Monday April 27, 2015
The Trans-Pacific Partnership and How Economists View Trade
A huge brawl is looming in Congress over the Trans-Pacific Partnership, a huge trade deal that would reduce trade barriers like tariffs with 11 other countries around the Pacific region. These 12 countries collectively make up about 40% of global economic output, and though a fair number of free trade agreements already exist between several of the countries, a deal of this magnitude would be a significant change to the contours of the global economy. In the United States, controversy and conspiracy theories have dogged the TPP, and many (most?) congressional Democrats appear to oppose or lean in opposition to the deal.
In polls, support for the general concept of free trade seems to run fairly high among the US population (perhaps around 60%, although numbers vary depending on the phrasing of the question). Among economists, the issue is one of the few where economists actually manage to agree on something, with consistently over 90% of economists polled consistently favoring free trade. Heads of the President’s Council of Economic Advisers going back to the Gerald Ford administration (and including every administration in between) have signed an open letter supporting the TPP. Given the field’s public reputation for lack of consensus on even basic concepts, this is pretty incredible. On an issue which falls neatly under the domain of economics and economists have a united front, why is the bill not seen as a no-brainer?
Part of the answer may come from perceptions that negotiations over the bill were conducted in secret. The bigger issue, and one that came up a great deal in NAFTA negotiations, is the perception that trade deals hurt American workers at the expense of big corporations.On that point, economists would generally point to the “law” of comparative advantage, a basic axiom that allowing specialization increases total welfare. Free trade does not increase welfare equally, but in the aggregate, it is a net social benefit. However, the benefits from the trade deals (lower prices than prices that would have existed had the deal not been passed) are much less visible than, say, a closed factory, and so the abstract case for free trade looks out-of-touch by comparison. Policies like increased investment in displaced workers like subsidies for retraining programs can alleviate the equity concerns. But at the end of the day, given a world with the deal in place vs. a world in which the only difference is that the deal failed, economists present a united front on preferring the former.
Monday April 20, 2015
Financialization Part II
Last week, I talked about the trend in developed nations over the past few decades for finance to take up an ever-larger proportion of GDP. I think this is one of the most under-reported issues in modern economics, and I’d like to go over some perspectives on it.
Finance does not provide a physical product from which people derive utility. It serves the function of connecting owners of capital (investment) to people need capital (investment). A properly functioning financial system, in a world of imperfect information, is crucial to the proper functioning of a market economy. A random person, with his or her own life to look after, does not have the time to scour the entire global economy to investment opportunities to earn returns beyond just putting their savings in their basement. Banks take this money as deposits and find investments that earn returns. This has the effect of smoothing consumption across time (i.e. when buying a house, you don’t have to somehow have $200,000 on hand- you can pay a down payment and take on a mortgage) and enabling reams of economics activity that would otherwise not be possible.
However, intuitively, there are questions of how much such activity can scale before it becomes harmful. If a car company sells more and more cars because more and more people want to buy cars, under standard economic theory, that is just a reflection of people’s preferences and shouldn’t be messed with (we should add a carbon tax for the gas emissions, but that’s another article entirely). But what about credit? After a certain point, too much credit is actually harmful. In the lead-up to the financial crisis, extension of too much credit to people who were unable to pay back their mortgage loans caused a massive financial crisis. Really, the word ‘credit’ is a nicer way of saying ‘access to debt’, and once we think of much of finance being about providing access to debt, the issue of diminishing social returns (and negative returns) becomes clearer.
The issue of privatized gains and socialized losses is even more damning- when banks profit, they make money, but if they lose sufficient amounts of money, they get access to all sorts of bailout provisions. Despite the anger over the billions and billions of dolars in bailouts, really, the US, or any other country, has no option but to bail banks out if the harm from the banks’ collapse will do tremendous damage to the wider economy. In 2008, the US (and, given the US’s reach, the world) economy was only a couple weeks from perhaps-unprecedented collapse. Financial institutions of sufficient size or reach into other institutions, like the hedge fund Long-Term Capital Management in the 90s, create significant negative externalities that are not priced in, extracting social rents.
One last major issue is the efficient market hypothesis, and its implications for much of the active management industry. The (semi-strong) efficient market hypothesis, one of the most misunderstood concepts in finance, means that, generally speaking, markets do a sufficiently good job at incorporating public information into prices that it is essentially impossible to beat the market over the long run. For example, when new information that is relevant to the stock price of a company (ex. a discovery of a new oil deposit may be relevant to the future performance of Exxon) becomes public, profit-maximizing investors will take this information into account and the price of affected companies will change because people shift their picks around in response to the new information. Over the long run, in markets where a lot of people are paying attention, if you are trying to beat the market by picking individual stocks, you are betting that your opinions about future performance are better than the aggregate opinion of all others who are also betting on stocks. Decades of studies have shown that this is extremely difficult over a long horizon (less than 1% of funds consistently beat the market over 20 years). And, because of the extra fees active money managers charge, generally, putting your money in the hands of active managers will get you less money over the long haul than putting your money in a simple index fund that tracks the market (Burton Malkiel’s famous book A Random Walk Down Wall Street is an excellent read on the subject). Much of the returns to “top” managers may be simply due to luck, and this is inefficiently allocated capital. After all, alpha (returns above market) by definition sum to 0- the amount of money made by outperformance of the market must be netted by underperformance of the market, and to have so much money go intoa zero-sum game seems very questionable.
There are many other critiques that can be made of the financial sector, but I felt I should include a view, espoused by University of Chicago economist John Cochrane (his post is in the Sources), that we should not leap to say that modern finance has become too big. Cochrane argues that there is alpha out there to chase and that people are simply acting rationally to pursue it, that the best tool economists have of looking at what the optimal size of an industry is is the market itself, and that the amount of resources devoted to finance is in part just a function of the fact that proper price discovery is really hard. Demand for finance has clearly shifted out in the past few decades, and what we’re seeing is a natural response. I would say that it does not seem immediately intuitive to me why (as finance has increased as a % of GDP) demand for finance has shifted out much more than demand for other things, especially given that the economies of scale in finance are so easy to handle (just look at Vanguard, an index fund investing firm, which only needs a few thousand people to service its accounts. It’s not like adding accounts means that so many more people need to be hired). The issue of inefficient size (as well as regulatory capture and lobbying) that allows for the propping-up of an entire industry is, however, something that is new. Finance is extremely complicated, but there is a great deal of evidence to indicate that there’s a lot of fat to trim.
Sources/Further Reading if you’re interested: