Bar Stool Economics

This fictitious story has circulated a lot through emails, however I find it worthwhile to be posted here. 

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that's what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.
"Since you are all such good customers", he said, "I'm going to reduce the cost of your daily beer by $20". Drinks for the ten now cost just $80.
The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his "fair share?"
They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:
The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.
"I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "but he got $10!"
"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar, too. It's unfair that he got ten times more than I!"
"That's true!!" shouted the seventh man. "Why should he get $10 back when I got only two? The wealthy get all the breaks!"
"Wait a minute," yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"
The nine men surrounded the tenth and beat him up.
The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

Beware Of Greeks Bearing Bonds

Here is the article by Michael Lewis on the Greek crisis and its origins. A very good read.

Alekos Papadopoulos’ Truths

Still, after more than 12 months since the beginning of the crisis in Greece, Greeks do not want to realize the situation they are in. Alekos Papadopoulos though, ex minister of finance, takes up the role of letting the public know how bad the situation is in Greece – something the politicians still do not want to reveal to the public -- and what is needed in order to to have a chance after many years of austerity and recession. Here is a must read article of a short version of  Alekos Papadopoulos talk at ELIAMEP, in Greek.  The whole speech can be found here. Some of the measures he proposes are:

“Σύμφωνα με μελέτες, το 30% περίπου του σημερινού κράτους είναι περιττό. Γι’ αυτό πέρα από τις καθολικές αποκρατικοποιήσεις των δημοσίων επιχειρήσεων προτείνω όλως ενδεικτικά την άμεση κατάργηση τμημάτων πανεπιστημίων και ΤΕΙ, δημοτικών επιχειρήσεων, ατροφικών νομικών προσώπων δημοσίου και ιδιωτικού δικαίου, άεργων διπλωματικών αντιπροσωπειών, στρατοπέδων, συγχώνευση μητροπόλεων, κατάργηση απολιθωμένων κρατικών υπηρεσιών, αποκεντρωμένων υπηρεσιών και γενικών γραμματειών διαφόρων υπουργείων. Περιορισμό του μεγάλου αριθμού στρατηγών, ναυάρχων, πτεράρχων και ταξιάρχων των ενόπλων δυνάμεων και των σωμάτων ασφαλείας, περιορισμό του πολυάριθμου διδακτικού προσωπικού με αύξηση των ωρών διδασκαλίας, δραστική περικοπή κατά 70% τουλάχιστον των πολυάριθμων Γενικών Διευθυντών και Διευθυντών υπουργείων και οργανισμών, δραστική μείωση του μεγάλου αριθμού των αντιπροέδρων των Ανωτάτων Δικαστηρίων και τέλος εξορθολογισμό ή κατάργηση και άλλων πολυάριθμων αφανών δημοσίων καταλυμάτων, τα οποία περιθάλπουν χρόνια τώρα τον κρατικό ανορθολογισμό”.

Two Opposite Articles On WSJ

Here are two opposite articles on WSJ published on the same day. The first one, accuses the FED’s policy for bringing into a difficult position Brazil and the rest of the world, and even accuses the U.S. for mindlessness and purposeful action to damage the other countries. The second one, explains that buying medium to long-term Treasuries is a valid monetary policy of the FED in order to stimulate the economy. The first one is written by a journalist. The second one by Alan Blinder, economics professor at Princeton. Who speaks logic is your call. Just read them.

World’s Debt

The above picture, published in the Economist shows the levels of government debt in 1932 and 2009. Another very interesting interactive page provided also by Economist, is the one that shows the levels of debt as well as the the measures of debt per person and the debt as % of GDP, for the globe for the last 11 years. It can be found here.

The Evolution Of The Greek Debt From The 60s

Greece’s 2010 Deficit At 9.3%

Greece’s deficit for 2010 has been revisited upwards to 9.3%, much higher than the 7.8% target for 2010. An article in Greek.

China’s Dagong Credit Rating Firm Lowers U.S. Credit Rating

China’s Dagong credit rating firm lowers U.S. credit rating from AA to A+. At the same time Moody’s rates the U.S. credit at AAA, the highest credit rating according to the same firm. You can read about today’s developments on Bloomberg, on Barrons, on MarketBeat and other sources.

