The irredeemable in pursuit of the insatiable

Nicholas Gruen

The jump not taken: illustration by John Leech from Handley Cross; or, Mr Jorrocks’s Hunt, by R.S Surtees, published by Bradbury and Evans in 1854.

In 1943, back working where he’d been during the first world war, the now-famous economist John Maynard Keynes wrote to a friend: “Here I am back… in the Treasury like a recurring decimal — but with one great difference. In 1918 most people’s only idea was to get back to pre-1914. No one today feels like that about 1939. That will make an enormous difference when we get down to it.”

And so it did.

And here we are like Keynes’s contemporaries in 1918. Keen to return to the set-up we know got us into this mess. In the midst of the financial services royal commission, scandals stretch as far as the eye can see. They are rife in finance, of course, but are also evident in the way professionals — from the commanding heights of academia to policy-makers and opinion leaders — have failed to move beyond a vision of reform that was already stale at its zenith in the 1980s and 90s. After the global financial crisis, that vision stands today bereft and becalmed, increasingly irrelevant in today’s financialised, professionalised, digitised world.

Trauma, intellectual growth and reform

The postwar reforms were profound, giving us a generation of unmatched prosperity. But there’s also a more recent time when we turned our back on the bad old days. In response to the recessions of 1975 and 1982, and after prime minister Malcolm Fraser’s feints towards economic liberalisation, the Hawke and Keating governments turned “economic rationalism” — as it was then called — into a comprehensive program to refurbish our economic institutions.

In each case reform was built on new understandings that had originated in the academy.

Where the Keynesian revolution had underpinned postwar reform, post-1960s reform was founded on a cluster of ideas. They included George Stigler’s critique of “regulatory capture,” Milton Friedman’s popularising of proposals for unbundling of delivery from the financing of government services (using vouchers and income-contingent loans, for instance), and Ronald Coase’s idea of reassigning property rights to achieve specific objectives (think pollution permits and spectrum auctions).

All these men were University of Chicago economists favouring greater reliance on markets.

But they thought of these ideas as technocratic rather than ideological. Many of them — like income-contingent student loans and the liberalisation of airlines, tariffs and agricultural subsidies — had egalitarian implications and were supported by many from the centre left to the centre right.

The institutional refurbishment following the second world war lasted twenty-five-odd years.

But it was only a few years before the Hawke-era reforms atrophied into a reductive formula under which change that looked more rather than less “market-based” was preferred on principle. This might reflect the lobbying power of business even with centre-left governments.

But it was also the product of faltering intellectual progress in the academy and the political class’s wider failure of imagination and empathy for the people for whom they ostensibly govern.

Market-oriented reform

Supporting greater “market orientation” worked well when it involved dismantling the detritus of eight decades of policy-making by deal-doing. Tariffs, agricultural subsidies and regulated shopping hours were slashed and government-sanctioned cartels in the airline industry broken up.

Reform also inspired some well-conceived new policies that could be achieved with the stroke of the pen, as when we more tightly targeted family payments around need. (Not all notable Australian policy successes followed this formula, and they showed Australian policy-makers at their best. They included programs to divert people from residential aged care — via Home and Community Care — and more sophisticated ways of partnering with communities through such initiatives as the AIDS strategy and Landcare.)

But relying on a summary aesthetic of greater “market orientation” was no way to reform sectors — utilities and finance, for instance — in which market failure is pervasive. There, as Mark Twain once put it, it’s not what you don’t know that does the damage. It’s what you know for sure that just ain’t so. Looking back, the landscape is strewn with disasters.

In infrastructure and utilities, monopoly problems abound, so regulation remains inevitable and new rent-seeking pathologies lie in wait for those unpicking the old ones. Here, our reform efforts brought forth overpriced tollways, energy, desalination plants, airports and airport carparks, and governments selling buildings they owned only to rent them back at vastly higher ongoing cost. And that was just the opening salvo of a lurch towards crony capitalism, as the insiders who engineered the changes parachuted into careers lobbying their successors on behalf of the beneficiaries of their reforms. In the process, we’ve seen massive overinvestment in electricity transmission and, until recently, underinvestment in other infrastructure.

That’s before we even get to finance.

