Why Nations Fail, a review

"Why Nations Fail" is different from a lot of development books. It neither focuses on specific policy proposals, and neither does it focus on specific micro or macroeconomic theories that lead lead a nation towards economic development.  Quite simply, this book wants to tell you why the same specific sets of policies will work in one nation, and lead nowhere in another. It wants to tell you how you know which nations can run with a specific set of development actions, and end up achieving their objectives.

This book is also different from your regular pseudo-cultural economics books which explain away economic development in successful countries to their specific cultural, anthropological, sociological, or religious makeup. Neither does it barrage you with pseudo-explanations that attribute success to geographical location as the differentiating factor. And neither does it shirk by merely pointing out that successful countries just had the luck of having a really brilliant leader who knew what to do. Yes, these can be big factors that certainly help, but the book in fact explains how each of these common success theories fall short. After all, how many times have we seen countries located strategically next to emerging economies, and led by seemingly smart and charismatic leaders, that still fall short of economic progress, while their neighbours, with seemingly less resources, more run of the mill leaders that come and go, leap into the industrialized world?

No, this is a book that focus on institutions.  It distinguishes between institutions that can be considered extractive from those that are more inclusive.  It then explains how inclusive institutions create the right incentives for local people to invest, to strive, and to take initiative, and how extractive ones discourage them.  If you've been with me on this blog for some time, you know I have a great deal of respect for institutional explanations, and how these institutions create very concrete transmission channels and mechanisms for economic policy. You can have the right policy, but it you do not have the right institutions for it, then no amount of effort will result in successful implementation. To have the right institutions, you need to know how it aligns its objectives with people's incentives and helps them overcome their constraints.

At the macroeconomic level, before you even think of specific goals and policies, you need to ask whether people can see themselves getting more prosperous if they work harder, invest their savings, and take risks with new ways of doing things.  Do they see that rewards go to those who make the effort and investment, or do they risk losing the fruits of their labour to an extractive regime that expropriates and gives everything to someone else more closely connected to the ruling elite? Do they know for a fact that they will have a voice going forward, to ensure that their economic interests are protected and represented, or will they lose out to an elite that's suddenly given a monopoly on their industry?

In my mind these are the questions that must run in the minds of the multitude of people who ultimately make the difference between a nation taking off and a nation not making it.  Steve Waldman posts that depression is a revealed preference, as a polity, and we are choosing continued depression because we prefer it to the alternatives. In the same vein, nations can choose slavery, apartheid, or pluralism, rule by absolute royal decree or rule of law, upward mobility for newcomers or stable representation for incumbents, openness to creative destruction or loyalty to existing regimes. these revealed preferences often also reveal whose interests are most given importance in society. Whether these interests are those of one person, a few elites, or the greater multitude makes all the difference for a nation's rise, and it continued stay up there.

The book provides enough stories and anecdotes from history to make this  view of development vivid.  Soviet Russia, ancient Rome, Maya city states, sub-saharan Africa, medieval China and Japan, medieval England, Spain and Europe, even the neolithic age, as are a bunch of other historical places and times make it to this thick book as examples. it's like reading history all over again, but with the end of analyzing why one people or nation makes it, while others don't, and still others fall. Highly recommended for both history and economics buffs.

Written by Daron Acemoglu, MIT professor of Economics; and James Robinson, Harvard professor of Government.

Natural rate brain twisters

Mike Sankowski has a good primer over at MMR on the fallacies about the 'natural rate'. His main points:

1. The NRoI doesn’t exist
2. If the NRoI does exist, it’s not stable
3. Then, even if it does exist and is stable, it’s power is so weak it’s not useful to consider it in policy.
4. Then, even if it does have a powerful impact on our economy, we have such a problem measuring it and observing it and knowing it in real time, we shouldn’t consider using it as any sort of guide for policy.
5. Then, even if we can observe and measure it and consider using it as a policy guide, the NRoI is focusing on the wrong goal and should not be used as a policy guide

I'll just add that it boggles me how economists purport to be able to calculate the ‘natural rate’ or the ‘equilibrium rate of interest’ in the ‘absence of the capital markets’. Since everything is linked to the capital market, how are they able to compute for the natural rate without it, and how do they at all know it is the ‘equilibrium’? Furthermore, what is the conceptual significance of a rate of interest in the absence of a capital market? 

