Economic Externailities and the G-20 Summit

The G-20 summit was last week in Pittsburgh.  While the summit did spend some time on politics, such as what to do about Iran's nuclear program, the heart of the meeting was about Economics.  Especially the kind of economic issues we call externalities.

Externalities are situations of market failure, which means in this context that outcomes delivered by profit-driven supply and demand are not the best outcomes from the point of view of overall global economic efficiency.  Externalities can be positive, which implies that markets produce too little of some activity that we benefit from (education for example), or negative, which implies that markets produce too much (pollution for example).  Most of the time, when heads of states and their ministers get together to discuss "common solutions," they are talking about negative externalities.

As we know too well, the last year witnessed many situations where actions taken in the pursuit of private benefits by firms - mainly financial - in a handful of countries wreaked havoc across borders.  In other words, the costs of these actions have been painfully borne by many countries, some of which had little input into or control over the decisions of the firms that took these actions.

In the hope of reducing the risk of such negative spillovers in the future, the G-20 discussed externalities related to banker pay, raising mandatory bank reserves, and the worrisome problem of financial institutions that are "too big to fail."  

On the question of bank reserve requirements, it turned out that the U.S. was in favor of higher reserves while the European Union was against.  At first blush, it seems like these positions are the reverse of what we would expect.  If you dig a little deeper though, it makes sense, and stems from the different approaches to regulation in the U.S. and the E.U..  The U.S. position is based on a more hands-off view of regulation, and is the argument that raising reserve requirements forces banks to maintain larger cushions to forestall bank runs and financial fragility, but that beyond this firms should be free to run their business as they see fit.  The E.U. objection is based on the argument that banks are already more strenuously regulated in Europe than the U.S., and therefore raising reserve requirements is redundant, only serving to hobble their ability to compete.  


The importance of the G-20 (as opposed to the G-8) as a forum for dialogue and discussion among the worlds most powerful economies (producing 90% of the world's output and 80% of trade) is itself a reflection of the growing clout of "emerging economies" such as the so-called BRICS (Brazil, Russian, India, China, South Africa).  A change in the balance of global economic power.

You can access an article from the New York Times about the G-20 summit here.


 

Flattening the World: Google Book Search

Google Book Search is the ambitious plan to digitize every book, in every language, published anywhere on earth, found in the world's libraries, as part of Google's core mission to "organize the world's information and make it universally accessible and useful."

The project, which began in 2002, has grown into a multibillion dollar effort, involving the mind-boggling logistics of scanning so many pages of text and surmounting copyright issues. It is hard to imagine many other companies with the sheer ambition and deep pockets that such an endeavor requires.

There is no doubt that the project has the potential to bring tremendous benefits to society. Books that are unavailable to most of us for a myriad of reasons - antiquity, obscurity, being out of print - would literally come back to life. Indeed, the phrase, "out of print" could risk becoming endangered itself. The ability to literally call up almost any book in the world on a computer screen seems like a wonderful facility. The ways in which such a facility might transform productivity are hard to imagine. Giving almost anyone anywhere access to the worlds greatest library collections is likely to be a tremendous boon, especially to people in poor and backward parts of the planet. This might "flatten the world" further, to paraphrase Thomas Friedman.

So why the fuss? Last October, Google reached a settlement with authors and publishers to end a class-action lawsuit that challenged the legality of the scanning project. Under the settlement, Google will pay $125 million and create a framework for a new system that will compensate authors and publishers whose books are still under copyright from book sales, advertising revenue and other fees, leaving a cut for Google.

A coalition has formed to oppose the proposed class-action settlement, which is awaiting court approval. Tentatively called the Open Book Alliance, it includes nonprofit groups, individuals and library associations. The group argues that the proposed settlement is anticompetitive. Curiously, Amazon, Microsoft and Yahoo recently announced plans to join the alliance.

What's the problem here? Most of Google's products (search, gmail, calendar, docs, gadgets,...) are free and convenient for many of us end-users. A concern is that as we become more dependent and comfortable with Google's suite of complementary products, we become less likely to switch to those of a competitor. This kind of "lock-in" and "switching costs" (economics jargon alert) translates into market power for Google. Currently this manifests itself in online advertising fees and revenue for Google. But if Google becomes dominant in digital books, there is concern that Google's monopoly power could lead to pricing power on books, subscriptions to libraries for access to Google Books and so on.

There is more than a bit of irony in the fact that Amazon plans to join the Open Book Alliance and oppose Google. Could Google Book Search do to Amazon what Amazon has done to independent booksellers?

And what of bricks and mortar bookshops? Newer copyrighted books may not be available under Google Book Search unless copyright holders agree to have their books available there. Another glimmer of hope here is the idea that many readers will want to turn those digital copies into paper copies, which could be individually printed by a bookstores in the neighborhood. In fact, Google Book Search has already entered into partnership with On Demand Books, which sells a $100,000 Espresso Book Machine, which booksellers can buy. The machine prints the pages, binds them together perfectly, cuts the book to size and then dumps a book out, literally off the press, with a satisfying clunk.