Here’s a marvellous passage in which the Financial Times’s Martin Wolf introduces finance as “a jungle inhabited by wild beasts”:
[T]he purchasers of promises will know that the sellers normally know much more than they do about their prospects. The name for this is “asymmetric information.” They will also know that those who have no intention of keeping their word will always make more attractive promises than those who do. This is “adverse selection.” They will know that even those who are inclined to be honest may be tempted… not to keep their promises. The source of this is “moral hazard.” The answer to adverse selection and moral hazard… is to collect more information. But this too has a drawback: “free-riding”… [T]hose who have made no investment in collecting [information] can benefit from the costly efforts of those who have… That will, in turn, reduce the incentive to invest in such information, thereby making markets subject to the vagaries of “rational ignorance.” If the ignorant follow those they deem to be better informed, there will be “herding.” Finally, where uncertainty is pervasive and inescapable — who, for example, knows the chances of nuclear terrorism or the economic impact of the internet? — the herds are likely both to blow and ultimately to burst “bubbles.”

Are you feeling lucky?

And that’s before allowing for the special status of the public–private partnership that is banking. Here, commercial banks resell basic banking services they access exclusively from the government-provided central bank that, as lender of last resort, effectively guarantees their liquidity. Oh, and if that isn’t enough, governments first guarantee them, as the Rudd government did over one panicked weekend in 2008, or, failing that, simply hand over money to keep the show on the road.

Bank of England governor Mervyn King describes this diabolically bad set-up as the worst “of all the alternatives.” We’ve duct-taped it back together: a little more capital adequacy here, tighter prudential standards there. Global debt is now $164 trillion, or 225 per cent of global gross domestic product, 12 per cent higher than its last peak in 2009. The banking system, both nationally and internationally, remains structurally unstable, just as it was before the crisis, amplifies the economic cycle, just as it did before the crisis, and will blow up again, drawing taxpayers back into its maw.

The road not taken

All this is a microcosm of a wider and longstanding intellectual complacency. In the sixty years since they were first articulated, there’s been little replenishment of the first generation of reform ideas I quoted above. And so our policy-makers and opinion leaders wing it against a backdrop in which two caricatured abstractions — “free markets” and “government intervention” — fight it out. This dichotomy feels compelling. It gets our ideological juices going and can fuel a thousand Twitter storms. But it makes little sense.

The standard view among economists, and more informally among the public, is this. Markets provide private goods like cookies, cars and cameras, while governments provide public goods shared by all, like roads, rubbish removal and regulation. That’s a good start, but it’s a lousy conclusion. It ignores how profoundly individual and collective endeavour are enmeshed.

And that’s before considering something that economists have largely ignored since Adam Smith founded his whole view of society on it — the dialectic of individual endeavour within the collective bonds of culture. The very language in which I’m addressing you is a public good that is owned — to the extent the term makes any sense — collectively. So are any number of other aspects of its transmission to you, from the open-source software powering so much of the internet and its epiphenomena to the internet itself.

In areas like education, health, aged care, finance, research, legal services and cultural industries like the arts, and in networks like media, transport, energy, telecommunications and other infrastructure, and in city planning, output is better thought of as the joint product of competitive and collective (collaborative and regulatory) activity. Each sector requires the evolution of quite different institutions in which public and private, competitive and collaborative considerations concatenate at every level from high policy down to workplaces.

And we’ve barely started on the project of trying to shed intellectual light on these issues in ways that might cash-out in practical improvements to the way our institutions work. We might have begun decades ago, if we’d understood reform as refurbishing the institutions of the mixed economy.

The scandal of royal commissions themselves, and beyond…

Let’s start with the scandal of the royal commission itself. A Productivity Commission inquiry costs three or four million dollars — a figure that might double or quintuple if we include the costs of outside participants in the inquiry. The PC actually has discovery powers not unlike a royal commission’s, though it’s never used them and it wouldn’t be the appropriate specialist body for searching out and pursuing wrongdoing. But it provides an indicative benchmark on the costs of a good look around. So too does the recent inquiry into the public service, which at around $10 million seems excessive to me but is similar.

Though I would expect its policy conclusions to be meagre — it is focused on misbehaviour — the royal commission is budgeted to cost government $57.5 million. Each of the major banks is spending around that on their favoured big law firm. Then there’s external PR, lobbying, day-to-day “issues management,” crisis and/or strategic issues management, and so on.

