David Gerard

Author: David Gerard

Review of The Big Short in the JEL

Yale economist Gary Gorton reviews Michael Lewis’s The Big Short and Gregory Zuckerman’s The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History in the latest Journal of Economic Literature.

Here’s how Gorton describes the books:

Their take is that a small band of wacky outsider characters were able to see the coming crash and profit from it, while greedy, corrupt, Wall Street types were not (p. 450).

Indeed, that sounds about right.  Gorton gives the authors credit for telling lively stories and for laying out the mechanics of financial markets that enabled the disaster.  Yet, a major puzzle remains:

[The widespread view is] that subprime vintages prior to 2006 were much safer; it was supported by the data… But, when the crisis came, there was no distinction between pre- and post-2006 vintages. Everything went down in value, including bonds linked to the earlier subprime vintages! Moreover, bonds completely unrelated to subprime risk, like triple-A bonds linked to credit card receivables, auto loans—everything went down in value! (p. 453).

In other words, we still don’t really understand what caused the crisis.

You should get to know the Journal of Economic Literature (JEL).  As the name suggests, the JEL provides literature reviews and book reviews that characterize and evaluate major strands of the economics literature (in addition to classifying pretty much everything in the profession.  Hence the  JEL classification codes).

My brief review of The Big Short is here, and our posts are Michael Lewis’s work are here

The Pope’s Children Revisited

“Economists festivals tend to be so po-faced, so bitchy"

In the wake of Michael Lewis’s recent piece, Professor Galambos reminds me of the excellent “In Search of the Pope’s Children” from 2006.   If you have read the piece on Germany, you might take a look at the first 15 minutes of part 3, which is amazingly prescient given this was done five years ago (like Lewis, McWilliams also invokes a prostitution metaphor to dissect the situation).   The piece also melds well with Lewis’s piece on Ireland.

Of more recent vintage, McWilliams is the author of The Generation Game and Follow the Money, and also launched a comedy tour dedicated to mocking Irish bankers.

Here’s more on the cheeky McWilliams.

Dividing the Pie — Made in China, Sold in the U.S.

This just across the Marginal Revolution wire, via the Federal Reserve Bank of San Francisco, is an estimate of who gets what piece of products made in China:

Goods and services from China accounted for only 2.7% of U.S. personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to U.S. businesses and workers transporting, selling, and marketing goods carrying the “Made in China” label.

So who gets what?

Table 1 shows that, of the 11.5% of U.S. consumer spending that goes for goods and services produced abroad, 7.3% reflects the cost of imports. The remaining 4.2% goes for U.S. transportation, wholesale, and retail activities. Thus, 36% of the price U.S. consumers pay for imported goods actually goes to U.S. companies and workers.

That’s a potentially interesting figure that suggests something we probably all know intuitively — that the firm that makes something isn’t necessarily the same firm that captures the value from its sale.

Last year I poked around for information like this when we were looking at what went into the price of shoes and found Rodrige, Comtois, & Slack’s breakdown in The Geography of Transport Systems.They split up the “cost of a $100 shoe made in China” (click to expand) to the various factors of production, and provide an  explanation here.

The analysis suggests that a $100 shoe has about $12 worth of labor and materials in it, almost none of that paid to labor ($0.40). I assume “profit” goes to the corporation (e.g., Nike, Earth Soles) and the “retailer” percentage includes both retailer costs and retailer profits.

Here’s an important point — the difference between Walmart and Footlocker for a given pair of shoes would probably come out of that 50% retailer percentage. Lower rent, lower personnel costs, lower profit per unit. So where does the difference in shoe quality come from? It seems to me it comes out of that $12 in labor and materials.

