47. Oops: things got a little out of hand

Here is how a UBS trader tries to explain how he lost $2.3bln
Everyone is guilty but him; he was just trying to recoup the money for the bank.

45. Fiscal cliff alarm

I have been telling you about the fiscal cliff for some time. Other people are starting to seriously worrying about it. An analysis from Reuters makes an interesting point about the output effects of government purchases and taxes. Until the Great recession, a one dollar of government cuts reduced output by only 50 cents. The reason was that, to stimulate economy, central banks would typically simultaneously lower interest rates. We will talk about in in more details  when we discuss the IS-IC model in chapter 9.
But now interest rates are at or near zero and central banks cannot reduce them. In other words, when the fiscal cliff comes, central banks will not be able to stimulate the economy and a dollar government cut will reduce output by an estimated 0.9-1.7 dollars. The fiscal cliff involved a combination of tax increases and spending cuts of around 4% of US GDP. This means that the US economy, which is predicted to grow at 2% if the cuts are avoided, will shrink significantly.

46. Larry Fink is also worried about the fiscal cliff

At a conference organized by the Economist, the British magazine you should read, Larry Fink said that the fiscal cliff is the biggest problem facing the newly elected president.

Who is Larry Fink? You can read about him in this Vanity Fair article It is long so here is a synopsis. In 1988 he founded an asset management company which is now the largest in the world, managing almost 4 trillion dollars, around 5% of all managed funds.

But, according to Wikipedia, he is not a banker: "Larry Fink flies on commercial airlines.[..] Likewise, according to an interviewer, he takes the train rather than a private jet when he spends time at his 26-acre country estate in North Salem, New York."

44. Civil and criminal cases

In the previous posting, all cases were civil, which means that shareholders will pay and nobody will go to jail.
Insider trading is treated differently. Mr Gupta is an immigrant from India who had a great career.Here is a fragment from Wikipedia: "Gupta is widely regarded as one of the first Indians to successfully break through the glass ceiling, as the first Indian-born CEO of a multinational corporation

43. Again? They will never let us leave in peace

 in Greenwich, CT

And in banking news
1. Bank of America
2. Wells Fargo According to the lawsuit, they have been doing this for 10 years and nobody noticed.
3. They got Bank of America how BofA was forced to pay $2.4billion.

If you are thinking about a career in a growth industry, please skip this one:

“I can’t predict the next scandal,” Mr. Berger said. “But I know that fraud is a growth industry, and so is greed.”

42. Can't We All Be More Like Scandinavians?

A very interesting explanation of inequality is in this article:
Can't We All Be More Like Scandinavians? Asymmetric Growth and Institutions in an Interdependent World"  It is written by some of the best economists - the first author will get a Nobel prize one day.

Here is the abstract:

In an interdependent world, could all countries adopt the same egalitarianism reward structures and institutions? To provide theoretical answers to this question, we develop a simple
model of economic growth in a world in which all countries benefit…t and potentially contribute
to advances in the world technology frontier. A greater gap of incomes between successful and
unsuccessful entrepreneurs (thus greater inequality) increases entrepreneurial effort and hence
a country’s contributions to the world technology frontier. We show that, under plausible assumptions, the world equilibrium is necessarily asymmetric: some countries will opt for a type of
“cutthroat” capitalism that generates greater inequality and more innovation and will become
the technology leaders, while others will free-ride on the cutthroat incentives of the leaders and
choose a more “cuddly”form of capitalism. Paradoxically, those with cuddly reward structures,
though poorer, may have higher welfare than cutthroat capitalists— but in the world equilibrium, it is not a best response for the cutthroat capitalists to switch to a more cuddly form of
capitalism. We also show that domestic constraints from social democratic parties or unions
may be beneficial for a country because they prevent cutthroat capitalism domestically, instead
inducing other countries to play this role.

An explanation in more accessible language:
As is the case with economists, they build a model. The model attempts to explain why some countries have cutthroat capitalism - see the previous posting - and some are more equal (for example Scandinavian countries). Main points:

There are two types of countries. Type A are unequal, with cut-throat capitalism (think US). Type B are more equal, with cuddly capitalism (think Scandinavian countries).

• the bigger the rewards to successful entrepreneurs, the greater is the incentive to innovate. This means that in type A countries there is more innovation.
• in type B countries rewards to successful entrepreneurs are smaller so those countries  innovate less. Instead they adopt innovation from the type A countries. 
• Type B countries are free-riding: they wait until a type A country invents something (which is expensive) and imitate it (which is cheaper).
• Type A countries are technological leaders and so are richer; type B countries are technological followers and so are poorer.
• But type B countries, while poorer, are more equal and so they are better off.