Even though the reasons why the credit rating of the U.S. may come under pressure is self evident, it is interesting to see how the articles treat the downgrade by the Chinese firm. They clearly state that their downgrade may be politically motivated and connected with the exchange rates war that is currently ongoing.

Bloomberg’s article mentions that Dagong’s application to become a Nationally Recognized Statistical Rating Organization in the U.S. was denied by the SEC. And Barron’s article mock’s the logic of Dagong’s report that the U.S. has been using the “virtual” financial economy to improve its GDP numbers.

El-Erian On Bloomberg About Greece

In a conference organized by the magazine Economist El-Erian, the CEO of PIMCO, talked about the choices of Greece and the likelihood of default. The Bloomberg article can be found here. In El-Erian’s own words:

“It’s in Greece’s interest to default as long as you can contain the contagion to other countries and it is done through orderly restructuring and repricing to retain competitiveness. Like Latin America’s “lost decade” in the 1980s, the alternative doesn’t promise growth and employment generation,” he said.

“I have never seen an 11 percent adjustment on the fiscal side being delivered” under the current program’s assumptions, said El-Erian, who worked at the IMF for 15 years. “Eleven percent is heroic.”

“The fiscal adjustment that Greece needs to do is unprecedented,” Giada Giani, senior European economist at Citigroup Inc., said at a conference in Brussels today. “There is a limit to the amount of fiscal tightening a country can bear and support without the tightening becoming self-defeating, so detrimental for economic growth that it doesn’t really deliver an improvement.”

I Am Not Alone

Krugman annoys others, too. Not just me. I just came across a piece by David Backus, a professor at NYU Stern, which describes his irritation by Krugman. I cannot agree more with David when he says that.

“And to be fair, there are two Paul Krugmans.  I admire the brilliant expositor of economic ideas.  I’m less enchanted with the political partisan who can’t resist using cheap debating tricks in what could be a useful exchange of ideas.  Even worse, he sometimes mixes the two, disguising politics as economic analysis.”

Negative TIPS Yields!

Indeed it sounds as impossible, but it is a reality. Even though it initially sounds as a very-very bad thing about the economy, it is the opposite. It means that investors believe that we will have inflation and they even accept a negative yield. So strong is their belief that prices will increase. This may prove right or wrong. This conviction is definitely due to the QE2. TIPS investors bet that the program will work and we will have inflation. Remember that for TIPS the face value is not fixed, like in Treasuries. The face value increases or decreases according to the inflation rate. Hence, negative yields can exist and it can be rationalized by a big probability of inflation, or higher values of inflation than previously thought, or both of the above.

Here I give some articles on this phenomenon. Article in Yahoo!Finance, in Bloomberg, in Reuters and in FT.

Roubini about Greece and Europe

An article with the interesting opinions of Roubini on Greece, Europe and Euro. The article is in Greek.

Pissarides, Azariadis and Ioannides’ Article On Kathimerini

In Kathimerini.gr the Nobel laureate economists Christopher Pissarides together with economists  Costas Azariadis and Ioannis Ioannides give their opinions on what the policies that will bring the Greek economy out of its dark state are. The main emphasis is on policies that enhance growth by making structural reforms in all the economic activity in the country, enhancing the private sector by reducing corporate taxes and by convincing the public that an unprecedented effort to transform the whole country is taking place in order to get behind these efforts themselves. In the article you will find a lot of interesting data about the Greek economy. The article can be found here and it is in Greek.

A Greek Cypriot Along With Two Americans To Receive The Nobel Prize In Economics

Christopher Pissarides, a Greek Cypriot born in Nicosia and faculty at LSE was awarded the Nobel prize in economics for 2010, along with Peter Diamond from MIT, and Dale Mortensen from Northwestern University, for their contributions in search theory and its applications. The Swedish Royal Academy of Sciences stated that they are nominated the prize “for their analysis of markets with frictions”.

Here is the link to the official announcement and here is the official document from the prize committee highlighting the contributions of the prize recipients.

The Real Estate and Credit Meltdown Discussion From USC

A good discussion that took place before I start my blog but I think it is good to include in order to get a better understanding of what happened, where we are, and where we are heading.