Do you see what I mean? If a typical $100 pair of shoes has $12 of parts and labor, then how much does a typical $37.50 pair of shoes have in terms of parts and labor? Somewhere between $0 and $12, I suspect. For the sake of argument, let’s say you could cut those by 25% to $9. That suggests Walmart could offer the same quality shoe (that is, a $12 shoe) by bumping the price up by $3 to $40.50…

Why can China produce at such low “costs”? The chart at the right shows the figures for manufacturing generally — 40% of the cost advantage stems from lower labor costs. My intuition was that labor costs were a major portion of the product costs, but that was incorrect. It is, however, a substantial source of the lower costs. So, to illustrate this point, suppose Indonesia could assemble these shoes for $12.50 — $0.50 more. Of the $0.50 Chinese cost advantage, 40% ($0.20) would be due to lower labor costs.

I would guess that the cost advantage is nowhere in the neighborhood of $0.50. If China produces 8 billion pairs of shoes annually (16 billion total shoes), then a penny per unit in labor savings is $80 million into someone’s pocket. An $0.08 labor cost advantage translates into well over a half billion dollars.

And here’s the iPod for comparison.

Of course, the lesson from the Fed and from Rodrige et al. is that the total amount paid for imported goods is not the same as the amount actually being paid to the country of origin.

English Major Downgrades U.S. Credit Rating

Sam Tanenhaus is the editor of the New York Times Book Review, and he, unsurprisingly, majored in English literature.  His old buddy, John Chambers, is the chairman of S&P’s sovereign rating committee, and Chambers, (perhaps) surprisingly, also majored in English literature. The two were friends at Grinnell College back in the day, and Tanenhaus takes time out to tell us about it at Slate.com.

For those of you completely uninterested in world affairs, Chambers has been making news because the S&P recently lowered America’s credit rating from AAA to AA+, causing something of a stir in world financial markets.

The article only hints at how Chambers got from Grinnell to Wall Street.  Instead, Tanenhaus gives us a taste of spending time in the cornfields of Iowa, the midwestern psyche, and the joys of hashing out the intricacies of Proust.  He then concludes with a more general meditation on the liberal arts:

John has told me the most important thing Grinnell taught him was how to write a well-argued paper. He learned his lesson well. The S&P report, whatever one thinks of its conclusions, is a model of clarity. Even an English major like me has no trouble making sense of the following: “The effectiveness, stability, and predictability of American policy-making and political institutions have weakened at a time of ongoing fiscal and economic challenges.” Or: “The fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

So keep that in mind next time you worry about whether you have the “right” major (or majors).  Clothes don’t make the man.

Add Germany to the List

Michael Lewis continues his Vanity Fair series with a rather disturbing article — disturbing on many levels — about Germany and the world financial crisis: “It’s the Economy, Dummkopf!”

Tyler Cowen at Marginal Revolution calls the piece ” funny, one-sided, slightly offensive, somewhat true.”

I agree with everything except the “slightly” part.  Not for the faint of heart.

ADDENDUM: Walter Russell Mead weighs in.  Paul Krugman expresses some optimism.  Follow his blog for much, much more on the nuts-and-bolts of what’s going on.

Some Non-Random Investment Advice

So, the Dow is down 635 Monday, then up 430 Tuesday, then down 520 again Wednesday?  What’s a member of the investor class to do?  Should I go bargain hunting and drop my kids’ college funds into Sears stock?  Is it time to buy gold? Or should I get out of the market all together and just park my cash in a bank somewhere?  (Are banks really charging to hold money now?)

Burton Malkiel, author of the extraordinarily influential A Random Walk Down Wall Street, advises you to take a deep breath and let it ride. Here he is in the Wall Street Journal:

My advice for investors is to stay the course. No one has ever become rich by being a long-term bear on the fortunes of the United States, and I doubt that anyone will do so in the future. This is still the most flexible and innovative economy in the world. Indeed, it is in times like this that investors should consider rebalancing their portfolios.  If increases in bond prices and declines in equities have produced an asset allocation that is heavier in fixed income than is appropriate, given your time horizon and tolerance for risk, then sell some bonds and buy stocks. Years from now you will be glad you did.

This is hardly a surprising message coming from Malkiel, who tirelessly points out that index funds routinely outperform professionally managed portfolios.  Indeed, I would say that the median economist believes this to be true. If you haven’t read him yet, you should think about picking up a copy of his book and getting to know it a little bit.

