Doha Busts...

As many of you have probably heard, trade talks that were being held in Geneva, pushed by the WTO chief Pascal Lamy, and being part of the so-called Doha round, ended quite quickly and without a positive outcome this week. An article in The Economist this weeks talks about why the Doha round has been such a bust. It states that this round has the burden of dealing with the previous Uruguay round's conclusions, where developed countries 'got their way' regarding negotiations about intellectual property and manufactured goods (not a lot though, but at least the subjects were on the table), but developing countries were still unheard when it came to talks about agriculture, which is their main concern. In the Uruguay round, quotas were turned into tariffs, which is what negotiations in Doha are all about. Therefore, developing countries want to have their say this time, and thus, this week, talks ended without interested parties reaching an agreement.

Economically speaking, countries in this negotiation are probably negotiating under the wrong terms. Paul Krugman states in a blog post, interestingly (but correctly, in my opinion), that:

Trade negotiations aren’t driven by economists’ calculations of welfare gains; they’re driven by enlightened mercantilism [...]

Each country is trying to get the most out of these talks, but thinking about what it is best for it from an archaic (and somewhat fruitless) perspective. Each country wants to be able to sell as much as it wants, but wants to be able to restrict its imports in order to give breathing room for its producers. Adam Smith and then David Ricardo made it quite clear quite a while back how trading with other countries is beneficial for all parties involved. Even if countries have to go through some 'creative destruction' (using Schumpeter's terminology), eventually each will be producing those products where each country holds some comparative advantage, and which are what the country is most productive at. Simple economic models, such as the Heckscher-Ohlin model show how such trade can be beneficial if each country specializes in that in which it is productive and uses its resources accordingly. Trade barriers, such as those that were not mitigated during this weeks talk create 'artificial advantages' by making other country's products more expensive in the local market (when tariffs are in place), or by making home products more competitive abroad (by using subsidies). In either case, resources are being wasted.

In these talks it is common to hear mainly producer's viewpoints. Consumers are rarely mentioned, and, in my opinion, this is the group who benefits the most from liberalizing trend. Cheaper products mean that a consumers purchasing power is increased. In addition to this, trade talks can lead to new markets opening up for some producers to sell their products. Just the fact that consumers in these new markets have an extra possibility of adding something new or different to their consumption bundle is a considerable gain. Some say pleasure comes with variety, and a less restricted trade gives this possibility to many consumers worldwide.

Anyway, this is a serious issue because, as Krugman says, we are negotiating based on premises that have long been useless, and as if economics has taught us nothing. Trade is not a zero-sum game, meaning that someone’s gain in NOT someone else’s loss. We can all benefit from less restricted trade, even if that benefit comes from countries coming to grips with reality and realizing that traditional exports are probably not as competitive as they once were and change in production plans need to be undertaken. Although Doha as such is not over, this was a heavy blow. Let's just hope for better outcomes in the next set of talks.

Agency Problems and the Sub-Prime Crisis

I just finished a summer school course at Harvard University and sat for my final exam a few days ago. The course's name is "Organizations, Management Behavior, and Economics", and although the topic was broad, many interesting ideas came up. A question in the final exam asked us basically to think about agency issues in relation to the current subprime crisis. An answer to part of this question seemed quite interesting to post, hence...

In order to address moral hazard or agency issues in two of the proposed levels, a quick introduction to these situations is called for. In the first place, agency issues deal with the fact that there is a separation in the wishes of a person who wants an action done, and the person who actually carries it out. One type of agency problems can be seen as ex-ante information problems (hidden information), where one of the parties carrying out a transaction has more complete information about some part of the transaction and can thus bargain in his favor. The other party, fearing this, might not be willing to negotiate and make cause the transaction to not occur at all, or for there to be adverse selection. Moral hazard, in turn, deals with (ex-post) hidden action. Douma & Schreuder (2002, p. 60), while speaking about moral hazard, say, “[moral hazard] refers to actions that parties in a transaction may take after they have agreed to execute the transaction”. With this in mind, it is possible to identify such problems at some levels of the ongoing sub-prime crisis.

Regarding sub-prime borrowers, moral hazard is bound to happen. Even though there is a label on these borrowers clearly stating that the possibility of repayment on their mortgage loans is not an optimal one, these borrowers started receiving loans at an accelerated rate during the housing market boom in the early and mid 2000s. When these borrowers received their loans, they signed a contract that stated that they would pay back the loans. Some of these borrowers intended to buy a home for their families, others just wanted to get in the real estate game and earn some money once the price of the houses they had purchased started to rise. Moral hazard shows up when these borrowers, once they have received the loan to buy a house for their family, one that would supposedly be off the market due to the fact that someone was going to live there for (presumably) several years, instead bought homes in order to sell them later, eventually flooding the market with an excess supply of houses, pushing the price of their homes down, and thus making the value of other people’s houses fall as well. Moral hazard occurs when these borrowers decided to buy houses for speculation instead of buying them as their homes, as stated in their mortgage contracts. When prices ultimately fell, those people who actually used the money correctly started getting foreclosure letters in their mailboxes. So moral hazard did play a role in the ongoing crises, but this was boosted because loan officers, thanks to agency issues, allowed it to happen.

