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Economics in Denial

Howard Davies

22 August 2012
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PARISIn an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”
 
 

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Trichet went on to appeal for inspiration from other disciplinesphysics, engineering, psychology, and biology – to help explain the phenomena he had experienced. It was a remarkable cry for help, and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad.
 
 

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So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate change expert, has argued that techniques from his discipline may help explain financial-market developments.
 


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Epidemiologists have suggested that the study of how infectious diseases are propagated may illuminate the unusual patterns of financial contagion that we have seen in the last five years.
 
 
 
These are fertile fields for future study, but what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models?
 
 
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George Soros has put generous funding behind the Institute for New Economic Thinking (INET). The Bank of England has also tried to stimulate fresh ideas. The proceedings of a conference that it organized earlier this year have now been edited under the provocative title What’s the Use of Economics?
 
 
 
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Some of the recommendations that emerged from that conference are straightforward and concrete. For example, there should be more teaching of economic history. We all have good reason to be grateful that US Federal Reserve Chairman Ben Bernanke is an expert on the Great Depression and the authorities’ flawed policy responses then, rather than in the finer points of dynamic stochastic general equilibrium theory. As a result, he was ready to adopt unconventional measures when the crisis erupted, and was persuasive in influencing his colleagues.
 
 
 
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Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions. Students should also be taught some humility. The models to which they are still exposed have some explanatory value, but within constrained parameters. And painful experience tells us that economic agents may not behave as the models suppose they will.
 
 
 
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But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-calledChicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.
 
 
 
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And there is disturbing evidence that news of the crisis has not yet reached some economics departments. Stephen King, Group Chief Economist of HSBC, notes that when he asks recent university graduates (and HSBC recruits a large number of them) how much time they spent in lectures and seminars on the financial crisis, “most admitted that the subject had not even been raised.” Indeed, according to King, “Young economists arrive in the financial world with little or no knowledge of how the financial system operates.”
 
 
 
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I am sure they learn fast at HSBC. (In the future, one assumes, they will learn quickly about money laundering regulations as well.) But it is depressing to hear that many university departments are still in denial. That is not because students lack interest: I teach a course at Sciences Po in Paris on the consequences of the crisis for financial markets, and the demand is overwhelming.
 
 
 

We should not focus attention exclusively on economists, however. Arguably the elements of the conventional intellectual toolkit found most wanting are the capital asset pricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address.



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On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” And the efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”
 
 

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This amounts to what we might call an “irrelevancedefense: Finance theorists cannot be held responsible, since no one in the real world pays attention to them!
 
 
 
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Fortunately, others in the profession do aspire to relevance, and they have been chastened by the events of the last five years, when price movements that the models predicted should occur once in a million years were observed several times a week. They are working hard to understand why, and to develop new approaches to measuring and monitoring risk, which is the main current concern of many banks.
 
 

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These efforts are arguably as important as the specific and detailed regulatory changes about which we hear much more. Our approach to regulation in the past was based on the assumption that financial markets could to a large extent be left to themselves, and that financial institutions and their boards were best placed to control risk and defend their firms.
 
 
 

These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation. Finding a new and stable relationship between the financial authorities and private firms will depend crucially on a reworking of our intellectual models. So the Bank of England is right to issue a call to arms. Economists would be right to heed it.




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Howard Davies was Director of the London School of Economics (2003-11), and was the first chairman of the United Kingdom’s principal financial regulatory body, the Financial Services Authority (1997-2003), which he established at the request of the British government. Previously, he served as Deputy Governor of the Bank of England and Director-General of the Confederation of British Industry.



Swiss private banks
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Bär’s leap
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A Swiss bank bets on emerging markets
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Aug 25th 2012
BERLIN
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WHO would want to be a Swiss private banker right now? This summer many of them were advised to holiday within Swiss borders rather than risk arrest or other forms of harassment by American and European tax authorities. In some cases their own bosses have been pressed into sending employee details to America’s Department of Justice, which is investigating 11 Swiss banks for encouraging tax evasion by American residents.



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Although consolidation is needed, few banks are interested in buying each other at the moment, mainly for fear of inheriting some horrible lawsuit in America. There is trouble closer to home, too: German politicians are threatening to tear up a treaty designed to head off attacks on Swiss banking secrecy.
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But at least one Swiss private banker is willing to stick his head above the parapet. Earlier this month Boris Collardi (pictured), the boss of Julius Bär, cemented the bank’s position as the country’s third-biggest wealth manager, still some way behind UBS and Credit Suisse (see chart), in a deal that should also double the bank’s presence in growing markets such as Asia and South America. Julius Bär is buying the non-American business of Merrill Lynch’s International Wealth Management (IWM) division, which manages $84 billion of clients’ money. The seller is Bank of America, which picked up Merrill during the worst of the 2008 financial crisis and will take a SFr240m ($249m) stake in Julius Bär as part of the deal.
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Mr Collardi, still only 38, has been changing the face of the once rather staid, family-dominated Bär since he took over in 2009. Last year he bought into GPS, a Brazilian wealth-management firm, and beefed up Bär’s workforce in Germany. More recently he has struck co-operation agreements with Macquarie, an Australian investment bank, and Bank of China. (In the interim, an attempt to buy Sarasin, a private Swiss bank owned by Rabobank of the Netherlands, came to nothing.) The aim is to have 50% of his business in emerging markets by 2015. The IWM deal may help him achieve that goal sooner than planned. Bär already has foreign offices in 29 cities, including Moscow, Cairo and Jakarta. IWM overlaps with some of those but will add eight others, and around 300 extra people in London.