For more on the epic market volatility, check out the always-awesome Political Calculations blog.

Meet your textbook author, Jonathan Gruber

It’s time again for us to profile one of our favorite textbook authors, today featuring Jonathan Gruber of Public Finance and Public Policy fame — the text from Econ 271 last term.  I certainly endorse everything about the book aside from the $200 price tag, and Alex Tabarrok calls this one of the best textbooks ever.  If you don’t want to wait around for me to teach 271 again, you can go straight to the source through MIT’s open courseware program.

As I pointed out in class a few dozen times, Gruber is a big deal in health economics, and Slate.com has a nice profile as part of its “most innovative and practical thinkers of our time” series. The dog bites man here is that Gruber has his hands both in Massachusetts health care reform (Romneycare), as well in the recent federal health care legislation (Obamacare).   Slate’s contrarian instincts find the potential 2012 presidential showdown between Romney and Obama too delicious a prospect to pass up.

Hi Guys!

Also included is an interview with Professor Gruber, along with a preview of the forthcoming health economics comic book, er, graphic novel.  Wow.

Perhaps it is different this time

On my daily rounds of the econosphere, including Professor Finkler’s post here, I note that Ken Rogoff’s Project Syndicate post is getting a lot of traction.

A perusal of the NYT website shows Rogoff here on the USA credit downgrade:

Europe’s plan was to have growth fix the problem. America’s plan was to have growth fix the problem. And that’s not going to work… I think it’s really starting to sink in that we’re not anywhere near an endgame.

And NYT columnist Thomas Friedman cites Rogoff here:

Why is everyone still referring to the recent financial crisis as the ‘Great Recession?’ … The phrase ‘Great Recession’ creates the impression that the economy is following the contours of a typical recession, only more severe — something like a really bad cold. … But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation. … In a conventional recession the resumption of growth implies a reasonably brisk return to normalcy. The economy not only regains its lost ground, but, within a year, it typically catches up to its rising long-run trend. The aftermath of a typical deep financial crisis is something completely different. … It typically takes an economy more than four years just to reach the same per capita income level that it had attained at its pre-crisis peak. … Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a ‘Great Recession.’ But, in a ‘Great Contraction,’ problem No. 1 is too much debt.

As for economists, Tyler Cowen thinks Rogoff’s contributions have legs:

I don’t expect anyone to change their mind at this point, but the “we should have had a much bigger stimulus” argument is unlikely to go down in intellectual history as the correct view.  Instead, Ken Rogoff and Scott Sumner are likely to go down as the prophets of our times.  We needed a big dose of inflation, promptly, right after the downturn.  Repeat and rinse as necessary.  But voters hate inflation and, collectively, we proved to be cowards.  Too bad.

And Peter Klein also cites Rogoff favorably, though Klein conditions his response with respect to what he believes should be the central implication:

The main point is that a recession like the present one is structural, and has nothing do with shibboleths like “insufficient aggregate demand.” I wish Rogoff (here or in his important book with Carmen Reinhart) talked about credit expansion as the source of structural, sectoral imbalances that generate macroeconomic crises.

It’s almost enough to make you want to pick up the vaunted Reinhart and Rogoff book.

UPDATE: Rogoff in the Financial Times

The Triumph of Ed Glaeser

You know you’ve hit the big time as an economist when the Appleton Public Library starts featuring your stuff.   Those of you who follow the LU blog have probably heard of Ed Glaeser and his recent book, The Triumph of the City. And now, readers of the Appleton Post Crescent have as well, with Bill Coan featuring Glaeser in his discussion of the impact of local libraries.

For those of you who missed it, here’s Glaeser talking about his book at one of our more trusted news outlets.

Is Time on Professor Finkler’s Side?

As you may have noticed, Professor Finkler and I are both keeping one eye on the doings in Washington, with the likes of Summers and Roberts weighing in on the deal.  To add to that lineup, Time Magazine has another five economists weigh in on the debt deal, including LU Econ Blog faves Alex Tabarrok and Simon Johnson.

