The Pin Factory Blog

Jose Mourinho’s Inter Milan side were crowned kings of European football on Saturday night, having won their domestic Italian league, the Italian cup competition and the Europe-wide Champion’s League in the space of a season. Remarkable stuff, but there is an economically interesting fact behind this.

Not one player in the Inter Milan starting team was Italian, let alone Milanese; the squad featured players from Brazil, Holland, Romania, Argentina, Macedonia, Ghana, Serbia and Cameroon, in addition to a Portuguese manager. This trend is repeated across Europe; English champions Chelsea regularly fielded just two English players in the starting team this year. Indeed, a relatively small amount of world-class footballers stay in their country of origin with even fewer remaining at their original club. The overwhelming majority of talented footballers are traded on what resembles an open labour market.

Free movement of labour is a controversial topic amongst liberal thinkers; some support open borders on grounds of freedom, while others invoke a private property argument relating to trespassing. Some also take a pragmatic view between the two.

The economic ideal is that individuals are free to seek employment across borders, and employers are thus free to employ the best person for the job, regardless of the candidate’s country of origin. The process is therefore more macro-efficient.

In this sense, the increasing internationalization of football’s workforce in recent decades provides an interesting natural experiment. I suspect that an examination of the data from all the top-flight clubs across Europe would reveal a very strong positive correlation between the number of foreign players at a club and the club’s position in the league. This correlation, in itself, would not imply that an international workforce causes more success at a club (although it fits very well with the theory). For example, it could be said that the correlation is due to the fact that high achieving teams are likely to be richer and so can afford to buy more players in from abroad, but even this explanation is still very compatible with the theory. The point can be tidied into a neat syllogism: Football clubs rationally pursue the course of action that is best for them; the clubs tend to employ more foreign players when they have the resources to do so; therefore clubs should be allowed employ players from abroad if they choose to.

As a control group, we can look at clubs from leagues with relatively low levels of foreign labour. French, Russian and Portuguese clubs employ proportionally less foreign players than their English, Spanish and Italian counterparts and have a correspondingly less-successful record in Europe-wide competitions. The success of ‘internationalized’ clubs such as Inter Milan, Chelsea, Manchester United and Barcelona in recent years has occurred despite a ridiculous contention from UEFA (the governing body of European Football) that mandatory numbers in any squad should be from the native country.

While the example of football clubs is a simplified model for the labour market as a whole, it is highly illustrative of the potential efficiency and booming growth that relatively free labour migration can have on an industry and of the wider effects of globalization in general. This point is particularly relevant at the moment with the political consensus that immigration must be tightly monitored and restricted.

The triumph of Inter Milan must serve as a reminder of the numerous benefits of foreign labour.
 

Yesterday, the German Finance Ministry announced a ban on the ‘naked short-selling’ (the practice of betting that the price of a share will fall without ever actually owning the share or planning to do so) of ten of the county’s largest banks and on betting against government bonds using credit default swaps. This could be a sign that the Germans fully anticipate further slides in the value of European debt, both public and private.

Some (like Money Week) view this move as a political ploy to re-position Merkel’s party in reaction to the trouncing they received in the recent regional elections. However, I think that this pair of bans are more realistically viewed as a damage-limitation exercise, an attempt to artificially protect the banks and German government from what could turn out to be a market raid on their shares and bonds respectively.

The brute fact is that the Eurozone is in serious trouble, saddled with enormous amounts of government and personal debt; there is a high risk of Greece, Portugal, Italy and Spain defaulting. If this were to happen, the Germans would be among the biggest losers. German banks own hundreds of billions worth of the debt of Greek, Spanish, Portuguese and Italian banks, and now the government (as of last Monday) is committed to protecting the bonds of the governments of these countries. In February, the WSJ estimated that German banks had about $240 billion outstanding with Spanish borrowers alone.

If any of the major banks of the PIGS (one ‘I’ now, congratulations Ireland!) were to fail, investors would question whether the major German holders of their debts would be able to survive. Similarly, the sovereign defaults of any of these countries would have disastrous consequences for German public finances and the value of German bonds.