Can anything be done about it? Yes, but it is not a good idea. If type A countries become more like type B countries, world economic progress will slow down and in the long run everyone will be worse off.

Clicking this link will download the article

41. Why they are talking so little about rising inequality

 Over the last 10 years income inequality has been increasing in many countries, especially in the US. This NYT graphics shows the details. Median family income in the US has stagnated since around year 2000 (top panel). The change in median income over a 11-year long period (for example over 2000-2011) was, until 2008, always positive with the exception of a minimal drop in the 1981-82 recession. It has been negative in the last three years (middle panel).

The article discusses the reasons and is worth reading. Here I just provide a list:

• digital revolution= education matters
• education - "US has lost its once-large global lead
• globalization which eliminated a lot of well-paying industrial jobs
• automation - also eliminated a lot of well-paying industrial jobs
• relative decline in earnings of low skilled workers - record earnings gap between college graduates and others; 
• unemployment rates: 11.3% no high school, 8.7% high schoo graduates, 6.5% some college, 4.1% bachelor's degree

 Immigration and minimal wages did not appear to matter much.

But there is another explanation for which the article provides a graphic (bottom panel)
Almost all benefits of economic growth went to the rich (bottom panel). Since 1980: income of the top 0.01% tripled, of the top 0.1% more than doubled, for the top 1% increased by 64%. Median income increased by only 11%.
Of course income is interrelated with the above factors.

Think whether inequality is beneficial or detrimental to the economy. One answer in posting 42.

40. Remeber Thelma and Louise?

You probably do not, because you are too young. It is a 1991 movie directed by Ridley Scott (of the Alien fame). Two women are on a run and they end up, on purpose, driving  towards the Grand Canyon and (spoiler alert!) plunging to their deaths.

Now you will know what politicians mean when they say "we will avoid the Thelma and Louise ending". By the way, the film terminology is popular: the "fiscal clliff tax increases" are called Taxmageddon.

This article discusses the expiry of the payroll tax cut. American workers pay the tax at the  rate of 6.2% of earnings up to $110 000. The tax has been temporarily reduced to 4.2%. Its extension is not likely as neither party has proposed it.

39. 25 years ago markets crashed

In this article the author describes what happened on October 19, 1987 and laments that people have been replaced by dumb computers. In normal times it works well, but when the going gets touch, high frequency traders abandon the market.

Of course we cannot end computerized trading any more than we can end using computers to type.

38. Michael Spence interview

I have just come across an interview with Michael Spence in the Wall Street Journal. It is 12 minutes long. This is the first time I am including video in the blog. Why?

• not because he explained why people  go to university (to signal ability in the job market - Job Market Signaling)
• not because he got a Nobel Prize in Economics (2001)
• not because he was the Dean of the Arts and Science faculty at Harvard and Dean of the Stanford Business School

(I could go on) 

but simply that was he says is very sensible. Enjoy

37. Canadian economy - good

This is from an article on the US economy

36. Central Bank transparency

It used to be that central bankers were very secretive. It stemmed from their desire to be seen as infallible. Reputation of the Central Bank, so the thinking went, required that the bank was never wrong. The best way to make sure you are never wrong is to say nothing.

In recent years central banks became more transparent. The new thinking is that the best working market is a market that is well informed. Providing rationale behind policy decisions, and improving communication in general, is seen as an important tool of monetary policy (Professor Pierre Siklos of WLU has written on this issue extensively; you may want to take a course from him in the future).

Nowadays central banks publish reports which provide insights into their thinking. The also publish minutes from the meetings of the interest - setting body.

Another innovation is disclosing disagreement between the members of the policy - setting body. In the minutes of the October 4, 2012 meeting, the Bank of England reports that "There were some differences of view between members (my underline) about the outlook and the likelihood that further easing in policy would be required"

You can find the report here. The statement cited above is on p. 9.

The Federal Reserve Board held a meeting on the same day. Its report also mentions disagreement. It is more transparent than the Bank of England:it names members who voted for and who voted against.

35. Who do they think they are? Bankers?

Some background. A newspaper belonging to the Rupert Murdoch media empire, News of the World, was a typical tabloid, similar in many respects to the National Enquirer (i.e. not really news, but revelations about important people). Its journalists hacked into phones of various important people to obtain information they later printed. They also paid police for information. Both actions were illegal in British law. When this came out, the CEO of the British arm of the Murdoch Empire, Rebekah Brooks, resigned. She is being prosecuted for her actions related to the affair. Now it turns out that  she got a parting gift of $10mln.