It’s too bad we don’t have a macro course going on right now.

Economists Weigh in on Debt Deal

Former White House economist, Larry Summers, gives his take on the debt deal, concluding that it “solves the wrong problem.”  These seem to be the takeaway points:

Despite claims of spending reductions in the $1 trillion range, the actual agreements reached so far likely will have little impact on actual spending over the next decade.   The deal confirms the very low levels of spending already negotiated for 2011 and 2012, and caps 2013 spending about where most would have expected this Congress to end up.  Beyond that outcomes are anyone’s guess—the reality is that Congress votes discretionary spending  annually and the current Congress cannot effectively constrain future actions…

Remarkably for a matter so consequential the agreement that the Supercommittee will seek to reduce the deficit by $1.5 trillion comes without any agreement on what the baseline is from which the $1.5 trillion is to be subtracted.  Is the $1.5 trillion from a baseline that includes or excludes the Bush tax cuts? Includes or excludes tax extenders and the annual AMT fix?

Reuters also provides some space for alternate viewpoints, including those of Cafe Hayek bloggers Russ Roberts and Don Boudreaux.  Roberts doesn’t seem to buy Summers’ claim that spending is “low” this year:

Spending in 2011 is estimated to come in at $3.8 trillion or just over 25 percent of GDP. That’s the highest ratio since 1945 — in 2005, the ratio was under 20%. Calling $3.8 trillion dollars “very low” is very hard to understand, unless you see a crying need for an even larger number…

What does it matter? As regular readers probably know, Roberts is in Hayek’s corner in the Keynes v. Hayek dust up, with Summers in the Keynesian corner. Hence, there is some disagreement as to what’s likely to happen here:

And that brings us to the essence of Summers’ worldview… The key problem, says Summers, isn’t that we spend too much, it’s that we spend too little to reduce the unacceptably high level of unemployment. According to Summers, growth is driven by aggregate demand and aggregate demand is driven by government spending. What is the evidence that increases in government spending lead to growth? Very little, unfortunately…

We’ve plowed this ground before.

Schumpeter a Marxist? “Not so fast,” says Galambos

Nathan Rosenberg explicates Schumpeter’s Marxist proclivities in the most recent issue of Industrial and Corporate Change.

Was Schumpeter a Marxist?

Abstract: This article explores the degree to which Joseph Schumpeter may be regarded as a follower of Karl Marx. It argues that Schumpeter and Marx shared a common vision, including agreement on the growth in the size of the firm and in industrial concentration, the inherent instability of capitalism and the inevitability of “crises”, and the eventual destruction of capitalist institutions and the arrival of a socialist form of economic organization as a result of the working out of the internal logic of capitalist evolution. Schumpeter’s main qualification is his insistence upon the importance of temporal lags, i.e., social forms that persist after they have lost their economic rationale, and he suggests that the essence of capitalism lies in the inevitable tendency of that system to depart from equilibrium. The article emphasizes the continuing importance of economic history for economics.

In one of the two responses to Rosenberg’s piece, Louis Galambos doesn’t think the shoe fits:

Was Schumpeter a Marxist? My own answer is “No.” Why? Because I have a simple standard for judging who is in and who is out when Marx is the subject. To be a Marxist, I think you need to use the labor theory of value; you need to use social classes as a central element in your theory; and you need to believe that the end point of capitalist development is the inevitable economic collapse of a system that cannot sustain itself even with desperate political and military measures.

Since Schumpeter did not use the labor theory of value, did not employ social classes as a central element in his grand theory, and certainly did not see economic collapse as the end point of capitalism, he cannot be a Marxist.

Each of these is available through The Mudd via the campus IP address.  Those of you who slogged through Capitalism, Socialism, and Democracy should find these very illuminating reads, indeed.

Sustainable China Initiative

Speaking of web interviews, check out Professor Finkler talking about the Henry Luce Foundation grant for the Sustainable China initiative.  A fluid speaker, indeed.