Yesterday’s bans, then, seem to be an attempt by the Germans to mitigate the damage resulting from the continuation of the Eurozone debt crisis. It is a ‘let’s cover our backsides’ operation on behalf of the Germans and the country’s major banks, suggesting that the Finance Ministry now accepts what many have been saying: the crisis will get a lot worse before it gets better, the vulnerable countries and the holders of their debt are in for a rough ride. Paradoxically, these very actions may create a self-fulfilling prophecy, sending markets out of control on a ‘they must know something I don’t’ line of reasoning. Surely no Finance Ministry would ban betting against major banks and government bonds unless they expected the market to undertake such trades.

The travails of the Euro make for a fascinating economic specimen, but this an experiment where the economic well being of hundreds of millions of citizens is at stake. The PIGS have lost their last-ditch tool, currency devaluation, in return for increasingly insignificant economic benefits. The German actions could be interpreted as a signal that the Eurozone is in for more trouble ahead.

€750 billion has been pledged to stop Greece defaulting and contagion spreading across Europe. EU Monetary Affairs Commissioner Olli Rehn stated, “The ECB shall defend the Euro whatever it takes”. The aim of this package is to stun markets into a more confident state of mind with regards the euro, preventing an immediate and catastrophic run on the currency and the debt of member states.

The judgement then, as in September 2008 with the vulnerable banks, is that the dangers of doing nothing far outweigh the problems that will result from the long-term debt problems created by acting to secure markets. Whether or not you agree with the judgement in this case depends on the extent to which you are ideologically wedded to the idea of a common currency for Europe. It is not clear, to one sceptical of the idea of the Euro, that the benefits of the single currency merit the enormous amounts of money being deployed to save it.

Indeed, it could be argued that the measures are merely delaying the pain by shifting today’s debt into the future. The package certainly represents a commitment to sustaining the value of the Euro, but contained in this commitment are two large gambles, the costs of which are likely to be paid by Eurozone citizens in the long term.

The first involves the survival of the Euro, which is less than secure at the moment. Once funds of this size are deployed as part of a rescue package, those financing the package are locked into a long-term investment in the health of the Euro. There is a possibility that the current amount, as large as it is, may not be sufficient to secure the safety of the currency, it is certainly not enough to cover the dangers of a large economy such as Spain’s becoming seriously embroiled in a default crisis. In this scenario, the Eurozone countries and ECB would be forced to provide even more funds in order to avoid losing the current investment. In this way, the package commits Eurozone authorities to an open-ended currency sustenance mission, the cost of which is extremely difficult to predict and mitigate.

The second, related gamble is slightly more specific and presents the danger of losses even if the Euro as a currency remains. Loans to at-risk governments, such as Greece and Portugal, have formed a key part of the strategy of the authorities, but these loans are in no way a safe investment. German taxpayers are clearly anxious about this, having displayed their dislike of propping up failing neighbours in recent regional elections. Bonds of the vulnerable countries may never recover their full value, with the associated losses falling squarely on Eurozone citizens.

On the optimistic side, it is comforting to hear finance ministers talking about the overriding importance of deficit reduction as a condition of support. Markets are making gains in reaction to the announced measures; let’s hope, for the sake of everyone, this is a sign of a long-term stabilisation rather than a blip on the course of a massive decline.

Some are optimistic, even excited about the changes brought about by Thursday’s general election. However, I remain unconvinced about the prospects of a Tory/Liberal coalition.

The blaring reality of the country’s future is the rising national debt. Britain may not be in as much danger of a sovereign default as some European countries, but the budgetary pressures applied by such a high national debt are serious. As debt rises, and growth falters, the chance of an increase in the cost of borrowing rises, further squeezing public finances and reinforcing the whole dismal cycle. This presents an existential risk to health of the UK economy.

Against this backdrop, much of the party debates seem almost trivial. Perhaps some good policies, education and tax reform included, may get through as a result of a ‘liberal coalition’, but the focus should really be on restoring fiscal discipline. None of the parties have exhibited an open or honest stance on the issue, this is a travesty.

An IFS report revealed that none of the parties have outlined more than a quarter of the measures that will be required to restore fiscal credibility. This has not been an election of ‘real change’, I see no justification for the ‘politics of hope’ and we are not entering a new era of a ‘fresh approach’ to governing. Commentators and the media are scrambling to make a narrative out of these confusing events, well here’s a straightforward one:

This was a fake election. Every party failed to take on the central, potentially crippling issue of the day. It was a race to see who could bury their heads farthest into the sand, who could toss the biggest bones to a style-obsessed electorate. Cameron and Osbourne attempted to position themselves as the party of fiscal sustainability, but failed to outline 82% of the spending cuts required.

