Monday, March 29, 2010


In Friday's edition of NY Times, David Brooks wrote a very interesting column (link) discussing the state of economics. Although subtle and rigorous in its assertions I doubt that the field of economics needs a fundamental change in the philosophical origins of economic methodology. I agree with the author that economists often ignore the notion of moral philosophy and history in economic analysis but that doesn't mean that old textbooks on classical microeconomics need to be disposed. The author points out the role of economic forecasters who often appear on the TV, essentially trying to forecast economy's future path. Econometrics, which constitutes time-series forecasts on which most economic projections are based, is a real discipline to which numerous new scientific articles are devoted, published mostly in The Econometrics Journal and Econometrica. In his famous 1983 article (link) Let's take the con out of econometrics, Ed Leamer wrote how econometric modelling can be misused if a researchers ditch the true role and significance of assumptions. A prominent example is the study of death penalty on crime deterrence. As you can read in more detail in Leamer's article, one study found out that each capital punishment deters more than 9 murders while another one found out that each additional capital punishment causes more murders.

The contradicting evidence doesn't imply the falsification of the scientific method in economics. It merely reveals the hidden difference in how economists set assumptions regarding the behavior of individuals, firms and countries. David Brooks pointed out that economists failed to predict the recent financial crisis. However, many economists (myself included) pointed out the true dangers of an over-leveraged economy and monetary easing which led to subprime mortgage crisis and the consequential aftermath.

Many of us have had clear evidence, models and studies that showed how an over-leveraged financial sector can induce a significant economic downturn. However, many policymakers ignored the evidence of the behavior of the financial system which could be easily compared with chaos theory in mathematics. In my recent paper on Iceland's financial crisis I showed that the depository banks' overall leverage and indebtedness in the small country was growing exponentially, beyond the limit of capital adequacy.

As Paul Krugman recently noted, lessons from the Great Depression were not learned because people forgot it too quickly. Although mainstream economics, as every field within economic science, needs some major cures, I disagree with author's assertion that economics is not a real science but a moral philosophy. True, economics is not exact science because human behavior is not as experimental as particle analysis in physics but economics tries to resemble the scientific methodology through models, data, statistical inference and evidence. In fact, new interdisciplinary fields within economics are emerging such as behavioral economics, neuroeconomics and transport economics in which economic analysis is combined with other disciplines such as law, psychology, sociology and neuroscience.

The limits of mathematical recourse in economics were already discussed by economic thinkers such as John Maynard Keynes. And agreeably, mathematical reasoning is bounded by economic reasoning. However, from the real point of view, we need models to address human behavior mostly because, as F.A Hayek noted, it's too complex to capture its essence in a scientific entirety. If the neccesity of assumptions, models and evidence were not the case, hardly any lessons would be learned from the episodes of crises, booms, busts and periods of economic advancement in human history.

Wednesday, March 24, 2010


Daily Telepgraph collected a few interesting graphs (link) depicting the UK economic performance and discussing the economic legacy of the Labour Party.

Tuesday, March 23, 2010


Hernan Buchi, former minister of finance in Chile, recently published a new book The Economic Transformation of Chile (link) where he outlined comprehensive economic reforms that boosted economic growth, lowered unemployment, reduced poverty and set the stage for more than two decades of robust growth and an economic turnaround which has been unprecendent in Latin America.

The books serves the reader with a menu of intriguing facts, curious statistics and precise analysis of how macroeconomic stability was achieved. Chile has been the leading nation in Latin America with the most stable and predictable inflation rate. Country's decent fiscal management and solid macroeconomic outlook were important cornerstones behind the invitation to the OECD.

According to Jose Pinera (link), Chile is expected to enter the club of developed nations in 2018, the first Latin American country ever. Chile pioneered the privatization of the pension system in early 1980s. Today, country's fully-funded pension system based on individual savings accounts is a model for the rest of the world (link) in overhauling unfunded pay-as-you-go social security systems.