You can get the full story on the Lawrence homepage.  The initiative includes this fall term’s Econ 209, Water, Politics, and Economic Development, which includes a trek to China in December.

Interview with Vernon Smith

Last week I had a discussion with Professor Azzi about the classic piece, “Market contestability in the presence of sunk (entry) costs,” where Vernon Smith and his colleagues examine the dynamics of market structure.  They find that even with the same initial conditions, an industry sometimes winds up competitive and sometimes winds up characterized by market power, a finding that we may well flesh out in IO this fall.

With that in mind, I was pleased to see a link to a ReasonTV.com video interview with Smith making the rounds on the econ blogosphere.  In the interview Smith — the pioneer of “experimental” economics — talks about how asset bubbles show up in the lab whether you want them to or not, and his assessment of the government’s bailout of many homeowners:

Forgiving debt is not a good idea, but you have to realize that we don’t face any good options. If it hadn’t been done, the banking system would likely have collapsed.

Aside from that note, Smith also touches upon the marginal revolution, The Theory of Moral Sentiments, and growing up through the Great Depression.  An interesting half hour all around.

I recall seeing him speak about the troubled state of electricity regulation a few years back, where he said something to the effect of: “the regulators’ solution is to set average revenues equal to average costs, and it’s this sort of average thinking that got us into this mess.”

Great line!

On the Brink

There has been much consternation these past few weeks about the federal budget and the debt ceiling, with the possibility that the ratings agencies could downgrade the U.S. credit rating.    While some cheer the possibility of a U.S. default as a necessary step to reign in spending, MIT economist Simon Johnson writes that such a default would yield rather unhappy consequences.

A government default would destroy the credit system as we know it. The fundamental benchmark interest rates in modern financial markets are the so-called risk-free rates on government bonds. Removing this pillar of the system—or creating a high degree of risk around U.S. Treasurys—would disrupt many private contracts and all kinds of transactions.

The result would be capital flight—but to where? Many banks would have a similar problem: A collapse in U.S. Treasury prices (the counterpart of higher interest rates, as bond prices and interest rates move in opposite directions) would destroy their balance sheets. There is no company in the United States that would be unaffected by a government default—and no bank or other financial institution that could provide a secure haven for savings. There would be a massive run into cash, on an order not seen since the Great Depression, with long lines of people at ATMs and teller windows withdrawing as much as possible.

Yikes.

But that’s not all:

Private credit, moreover, would disappear from the U.S. economic system, confronting the Federal Reserve with an unpleasant choice. Either it could step in and provide an enormous amount of credit directly to households and firms (much like Gosbank, the Soviet Union’s central bank), or it could stand by idly while GDP fell 20 to 30 percent—the magnitude of decline that we have seen in modern economies when credit suddenly dries up.

With the private sector in free fall, consumption and investment would decline sharply. America’s ability to export would also be undermined, because foreign markets would likely be affected, and because, in any case, if export firms cannot get credit, they most likely cannot produce.

Not exactly a rosy picture.

“The closer you look, the worse it gets”

The economic situation in Greece is downright gruesome, and I have to wonder how bad the social unrest is to become there.  The principal source of my pessimism is a piece from last October where Michael Lewis essentially argues that the situation is hopeless:

But beyond a $1.2 trillion debt (roughly a quarter-million dollars for each working adult), there is a more frightening deficit. After systematically looting their own treasury, in a breathtaking binge of tax evasion, bribery, and creative accounting spurred on by Goldman Sachs, Greeks are sure of one thing: they can’t trust their fellow Greeks.

I saw a couple of updates to that unhappy picture this week.  First up, James Surowiecki in the New Yorker gives an accounting of Greece’s rampant tax evasion, a point Lewis also makes rather starkly. Indeed, the Surowiecki piece reads like an Executive Summary of Lewis’s article, with each arguing that the social and cultural aspects in Greece are broken and are effectively impossible to fix.