Bottom line - not only bankers do what they can get away with.

Interesting note: Rebekah Brooks joined News of the World as a secretary in 1989 when she was 20. Never finished university.  By 2000 she was the editor. Apparently she was very ambitious. Great career, as long as laws are not broken.

34. Household debt and monetary policy

Monetary policy, as we teach it, is not affected by the level of household debt. Turns out we should be teaching something different. Bank of Canada Governor says the bank may react to the high level of household debt in Canada by raising interest rates.

There is no straightforward way of incorporating household debt into monetary policy. The reason for the statement is the concern that debt is getting too high, creating risks in the economy. As the mandate of the Bank of Canada is to maintain inflation rate around 2%, household debt should not matter. But apparently it does.

What this means is that the Bank of Canada, in its conduct of monetary policy, learned some lessons from the Great Recession (or, more precisely, the prelude to the great recession) and is now going to react to bubbles.

33. Economy - bad

according to OECD chief

• in particular youth unemployment is a problem
• income inequality is the highest in 30 years
• five years after the beginning of the crisis the OECD countries are stuck with low growth and high unemployment.
• growth in the OECD countries will fall in the next year

32. Regulating banks (for EC223)

A big problem that arose from the Great Recession is what to do with large banks. A failure of a large bank (think Lehman Brothers) can cause considerable damage to the world economy. Some banks were deemed too big to fail: their failure would have caused catastrophic damage to the world economy.

What does being "too big to fail" mean? It means that, if such bank runs into problems it will be rescued by the government (as, for example, happened with Citigroup, Nexia and RBC). These banks have therefore an implicit guarantee from the government. This makes them safer than other banks and lowers their cost of capital. If unregulated competition was allowed, these banks would be more profitable and will buy up smaller banks, reducing competition. Eventually, in effect, the taxpayers would provide a blanket guarantee to the banking system.

To prevent that, G20 endorsed proposals to increase supervision and capital requirements of the "too big to fail" banks.  The proposal dealt with the largest banks that were "systematically important" on the world scale.

The article reports that the Basel Committee on Banking Supervision, of which Canada is a member, recommends to extend the regulations to a second tier banks: "domestic systematically important banks". These recommendations will likely cover 5biggest Canadian banks (they may also include the National Bank of Canada which is much smaller than the top five, but is much bigger than any other bank.

31. Household wealth and debt

On Monday Statistics Canada published revised National Balance Sheet accounts. The revision is technical; I will just point out some numbers:

National wealth:  $6 805 billion
Net foreign debt: $   277 billion
National net worth (difference between the two) $6 529 trillion, or about 4 times GDP
National net worth per person: $188 300 (remember it as around $200 000)

Big problem: household debt. It was, as percentage of disposable income:

•   87%   in 1990
• 141%   in 2007 (before the start of the Great Recession
• 162%   in 2011

This is not a big problem at present. Household debt service ratio (debt payments to disposable income) is close to historical lows since the interest rates are low.

But the ratio of debt to net worth increased significantly as the result of the Great Recession:

• from 1990 to 2007 it was between 18.4% and 21%
• from 2008 on it was over 24%.

If, as it is quite likely, the "fiscal cliff" is  not resolved, the US economy will go into a recession next year, dragging us along. In a recession households will "deleverage" (reduce their debt).
Deleveraging takes time and so consumption will be low for a long time, prolonging the recession.

30. Extra! Extra! Chinese exchange rate

set mostly by markets , says the head of China's Central Bank.

This is more politics than anything else: Republicans want to call China a "currency manipulator"; this would involve restrictions of foreign trade.

29. And one more article making a fundamental error

Statistics Canada revised data on labour productivity in the business sector to bring them in line with international standards.The revised data show that Canadian productivity was lower than previously thought.

How much? It is difficult to say since the author confuses levels with rates of growth. Read the following fragment:

"The result means business sector labour productivity was an average of 0.1 per cent lower per year from 1981 to the second quarter of this year."

Big deal, you think. 0.1%, or 1/1000 lower is not much. But in the next sentence he writes: "The largest impact was in the years 1981 to 1990, when productivity growth was revised down by 0.3 per cent per year – to 1 per cent from 1.3 per cent."

So he really means productivity growth. But you would not guess it from what he writes.

You should read the article and find other places where the writing is vague.

