Monday, April 30, 2012

Tim Harford, The Undercover Economist, 2011

This book makes economics fun to read. “Countries that are rich or rapidly growing have embraced the basic lessons of economics we have learned in this book: fight scarcity power and corruption; correct externalities; try to maximise information; get the incentives right; engage with other countries; and most of all embrace markets, which do most of these jobs at the same time.”

“The economist can show that allowing lots of skilled immigrants will help control the gap between skilled and unskilled wages, while allowing unskilled immigrants will do the reverse. What societies and their leaders do with the information is another matter….It is hard to wield the models that underlie such subjects and remain unmoved by the real world behind them. So economists often step beyond their role as engineers of economic policy and become advocates.”

“While the perfectly competitive market is perfectly efficient, efficiency is not enough to ensure a fair society, or even a society in which we would want to live…What we need is a way to make our economies both efficient and fair.”

“Taxes are often higher when price sensitivity is low…If you think that taxes on petrol are motivated by environmental concerns, think again: despite the environmental impacts of air travel, electricity and domestic heating, 90 percent of all “environmental” taxes in the UK in 2009 were paid by motorists.”

“But the old dilemma between efficiency and fairness was about to be shuttered by a young New Yorker called Kenneth Arrow…He proved that not only are all perfect markets efficient, all efficient outcomes can be achieved using a competitive market, by adjusting the starting position.

Reading this book will give you a glimpse how externality charges can help tackle environmental problems or how auctions can be used to run electricity networks; why globalisation is green or free trade is good for most people; why markets speak the truth and why government action is most important at the margin; why rents are high, why second-hand cars tend to be cheap and of poor quality and why health insurance cannot be provided by the private sector alone. Finally, why China has managed to grow while the former Soviet Union did not and why poor countries are poor: "...there is nothing to hold the consequences of ambition or self-interest in check". “Shock therapy” is seldom the best cure.

Harford attempts to explain what went wrong with the banking crisis. His explanation of “rotten eggs and rotten investments” is not very comprehensible but basically he claims that the design of collateralised debt obligations contained mathematical errors that increased, instead of decreasing, the risk to investors and the banks. As a result the Greenspan doctrine was shuttered. “This doctrine held that self-interest was the best guardian of bank’s balance sheets…Mr Greenspan admitted  that he had been wrong. He told Congress, ‘Those of us who have looked to the self–interest of lending institutions to protect shareholder’s equity – myself especially – are in a state of shocked disbelief’.”  That was in October 2008. I wish that the Governor of the Central Bank of Cyprus, Mr Orphanides, took note then. If he did, he might have attempted to limit the blunder of Cypriot Banks to expose themselves to the Greek sovereign debt and the Greek market, to the extend that this is threatening to cause Cyprus a long recession in 2012!

The author points out in his book that bailing out the banks should not necessarily cost the taxpayer any money. “The Treasury even turned a profit, because the banks paid fees for these {government} guarantees Other money was spend injecting capital into the banks; the British government received shares in the banks; this transaction may also make a profit…Pietro Veronesi and Luigi Zingales, two economists at the University of Chicago, studied the effect of the US bailout that saw Treasury Secretary Henry ‘Hank’ Paulson call bank bosses to a meeting on 13 October 2008, shortly after the collapse of Lehman Brothers. Paulson stumped up $125 billion of US taxpayers’ money in exchange for shares in US banks…The treasury also guaranteed new issues of bank debt. Veronesi and Zingales concluded that Paulson’s move cost taxpayers $20 billion-$45 billion…Three weeks before Paulson’s gift, the world’s most successful investor, Warren Buffett, had injected capital into Goldman Sachs, and he had secured more generous terms. Veronesi and Zingales reckon that if Paulson had successfully demanded Buffett’s terms, the taxpayer would have made more than $40 billion, a roughly even split with the Bank’s creditors. The bailout was worth doing. It’s just a shame that Mr. Paulson didn’t drive a harder bargain.”

The book gives an account of the consequences of the banking crisis: “As the banks teetered on the brink of collapse, they tried to suck up as much cash as possible to prevent their bankruptcy…Business suddenly found their access to credit drying up, consumers spent less, feeling the same pressures. Potentially healthy businesses were crushed by the financial turmoil. Andy Haldane reckons the crisis could have lowered the UK’s national income by 10 per cent – and put it on a permanently lower trajectory…It’s because the economy has shrunk so much that taxes must rise and government spending must fall if the government’s books are to balance – not because the government threw money at bailing out the banks.”   

Harford claims that “In the end, economics is about people – something that economists have done a very bad job in explaining. And economic growth is about a better life for individuals – more choice, less fear, less toil and hardship.” I wish he was right. Economics is definitely about understanding people and their behaviour. But I am afraid that, just like in any other profession, there are too many economists employed by special interest groups trying to promote their self-interest without any checks. 

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