Sunday, March 21, 2010


There's an interesting story from Washington Examiner (link) discussing the coming economic crisis in California (which has been notably called "The Greece of America") and the flourising economy in Texas which enjoyed a decade of robust growth, low taxes, favorable demographic outlook and superior public services. Not surprisingly, unions in free labor market in Texas did not allow public sector unions extracting $100 million from taxpayers for TV-adds in defence of the status quo for public employees:

"Californians have responded by leaving the state. From 2000 to 2009, the Census Bureau estimates, there has been a domestic outflow of 1,509,000 people from California -- almost as many as the number of immigrants coming in. Population growth has not been above the national average and, for the first time in history, it appears that California will gain no House seats or electoral votes from the reapportionment following the 2010 census... Texas is a different story. Texas has low taxes -- and no state income taxes -- and a much smaller government. Its legislature meets for only 90 days every two years, compared with California's year-round legislature. Its fiscal condition is sound. Public employee unions are weak or nonexistent."

Thursday, March 18, 2010


I recently presented my recent paper on Iceland's economic and financial crisis (link) in the European Parliament in Brussels (link). Three days ago, the publication of the paper has also been approved by the SSRN (link).

Let me briefly touch the evolution of Icelandic crisis. The roots of the Icelandic financial crisis go back to late 1980s, when the Icelandic economy recovered from subsequent periods of high, volatile and unpredictable inflation. In 1983, the annual inflation rate reached as high as 100 percent. Throughout the 1980s, the economic policymakers were gradually abandoning the Keynesian doctrine. Until the oil shocks plunged the country into rampant inflation and fragile economic growth, it was widely believed that a little higher inflation is the price of low unemployment.

The period from late 1980s to early 1990s had been an important milestone for Iceland's macroeconomic recovery alongside the change in the political tide. The central bank was granted independence in inflation targeting, the government pursued a wide array of structural and economic reforms to boost the economic growth. Corporate tax rate had been reduced from a near 50 percent bracket, labor and product markets were liberalized and the financial sector was in the beginning of the privatization. The beginning of the 20th century was an unusually favorable period for Iceland's macroeconomic stability. Aside from one of the world's best institutions and governance, Iceland is perhaps the only developed country with favorable long-term demographics. The share of the population above the age thresold of 65 is only 11 percent. For instance, in Italy more than 20 percent of the population is in the age thresold of 65 and above. Iceland's favorable demographic outlook and a bold move towards defined-contribution pension system make the country the only developed nation with stable and fiscally solvent social security transition in the long-run. (total assets of pension funds as a share of GDP stood at 114 percent of the GDP in 2008 - more than any other OECD nation).

In 2001/2002, Iceland fell into a short-lived recession, mostly as a result of external imbalances and current-account adjustment to the global economic slowdown. In spite of the favorable macroeconomic outlook, Iceland's central bank failed in terms of the inflation targeting. From 1980 onwards, Iceland has had the most volatile inflation rate in the OECD, surpassing countries with unstable inflation such as Greece. Between 1980 and 2009, the average standard deviation of inflation was 20.45 percentage points, almost 20 times the deviation of inflation in countries with the least volatile inflation (Austria, Germany, Netherlands). Behind the unpredictable inflation rate was an unprecendent development of banking and financial industry. Iceland maintained high interest rate to contain inflationary pressures which were the main threat to macroeconomic stability since 1980s. Consequently, there was a large interest rate differential between Iceland and the rest of the world.

In a small and open economy such as Iceland high interest rate differential triggered "carry trading" against uncovered interst parity. Investors thus borrowed in Icelandic currency and invested in Icelandic stock and bonds in search of high short-term yields and then, after a certain period of time, swapped it into safer currencies. In the mean time, Icelandic currency (Krona) strongly appreciated and created an artificial wealth illusion which stimulated imports and further boosted economic growth towards an incredible 7 percent in 2007. The central bank raised the key interest rate further to contain potential inflationary pressure. Consequently, massive capital inflows strengthened krona's appreciation.

At the same time, the banking industry expanded abroad and enjoyed significant return on equity as a result of high interest margins on short-term loans in Krona-denominated loans. Icelandic banks were recognized as well-managed and, at the same time, enjoyed favorable ratings from Fitch, S&P and Moody. Three largest banks (Kaupthing, Glintir and Landsbanki) grew for more than 10 times the country's GDP. These banks easily expanded abroad as world interest rates converged towards zero. In such circumstances, banks offered loans in foreign currency and enjoyed strong interest margins from short-term loans in domestic currency. Icelandic households avoided loans in Icelandic currency given high interest rate but had significant foreign currency loan portfolio offered at very low rates. In a few years, loans in foreign currency exceeded domestic money supply by several times.