Quid Pro Quo

No sooner has fear of an imminent systemic collapse of the financial sector subsided and banks receiving emergency funds to weather the financial turbulence are in a position to return the assistance to the Treasury, than "outsize" bonuses seem to be back at many banks.

Should we be bothered?  Is there a case for regulating compensation in banks and similar financial institutions?

At first blush, given our laissez faire beliefs, we would say no.  Let the market work.  Shouldn't banks be free to determine compensation practices as they see fit, as firms in other industries, such as say retail or manufacturing?

This has become an interesting and important question.  This was among the most prominent topics of discussion at last week's G-20 meeting of finance ministers from the world's most powerful economies.

The first step in the argument for regulation of bonus-pay at banks is the belief that the promise of outsize (often multi-million dollar) bonuses at financial firms provided incentives for taking outsize risks.  The second step is to understand that excessive risk taking by financial firms can be problematic because the financial sector is tightly interlinked via interbank loans and other financial flows.  A string of gambles gone awry at one firm has the potential to jeopardize the entire financial sector and, turn affect the functioning of the  "real" economy.  Because finance is such an important ingredient to the smooth functioning of a modern market economy, concern over the devastating consequences of such a chain-reaction, once set in motion, prompted the kind of intervention and rescue of banks that we saw earlier in the year.  In other words, because the financial sector is at the core of the economy, we cannot afford to let the financial sector collapse.  In economics this kind of a situation is referred to as negative externalities or spillovers.  So while we all share in the costs if the financial sector experiences turmoil, when the financial sector does well, the bonuses are awarded to the select few.  You could say that the costs are socialized, but the benefits are privatized.

Another important issue in this context is the fact that the bonuses are often based on relatively short-term performance criteria, but the negative spillovers may come to pass only when the system is under extreme stress, something that takes a while to build up, and happens relatively infrequently.  A large lag between the quid and the quo, you could say.

This is the sort of reasoning behind the discussion at the G-20 meeting.  So far it appears they haven't been able to agree on how to regulate banker pay (BBC news article here).  However, requiring higher capital reserve requirements  for banks, which would provide a thicker cushion against unexpected financial shocks, seems to have broad consensus.   

Slumdog or Millionaire? The Zombie Economy.

So, is the economy in recovery mode, or not?

Many of you have read in the news that some economists believe that the economy is on a path to recovery.  There are positive signs, no doubt.  According to the Commerce Department, the economy contracted by only 1% in the second quarter ending in June, as compared to a contraction of 6.4% in the first quarter.  Home-sales were up by 11% and jobless claims fell by 1.5% in June, and a widely cited measure of stress in financial markets, the TED spread (the difference between Treasury bills and a three-month LIBOR) is down to pre-crisis historical levels.  (See for yourself here).

But this is as we should expect, given the injection of gigantic doses of macroeconomic steroids into the body-economic in the form of fiscal and monetary stimulus.  As you probably recall, a macroeconomic stimulus package consisting of a $2.5 Trillion financial sector bailout and a $787 Billion fiscal package was approved in the Spring, and is still being drip-fed to the economy.  It would therefore be surprising if the economy did not experience some "defibrillation."  And since the stimulus is still in the process of being disbursed and spent, we shouldn't be surprised if things to look up even more in the third and fourth quarter.

But there are reasons to be worried that the recovery, such as it is, is fragile.  There are at least two sources of concern.  One is the fact that even though we are out of the woods in terms of a systemic financial sector meltdown, credit continues to be rationed by banks.  It is still hard to get credit if you need it, for both individuals and firms.  A second wildcard is the impact to the economy of the sharp increase in the individual savings rate.  The Commerce Department reports that the individual savings rate has shot up from an average of nearly zero to about 5.2%.  The decline in consumer spending associated with this is attributable in part to the approximately $14 Trillion in wealth that has been wiped out by the collapse in home values and stock portfolios over the past year.  A rule of thumb that economists use to estimate the impact of this kind of wealth effect is that every $1 decrease in wealth translates into a spending decline of 3 to 5%.  To envision the possible after-shocks of this change in behavior on the economy all you need to know is that in the recent past consumer spending has accounted for about 70% of U.S. economic activity.  The great unknown here is how far the savings rate will go before it stabilizes.  7-8% is a number that many economists expect.  But what if it goes to 10%?  If the unemployment rate, currently around 9.7%, doesn't improve soon, then this is not outside the realm of possibility.

Under normal circumstances, higher savings rates and lower budget deficits are considered a virtue.  But when the economy is in a recession, many of the behaviors that were virtues become vices, so to speak.  If everyone decides to save a lot more, then consumer spending shrinks in the aggregate, dealing another punch in the solar plexus to the overall economy.  This situation is referred to by economists as the "Paradox of Thrift."  The logic for expanded government spending  (also referred to as deficit spending) in such a situation is as a temporary replacement for consumer spending.

Nevertheless, all of this is still within the logic of the macroeconomic stimulus.  The entire point of such a large stimulus in the teeth of a recession is to unclog the arteries of the financial system, prime the engines of the body-economic, and jolt the economy into a recovery so that when the stimulus spending peters out we are unable to notice the difference because the economy has hit its own stride.