Are we seeing the same thing in China?  The Wall Street Journal reported yesterday that a Chinese think tank had worked with the World Bank to write “China 2030,” scheduled for release Monday.  The situations of China and the Soviet Union couldn’t be more different, with China’s economy expanding at rates never before seen:  over 10 percent a year, on average, for thirty years.  It’s a wonderful success story.  The question is whether it can continue to grow at something close to this rate under its current system, the beautifully named “socialism with Chinese characteristics.”  Many would bet that further expansion will require adoption of institutions similar to developed countries around the world.  There’s a lot to choose from there, but in most the state-owned sector is smaller, governments issue reasonably transparent financial statements (Greece notwithstanding), and banks do more than funnel money to state-run enterprises.  We’ll see more specifics when the report comes out.

In the meantime, the next decade promises to be an interesting time in China.  If the success to date has been miraculous, the future may be even more so.  Or not.  Experience tells us it’s hard to guess turning points, even when they’re right around the corner.

We talked last night about how differently the crises played out in Mexico and Greece.  The question, of course, is why, but we’ll leave that one for you.  Here are some of the specifics — and keep in mind that Mexico’s economy is roughly five times the size of Greece’s.  

Mexico.  In December 1994, Mexico was unable to roll over its government debt, most of it short term, much of it indexed to the dollar.  On January 31, 1995, the US loaned Mexico $20b, with oil revenue as collateral, and other governments and international agencies arranged roughly $30b in lines of credit.  Mexico ran a government surplus in 1995 and paid back the loan in full in 1997.  None of the lines of credit were used.  After shrinking by 6% in 1995, the Mexican economy grew 5% in 1996 and 7% in 1997.

Greece.  In late 2009, interest rates on Greek debt rose sharply.  Greece ran government deficits of 37b euros in 2009, 24b in 2010, and 22b in 2011.  (A euro is currently worth 1.32 US dollars.  These numbers are from the EIU, but there remains some uncertainty about Greece’s finances.)  Since 2010, all of this has been financed with the direct support of the EU and the IMF, and the indirect support of the ECB.  Greece is currently negotiating support for partial repayment of its debt, but continues to resist calls from creditors to cut its deficit further.  The Greek economy continues to contract, and there is no end in sight for the Greek crisis.  

Tom Sargent notes that the US faced similar issues with its states; see his piece in today’s Wall Street Journal.  It’s behind their paywall, but worth tracking down.  Here’s an excerpt:

“By refusing to bail out the states in the 1840s, the United States preserved its federal system, with substantial fiscal independence for state governments. Facing a similar moment, Europe might learn from our experience.”

European countries are, of course, different from American states in many ways, including history and culture.  Despite an explicit rule against bailouts, the EU has somehow gotten into a situation where the member states expect help from the center, but the center has (by design) limited authority.  Should the EU leave member states to deal with their own problems, as the US did in the 1840s?  Or help those in need?  What changes in institutions should be established now to deal with such situations?  It’s an awkward situation at best, but perhaps, as in US history, an opportunity to create better institutions for the future.

I saw in the news today that Starbucks has entered a joint venture with Tata, one of India’s most respected business groups, to open coffee shops in India. I don’t know if India has an urgent need for coffee, but it reminded me that international ventures often run across obstacles that wouldn’t cross your mind.  One of my favorite stories concerns Starbucks’ ill-fated attempt to enter the Norwegian market.

I was giving a talk at a Norwegian business school a few years ago and met a guy who worked for one of Norway’s leading venture capitalists.  He had just spent – and ultimately lost — a fortune on the exclusive rights to open Starbucks franchises in Norway.  Norway is one of the world’s leading coffee consumers (not seeing the sun for months at a time can have that effect on you), so bringing a high-profile global brand like Starbucks to Norway seemed like a no-brainer.

When they ultimately got around to running the numbers, they discovered two surprising facts about the Starbucks business model. It turns out that Starbucks outlets aren’t really coffee shops.  They’re dairy stores.  Most of their value added comes from heating up milk, which is then flavored with coffee:  cappuccinos, lattes, mochas, and so on.  In addition, most of this warmed-up milk is bought by young women, who happen to have a strong preference for cleanliness in their coffee/warm-milk shops.  Unfortunately, those two particular inputs into the Starbucks production function, milk and cleaning services, are both extremely expensive in Norway, which makes it difficult to “add value” while selling the final product at a reasonable price.

Why is dairy so expensive? Tariffs on imported milk products are kept extremely high to protect Norwegian farmers from foreign competition (you can find butter and cheese alongside single malt Scotch at duty free shops).  These tariffs have to be very high, of course, since Norway isn’t a very efficient place to run a dairy farm: neither the land nor the weather is conducive to raising and keeping cows. But a small number of Norwegian farmers have enough political clout to keep these tariffs in place, while a large number of Norwegian consumers must then pay $10 for a cappuccino or $45 for a pound of butter.