From 2004 onwards, Iceland's banking industry emerged as one of the most over-leveraged in the world. High leverage could be sustained as long as the global interbank marked was stable. When the subprime mortgage crisis spread across the U.S, there were early signs that Iceland will likely experience a significant contraction and current account deficit. For example, Danske Bank from Denmark warned in 2006 how disastrous could be the Icelandic crisis:

“On most measures, the small Icelandic economy is one of the most overheated in the OECD. Unemployment stands at 1 percent, wage growth is above 7 percent, and inflation is running above 4 percent despite a strong ISK. The current account deficit is closing in on 20 percent of the GDP. The Icelandic central bank has been hiking rates substantially in order to cool the economy and rates are now above 10 percent. Based on the macro data alone, we think that the economy is heading for a recession in 2006-07. GDP could probably dip 5-10 percent in the next two years and inflation is likely to spike above 10 percent as the ISK depreciates markedly. However, on top of the macro boom, there has been a stunning expansion of debt, leverage and risk-taking that is almost without precedence anywhere in the world. External debt is now at 300 percent of the GDP while short-term external debt is just short of 55 percent of the GDP. This is 133 percent of Icelandic export revenues.”

The global interbank market froze after the failure of Lehman Brothers when the crisis spread globally. At that time, CDS rates on Icelandic banks rose as investors demanded higher premia given the significant magnitude of financial risk. Bond spreads literally exploded. The three largest banks filed for bankruptcy. When the banks failed, gross external liabilites rose to more than 900 percent of country's GDP. Given spare fiscal and monetary capacity, the central bank failed to act as a lender of the last resort and the bailout such as Bear Stearns seemed implausible. The country fell into the deepest and most significant crisis ever experienced by a small country in a peace-time history. The recession, which lasted for more than year, was marred by turbulent inflation rate, stunning negative output gap and high unemployment rate.

The prospects for the Icelandic recovery were initially bleak due to unemployment surge, current account deficit and high public debt. In 2010, the recovery prospects seem more favorable with economic growth rate returning to 4 percent level by 2014. There's also been a lot of debate about Iceland's potential EMU membership - mostly in the light of Icesave deposit repayment to Dutch and British taxpayers. As I thoroughly discussed in the paper, Iceland is not an optimum currency area mostly because adjustment to common monetary policy would require a substantial exchange rate alignment which would inevitably result in inflationary wage pressure and seriously deteriorate country's macroeconomic stability in the long run.

Tuesday, March 16, 2010

Saturday, March 13, 2010


Here's a list of interesting readings for this week.

Gary Becker (link) and Richard Posner (link) briefly discuss the economic effects of fiscal stimulus and review the main literature on fiscal multiplier and the macroeconomic cost of the stimulus bill.

Congressional Budget Office published Budget Outlook 2010 (link) in which it analyzed the total effects of policy alternatives on federal budget deficit.

In NY Times, Paul Krugman discussed (link) the painfulness of financial crisis in Ireland and the U.S and suggesting what we should learn from banking regulation in Canada to prevent future crises of similar proportions.

In How to close the productivity gap between the US and Europe: A quantitative assessment using a semi-endogenous growth model, Werner Roeger, Janos Varga and Jan in 't Veld from the European Commission suggest (link) that to catch-up the US productivity level, the EU should strengthen market competition and eliminate administrative and financial barriers to market entry to start closing the gap in knowledge investment.

In Waging War on Black Teens, Richard W. Rahn and Izzy Santa wrote (link) about the high unemployment rate among young African Americans. Furthermore, they suggest that minimum wage mandate is the main cause of steep unemployment rise thereupon.

The Economist (link) summarized the estimated total cost of reconstruction after the earthquake in Chile at $20-30 billion (13-19 percent of the GDP). Chile's sovereign wealth fund has just over $11 billion saved during the pre-crisis period of high copper prices which, at that time, stood at record levels.

Thursday, March 04, 2010


Here (link) is the story of how decades of economic freedom prevent the unthinkable consequences of an earthquake which recently damaged Chile.