 net increase in employment, but the stock market fell significantly because people are worried that the Federal Reserve will overreact by raising rates.

I think most people would agree that rate hikes of the magnitude of what happened 10 years ago would cause serious problems today.  But the situation in July of 2004 wasn't so different - as of today, the unemployment rate is exactly the same, 5.5%.  The Shiller PE ratio is higher today - 27.7 vs. 26.4 in July of 2004.  Inflation was higher then - 3% versus 1.7%, measured by the trailing 12 month change in the CPI, but inflation expectations, measured by the difference between 10 year TIPS and Treasuries were only 2.5% then versus 2% today.

So with just another half a percentage point of inflation we will be in the situation that convinced the Fed to dramatically increase rates just 10 years ago. 

By any reasonable estimate, the welfare cost of an additional 0.5% of inflation is low, but the welfare cost of recessions is high.  Interest rate hikes by the Federal Reserve appear to cause recessions.  Are they really worth it?

I have been aware of this problem for a while - I shared a computer lab with Campbell Harvey while he wrote his pioneering dissertation on the relationship between the term structure of interest rates and the business cycle 30 years ago.  My boss's boss at the Federal Reserve Bank of New York published the other seminal paper on the same topic while I was there in the early 1990s.  I also happen to be in interest rate sensitive businesses that would have difficulties if rates move sharply higher.

There are many examples - the Federal Funds rate rose from 6.5% in August of 1987 to 8.4% at the end of September, and the market crashed on October 19.  At the beginning of 1999 the rate was 4.1%, but in July of 2000 it reached 7%.  A recession began in March of 2001.

The key problem for the Federal Reserve is its dual mandate - price stability and economic growth.  All in all, it seems as if the Fed before 2008 leaned too much in the direction of price stability.  Ever since November of 2008 the Fed has leaned in the direction of growth.  Let's hope it keeps doing so. 

Saturday, February 28, 2015

Pointless Regulation

A recent issue of the American Economic Review contains a great example of pointless regulation.  The paper, Cellular Service Demand: Biased Beliefs, Learning, and Bill Shock, by Michael Grubb and Matthew Osborne, begins with a statement from President Obama:
Far too many Americans know what it’s like to open up their cell-phone bill and be shocked by hundreds or even thousands of dollars in unexpected fees and charges.  But we can put an end to that with a simple step:  an alert warning consumers that they’re about to hit their limit before fees and charges add up. Our phones shouldn’t cost us more than the monthly rent or mortgage.
The Obama administration, threatening to impose regulations, reached an agreement with mobile phone companies under which they would inform consumers when they approach their voice, text and data limits.  This agreement is why you now receive annoying texts from your service provider - I count 23 from my provider over the past 6 months.

How could anyone argue with something as consumer friendly as this?  Particularly since it only provides information?  More information is always good, right?  Not really.  Grubb and Osborne show that firms can change their pricing plans to take account of consumer reactions to the new information, and that overall consumer welfare will be lower than before the new information was provided. Phone company profits would be unchanged.

Politicians want voters to think that they are addressing the problems of ordinary people, like high phone bills.  Anything they do, however, only makes things worse.  Economists read about it in the AER, but voters only hear the speeches and campaign commercials and are fooled over and over.

Monday, February 23, 2015

Capital Confusion

Today's column by Paul Krugman dips into some interesting issues.  I agree with Krugman that efforts to educate more people will not improve the employment situation, although my reasons for thinking so are different from his.  But this paragraph puzzled me:
Corporate profits have soared as a share of national income, but there is no sign of a rise in the rate of return on investment.  How is that possible?  Well, it's what you would expect if rising profits reflect monopoly power rather than returns to capital.
This isn't explained very well, probably because Krugman has limited space in his column. The column was prompted by comments made by Larry Summers, some of which were transcribed here.  Summers said:
you tend to think record high profits would mean record high returns to capital, would also mean really high interest rates. And what we actually have is really low real interest rates. The way to think about that is there's a lot of rents in what we're calling profits that don't really represent a return to investment, but represent a rent.
Summers is apparently saying that companies earning record profits are essentially stealing money from labor or consumers, which doesn't increase overall demand for capital, which means that interest rates stay low.  Productive investment, by contrast, makes everyone richer, raising demand for all types of capital, raising interest rates.  Krugman's statement that there is "no sign of a rise in the rate of return on investment" isn't quite right, because investments in whatever generates rents would show high rates of return.  But if he means interest rates, then there is some logic to the story.

But there are other reasons why interest rates might be low, even if companies are making productive investments.  The investments might be risky, resulting in a large risk premium for rates of return on capital over returns on lower risk bonds or government securities.  Investors might be very risk averse (still skittish from the crash), resulting in high risk premiums. Or the Federal Reserve might be buying up bonds, driving down interest rates relative to rates of return on equity capital.

Krugman jumps to the conclusion that corporate monopoly power has risen, but I don't think there is any credible evidence to support the hypothesis.  As I wrote here, and as a recent paper* shows, monopoly power measured by industrial concentration has, if anything, declined over the past several decades.  He then jumps further, claiming that "a tiny group of individuals holding strategic positions" is getting "all the big gains."

The big story is the leaps of logic Krugman makes to get to his preferred conclusions.  A smaller, but still interesting story is his use of the word "capital."  I use the word to mean resources of any kind that anyone uses to produce future consumption.  Krugman seems to resist using the term to describe assets that produce rents, as opposed to assets that are genuinely productive.  He also hates the use of the term "human capital." Why?  Of course he is right that labor is different than factories, but the genius represented by the term "human capital" is the recognition that they have certain things in common.  Sensitivity about the use of the term "capital" seems to me to indicate extreme ideological preferences, and a soft spot for Marxist thinking.