What about unskilled labor? Norway doesn’t have a minimum wage per se, but agreements among unions, trade associations, and the government keep salaries for unskilled workers very high, in the neighborhood of $40,000 to $50,000 per year plus fairly lavish benefits.  Moreover, even though wages are high, unskilled labor is scarce.  Immigration, which seems like a natural solution to this scarcity, is strictly controlled and favors skilled professionals (and Swedish bartenders).  This is deemed necessary to protect Norway’s generous and expensive social welfare system from being overburdened.

The net effect is that there is no Starbucks in Norway. Although I did read a report recently that a Starbucks is being planned for the Oslo airport and is scheduled to open sometime this year. This exception seems to prove the rule: international airports seem to be one place where people are willing pay ridiculous prices for almost anything.

Posted by Dave Backus for Stan Zin

Paul Romer’s post about the differences between the FAA and financial regulators got me thinking.  Are the latter so bogged down in detail that they miss the point?  Do they lack bottom-line responsibility?

First, there is some oversight of the financial regulatory process:  a) Congress, of course, always gets involved.  Alas, that’s usually for theatrics rather than objective fact-finding; still, it is involvement.  And b) Like many federal agencies, the FDIC does have an Inspector General that does after-the-fact reviews and audits.  So does the Federal Reserve.  So does the Federal Housing Finance Agency.  The Office of the Comptroller of the Currency (OCC) doesn’t appear to have its own IG; my guess is that the Treasury Department’s IG also covers the OCC, since the OCC is lodged in Treasury.

Second, there is another way to think about the limitations of financial regulation.  In some other areas of health-safety-environment regulation, there has been some movement away from “command and control” regulation and toward what I have called “an outputs and markets” orientation.  For example, “cap and trade” in environmental regulation; auctions in electromagnetic spectrum regulation; property rights in fisheries regulation.  But one is hard pressed to find any comparable movement toward an “outputs and markets” orientation in financial regulation.  In this respect Paul is exactly right, financial regulation, as currently practiced, is different.

Third, bank prudential regulation (i.e., safety and soundness regulation) has a combination of a massive rule book and a corps of examiners and supervisors who are responsible for enforcing the rule book through roughly annual examinations and then supervisory reviews.  In principle, this places the responsibility for a bank’s safety on a relatively small group of people.  But with 7000+ depository institutions in the U.S., the corps is large; and the failure of a bank, though nowadays perhaps as dramatic, isn’t as generally well understood by the public as the crash of an airplane.   I’m still not sure whether FAA-style would work, or whether financial markets are simply more complex than airplanes, and therefore more difficult to regulate.

Tyler Cowen recently pointed to a paper of mine on financial regulation and the dynamics of rules that I wrote for the IMF.  Dave Backus and John Cochrane then blogged their thoughtful reactions.  I take up the discussion about financial regulation in a separate post, but here I want to focus on the role of the blogosphere in the scientific process.

The sequence with Tyler, Dave, and John suggests how blogs might change economic discourse.  Blogs are a more open way to organize competition in the market for ideas.  Blogs also allow more people to see economists thinking out loud, something that used to require a seat in the seminar room.

Marginal Revolution, Tyler’s blog with Alex Tabarrok, is a new alternative to the traditional gatekeepers in economics — the journal editors or the program leaders at the NBER.  Tyler and Alex earned this position simply by being good at what they do.  Adding sites like this may do more to increase competition in the space of ideas than traditional strategies such as creating new journals.  A mention from a site like MR is now an alternative way for new ideas to get attention, one that can parallel the traditional mechanisms.

On the NYU Stern Economics blog, Dave Backus offered comments and questions about my paper, just as he would in a seminar.  In the same spirit, John Cochrane responded with some evidence of his own, which raised new questions.  As an author, it’s enormously helpful to get seminar-style comments and questions so quickly from a diverse group of people.  An added bonus is that those who are interested can follow along.

I’ve had other productive exchanges in the blogosphere but one in particular stands out. Chris Blattman attended a presentation I gave on charter cities.  He asked a question as I was speaking and we talked about it afterwards. Then he wrote a blog post with more detailed comments.  With time to reflect, I responded with a post of my own and Chris followed up with two more  posts.  The exchange with Chris gave his readers a window into our discussion, but it also had a lasting effect on my thinking about rules. The development of the ideas in my IMF paper resulted in part from this exchange.

Recently, Paul Krugman welcomed the more open process of science that the internet allows.  He is unsentimental about the “old days” when senior economists acted as gatekeepers and slowed down discussion of new ideas.  This kind of behavior is what motivated the old saying that “science progresses funeral by funeral.”