The hung parliament is a false culprit; none of the individual parties presented the electorate with a credible plan. Many countries manage an economy effectively with coalition governments; the problem for the UK is that the politicians coalesced around fantasy economic plans, not facing up to the real challenge.

To me, the situation points to a Conservative minority government supported minimally by a distant Liberal party, who have every incentive to disassociate themselves from the poisonous cuts to come. A lot depends on Labour; if they present an ‘anti-cuts’ agenda in reaction to the Conservatives, the debate could shift in the worst direction.

I have the feeling we are only at the beginning of the process of coming to terms with the scale of the problem.

In a briefing paper released today, I examine the tendencies and accuracy of treasury forecasts for GDP growth contained in the spring budget. My sample contains three different types of forecast: Type I are forecasts for the same year as the budget, Type II are forecasts for the next year and Type III are forecasts for the year after next. All are made simultaneously in each spring budget. Using some basic statistical and probabilistic analysis, I reach three key conclusions based on my sample of thirty forecasts:

• There is a low correlation between forecast and outturn for Type II and III forecasts.
• All three types of forecasts are less likely to be accurate when economic growth is changing faster in either a positive or negative direction.
• There is strong evidence of a bias towards overestimation in each type of forecast

Statistical analysis can sometimes be quite dry, so I think it is important to spell out the significance of the findings. First, and most obviously, it seems we should place little trust in the predictive power of the Type II and III forecasts given their low correlation with outturns. Second, and perhaps more significantly, the combination of a forecasting process that does very badly at foreseeing higher growth in either a positive or negative direction, and the finding of strong evidence for a bias towards overestimation, means that treasury fiscal projections for future spending and borrowing plans (both elastic to changes in growth) can be highly inaccurate and unrealistically optimistic.

For example, in 2007 the treasury was predicting 2009 growth at positive 2.5%. In fact, the economy shrank by 5% in 2009. The projections for the national debt and deficit, which are given as a percentage of GDP, were accordingly way off the mark. This seriously undermines any attempt at fiscal discipline.

I argue that to counteract the effect of such inaccurate projections, government should use very pessimistic assumptions about future growth when projecting debt and borrowing. Currently, the treasury seems to place quite a lot of confidence in its forecasts, adjusting the figure down by just a quarter per cent when it plans future borrowing. The data suggests that this figure should be far larger. I don’t go as far as to suggest an actual figure: perhaps that is for a different paper.

“David wants to take six billion out of the economy when it is most at risk” said Gordon Brown, more times than I care to remember in each of the television debates. This statement hints at an economic misunderstanding that is almost as old as the subject itself, and is worryingly ubiquitous in the post-crisis discourse.

The fallacy was first laid out and refuted by Frederic Bastiat in 1850 in the form of the ‘broken window fallacy’. Bastiat’s example goes as follows: while at a first glance it may seem that the breaking of a bakery’s window in town somewhere creates employment for the glazier and must therefore be a good thing for the town, this doesn’t take into account the “unseen” consequences of the act. The baker has to pay the glazier; while the glazier benefits from this, it means that the baker is not able to buy that new suit he really wanted. So, stay with me on this, if the window had never been broken, the baker would have a new suit and the tailor would have been paid for the suit – the wants of two people have been fulfilled. But with the window broken, the only person who benefits is the glazier.

Now, this is not a mere argument against vandalism, but a profound allegory at the heart of which is a truth that is missed by many commentators and economists.

So, what of the six billion? Lets go with Brown for now on the point that this money is ‘stimulus money’, which is a dubious assumption given that much of it is probably waste. This money, like the money used to pay the glazier, has to come from somewhere, the government has to raise it via taxation or bond issuing. When the government ‘puts money into the economy’ it is really just moving it from one area (the pocket of individuals or the portfolio of the bond investors) to another*. The money has to be removed from the economy before it can be ‘put back in’.

The argument, made by economist and ex-MPC member David Blanchflower, that ‘this was a public-sector sustained recovery’, just doesn’t make much sense, especially as a justification for keeping an extra six billion in the economy. The public sector gets its money from the private sector, so the money is in reality just being retargeted by the government into whatever the £6bn is being spent on.

