Time of markets and time of politics

Krugman's Eurovenn, or notes reading Martin Wollf

Barclay's math says italy's down. Tyler Cowen posted a summary of Barclays Capital Inst sales:

1) At this point, it seems Italy is now mathematically beyond point of no return
2) While reforms are necessary, in and of itself not be enough to prevent crisis
3) Reason? Simple math--growth and austerity not enough to offset cost of debt
4) On our ests, yields above 5.5% is inflection point where game is over
5) The danger:high rates reinforce stability concerns, leading to higher rates
6) and deeper conviction of a self sustaining credit event and eventual default
7) We think decisions at eurozone summit is step forward but EFSF not adequate
8) Time has run out--policy reforms not sufficient to break neg mkt dynamics
9) Investors do not have the patience to wait for austerity, growth to work
10) And rate of change in negatives not enuff to offset slow drip of positives
11) Conclusion: We think ECB needs to step up to the plate, print and buy bonds

12) At the moment ECB remains unwilling to be lender last resort on scale needed

13) But frankly will have hand forced by market given massive systemic risk

Hint:Not Good.Sell EUR, Buy Gold

Bullet point number 8 points at the difference markets' and politics' time. Markets dynamics are on a different time level than politics. It takes longer to reach politically acceptable solutions, and even more longer to build institutions. This crisis speaks about a mismatch between financial systems and institutions and so the intersection between the later and what would be needed to solve the crisis is zero. 

It is NOT about inequality

The mechanisms that make economies create value are not based on equality, but cooperation. These are nicely explained in E.D. Beinhocker's book. Cooperation is crucial to the functioning of institutions (N. Fergusson's killer apps). Yet researchs point that fairness is a necessary element of cooperation. If some players feel the game is rigged, they simply want to end the game. S.F. Brosnan and F.B.M. de Wall showed that capuchin monkeys react the same way too:

Monkeys refused to participate if they witnessed a conspecific obtain a more attractive reward for equal effort, an effect amplified if the partner received such a reward without any effort at all. These reactions support an early evolutionary origin of inequity aversion. [...] People judge fairness based both on the distribution of gains and on the possible alternatives to a given outcome. Capuchin monkeys, too, seem to measure reward in relative terms, comparing their own rewards with those available, and their own efforts with those of others. They respond negatively to previously acceptable rewards if a partner gets a better deal. Although our data cannot elucidate the precise motivations underlying these responses, one possibility is that monkeys, similarly to humans, are guided by social emotions. These emotions, known as ‘passions’ by econom- ists, guide human reactions to the efforts, gains, losses and attitudes of others. Clearly if these reactions evolved to promote long- term human cooperation, they may exist in other animals as well.

Islamic finance watch

A good explanation of what a sukuk is provided by the Economist: 

A sukuk is structured to avoid the Islamic prohibition on interest payments. It manages this by paying bondholders with the cashflows generated by specific assets, which are put into a special-purpose vehicle (SPV) as part of the deal. Many seem to have thought that the bonds were “asset-backed”, giving them a claim on the assets in the event of a default. Most sukuk, however, are “asset-based”, handing investors ownership of the cashflows but not of the assets themselves. “Many sukuk holders have a perception that they hold a security that is collateralised,” says Anouar Hassoune of Moody’s, a rating agency. “In 90% of cases, that is incorrect.”

If the lionization of firms is unhelpful, how about gazelisation ?

The Mighty Middle by GOOD infographics

There has been a wave of skepticism against small firms. Charles Kenny exposes why support for SMEs in developed economies is not beneficial to the economy as a whole (but beneficial to politicians). Felix Salmon argues that lionizing small business is unhelpful. James Surowiecki compares the growth rate of different developed economies with more of less percentage of small firms:

The developed countries with the highest percentage of workers employed by small businesses include Greece, Portugal, Spain, and Italy—that is, the four countries whose economic woes are wreaking such havoc on financial markets. Meanwhile, the countries with the lowest percentage of workers employed by small businesses are Germany, Sweden, Denmark, and the U.S.—some of the strongest economies in the world.

These articles deserve a few comment. First, the debate over firm's size and growth started with D. Birch claiming that small firms generated a large share of net job creation. The literature on SMEs (here's an excellent review of it by Henrekson) and job generation separates now between "elephants" (large companies), "mices" (small one that tend to stay small) and "gazelles"(not nessarily small but fast growing). So it is not simply Big versus Small.  Second, the lacking component of this debate is the link with entrepreneurship. The praise of SMEs is attached to the notion developed economies have of it. Whereas a classification of firm's size is fixed in time, entrepreneurship as a concept captures a process. The benefits or disadvantages of small firms don't come exclusive from it size, but how the size relates to entrepreneurship and innovation, and the of "population" of firms. Perspectives from evolutionary economics would enrich the debate. Big is not necessarily better in evolutionary economics and you adaptive efficiency has to be taken into account. By te same token, as this study from Badudenko shows, reaching an optimal scale of production can be more important than technical efficiency.

Risky jobs

According to Carney,  the "too big to fail" debate should unite both side, up against the big banks, because they: 

have rigged the game so that they profit without creating value. In fact, they profit from activities that weaken the economy by creating instability. Today, big banks give capitalism a bad name. Believers in the free market should stop giving banks cover.

Unfortunately these story are all too often very simplistic. These lines of argument overlook the fact that today's unstable situation is the result of a long process of financial deregulation. The end of the Bretton Woods system meant companies had to cope with floating exchange rate and banks responded by providing risk management instruments. They have rigged the game because the rules have slowly changed. Some players now (high frequency traders for example) benefit from risks. In fact it has become their risky job to cope with uncertainty.  Whether or not that deters financial systems to carry on the main function they are supposed to fulfill - the efficient allocation of capital - is a question political economy. Arguing over the size of banks and trying to regulate it will be a useless debate unless we rethink the function of financial systems too.

New Economic Thinking

The Institute for New Economic Thinking attributed recently three grants demonstrating the linkages between finance and real economy. The interview of G. Epstein, who advanced the concept of financialization and  J. Crotty here:

They build on James Tobin's concept of functional efficiency to separate the financial sector's beneficial activities (mobilizing savings, financing investment, and reducing risk) from its socially inefficient activities (gambling, and distorting the political process).

K. Pistor's work on "law and finance" and how law is underconceptualized and W. Lazonick's on how finance might harm innovation (echoing Levenstein's study) are also recognized as fresh economic thinking. The questions these scholars ask are essential if economics is to regain its scientific added value. The fact that an institute has to name that "new thinking" - where in fact, it is just "thinking" is telling about the relationship between the dominant ideology and its critics in economics fields.

Theories and reality

A lively debate with a methodenstreit flavour about economics and its relationship with reality kicked off by John Kay's paper for Inet. Inet sent Kay's paper to some economists with the opportunity to respond. Their blog received plenty of it. The debate is timely for Christopher Sims and Thomas Sargent just won the Nobel Prize in Economics for their "empirical research on cause and effect in the macroeconomy". To put it crudely,  on how best finding macroeconomic things out ! Finding things out always implies having a map. The problem is which form this map should take.