Of course, the internet offers its own set of challenges to productive discourse.  Part of the point of my IMF paper was that new technologies typically require a rethink of existing rules.  For example, anonymous reviews may have been helpful when they were moderated by journal editors and seen only by the author of the paper under review. On open science blogs, there may be no useful role for anonymity. As Krugman has also noted, there are still a few glitches to be worked out, such as how to prevent online impersonation.  But with a little tolerance for noise while the rules catch up, we will eventually figure out how to do science over the internet.  The system that emerges might keep the signal-to-noise ratio high yet still be more open and dynamic.

Posted by Dave Backus for Paul Romer

I suggested in a recent paper that regulation of financial institutions could look less like the legalistic regulation at OSHA and more like the regulation at the FAA.  Dave Backus asked what it would look like in practice.  John Cochrane, the Chicago Booth financial economist and accomplished glider pilot, expressed doubt based on his own experience with the FAA.

 One answer to Dave’s question is to look North, to Canada.  Its system of financial regulation is closer to what I have in mind when I speak of FAA-style regulation.  Canada has a single financial regulator who can, in effect, say to a bank, “This practice is not safe.  Stop taking any new business until you change how you operate.”  This is the kind of power that the FAA has.  It can withhold an airworthiness certificate for a newly designed aircraft until its employees are satisfied that the plane is safe.  The agency can also ground any model of aircraft if new information emerges about a threat to flight safety. It can mandate expensive modifications that must be made to the plane before it is deemed airworthy and hence legal to fly again.

Michael Bordo, Hugh Rockoff, and Angela Redish have a recent article (gated, unfortunately) that describes the history of the Canadian system of financial regulation.  They show that this system has consistently avoided the financial crises that emerged in the United States.  They also observe that there are structural features of the Canadian system that make it easier to implement something like the FAA system.  For example, Canada has a very small number of very large financial organizations and a single regulator, the Office of the Superintendent of Financial Institutions, (OFSI).  According to Bordo et al, “Canadian regulation under OSFI proved tougher than in the United States, mandating higher capital requirements, lower leverage, less securitization, the curtailment of off balance sheet vehicles, and restricting the assets that banks could purchase.”

The Canadian experience shows that having a large number of institutions, each of which is small enough to fail, is not necessary for stability.  The US experience with the S&L crisis in the 1980s also shows that large numbers of small institutions is not sufficient for stability either.  See, for example, my paper with George Akerlof.

More generally, it is hard to point to a successful regulatory model that achieves financial sector stability by designing in good ex post mechanisms for unwinding the consequences of unlimited risk taking.  (Good luck with those living wills.)  The demonstrated path to stability is to give a single hierarchical organization the ex ante power to prevent a levels of risk-taking that are inefficient.

But how would a regulatory system decide whether a specific financial practice is safe? Perhaps in the same way that one decides whether a plane is safe.  Grant responsibility for making a judgment to someone who is objective; and hold this person accountable based on how things turn out.

Others have noted that the regulation of flight safety offers an interesting case for financial regulators to consider. For example, Andrew Lo and co-authors (link) have called for an analog of the National Transportation Safety Board.  This independent agency has no regulatory responsibility.  Its job is exclusively to establish the facts following any major transportation accident.  It is part of how the government as whole establishes how well the decisions at the FAA are indeed turning out.

Cochrane points out that any system of regulation like the one implemented by the FAA entails some social cost.  There can be no doubt on this point.  Giving responsibility to regulators does not guarantee that they will always hit the right balance in making tradeoffs about risk and benefit.  Moreover, good regulators should get high salaries.

I may lose some readers, but let me indulge in some casual economic theory.  Let S denote the idealized social optimum. Let X and Y represent the outcome for society under two different regulatory regimes. Let’s stipulate that both are less than ideal in the sense that S > X and S > Y.

Let N denote the value for society with no regulation. The interesting question is whether S is close to N. In many parts of the economy, this should be true. Economists successfully made this case, for example, with respect to price regulation for trucking and air travel. In such cases, there is no reason to worry about the relative merits of the alternative regulatory regimes X and Y. Just get rid of the regulation.

But if a worldwide crisis suggests that S is substantially bigger than N, it is possible to have inequalities of the form  S > X > Y > N. In this case, Y is better than no regulation, but X would be even better than Y. The fact that X and Y are both less than S is not decision relevant.

It could even be that S > X > N > Y. Then deregulation that moves the economy from Y to N is an improvement, but moving instead to system X would be even better.  The danger in this case lies in assuming that all regulation has to look like Y and neglecting a possibility like X.