Loan officers are hired in order to make out loans. That is their job and that is what they are hired to do, and thus why they receive a paycheck. However, the owners of the organization that issues these loans is not only interested in making loans, but making loans that get paid back and thus bring about profits. There is thus an agency issue, where the loan officer is the agent and the owner of the financial (mortgage) organization are the principals. The problem arises because both parties here don’t have the same goals, and the agent does not have sufficient (or well designed) incentives in order to carry out the principal’s will. The loan officer gets paid to issue loans, and thus, during the housing boom, loans were issued to whoever wanted to get them. In addition to this, rising house prices somewhat helped in thinking that the loans would be paid back. This agency problem led loan officers to issue loans that would not be paid to people who were not actually going to spend their money on what they said they would. Both issues thus played and are playing a role in the ongoing subprime crisis.

Even though this topic has been talked about for quite some time now, it still seemed interesting. By the way, summer at Harvard has been amazing!

Site Hits Boost

Due to a recent link to a post on this blog from Greg Mankiw's Blog, page views for it have skyrocketed. That's what some good publicity will do for you (Thanks Dr. Mankiw!). Anyway, I'll try to keep posting up in case anyone found anything here interesting and is expecting more!

Cheers!

Menu Costs and Price Stickiness in Harvard Square Revisited

Check it out:

Greg Mankiw's Blog: Time to Pay the Menu Cost

Greg Mankiw posts the picture of this sign I found in his blog! You can find some of my comments on it on a previous post. Cheers for that! Hahaha....

Menu Costs and Price Stickiness In Harvard Square

While walking around the wonder that is Harvard University and Harvard Square, I came about this sign in a small pizza place. It exemplifies and explains in a concise manner the existence of sticky prices.

Classical theory suggests that prices adjust rather quickly in order to even out supply and demand of products, and that firms act in order to maximize their profits. When input prices rise (thus increasing costs), firms should raise their prices accordingly. Prices should not remain fixed.

This sign seems to agree with new keynesian ideas that prices tend to be sticky. Firms do not wish to change their prices due to things like menu costs. They also don't want to continually change their prices because this might have an adverse effect on costumer satisfaction. This is exactly the case in this situation. However, a time must come where prices tend to change (and rampant world inflation seems to be a just cause for this!). I believe that we can expect the new price to hold for a couple of years though....

It is interesting how even shop signs around Harvard can teach you a thing or two about economics!

Regulation in Financial Markets Today

A recent column by Paul Krugman in the New York Times got me thinking on regulation in financial markets (and markets in general), which ultimately boils down to the discussion between classical laissez-faire and Keynesian interventionist policies.

What makes Krugman also wonder about this is that as the US recessions wanes, it is likely that financial markets will continue to work as they have done in recent times, which is considered to be a likely cause for the US' current problems. There has been some talk about regulation other non-bank financial institutions, and making successive reforms in financial market regulation in order to control newly formed ways of winding around current regulation. However, with the (likely) recession (possibly) coming to a halt, taking the economy on an upward trail, means that the urge for regulation will never come. Should it?

This creation of new financial mechanisms, and generally ways to escape regulation in any market, are due to occur thanks to people's never-ending quest for profit, which is what makes markets the slippery subjects they are. Slippery meaning that regulation does not bode well for them, and thus there will likely be someone who finds a way to bypass regulation (legally or illegally). This is the main argument for non-regulation. Let the market be (laissez-faire), and it will come on its own to some equilibrium where efficiency is at its prime. Regulation will just mess up its inner workings down to the point of inefficiency and undesired allocation of resources. This is generally true, in my opinion, but not in every case. An example of when this is not the case such stands out: Prohibition in the early twentieth century, where regulating alcohol consumption led to moon-shining and black markets for alcohol, which were clearly hazardous for people's health and generally not good for public, since more resources had to go into keeping prohibition in place. However, as it has been discussed in a previous post, what should be done when the actual market outcome is unwanted and undesirable?

Answering this question is difficult because (1) finding a solution to an inefficient outcome is hard to do, and, most importantly, (2) agreeing on what an undesirable outcome is is even harder. The latter obliges people to be subjective and let their emotions take over. Therefore, I will not try to answer such a complicated question, but I will state my own opinion, for the particular case of financial markets today.

Letting the financial market be ultimately gives people a chance to be as creative as possible to play around with its uncountable number of mechanisms in order to obtain a profit. Financial markets are places were fortunes are either made or lost in a blink of an eye. Speculations plays a major role. In my opinion this is not wrong, but has the potential to be disastrous. Looking at the case of the current US slowdown, speculation in the real estate market lead to a bubble that finally burst. This was troublesome, but it was not the main cause of the problem. The bubble occurred in part because people where being lent out money in the financial system in order to buy homes for speculation and not for living in. Furthermore, people who could not a afford such home (sub-prime borrowers) were receiving these loans. Even worse, these loans where used as collateral for the banks to receive loans from people (mortgage backed securities). So, when the bubble burst, people lost their wealth as home prices fell. They couldn't pay there mortgage. Those who has mortgage backed securities lost their wealth as well because the banks could not repay them. So the banks stopped lending money, leading to a credit-crunch. No one wanted to spend, so there is a recession. Looking back, it was the financial market, which is largely unregulated, the epicenter of disaster.

