Dani Rodrik's weblog

Unfair to Brazil

Paul Krugman writes that the crisis shows how "we are all Brazilians now."  I thought that was quite unfair to Brazilians, who after all became investment-grade in April.  Oh wait. Who upgraded Brazil's sovereign debt?  Standard & Poor's, the same firm that was the leading credit rating agency in the subprime mortgage market?  Never mind...

Seriously, Krugman presents a characteristically insightful model of contagion, which has helped me think through the issues.  The basic story is that highly-leveraged institution are bumping against a maximum-leverage ceiling, and when their balance sheets take a hit they have to respond by dumping some of their assets, which only exacerbates the downward price spiral. 

There is an interesting paradox buried in the Krugman model.  On the one hand, the more leveraged you are, the larger is the sell-off you need to engage in to restore your original leverage ratio following any initial reduction in asset prices.  That makes high leverage the prime culprit of the present crisis, and rationalizes Krugman's (and many others') view that liquidity is of no help; only recapitalization will work.  On the other hand, if the leverage constraint were not binding (as Krugman forces it to be in his model)--i.e, if you were able to ramp up debt--then you would not have had to dump any assets in the first place.  In this second view, the problem is liquidity.  Is this a possible justification of the Paulson plan? 

The other shoe drops

Yes markets in the U.S. and Europe are doing terribly, but to me the real news today is that emerging markets have taken a huge tumble: Russia went down 20% before it closed down again, Argentina and Brazil are both down by more than 10%, Mexico by 7%, South Africa by 8%, and Turkey by 9%.  There goes the decoupling theory...

And what could be a really, really bad portent: China went down by more than 5% today. China is used to large swings in its stock markets, but this time it is happening in the midst of extremely unfavorable external circumstances--in fact because of them.

When other countries experiences financial crises, they lose a few percentage points of GDP and they get it over with.  A lot more is at stake in China.  China's precarious social balance and political stability hinge on continued high growth.  Derail that growth engine, and you could have some really scary consequences that will affect 1.3 billion people and their neighbors.

(And talk about bad timing....) 

The $700 billion question: why did the House change its mind?

by Filipe Campante and Davin Chor, guest bloggers

At first, pundits and analysts were left wondering why 228 representatives chose to “Just Say Nay”. After the eventual approval of the “bailout” (or “rescue”?) package, many have pointed to the tax provisions added by the Senate, or to the renewed persuasion efforts from political leaders, as explanations for the turnaround. But a closer look at the data helps us understand why some of the initially unconvinced were more persuadable than others: extreme ideological positions and the scope of the financial sector in home districts were the key factors.

Much was made of the political pressures faced by different representatives. Those who were most sensitive to their constituents’ antagonistic sentiments towards the bill because of electoral concerns were indeed more likely to reject it. We found that a member facing a competitive race was 30% more likely to say “Nay” than her colleague with a “safe” seat. Also, a member who was stepping down was almost 50% more likely to vote for the bill than a colleague with a seat to defend. But the reelection incentives did not seem to matter in explaining the change of heart: a representative in a “safe” seat who voted against the bill initially was not more likely to switch his vote than his threatened colleague.

A more crucial factor was ideology. While Republicans were indeed more likely to reject the bill, what mattered the most was how extreme the ideological position of each representative was. This turned out to be the single best predictor of the “Nay” vote, and particularly so for Republicans: an extremely conservative representative – say, an ideological kin of Sen. Tom Coburn (R-OK), the most conservative of all senators – was about 60% more likely to cast a “Nay” vote than a fellow GOP representative, otherwise identical, who just happened to be as centrist as Sen. Olympia Snowe (R-ME).

What is more, ideology was also very important in understanding which representatives had a change of heart. Among those who initially voted against the bill, the more ideologically extreme were significantly less likely to change their votes in the second go-around. Only the less extreme among the extremists proved within the reach of persuasion.

The other crucial factor was the role of the financial sector. Congresspersons representing districts where the financial sector is a more prominent employer were far more likely to vote for the package in the first round and, if at first voting against it, also to eventually change their minds. This suggests that those constituents who were particularly vulnerable to the rejection of the bill, and to the market reaction after the first vote, were indeed able to make their concerns heard. On the other hand, we could find no evidence that economic conditions such as the prevalence of subprime loans or the unemployment rate influenced voting patterns, indicating how much the current crisis has expanded far beyond local concerns about toxic mortgages in housing markets.

(Incidentally, members of the Black Caucus also played a role. They were indeed more likely to say “Nay” in the first vote, and those who did vote “Nay” were about 30% more likely to reverse their vote in the second round than other representatives – we leave it to the political junkies out there to explain this change.)

In sum, a closer look at the data suggests that the voting patterns were fairly predictable after all – the stunning rejection and the subsequent approval of the bailout package were two sides of a familiar political coin.

(See technical appendix here.)

When property rights can be a hindrance

This is a good time to remember that we live in a complex world, in which first-best logic about the shape that efficiency enhancing institutions take can go badly wrong.  When there are inherent informational limits and unavoidable transaction costs, institutional arrangements that look otherwise crazy may start making a whole lot of sense.

Economic history provides a deep reservoir of illustrations. The latest example that has just come to my attention is the story of the Spanish Mesta, as told in a recent paper by Mauricio Drelichman: 

The experience of Early Modern Spain has many times been cast in the light of institutional analysis, and its failure to keep up with the European economic leaders blamed on a flawed array of growth-stifling institutions including the nobility, the Catholic Church and the trade guilds. None of them, however, rose quite to the status of the Mesta, the national association of migratory shepherds, as the favorite whipping boy of those seeking a culprit for the protracted stagnation of the Spanish economy. Echoing the sentiment of eighteenth century liberal reformers, early and mid-twentieth century scholars blamed the rights of passage granted to migratory shepherding for preventing the development of an enclosure movement, and thus forestalling agrarian productivity growth; the rental privileges that guaranteed the access of flocks to winter pastures were accused of introducing distortions in land markets; and even the export focus of Spanish fine wool was singled out as one of the main reasons for the failure of the country to industrialize.

But things are not always what they seem.

The privileges accorded to the Mesta were a tool that enabled Medieval Castile to realize its comparative advantage in fine wool; in the absence of efficient land markets and in view of the logistic problems posed by the long migrations, rights of passage and grazing allowed the optimal economic activity of migratory shepherding to flourish in what would have otherwise been a hostile environment. The Crown, however, could fine-tune the level of enforcement of those privileges in order to strike a balance between agricultural and shepherding interests, tilting the property rights environment in favor of the sector in whose favor the terms of trade were evolving at any given time and responding to local political realities. A combination of seemingly inefficient privileges and selective enforcement is obviously inferior to a well-functioning market in land and in rights of passage. In the absence of such a market, however, this combination can easily be construed as a second-best institutional arrangement.

In the imperfect contractual environment of the time it simply made sense to privilege shepherd at the expense of the property rights of the agriculturalists.  Drelichman documents how the Crown reversed these privileges as world prices of wool declined in the second half of the16th century and Spain lost some of its comparative advantage in wool--an efficient response once again.

As Avinash Dixit puts it in a delicious turn of phrase (in his forthcoming Presidential address to the American Economic Association), "everything is 'second-best' at best."

Blasphemy!

Isn’t it possible, then, that rather than causing a Great Depression, significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?

So asks Ken Rogoff (HT: Mark Thoma), who thereby joins the populists club. 

How come such creative thinking is nowhere to be seen when it is a crisis in an emerging market that we are talking about?