Brown is right to say that he is keeping the money in the economy, but wrong to assert that cutting this money would be taking it out of the economy. In fact, it would be giving the money back to the economy, but in a different place (hopefully the pockets of taxpayers). If this all sounds a bit confusing, I would recommend Henry Hazlitt’s Economics in One Lesson, a short, easy book expounding the ideas of Bastiat and available free to read online.

*That is assuming that it isn’t just printing all the money, which introduces the idea of inflation and a whole different can of worms.

Years of fiscal profligacy and an expensive financial crisis have taken their toll on Europe. The sustainability of the European ‘Social Model’ is becoming increasingly unclear. Greece has received huge bailout funds but may still fail to meet it’s debt obligations, Portugal has been forced to effectively halt party politics in order to work through a solution to it’s budget crisis, Spain is acting to tidy up public finances but still looking shaky, as are Italy and Austria, and Germany is rightly terrified of the potentially dire consequences of the Greek disease spreading further. The nightmare scenario is that one of the weaker countries defaults on it’s debts, or gets close enough to seriously spook the markets, thus setting off a domino effect throughout the region.

Which brings us to the UK. Alistair Darling rightly points out that investors are prepared to buy UK gilts with a comparatively long yield, perhaps indicating relatively high confidence. However, this should not make the next government too complacent. The UK deficit is still more than a hundred billion pounds over the amount required of Euro-zone countries in the ‘convergence criteria’, the rules agreed in Maastricht regarding economic prudence for Europe.

Indeed, investors and analysts in the city are warning that the UK may be downgraded from the current AAA credit rating in a post-election re-evaluation of the country’s public finances. An increase in the cost of borrowing would have disastrous fiscal consequences for the UK, meaning that an even larger proportion of spending would go on debt interest payments. Currently, the treasury forecasts that it will spend more on servicing debt than it will on policing or defence in the coming financial year. Some argue that the only thing separating the UK from the travails of the PIIGS is her comparatively stable economic history and reputation as a financial centre. Whether such a reputation will remain after years of fiscal imbalances remains to be seen.

The UK has a major potential advantage in the city of London. The next UK government will be forced to make extremely difficult decisions about the nature and origins of economic growth: does it risk political humiliation and bow to the City, thus securing a competitive advantage for the nation, or does it ‘rebalance’ the economy, reducing the role of the City, and risk losing what is seen by many as the most dynamic area of the UK economy. The prospect of a hung parliament may complicate things even further.

Either way, it seems clear that times are different now. In the UK and across Europe, governments will not have the kind of money to engage in rounds of public spending of the type seen by Labour in 2001. Will this be a catalyst for reforming public services and welfare states across Europe? The increased pressure on public finances as well as demographic issues, especially in Germany and Italy, would suggest so.

It would be ironic if, as the USA moves towards a more European-style healthcare system, Europe (UK included) starts to realise it can’t afford its own.
 

Today sees the publication of a think piece I have written in reaction to what I believe are two flawed elements of US financial reform bills. The US financial services sector is the largest and most important in the world, many global leaders in investment banking are based and chiefly regulated in the USA. What happens to institutions of the size of JP Morgan Stanley, Goldman Sachs, Citigroup and Lehman Brothers can, as we have seen, have enormous consequences for the financial systems and economies of the world.

It is beyond dispute that reform is necessary, and a diagnosis of the events that caused the crash comes to bear on the proposed reforms. It is my view that at the heart of the crisis was an incentive problem, whereby certain firms where effectively marked as too big to fail, their profits privatised and losses socialised. This is not capitalism; it is neither economically efficient nor morally acceptable and government reforms must reflect the need to establish the appropriate market incentives in finance.

Both the Senate and House bills ostensibly aim to resolve the ‘too big to fail’ problem, but propose reforms that are at best a waste of time and at worst potentially damaging to the financial system. Most alarmingly, Senator Dodd’s reform bill, currently working through the Senate, establishes the principle that the FDIC (Federal Deposit Insurance Corporation) may draw funds from the government to help liquidate banks in a crisis. It is argued that this measure enshrines the principle of a taxpayer bailout, qualifying the legislation as a Bailout Bill.

The legislation shows no commitment to competitive markets in the sector by bestowing the advantage of a potential preferable liquidation on the larger financial firms in case of failure and by failing to ‘break up’ the largest firms as a first port of call. In doing so, it is argued, the bill could cement the fundamental incentive problem, increasing systemic risk and the probability of future large bailouts by the treasury effectively with taxpayer dollars.

