Sunday, December 18, 2011

Europe - no disasters in the waiting but little hope after that!

There are two parts to the Europe question.
1. Will the Euro survive?
2. What happens to Europe in the medium term in case it does?
The caveat in the second question is because it is terribly difficult to predict what happens to Europe if Euro does not survive. Predictions range to as much as 25% loss of output across Europe.

To me, the first question seems moot, especially in the light of the rather widely known fallout of Euro's failure and the fact that the near term survival of Euro is actually pretty much on tap for the policymakers in Berlin, Paris and Frankfurt (where ECB is based out of). I believe that contrary to popular belief and most scenarios of doomsday, Euro as a currency is far from failure. Sure it is under threat and is beseiged from many sides. However, for Euro to fail, Germany and France will have to lose market access or the cost of saving Euro in terms of bailouts has to go way beyond their current and future bond market-funded balance sheets. Either of these is remote scenario.

What is Germany upto really? Angela Merkel has been painted black and grey and white in the last few weeks by analysts around the world. But what the Germans are really trying to get out of the rest of the Eurozone is actually a commitment to lead fiscal lives similar to Germany's. This in turn is based on a more productive workforce, longer hours, higher retirement age, less state doles and so on. In the bargain the peripheral countries get to enjoy being part of the Euro - certainly a privilege in the times of crisis. Italy would have lost market access long back had it not been for its currency i.e. Euro. Of course one can argue that it might not have been lent to as much as it has been if it had not been for the Euro. Very true. Precisely the sort of thing that Germans want to avoid in future. They seem to have correctly concluded that bond market investors are not as well informed and choosy as they are made out to be. They will lend to seemingly sound but actually bad credit in much the same way American banks lent to sub-prime individual borrowers. Greece was a major case in point for this. Post facto, it seems ridiculous that anyone lent to Greece - Euro-denominated bonds or otherwise! Presumably everyone was counting on the rescue or explicit underwriting by Germany and France - which was never really there and which never happened when the time came. Having seen the inability of bond investors to rein in fiscally imprudent countries, Germany has correctly understood that the future of Euro depends on a "no-bailout covenant". And hence, if the suppy of money is going to be there in the lax times (from over-enthusiastic investors), Germany wants the demand curbed at the source - through fiscal deficit limits and gross public debt limits. Prudent if you ask me!

Why do I believe that Euro does not have that much of survival threat? For one, rescue is one round of QE away! Very much as the Americans have been shouting from the rooftops to the Eurozone leaders for a while now. Eurobonds have been talked about enough by now for even an implicit acceptance of the same by Germany to send the bond market investors into risk-on mode! Lastly the leaders of the rest of the peripheral countries seem to be complying with the demands of fiscal prudence - which most realize are in their own interest even if Euro does not survive. Germany and Euro-saving are good outside factors to blame to overcome any internal resistance for most of these countries. Push is unlikely to come to shove and even if it does, a combination of ECB, IMF, EFSF and maybe even the Fed will figure out a good way forward. It is in Germany's interest to keep things muddling through rather than conclude them very positively in a sudden stroke of brilliance. The most that sort of heroism will achieve is massive risk-on trades around the world, positive sentiment all round and in effect loss of another chance for the well managed economies of Eurozone to establish some displine amongst the rest. Since it seems more or less coordinated brinkmanship, the only danger is that of an unforeseen financial accident. In absence of that Eurozone worries will eventually go but probably drag on for another couple of quarters - as the economies sort out the fine print of greater fiscal union and iron out inevitable differences.

Disaster hence is unlikely. That does not mean that the proverbial "aaaal" is well though! The reason Eurozone went into this crisis is fiscal profligacy of its peripheral economies and the loss of confidence amongst bond investors for the debt issued by those countries. The confidence may slowly return to make investors take some cautious bets. However, the fundamental productivity challenges of Euro-area economies will not go away. If anything the battling with the crisis has only diverted the attention of the economic policy makers from them. Last but not the least the unfavorable and worsening-by-the-year demographics of most of European countries is not helping at all in boosting productivity. While Spanish unemployment may come down and Irish banking sector may after all be restored to half decent health and the clouds over most of Europe's banks may go away, the painful process of adjusting to a new economic environment where money is neither cheap nor abundant, governments are not the welfare states they used to be and where everyone is required to work longer and more productively will take its toll on growth. Europe may lose its own decade a la Japan. That is a far bigger disaster - however slowly it bites!

Tuesday, December 06, 2011

Behavioral Economics and Finance - Waking up to reality!!

I had always wanted to read more about behavioural economics and finance but had been putting it off till recently. Owing to some generic stimuli as well as a real potential use in my professional life I have started reading up quite extensively on the topic. This area is indeed like the proverbial rabbit-hole – one does not know how far it can take us and what all it can open up.

An actual account of what behavioural economics is probably for later. Here is a good link to start with. A useful paper covering the background can be found here. A good lecture series - here - is also available on youtube. What is more interesting right away is the potential this domain has for reforming economics as well as finance as we know it. There are many way in which it can do so. I have summarized the following. These are not extensive.

1. There has been an appalling lack of reliance on the use of scientific method in evaluating candidate models and theories in economics. Data is used but it is historical and probably selected with a bias. In fact considering that most theories are designed to explain past observation, it is no achievement that the theory at least partially explains what was observed. It is like in-sample optimization. There is rarely an equivalent of out-of-sample optimization. Unlike theories of physics and chemistry, those of economics do not necessarily pass by predicting things that can then be verified. There are of course many reasons for that – most important being the inability to recreate precise conditions of testing theory. But there is no serious attempt to work around this limitation.

The results are obvious. Many theories are worshipped in the face of consistent contradictory evidence against them – efficient market hypothesis being the commonest example. Behavioral school of thought starts from the actual nature of human beings and then goes to construct its theories. This is not fool-proof nor does it have a certainty of producing results. But at least in the spirit of common sense as well as robust scientific process it seems like a good idea!

2. Rational economic agent is a foolish concept. It is probably the worst part of the theoretical foundations of the neoclassical economics and modern finance. The metanarrative of the REA is one where there is perfect and symmetric knowledge, no emotional interference from the actors’ minds, perfect coherence between the mathematically right answer and the appealing-to-real-human answer. The attempt is laudable to explain human choices. However, it is fundamentally wrong in so many of its assumptions that it explains almost nothing relevant and predicts even less. The most damaging characteristic of the metanarrative however is its treatment of what is not within its purview. When human beings do not follow the predictions of the REA school of thought, it is termed “irrational”, “inefficient” and some such term. This treatment itself smacks of a rather narrow thinking process which is quite dogmatic and terms everything outside of it (almost the whole real world) as some sort of anomaly. There is some intellectual hubris here. More damagingly, there is a na├»ve hope that the “anomalies” only await some refinement of theory and can then be “explained away” while preserving the grand narrative of the rational economic agent!

3. Considering the complex nature of macroeconomics and the problem it deals with there is a serious lack of multi-disciplinary approach. Sociology and psychology have a lot to teach economics in terms of the behaviour of its key decision makers. Physics has a lot to teach in terms of experimental method as well as some models of collective behaviour.

All in all, post the recent crises through last couple of decades, economics as a discipline is anyway due for an overhaul. Being able to predict bubbles, having the ability to explain the complex interactions amongst global consumers, producers, investors and investees and in general creating a coherent thinking framework which does not keep relying on the proverbial “other hand” of the economist is certainly the need of the hour.