The natural rate means something different for everyone, even for economists, so there can never be one objective measure for it. Personally, I have my own personal ‘natural rate of interest’, but that is personal to me. I’m sure the ‘natural’ rate would be different for you, and different for the next person. Furthermore, the ‘natural’ rate would be different for me tomorrow, and different again next week. It depends on a lot of personal factors that affect how I value whether or not to take out that next loan or make the next investment. Kind of like the risk premium, it’s going to be a different value for everyone, and its value would change as their personal circumstances change. 

There’s no economy-wide risk premium, and there’s no economy-wide natural rate.  Averaging out everyone’s natural rates to get at one overall natural rate to target still ends up with people with higher than average personal natural rates who still end up misallocating funds (and ending up affecting everybody else’s natural rate). I tend to equate the natural rate with risk premium. Having said that, even economists who argue about the merits of calculating a natural rate will calculate the risk premium as exogenous to the interest rate set by the central bank. So how can something calculated exogenously to the natural rate also be endogenous to it?

Are you still with me? Maybe not. That's how convoluted it gets when you start thinking of an economy's so-called natural rate. Mike is right - to calculate it is to focus on the wrong goal and it should not be used as a policy guide.

Some limits to bank printing 'out of thin air'

In this post I want to highlight an interesting discussion I had over at MNE with other commenters about banks and their ability to print money for their acquisitions. An anonymous commented said:

Bank credit money is also created when banks make asset purchases or payments on their own account, not only when they make loans." to which Matt Franko added "imo they must be able to buy the property and construction of their branches by crediting bank accounts of the landowners and contractors.

I was at first resistant to Matt's assertion that banks can print every time they want to make an acquisition. But thinking it through, that's almost about right, but I wanted to add a clarification, based on my own understanding, that not all payments banks make, though they’re paid as credits to accounts, are new money. That credit will result in a debit, and sometimes the debit is to their equity.  For example, if they buy their office supplies, pay their workers, or settle their utility bills, it does not add new money to the economy. If the bank uses its earnings (part of its equity) which is money received from elsewhere, it is not money created at the point of credit. Anonymous commenter says: 

Whenever they spend or lend they do so with their own privately created credit. They only use reserves to settle with each other or with the central bank and treasury (or when they borrow/lend reserves from/to each other,)or cash when people withdraw it. Everything else is done with the 'inside money' they create themselves. ..

When a bank purchases something or pays someone they credit an account, as they do when they make a loan. The credit is typed into existence through a computer keyboard. This adds to the bank's overall liabilities. Banks have to maintain a *ratio* of capital and or reserves. That ratio has to "come from somewhere" in the case of said purchases/payments, but it's only a fraction of the overall credit/deposit money credited by the bank. If the created deposit is then transferred to another bank then of course settlement takes place with reserves, as always.

Not much I really disagree with. I just would add that loans and branch locations are two different animals. When a bank buys a branch property, it has to be funded by a corresponding liability - its own equity, a loan from somewhere else, or via deposits. But when a bank buys a loan, it expects a positive income from the spread between the loan and the cost of the liability that results from it. Then when a bank buys property for a branch, or a computer printer, there's usually no income assumption, as they’re an expense outlay for the bank.  While it is true that purchases or payments are created as an accounting entry by the bank, if they result in net equity outflow, that outflow cannot be compensated by the bank by printing reserves into existence. One has to distinguish whether that payment is for an expense or for funding a loan. Anything that is considered an expense outlay is not new money created by the bank. And any net cost that results from that purchase is not funded with new money, as is the case with equity capital that has to be raised to maintain the ratio. That’s why, as Tom Hickey said, "the bulk of horizontal money creation comes from credit extension, not asset purchases or payments on their own account". Tom also mentions in the discussion. 

When a bank creates bank money to purchase assets other than loans or fund expenses, it is in effect borrowing at the price of reserves, since it is creating deposits that have to clear (after netting). Even if a bak uses its own excess reserves, that's interest it is losing on lending in the interbank market. Banks can create money but not "for nothing." But it is true that banks borrow at a much lower rate than non-banks in the sense that they don't have the spread to deal with.