While the two reform bills do too little in relation to solving the central incentive problem at play, it is argued that there is an overreaction in the direction of ‘alternative investments’. The regulatory proposals are likely to be futile in this field, as well as being unnecessary.

The House reform bill has already been passed, but the more influential bill written by Senator Dodd and the Banking Committee still faces debate in the Senate. It is crucial, for the sake of US financial stability and that of the world, that some of the bill’s shortcomings are recognised and remedied.

The website ‘Unfair Internships’ argues that unpaid internships are, well, unfair, campaigning for a US-style system, where:

There aren't many circumstances where you can have an internship [at a for-profit company] and not be paid and still be in compliance with the law” (Taken from a WSJ article, quoting a US Labour Department Official).

It is argued, on ‘Unfair Internships’, that unpaid internships violate a principle apparently at the “core of the capitalist system”, namely that “work should be compensated according to productivity”. The author of the blog even goes as far as to accuse the WSJ editorial staff of not understanding economics.

The basic principle alluded to is completely false. A wage is a price at which a worker is prepared to sell her/his labour, this price is defined as the equilibrium between what the employer is prepared to pay and the labourer is prepared to sell at. Expected productivity is one input into deciding how high a price the firm will pay for the worker’s labour, while the circumstances of the labourer and how much they value the possibility of working for the employer (experience, working environment etc.) also affect the wage. It can be assumed that a profit-maximising firm will pay as low a wage as the worker is prepared to work for, so an unpaid internship indicates that the worker values something – possibly the experience gained or the contacts made – about the work placement that cancels out their need for monetary compensation. Another ‘capitalist principle’ is that workers should be free to value their own labour; unpaid internships fit in with capitalist principles thus.

An objection to this view could be that would-be interns from families who cannot support an unpaid family member are discriminated against and will lose out to the rich, who can afford to forgo a wage for some months. This may be true, but it is equally unfair to expect companies to compensate for this, the likelihood is that if forced to pay interns, many such intern opportunities would disappear. There are many ways in which a rich background benefits those beginning a career, but forcing companies to pay interns a wage risks getting rid of such schemes altogether, definitely not beneficial to anyone.

If the campaigners for mandatory-wage internships want to reduce their perceived inequality here, they would do better to look at in a wider framework of government programs to encourage social mobility; to suggest that the burden of redistributionary measures should be carried by firms is likely to have the opposite effect.

Property is, for the majority of citizens, the single biggest investment made in a lifetime. Most people’s portfolios are far less diversified when you factor in the fraction that is dominated by house price movements. Indeed, many who would consider their wealth relatively ‘safe’ from fluctuations in market prices by keeping the majority in cash are far more dependent on economic circumstance than they realise, owing to the large investment they have made in bricks and mortar.

‘Sophisticated’ investors can hedge most investments through futures markets in the particular investment, but housing is unique in having a futures market that is ‘index-based’, i.e. you can hedge risk for the market movements as a whole, but not for your particular area or property. Property is inherently heterogeneous, and just as derivatives instruments have blossomed and specialised in other areas over the last decade, housing derivatives should do the same. Everyone has to buy a house, so why not allow people to hedge against the particular risk they are taking in doing so.

Credit goes to Robert Shiller for the popularisation of this idea, and interesting research (drawing from techniques of the biomedical sciences of all things) has been done into the nature of heterogeneous derivative instruments. I think that the broad argument for widespread involvement in such markets is worth restating though.

I would argue that recent events highlight the need for such a facility in the housing market. When house prices plunged in 2008, UK citizens where clearly horrified at the amount of their net worth that was evaporating after years rising in an overheated housing market. As a result, consumer spending dropped and recession deepened.

This wasn’t the first overheated housing market, and it surely won’t be the last; loose monetary policy seems to be a speciality of this generation of central bankers. I think this only strengthens the case for a hedging facility in housing. If people had less to lose from a drop in house prices, the economy would be more robust and efficient as a whole.

The argument for a more sophisticated futures market in house prices is even more convincing in the UK, where the proportion of buyers to renters is much higher and house prices in general are higher.

There is a need for this market, and clear profit opportunity for firms involved. I’ll keep harping on until more notice is taken.