Socialism vs Free Trade Incentives

I came across the following extremely enlightening story which I republish exactly as I read it. The message of the story speaks directly on the main flaw of socialistic and communistic systems. Apart from the one flaw that all economic systems share, that are run by normal people with all the sins they have – greed, pride, fear, wrath, sloth, lust, envy and gluttony, the socialistic systems cannot motivate people to produce wealth. They encourage sloth and lazy behavior and they discourage hard work. No surprise why countries that adopted these policies ended up ones of the poorest in the world and they fell apart. So, here is the story:

An economics professor at a local college made a statement that he had never failed a single student before, but had once failed an entire class.

That class had insisted that Obama’s socialism worked and that no one would be poor and no one would be rich, a great equalizer.

The professor then said, “OK, we will have an experiment in this class on Obama’s plan”.

All grades would be averaged and everyone would receive the same grade so no one would fail and no one would receive an A.

After the first test, the grades were averaged and everyone got a B.
The students who studied hard were upset and the students who studied little were happy.

As the second test rolled around, the students who studied little had studied even less and the ones who studied hard decided they wanted a free ride too so they studied little. The second test average was a D! No one was happy. When the 3rd test rolled around, the average was an F.

The scores never increased as bickering, blame and name-calling all resulted in hard feelings and no one would study for the benefit of anyone else.

All failed, to their great surprise, and the professor told them that socialism would also ultimately fail because when the reward is great, the effort to succeed is great but when government takes all the reward away, no one will try or want to succeed.

Could not be any simpler than that.

Illuminating Orszag’s Resignation

Digging on databases and going back on November 2009, we find evidence that the reasons of Peter Orszag’s resignation from being the White House’s budget chief, may not have been what he stated when he left the office. The reason may as well have been his failure to pass stricter policies to fight deficits. His statements from that period clearly show how he viewed his job. Here are some quotations from the Bloomberg article:

• “The government needs to reduce the federal budget deficit to a “sustainable” level of about 3 percent of U.S. gross domestic product within six years.”
• “In the medium term out in 2015, 2016, 2017, we need to get to something around 3 percent of the economy so that debt is no longer rising as a share of the economy,” Orszag, director of the Office of Management and Budget, said.
• “Frankly I feel like my credibility is on the line in the document that we put out” in early February,” Orszag said.

In light of these statement and given that up to the time Mr. Orszag left office, the White House had not taken action in curbing the threatening debt, we may understand how Mr. Orszag may have been feeling.

This is the first time, during this presidency, a close ally of Mr. Obama leaves office. This case is more alarming, given that the decision of leaving the office is totally Mr. Orszag’s. It is not normal for people in the highest positions to leave them for no good reason.

Unemployment Or Employment

In contrast to the better-known unemployment rate, which measures the percentage of working-age Americans who are actively seeking jobs but do not have one, the civilian employment-population ratio measures the percentage of working-age Americans who have a job, whether they are seeking one or not.

This distinction matters because the state of an economy affects whether someone looks for a job at all. Bad times discourage potential workers from seeking jobs; boom times encourage marginal workers to seek them. As our population grows, we have more working-age adults who need work. A growing economy needs to replace the jobs we have lost and add new ones to accommodate these added potential workers.

The following graph describes the bleak employment outlook. The drop in employment during the 2007 downturn has been unprecedented. The employment ratio has fallen from the 63% pre-crisis level to 58.5%, and it has constantly been declining during the last three months, at the time that the unemployment rate has remained constant at 9.5%.  No other time in the history has seen such a steep decline in employment.

Interest Rates, The Income Effect, And The Substitution Effect

John Michaelson published today on WSJ a piece entitled “The high costs of very low interest rates”, in which he first gives reasons why the policy of keeping the short term interest rate to its current near zero levels is not productive, and then he explains what he sees as benefits of raising the short term rate. This article constitutes a good piece for thought. Let’s discuss its merits. In short, the consequences of the near zero rate policy, as stated by Mr. Michaelson, are:

• Negligible returns on savings. This hurts consumers who “have less to spend” (the income effect), “and those nearing retirement have to save more”. Also, “the owners or managers of pension plans, foundations, trusts and the like must also make higher contributions to make up for lower investment earnings in order to meet their obligations. In the case of public pension plans, these higher contributions contribute to local and state fiscal crises.”
• Banks are not forced to lend to the real economy, rather they enjoy the benefits of a riskless yield curve arbitrage, by borrowing at near zero and buying long-term Treasuries or high grade corporates.