Note that the Statistics Canada report is precise in its language: "The combined result of the revisions to gross domestic product (GDP) and hours worked was an average 0.1 percentage point decrease in the annual growth rate of labour productivity in the business sector over the three decades between 1981 and 2011."

How big is the overall correction to productivity? Not very big. (Click on description for chart 4 to see actual data). According to original data, between Q1 1981 and Q2 2012 productivity increased by 49.27%; according to new data, by 48.32%.

So the article is not only misleading but also is about a small change.

28. Support for teaching you mental arithmetics.

Here is an enlargement:

This is from the Business section of the Globe and Mail, May 18, 2006, page B10

27. Support for doing the readings I discuss in class

The Globe and Mail has published a series on higher education. On Saturday it asked:

What’s the one thing every graduating student should know?

Here is one of the answers:

“Every student graduating from college or university should be capable of doing a critical assessment of an article or editorial they read in the newspaper. If they can't do this, how can they be informed and contributing members of their communities and workplaces and how will they be able to make the myriad of informed decisions they will be asked to make throughout their lives?” Harvey Weingarten, president of the Higher Education Quality Council of Ontario

26. On exchange rates

The Economist has published an interesting article on exchange rates.

Treat it as the first test of your understanding of what a good economic publication writes.
It is a difficult test as, so far, we discussed many relevant issues only in the blog, and not in the course.

We will return to this article later in the course

25. Growth in China

is also slowing down

24. IMF thinks growth will be slow for a significant amount of time

IMF chief economist Olivier Blanchard, who will visit Waterloo in November, discussed the IMF report on world economy. IMF is predicting slower growth than it did in July. There is a general feeling of uncertainty and Blanchard is concerned that the slow growth will continue.

23. End of Growth?

As it happens, two well-known authors are coming to Laurier to talk about the end of growth.
Want to know the future? It will cost you ($15).
Suzuki will likely talk about the environment, Rubin is anyone's guess.

22. Growth over?

A prominent economist, Robert Gordon from Northwestern, wrote a paper suggesting growth in the US may be over. By extension, this would also mean the end of growth in other developed countries (but not in China, India and other developing countries).

Economic growth, as we know it, is due to innovation.The paper looks at big waves of innovation (industrial revolutions): IR1 (steam and railroads, 1750-1830), IR2 (electricity, internal combustion engine, running water, indoor toilets, communications, entertainment, chemicals, petroleum, 1870-1900) and IR3 (computers, the web, mobile phones). He argues that the second industrial revolution was most important, and since its effects spread throughout the world (for example cars, air travel, good hygiene) the potential for future innovation is not as high.

He also argues that even if the pace of innovation has not decreased, there are six factors that would slow economic growth in the US in the future. Here is their list, with the contribution, in his opinion, to the slowdown in the rate of economic growth for the bottom 99% of the US population:

Without slowdown - assume that growth continues at the rate of 1.8%, the 1987-2007 average. Note that the Great Recession is not taken into account - rightfully so as it would dominate the numbers. The Great Recession is an unusually severe, one time (hopefully) event and so should not be included in discussion of long-term growth

Slowdown factors and how much they will reduce the growth rate (in percentage points):

1. baby boomer retirement: -0.2%
2. slower progress in educational attainment (it is already very high): - 0.2%
3. rising inequality: - 0.5% (he assumes that income inequality will continue to increase at the the same rate as in the past, lowering growth for the bottom 99%) 
4. globalization: -0.2% (more outsourcing, fewer good middle class jobs)
5. energy prices and environmental costs: - 0.2%
6. effect of high consumer and government debts: -0.3%

After taking all this into account, growth will slow down to 0.2% per year.

Gordon does not say it will happen, nor does he say his estimates are precise. He treats the estimates as a thought-provoking warning.

For Canada, factors 1,2, 4 and environment are similar; inequality has risen slower than in the US; we benefit from higher energy prices since we are an exporter; our consumer debt is higher and government debt is lower. So perhaps the effect on Canadian growth would be smaller, but not much smaller.

This is a long paper which you can download at the university from NBER. For your convenience I copy the abstract below.

If you do not want to read the whole paper, from this address you can download a long summary;
A shorter summary with graphs is here.
A much shorter summary by a well known Financial Times writer (with his opinion) is here.