Stock analysts fear Mr Collardi may have bitten off more than he can chew. Bär’s share price plummeted once the IWM deal became public; to alleviate shareholder concerns about dilution, on August 20th Bär reduced the size of a planned rights issue. IWM is overstaffed and loss-making, according to analysts’ calculations. Bär will have to cut staff, reconcile two clunky IT systems and force a new culture on the Merrill bankers: they are rewarded deal by deal, whereas Bär’s bonuses depend on the bank’s overall performance. Bär is putting aside SFr400m for “restructuring costs, including payments to retain staff; Bank of America is also chucking in $125m to keep people in place. Bär will pay only for the assets that are successfully transferred—it anticipates that at least SFr10 billion will be withdrawn by IWM clients.




It will take time to judge whether Bär’s leap has been successful. Critics wonder whether Mr Collardi’s youthful ambition is leading him to risk a solid franchise for an uncertain future.



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But his boldness has logic. UBS and Credit Suisse, the two giants of Swiss banking, still have to convince wealth-management clients that their investment-banking arms will not cause them more trouble; the IWM deal consolidates Bär’s status as the biggestpure playwealth manager in Switzerland.





And the industry can no longer rely on Swiss banking secrecy to attract assets. The Department of Justice will not be placated; tax treaties with Britain, Germany and Austria that preserve bank secrecy may well be torpedoed by Swiss citizens in a referendum planned for November. Even some Swiss bankers are now calling for Switzerland to fall into line with the European Union’s savings directive, which requires cross-border exchange of information.
 


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Hans Bär, who ran the bank from 1975 to 1993, shocked the Swiss when he wrote in 2004 that banking secrecymakes us fat, but impotent”. His latest successor is right to seek out new sources of growth.

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China’s House Divided

Christopher R. Hill

22 August 2012
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DENVERThere has been much talk about America’s decline in recent years, with the corollary that China will take its place. But, while the United States does indeed face problems that urgently need to be addressed, if China is to rise further, to say nothing of supplanting the US internationally, it must first put its own house in order.

 
 
 


Those who argue that America is in decline have a difficult case to make in economic terms. For all its recent woes (which many countries would gladly exchange for their own), the US remains a dynamo of industry and innovation, and may be emerging as an energy powerhouse as well.
 
 

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What threatens America’s global leadership is, rather, some of the most divided and disruptive domestic politics in its history. A country whose people have traditionally prided themselves on practicality is experiencing a debilitating bout of excessive theorizing, ideology, and so-callednew ideas,” thereby forestalling the practical ideas that come from constructive interaction with one’s political opponents.
 
 
 
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The demise of compromise and collegiality in domestic politics has raised new challenges in America’s interaction with others as well. Foreign-policy debate in the US has become a proxy for who is “tougher,” which does not necessarily mean wiser.
 
 
 
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Thus, the American art of diplomatic engagement, the ability to talk with different sides while holding one’s own views to oneself, has been largely replaced by a penchant for loud talk, finger-pointing, self-righteousness, and recrimination. Countries used to welcome and look for American engagement. Now some are more likely to fear it, especially if it comes in the form of playing to domestic American constituencies’ appetite for supposed toughness.
 

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But, before the US hands over international leadership to the Chinese, it would be instructive to look at China’s own internal political divisions and inability to synchronize its domestic politics with its growing global responsibilities. China’s problems make those afflicting the US polity seem trivial in comparison.
 
 
 
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In recent years, China has been increasingly embroiled in a nineteenth-century-style dispute with several of its Southeast Asian neighbors over conflicting claims to the South China Sea. Before one laments Americans’ unwillingness to crack a history book on an international subject, it is enlightening to watch China in action, systematically complicating its vitally important relationships in the region over what?
 
 
 
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China’s so-callednine dashesclaim, which essentially seeks to turn the entire South China Sea into a southern Chinese lake, represents a legacy of Chiang Kai-Shek’s Republic of China. And where did the Generalissimo find the inspiration for this claim? China argues that the waters have been Chinese for a thousand years, but the likelier inspiration is more recent, reflecting Imperial Japan’s occupation of Taiwan until 1945. Thus, China, whose culture and achievements are the envy of the world, is today in a war of words – and a few naval vessels as well – with almost all of its southern neighbors over a recently inherited claim on an issue that calls for a respectful process of international negotiation.
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Various considerations typically underlie policy choices in such situations. But, in the case of China’s ham-handedness in the South China Sea, domestic constituencies decryingweakness” and demanding toughness from political leaders are a key factor. Among China’s 500 million Internet users, for example, one senses a palpable rise in nationalist sentiment, reflected in bitter criticism of official weakness” in defending Chinese interests.
 