Mr. Michaelson acknowledges that the FED’s policy was intended to revitalize consumption and lending. However, he points that the beneficiaries of this policy, the consumers, the banks, and the companies do not play by the book, i.e., they do not consume, they do not lend, and they do not invest. He also warns against the near zero interest rate policy, citing the example of Japan in the nineties and its lost decade.

Turning onto the benefits of increasing the short term rate, he sees that this could lead to:

• “More funds will flow to borrowers who will invest them in job-creating activities and increase consumption”, ending the carry trade on dollar and the yield curve arbitrage.
• “Will cause Americans to feel more confident about their economic future”.

Hence, raising the short-term interest rate to a merely low level, than the near zero current level, it will make banks “less tolerant  of underperforming assets and seek to move those assets more swiftly to superior owners and operators, creating additional efficiencies and job-creating growth”.

Mr. Michaelson’s argument is indeed well structured and it may actually be, very succinctly, describing the current problem and its solution. However, I would like to make a few comments. First, in reference to the Japan’s lost decade, this is not a result of the near-zero interest rate policy, alone. The author seems to suggest that the failure of the Japanese economy in the nineties, is solely due to this policy, however, one could not forget that it is never one policy that is only implemented, and other policies could have contributed to this result. For example, regarding Japan, one could also cite the lack of nerve from the side of the authorities in forcing their banks to come clean fast enough. Rather, they chose to hide the problems that the banks’ portfolios had, effectively undermining their efforts for recovery.

In addition, I would like to emphasize that there are some moving parts in Mr. Michaelson’s argument. Even though an increase in the rate will discourage the carry trade and the yield curve arbitrage, and at the same time will encourage undertaking more risky and job-creating investments, the effect of raising interest rates on consumers and the firms is not as clear. And in Mr. Michaelson’s argument the behavior of the consumers is very critical. The consumers, in his argument, encouraged by the income effect, will increase current consumption and this will also encourage the firms – who currently sit on piles of cash – to invest more, hence create more jobs, which will lead to more consumption, and so on.  This is based on the presumption that the income effect is stronger than the substitution effect – the tendency of the consumers to save more when interest rates are higher, given that it will result to higher future consumption. Even though the debate on which effect is stronger is still alive, the widely accepted conclusion seems to be that the substitution effect wins. This goes against Mr. Michaelson’s argument. However, there is a silver lining in that the win of the substitution effect over the income effect is not very strong, hence it could be that this time around the income effect could dominate.

This is indeed a suggestion contrary to the conventional wisdom, but it could as well be right, this time.  

Why Increasing China’s Labor Costs Is Good For Everyone (Almost)

The featured article on Economist is about the rising power of the Chinese worker. Indeed. A long waited increase in Chinese workers salaries will have many good implications for China itself and the rest of the world. This article analyzes some of these benefits. In addition to the mentioned benefits in the article, which I summarize briefly bellow, there is one more.

This is that an increase in Chinese workers salaries will improve the competitiveness of other countries, like the Europe’s south, who now suffer, from the abundance of cheap labor in motherland China. In sort, the benefits from increasing China’s labor costs are:

1. Increase the ability for the Chinese workers to enjoy the fruits of their labor.
2. Balance the Chinese economy which is currently heavily depended upon investment.
3. Boost the world economy, by increasing consumption.
4. Balance the China’s trade imbalances with the rest of the world.
5. Adjustment in the Juan’s exchange rate.
6. Increase the employment in the rest of the world, as less jobs from the other countries are going to be lost to China.
7. Improve the competitiveness of other countries.

The main cost from this increase, will be the increase in the price of Chinese products, but this is counterbalanced with all the above benefits, especially that of increasing employment in other countries, and also the fact that at this time a little inflation is not bad.  The ones who may lose more form this rise, is going to be the shareholders of the big corporations who have factories in China.