What I tried to do in my paper, with comparisons that run from the FAA, to the Army, to OSHA, was to suggest that there are many different ways to implement regulations and that we should consider the costs and benefits of the various alternatives with an open mind.  Economists can all give the familiar theoretical arguments about why unregulated air traffic combined with the right kind of legal liability could achieve the desired level of flight safety. In fact, the experience in the US with legal liability rules for aircraft manufacturers was horrific. The rules that prevailed in the 1970s nearly killed the US light aircraft industry. Moreover, for passenger travel, the revealed preference of policy makers has been to opt for something like the FAA system of regulation over less regulated solutions.

In one notable recent example, in the lead up to the Beijing Olympics, the Chinese government adopted the FAA regulations wholesale, and flight safety improved dramatically. For more detail see Brandon Fuller’s post on China’s air safety overhaul (link).  This episode shows that government officials made a conscious decision to adopt regulation.  It also shows that the regulations do make a difference.  Chinese pilots flying essentially the same planes under different rules now have far fewer fatal crashes.

Posted by Dave Backus for Paul Romer

Today, the U.S. Federal Open Market Committee (FOMC) announced a major update of its framework for setting monetary policy. While the FOMC emphasizes its “dual mandate” (regarding inflation and employment), the new framework is fully consistent with an inflation-targeting central bank.

The key change was the announcement of an agreed quantitative longer-run goal for inflation (2.0% as measured by the annual change of the PCE deflator). A public and quantitative target is the sine qua non of inflation targeting. The new target shows up clearly in the January 2012 summary of economic projections by individual FOMC members. Compared to the November 2011 range of projections for “longer run” PCE inflation of 1.5% to 2.0%, the January projections show only 2.0% (i.e. no range).

In the northwest of Australia is an area the size of Texas called The Kimberly. About 30,000 people live there. It’s a vast, empty, barren and beautiful place. The main town in the eastern Kimberly is Kununurra, south of which lies the massive Lake Arglye created by the Argyle Dam.

Back in the early 1970s, the mining lease for the area south of (what is now) Lake Arglye, Australia, was owned by a South African company. This company engaged some Australia geologists to wander around their lease to see if there were any viable deposits there. The contract specifically engaged them to look for and report any uranium indications.

One of the geologists found some high quality diamonds lying in a creek bed. Being a bit cynical, she figured these had been dropped by her supervising geologists as a test to make sure she was doing her job. Going back to camp that night she told her supervisor that she found the “testers.”

The supervisor had no idea what she was talking about.

Once the confusion was clarified, they all got excited (understandably) and decided to look more carefully. The stones they’d found earlier were not a fluke: they came from an enormous diamond deposit upstream.

Then the fun started. The geology team looked carefully at the exploration contract and confirmed that they were only obliged to tell the South African mining company if they found uranium. So they kept it quiet.

The mining lease had about three years to run. It’s hard to keep a secret for three years. So by the time the lease is almost up, word is out that CRA (the Australian company leading the consortium that the geologists were now working with) had found diamonds somewhere near Kununurra.

The play was to wait for the original mining lease to expire and then snap it up. However, this wouldn’t happen if the mining lease was renewed.

So to trick the South African company, CRA hired every earth mover, and every spare bit of labor and moved them 100km west of Kununurra (the diamonds are south of Kununurra). The South African company went nuts and started buying up land west of Kununarra.

And let the original mining lease lapsed.

Meanwhile, CRA (now Rio Tinto) started the mine and made out like bandits.

For a “traditional” game theorist, this example of deception raises an interesting challenge. If it is commonly known among players what’s at stake, and if it is commonly known that the players are rational, then there exists no Nash equilibrium where the players choose “pure” strategies (that is, strategies that are not chosen randomly). To see why not, consider the following chain of thought: if the SA company expects CRA to deceive, then the SA company should not buy the area where CRA is working on; given this choice by the SA company, CRA is better off working on the diamond mine; but then there is no deception, which makes the SA company’s belief a non-Nash-equilibrium belief.

In order to reconcile theory and empirical observation, game theorists have considered “deception” games in a bounded-rationality setting (that is, assuming that players are not quite as “smart” as a “traditional” game theorist would). A good example is this paper by Ettinger & Jehiel. Still another possible solution is to consider a Nash equilibrium in “mixed strategies,” whereby players randomly choose between different strategies: CRA between deceiving and not deceiving, the SA company between following CRA’s location choice and not doing so. However, the facts from the story don’t seem quite consistent with this view.

The Kununurra example shows how the seemly abstract assumptions of models can really matter in practice. In particular, in this instance, to use economics to explain the strategic interactions between mining companies requires us to push against the very frontier of economic theory. That’s what research is for, after all…

Posted by John Asker and Luis Cabral, with thanks to various Stern colleagues for comments on an earlier draft.