 
 

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China’s government is extremely sensitive to such attacks. If a Chinese blogger criticizes the government over its crackdown on Falun Gong, or supports Tibet’s opposition, the Internet police rush to the scene of the supposed crime. But if the blogosphere emits jingoistic calls for more raw materials, the government salutes and works harder to obtain them.
 
 
 
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Domestic pressures have tied China in knots on other issues as well. Many international observers might forgive China its behavior in the South China Sea, given that many countries, large and small, have maritime disputes with neighbors. But China’s own constituencies, whether netizens or competing official institutions, have contributed to an international record that is earning China derision from small neighbors and great powers alike.
 
 
 
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China’s continued support for a nuclear aspirant like North Korea is a case in point. No responsible country in the world today sees any merit to North Korea’s behavior. Yet China’s preoccupation with its internal politics is such that it cannot see the price that it pays for reacting to every North Korean outrage with only vague opprobrium, combined with expressions of hope-over-experience that North Korea will reform. For example, the equanimity of its response to North Korea’s military attacks against South Korea in 2010 left South Koreans, who are also China’s neighbors, in despair about bilateral relations.
 
 

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The origin of China’s desultory policy lies in its leadership’s failure to shape or sharpen the drift of domestic politics: many Chinese still see plucky little North Korea as a friend and ally. So China does nothing to signal a more serious way forward, much less earn respect in the broader international community, which is now thoroughly disgusted by North Korea’s behavior.
 
 
 
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The list of untenable policies goes on. Syria is the latest international problem that China, again constrained by domestic politics, cannot seem to get right. No one expects China to line up in perfect formation with the US or the European Union on this and other issues. But its consistent preference for lining up on the other side of the divide even when doing so runs counter to its own national interestscalls into question whether it has the internal fortitude to be a leader.
 
 

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None of this is meant to minimize the consequences of political polarization in the US. But, whereas America’s problem in the world today is that domestic pressures sometimes lead to an excess of fortitude, China’s problem is that similarly constraining pressures produce foreign-policy weakness.



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Christopher R. Hill, currently Dean of the Korbel School of International Studies at the University of Denver, was one of the main architects of American diplomacy in the 1990’s and 2000’s. A key negotiator of the Dayton Accords, which ended the war in Bosnia, and a special envoy to Kosovo in the late 1990’s, he then led the US delegation to the six-party talks on North Korea’s nuclear program and was US Ambassador to Iraq from 2009 to 2010. He has also served as US Ambassador to Macedonia, Poland, and South Korea, and as US Assistant Secretary of State for Asian and Pacific Affairs.




August 23, 2012 8:21 pm
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Republicans eye return to gold standard
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Mitt Romney speaks during campaign event in Hobbs, New Mexico©AFP





The gold standard has returned to mainstream US politics for the first time in 30 years, with a “gold commissionset to become part of official Republican party policy.



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Drafts of the party platform, which it will adopt at a convention in Tampa Bay, Florida, next week, call for an audit of Federal Reserve monetary policy and a commission to look at restoring the link between the dollar and gold.



The move shows how five years of easy monetary policy – and the efforts of libertarian congressman Ron Paul – have made the once-fringe idea of returning to gold-as-money a legitimate part of Republican debate.



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Marsha Blackburn, a Republican congresswoman from Tennessee and co-chair of the platform committee, said the issues were not adopted merely to placate Mr Paul and the delegates that he picked up during his campaign for the party’s nomination.



“These were adopted because they are things that Republicans agree on,” Ms Blackburn told the Financial Times. “The House recently passed a bill on this, and this is something that we think needs to be done.”




The proposal is reminiscent of the Gold Commission created by former president Ronald Reagan in 1981, 10 years after Richard Nixon broke the link between gold and the dollar during the 1971 oil crisis. That commission ultimately supported the status quo.



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“There is a growing recognition within the Republican party and in America more generally that we’re not going to be able to print our way to prosperity,” said Sean Fieler, chairman of the American Principles Project, a conservative group that has pushed for a return to the gold standard.




A commission would have no power except to make recommendations, but Mr Fieler said it would provide a chance to educate politicians and the public about the merits of a return to gold. “We’re not going to go from a standing start to the gold standard,” he said.




The Republican platform in 1980 referred to “restoration of a dependable monetary standard”, while the 1984 platform said that “the gold standard may be a useful mechanism”. More recent platforms did not mention it.





Any commission on a return to the gold standard would have to address a host of theoretical, empirical and practical issues.




Inflation has remained under control in recent years, despite claims that expansion of the Fed’s balance sheet would lead to runaway price rises, while gold has been highly volatile. The price of the metal is up by more than 500 per cent in dollar terms over the past decade.



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A return to a fixed money supply would also remove the central bank’s ability to offset demand shocks by varying interest rates. That could mean a more volatile economy and higher average unemployment over time.




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On the campaign trail in New Mexico on Thursday, Republican presidential hopeful Mitt Romney said it was “a real achievable objective” for the US to reach energy independence by 2020, touting his plan to open a stretch of the south-east coast for oil development and speed up drilling on federal lands.




 
Copyright The Financial Times Limited 2012