Back in simpler times, Adam Smith though that financial markets should be regulated through the usury rate. What should be done today in modern complex markets when they have the potential of sending the world's must advanced economy in to a spiral of recession? In my opinion, a little more regulation is worth its cost in order to prevent such outcomes. Giving the FED the capacity to overlook both bank and non-bank financial organizations is a good idea. Furthermore, the future is never clear, so some preemptive solutions for troubles that are yet to come must be thought of. As Krugman posits, this opportunity to do something about the current deregulation should not be allowed to slip away.

Its interesting to see how two different markets today are yielding somewhat inefficient outcomes, namely, the world food market, and financial markets in the US. Is Keynesian reasoning becoming useful for world policy-making once again?

Adam Smith and Counter-Productive Markets, Is This the Case Today?

While re-reading a chapter from Amartya Sen's Development as Freedom, when Sen is about to explain that markets are important for development, not only for the productive economic outcomes they yield, but also because of the fact that markets give people the freedom to choose, to make transactions and to exchange freely (which are substantive freedoms that according to Sen must be taken into account in any measure of development), he mentions a case where Adam Smith in his Wealth of Nations actually supports market regulation. So, I turn to the original source to see what this was about.

In Book II, Chapter IV, Paragraphs 14-15 of The Wealth of Nations, Smith talks about the markets for loanable funds (though he uses other terms), and whether or not the usury rate for interest in this market must be controlled. The usury rate is a legal maximum interest that can be charged on these loans. Keep in mind that in this market different interest rates serve as equilibrium prices depending on the conditions and risk of the loan. He is very clear in stating that interest is the rightful payment that a person must receive for forgoing the use of his capital and lending it out to someone else, and, hence, it should be lawful to allow people to charge an interest for lending out their capital (in his time, some countries didn't allow charging interests; i.e. the usury rate was zero). The loans would be placed at the ongoing market interest rate for each loan; riskier loans entail a greater interest rate. Now, the usury rate here plays a role in determining the allocation of capital. Smith explains that if the usury rate is below the lowest market rate (that for the safest loans), no loans will be issued because people don't find it worthwhile to lend their capital, and thus, this capital is not allocated to a productive process as it would have been if it were loaned. If the usury rate is exactly at this lowest rate, potential borrowers who don't have enough collateral (thus making the loan risky), but who are honest and will pay won't receive loans, and once again, capital is not allocated efficiently. So, the usury rate must be higher that the lowest market rate, but how much?

Smith explains that if the usury rate is too high, loans will only be given out to "prodigals and projectors" (speculators in modern terms), since it is only they who are willing to pay high interest rates. A borrower wishing to undertake a productive enterprise will only be willing to pay a part of his profits back as interests. If the rate is too high, taking out the loan is not profitable. Lenders, on the other hand, will prefer to loan their capital to "prodigals and projectors" in order to benefit from the higher returns (I'm guessing eighteenth century Englishmen were not risk-averse...). If this happens, once again, capital is not put to productive uses, but is put instead in the hands of those most likely to waste or misuse it. In this case, the market outcome is counter-productive. Therefore, Smith concludes that the usury rate must be above the lowest market rate, but not very much so. This would cause loans and capital to be allocated to people with plans of starting productive processes, thus yielding a more efficient outcome.

"Prodigals and projectors" have the capacity of creating market bubbles. This is one of the reasons for the United States' current crisis; home prices rose a lot for several years, but it turned out to be s speculative bubble, where people bought homes not to live in but as an "investment", expecting a future return when prices rose. When prices started falling, many people saw the wealth diminish, and lost confidence in the system. Many people had their homes repossessed, a lot of whom had taken out a loan in order to pay for the house they were going to live in. So, speculation caused bad outcomes for those who Smith would deem "honest" borrowers. This was truly a non-efficient market outcome. Furthermore, Paul Krugman in his column in the New York Times yesterday (you might need to sign up to read it), states that one of the possible reasons for rising food prices is commodity speculation. People, expecting higher food prices, make deals on commodity futures, and, as a result of a self-fulfilling prophecy, food prices rise. Would Adam Smith, the father and foremost proponent of free markets say that this inefficient market outcome requires some sort of cap for commodity and property speculation? Maybe so...

Returning to Amartya Sen, I totally agree with both points of view about the importance of markets in development. Markets are the best tool for our disposal for the allocation of resources, as I have stated in a previous post, and they bring about the best opportunities for development in a traditional way. However, looking at development as freedom, the freedom to choose and exchange brought about by markets must be taken into account as part of development (the same market outcome under authoritarian rule would not be as good). However, sometimes markets allocate resources in a counter-productive way for society, and a little intervention or regulation is called for.