*Joshua Drucker, "Regional Industrial Structure Concentration in the United States: Trends and Implications," Economic Geography, October 2011, v. 87, iss. 4, pp. 421-52.

Friday, February 20, 2015

Libya's Unraveling

Last Sunday's New York Times editorial is a good illustration of what can go wrong with the thinking behind U.S. foreign policy. The editorial is correct about how bad things are in Libya, but it makes no mention of U.S. responsibility for contributing to the mess.

Four years ago, during the U.S. "led from behind" military campaign to overthrow Libya's government, a Times editorial criticized Republicans for considering "bailing out" of the operation, arguing that Qaddafi had to be removed from power because "We are certain if NATO had not intervened, thousands more Libyans would have been slaughtered."

The New York Times is a window into the thinking of the U.S. policy making elite.  In 2011 they were caught up in the excitement of the "Arab Spring," cheering on protests in Egypt, which inspired protests in Libya.  The Libyan government cracked down, leading the Times to encourage the U.S. to support a revolution.

In 2010 my family and I almost traveled to Libya.  Tour companies were just beginning to offer trips there, because the country seemed safe and stable.  We ended up going to Morocco instead, but hoped to see Libya another year.  The murder rate in Libya was the second lowest in North Africa, and the standard of living was high for the region.

The revolution enabled by the U.S. has resulted in thousands of deaths, certainly more than would have died in a government suppression of the revolt, and hundreds are still being killed every month.  The economy is in shambles.  Destroying a government that the West was able to work with has opened opportunities for ISIS and other groups that are unalterably opposed to the West.

Instead of calling for the UN to "redouble efforts" in Libya, the Times should admit that the 2011 intervention was a mistake. Perhaps the U.S. should have saved up its intervention capital for a situation where it is really needed, such as Ukraine.

Saturday, February 14, 2015

Killing Russians

In the late 1970s, National Security Advisor Zbigniew Brzezinski was being briefed on nuclear war plans against the Soviet Union:
Brzezinski asked the question: “Where are the criteria for killing Russians?" The briefer misunderstood the thrust of the question and replied that a nuclear barrage against Soviet industrial centers would kill roughly 113,000,000 people. Brzezinski retorted, “No, no, I mean Russian Russians.” To Brzezinski the ethnic Russians bore the responsibility for the Cold War because they were the core group within the Soviet Union.  This was the group you had to "deter," or, if it came to war, kill.  The briefer “felt that he was listening to the voice of 600 years of Polish history.” Robert C. Grogin, Natural Enemies: The United States and the Soviet Union in the Cold War, p. 296
Although on a far smaller scale, something similar is going on today.  A recent New York Times story based on high-level sources, including Hilary Clinton's probable pick for defense secretary, makes it clear that the U.S. wants to kill Russians in order to convince Putin to withdraw from Ukraine. 

The story notes that the issue of Russian casualties in Ukraine is "delicate" because, officially, Russia is not intervening there.  Funerals are held in secret, and families are told that their sons died in training accidents.  If the cease fire fails, the U.S. has contingency plans to exploit the potential for unrest over casualties by causing more of them with Javelin anti-tank missiles.

Saturday, February 7, 2015

Excess Government

Last month I was in Nicaragua, a fascinating country.  While I was there I thought about something I will call "excess government."  I start by assuming that the most basic need of a society is order - meaning that people feel safe in their homes and businesses, and while walking the streets.  Once there is order, people will find ways to feed, clothe, house and entertain themselves.  Government should be strong enough to ensure order, but no bigger.  In some countries, the optimal size of government might be zero, but others might require tyrannical dictatorship.

Societies differ in their natural tendency toward disorder and civil war.  The greater the tendency toward disorder, the more beneficial a strong central government can be.  Libya is perhaps the best recent example of a country that might have required a strong, perhaps even tyrannical government.  When that government was destroyed, chaos ensued.

Nicaragua is an interesting case.  I was told by senior officials there that it is the safest country in Central America.  (They claimed that Costa Rica falsifies its numbers to placate tourists. I need to learn more about Costa Rica)  According to available statistics, of the 11 countries that are within 500 miles of Nicaragua, only two have murder rates lower than Nicaragua's; Cuba, whose central government is even stronger than Nicaragua's, and Costa Rica.  Even the Cayman Islands report a higher murder rate than Nicaragua.

Given the neighborhood and Nicaragua's history of civil war and revolution, the level of social disorder would probably be much higher without the strong hand of the Sandinista government.  Perhaps there is no "excess government" there at all.

The graph above shows government strength on the vertical axis, and the country's background, exogenous risk of civil disorder on the horizontal axis.  The green line shows the optimal strength of government given the risk of civil disorder.

many European countries are stable enough to do well with no government at all - the U.S., with a slightly higher risk of disorder, could manage with very limited government.  Both have significant excess government.  North Korea has the most excess government, while Libya currently has too little central government.  China has a high risk of disorder, but still has too much government.  Nicaragua and Russia have the right level of government given the risks.

I am, of course, only guessing at the positions of the countries in the chart, but I think there are objective ways that could be used to measure the risk of civil disorder and the strength of government.  A line fitted to the points might be a way to guess at the optimal tradeoff, and vertical deviation from the line would be a reasonable measure of excess government.

By labeling strong governments as optimal, I don't mean to suggest that big government is costless. Strong governments mean high taxes which distort and reduce economic activity, and they reduce personal freedom, which has intrinsic value.  In addition, strong governments are inevitably corrupt, and extract wealth from the private economy.

But chaotic violence is even more costly than big government.  I still believe that the ideal human society would have no government, but there are very few countries in the world that are ready for it.