This is also why, I believe, a bank that has no earnings or no equity cannot continue spending just because it can create money out of thin air by crediting an account. If the spending is going to be funded by liabilities, then the bank incurs greater liquidity and insolvency risk.  As Dan Kervick also adds: 

But the money they create to buy stuff for themselves is just as much a liability as money they create in the process of making a loan. They create an account for the seller of the goods and credit that account. If the seller of the goods then writes a check on that account to someone whose account is at another bank, the first bank will have to make a payment to that other bank that is settled and cleared through the banks' reserve accounts at the central bank. And if the seller comes into the bank and decides to withdraw the total amount in the account, the bank will have to hand him a bunch of vault cash. Clonal also adds: 

I believe the fact that revenue is recognized immediately on making the loan is where all the problems are coming from. More money than the amount of the loan is created at the time of the inception of the loan. The excess money is then capitalized after accounting for things like provisions for loan losses etc.

To which I acknowledge, I could be referring to an outmoded banking model. As far as I know, if a bank keeps the loan in its books, revenue is recognized as and when it receives interest income, not when the loan is made. Of course, if a bank securitizes everything or most of the loans it makes, revenue will be recognized when the loan is sold, even if it's at the point the loan is made.

P.S. I add in comment discussion that Basel rules further limit this printing.

Bartering in the Greek Euro odyssey

I want to highlight in this post the flourishing barter system in Greece. It is one that grew out of necessity, due to the lack of circulating income within the country, which is then the result of three years of austerity measures. What do people do when insufficient money is going around, and each has less income to buy his needs, yet still has his demands, as does his neighbour? Last year the New York Times reported on the Greek Volos network:

Part alternative currency, part barter system, part open-air market, the Volos network has grown exponentially in the past year, from 50 to 400 members. It is one of several such groups cropping up around the country, as Greeks squeezed by large wage cuts, tax increases and growing fears about whether they will continue to use the euro have looked for creative ways to cope with a radically changing economic landscape.
“Ever since the crisis there’s been a boom in such networks all over Greece,” said  George Stathakis, a professor of political economy and vice chancellor of the University of Crete. In spite of the large public sector in Greece, which employs one in five workers, the country’s social services often are not up to the task of helping people in need, he added. “There are so many huge gaps that have to be filled by new kinds of networks,” he said. Here in Volos, the group’s founders are adamant that they work in parallel to the regular economy, inspired more by a need for solidarity in rough times than a political push for Greece to leave the euro zone and return to the drachma.

Back in 2008, I mused whether there could be a private sector solution to the aggregate demand problem. Back then, austerity was already being trumpeted by many policymakers and opinion makers as the necessary solution to the economic crisis, while rejecting Keynesian solutions as wasteful and 'crowds out' private sector investment. (Pundits who believed that people stopped spending because of too much government waste rather than because people with the money started hoarding them out of fear, or because of escalated debt calls and investment writedowns). 

Back in 2008, in the similar situation of less transactions, and less income going around, bartering also seemed to me the circuit breaker to this vicious cycle of fear and recession.  "Could the private sector solution involve local companies engaging in quasi-barter trade with each other? Or paying via in-kind currencies? For example, we can have businesses paying employees via credits that can be used by consumers to buy/pay for services of other local producers. So in essence, in an economic downturn where actual cash flow is scarce, demand is created by empowering cash-starved businesses to pay employees and suppliers in some 'credit principle' that other businesses will then consider acceptable form of payment. I don’t really know how this type of arrangement can be made to work, but if it can, it will work only if enough businesses participate. The world is now more globalized than ever before, and this solution would again only be possible if an economy has enough industry diversity to be self-sustaining on its own, otherwise the arrangement will need to be global in scope."

What's happening in Greece shows us that despite the constraints caused by policymakers that are both literally and figuratively distanced from the problems and challenges of regular people, life still has to go on.  I would still expect that this situation (in Greece and in all of the Eurozone) be finally resolved properly, as bartering remains a short-term solution. It gets bogged down by the constant requirement of a double coincidence of wants, and results in far less efficiency and productivity than when commerce is done with a state-backed currency.  Still, for what it's worth, for now this development is a triumph of the human spirit over outsize constraints, of necessity over adversity.