The second piece is from Tyler Cowen in the New York Times, where he argues that the situation is pretty dire even without factoring in the social difficulties of implementing meaningful policy reform. Cowen’s piece discusses some of the difficult choices facing the EU, and reminds us that lurking in the background are the potentially large problems of EU members from Italy to Portugal to Spain.  Cowen doesn’t have much hope, concluding that “There’s a lot of news on the way, but probably very little of it will be good.”

Well, enjoy your weekend!

Is China’s Capacity Too Big Not to Fail?

I was having a discussion with one of my colleagues about Chinese economic growth prospects, and I invoked this Nouriel Roubini (a.k.a., Dr. Doom) piece, “China’s Bad Growth Bet.”  The basic argument is that China is overcapitalized and this will lead to problems:

China has grown for the last few decades on the back of export-led industrialization and a weak currency, which have resulted in high corporate and household savings rates and reliance on net exports and fixed investment (infrastructure, real estate, and industrial capacity for import-competing and export sectors). When net exports collapsed in 2008-2009 from 11% of GDP to 5%, China’s leader reacted by further increasing the fixed-investment share of GDP from 42% to 47%.

Thus, China did not suffer a severe recession – as occurred in Japan, Germany, and elsewhere in emerging Asia in 2009 – only because fixed investment exploded. And the fixed-investment share of GDP has increased further in 2010-2011, to almost 50%.

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Continue reading Is China’s Capacity Too Big Not to Fail?

Streaming Profitability

The Atlantic Monthly pauses from its Ideas Report to try to explain why Netflix is so successful. Here’s the gist:

An Oldie but Goodie

In fact, the dirty little secret of the media industry is that content aggregators, not content creators, have long been the overwhelming source of value creation…

The economic structure of the media business is not fundamentally different from that of business in general. The most-prevalent sources of industrial strength are the mutually reinforcing competitive advantages of scale and customer captivity. Content creation simply does not lend itself to either, while aggregation is amenable to both.

I’m not sure what to make of this piece.  It reads something like a five-forces analysis, and argues not only that Netflix is the real deal, but that there are significant barriers to entry in the streaming content business.  It will be interesting to send this balloon up in next year’s IO class and see if anyone cares to shoot it down.

Thoughts on The Big Short

I finished up Michael Lewis‘s The Big Short and I think I found it worthwhile and poignant.   It’s a character-driven piece that follows some of the players — as the title suggests — who shorted the housing market and went to the bank.  To Lewis’s credit, he seems to do a pretty good job of explaining the crazy financial instruments created and deployed to bet against subprime mortgages.  To my debit (?), I still don’t understand what was going on with all of this.

The big villains of the story are certainly the ratings agencies, who could have stopped much of this chicanery in its tracks by rating garbage as garbage rather than as AAA investment-grade bonds.  But, perhaps a pithier point comes in the book’s denouement and is worth quoting at some length:

The people on the short side of the subprime mortage market had gambled with odds in their favor. The people on the other side — the entire financial system, essentially — had gambled with odss against them. Up to this point, the story could not be simpler. What’s strange and complicated about it, however, is that pretty much all the important people on both sides of the gamble left the table rich… Continue reading Thoughts on The Big Short

The Great Portland Flush

In our continuing series of thorny policy issues, here’s one from the great northwest.  The city of Portland flushed millions of gallons of treated drinking water because a man urinated in it.  Does that seem reasonable? Or is it a wee bit crazy?

Here’s the abbreviated story from the NYT.

Portland is disposing of eight million gallons of drinking water because a man was caught on camera urinating in a reservoir. Water from the city’s five open-air reservoirs goes directly to customers. A city official said he did not want to serve water with urine in it.

Critics call that an overreaction, saying animals routinely defecate and urinate in the reservoirs and sometimes die in them. Health officials say that urine is sterile in healthy people and that the urine was so diluted it posed little health risk.

Officials say it will cost the system’s customers less than $8,000 to treat it as sewage. The 21-year-old man caught on camera has not been charged.

I will spend the next year trying to figure out how to make this into a final exam question.