Robert J. Gordon

NBER Working Paper No. 18315
Issued in August 2012
NBER Program(s):   DAE   EFG   PR

This paper raises basic questions about the process of economic growth. It questions the assumption, nearly universal since Solow’s seminal contributions of the 1950s, that economic growth is a continuous process that will persist forever. There was virtually no growth before 1750, and thus there is no guarantee that growth will continue indefinitely. Rather, the paper suggests that the rapid progress made over the past 250 years could well turn out to be a unique episode in human history. The paper is only about the United States and views the future from 2007 while pretending that the financial crisis did not happen. Its point of departure is growth in per-capita real GDP in the frontier country since 1300, the U.K. until 1906 and the U.S. afterwards. Growth in this frontier gradually accelerated after 1750, reached a peak in the middle of the 20th century, and has been slowing down since. The paper is about “how much further could the frontier growth rate decline?”

The analysis links periods of slow and rapid growth to the timing of the three industrial revolutions (IR’s), that is, IR #1 (steam, railroads) from 1750 to 1830; IR #2 (electricity, internal combustion engine, running water, indoor toilets, communications, entertainment, chemicals, petroleum) from 1870 to 1900; and IR #3 (computers, the web, mobile phones) from 1960 to present. It provides evidence that IR #2 was more important than the others and was largely responsible for 80 years of relatively rapid productivity growth between 1890 and 1972. Once the spin-off inventions from IR #2 (airplanes, air conditioning, interstate highways) had run their course, productivity growth during 1972-96 was much slower than before. In contrast, IR #3 created only a short-lived growth revival between 1996 and 2004. Many of the original and spin-off inventions of IR #2 could happen only once – urbanization, transportation speed, the freedom of females from the drudgery of carrying tons of water per year, and the role of central heating and air conditioning in achieving a year-round constant temperature.

Even if innovation were to continue into the future at the rate of the two decades before 2007, the U.S. faces six headwinds that are in the process of dragging long-term growth to half or less of the 1.9 percent annual rate experienced between 1860 and 2007. These include demography, education, inequality, globalization, energy/environment, and the overhang of consumer and government debt. A provocative “exercise in subtraction” suggests that future growth in consumption per capita for the bottom 99 percent of the income distribution could fall below 0.5 percent per year for an extended period of decades.

21. I do try to use our sources

but the charges were apparently not  worth the Globe's attention (the National Post did, but the article does not provide details). Instead, they chose to reprint a crazy, stupid article from Reuters. The author of the article is worried that current monetary policy is not effective in increasing consumption and suggests that "Instead of printing money to buy bonds, the Fed could print money to give to citizens."  She says that "The suggestion is not as crazy as it might seem."

Indeed, it is much crazier.

Ask yourself the following question: what would happen if the central bank printed money and gave it directly to households? Who will if provide work for?

Answer: the printer. Also the paper maker and the ink producer, as well as the distributors of the cash.
Printing free newspapers will be more effective.

20. Extra! Extra!

JPMorgan Unit Is Sued Over Mortgage Pools

Wow! (but no jail: these are civil suits)

Here is what happened. In 2005-7 the investment bank Bear Stearns sold mortgage-backed securities to investors. The accusation is that "The firms made material misrepresentations about the quality of the loans in the securities [...] and ignored evidence of broad defects among the loans that they pooled and sold to investors".

Another accusation is that they double dipped:  Suit says Bear Stearns double dipped with mortgage bonds . 

Here is how it worked:

1. A loan originator (a bank) would give mortgage to a borrower.

2. Bear Stearns would buy many such mortgages from loan originators, package them into securities and sell them to investors.

3. The purchase contract between Bear Stearns and the loan originator included a clause that, if a mortgage was defaulted within a short time after Bear Stearns bought it, the loan originator would compensate Bearn Stearns for losses.

This makes sense since the loan originator knew the borrower, Bear Stearns did not.

4. And so they did. Bearn Stearns received substantial amounts of compensation. It did not pass it on to investors. They are now suing.

Apparently this was a fairly common practice

Here it is in more familiar terms:

- you buy, say, electronic parts. The sellers promise to pay you a fine if they are defective.

- you sell a box of parts, claiming they are in perfect order.

- the sellers let you know that the parts were, in fact, defective and pay fines.

-  you do not pass on the money to the buyer of the box of parts, but keep them.

So the buyer of box of parts pays you for good parts, and the seller of the parts pays you because they are defective. Your company makes a profit and you get a bonus, and buy yourself a car, much, much better than the one in the familiar song...

Nice deal if you can get it and get away with it.

19. The real wage

Today we will discuss real wages. Here are some data on, well, a student's? real wage

If the link does not work, Google: How long does it take to afford a beer?