Add to this substantial in-house expenditure on all these items. Smaller firms would be spending less, but there are many more of them — in banking, funds management and financial advice. Consistent with the adage “never let a good deed go unpunished,” the industry super funds have also been drawn in, their solid investment returns and relative lack of scandals putting the big end of town to shame.

So half a billion dollars seems like a safe underestimate of the total cost of this exercise. Much of it goes on massively inflated salaries to top lawyers — think ten to fifteen thousand dollars a day. But more goes on sheer inefficiency. The legal system has virtually no regard for directing lawyers’ efforts to where they’re most valuable. So the commission sends out trawling requests for all records of all misconduct. This has at least uncovered lots of bad things, though many had already been reported to authorities and then kept quiet.

Still, this approach is prodigiously wasteful in other legal proceedings for reasons we’ll discuss shortly. Sure enough, ASIC’s gun-shyness in pursuing corporate wrongdoing arises partly from this wastefulness. It blew $20 million in legal costs going after OneTel and $30 million going after Andrew “Twiggy” Forrest. $30 million! Presumably total costs, including Twiggy’s, exceeded this figure handsomely. But looking at the case notes, and even allowing for the inevitability of “gold plating” some processes when one is pursuing the potential wrongdoing of the wealthy, this is an extraordinary amount to determine a legal question. Oscar Wilde once described fox-hunting as the unspeakable in pursuit of the uneatable. Here we’ve sent in the irredeemable in pursuit of the insatiable.

Why we might have expected better: the professions

One theme of the economic reform playbook from the University of Chicago was the way the professions are just one genteel instance of Adam Smith’s famous line, “People of the same trade seldom meet… even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

This should figure in any list of the unfinished business of economic reform. Policy reform has been all over this question in vocational training, with “competency based” training and certification.

Reform in the professions does figure in the list of unfinished reforms Gary Banks compiled as chair of the Productivity Commission. But how often do we see high-profile champions of reform highlight the issue?

And if it were to be taken seriously, there’d be so much more to successful reform than simple deregulation of barriers to entry. At both macro and micro levels, professions typically exert a huge influence on the demand for their services. The lawyers representing each side in a case effectively dominate legal procedure and will gold plate each stage of the process to an extraordinary degree.

(Ask Twiggy Forrest or his adversary, ASIC.) Likewise, in the country where the market is least constrained by government acting as “informed purchaser” of health services for the community — the United States — health spending has surged to being half as large again as the health sectors of comparable countries, with worse health outcomes.

I’ve only highlighted financial aspects of reforming the professions. Making them truly responsive to our needs is a bigger prize. Imagine a market in which you might be able to find medicos, lawyers, investment advisers and managers in the way you can assess which restaurant suits you on TripAdvisor. Throw in consumer advocates, found in the same way, who help you navigate the maze of professional services to best meet your needs.

The analogy with TripAdvisor is facile, of course; and nor could the idea be dictated in a learned journal. It could only succeed if pursued iteratively, building the institutions in situ with co-design and dialogue between practitioners, their clients and disinterested experts guiding experiments to build better practice. The ideal is well expressed by businessperson Charlie Munger: “A seamless web of deserved trust.” Where have we heard that, or anything like it, in the endless debates on “reform”?

An information age for spin doctors and conmen

Commentators on the royal commission have been shocked, shocked that AMP sought amendments to Ernst and Young’s reports. But what else would you expect? We might be taken aback by the frequency, regularity and flagrancy of AMP’s entreaties. But who really believes that firms aren’t heavily invested in getting what they want from those they hire to perform “independent” analysis?

This applies to auditing, which should be a truly fundamental public good, its purpose being to ensure that the connections between the different parts of our immensely complex economy are based on financial reality.

The constraint that stops auditors spinning any old pack of lies — the way those advertising patent medicines did in the nineteenth century — is that auditors wanting to remain in business must conform to professional standards. But that leaves plenty of wiggle room, and so increasing effort and resources go into “stretching the envelope,” to use a tellingly recent expression.

This is just one small example of how an information supply chain gets subtly perverted.

Within governments, the same thing happens endlessly. We’ve set it up that way. All manner of “impact analyses,” from regulatory to environmental, are performed or commissioned by the very agencies whose impact is under review. Auditors are chosen by the firms they audit the world over, and the Australian approach of having agencies complete “regulatory impact analyses” in defence of the regulations they are promoting is offered as typifying best practice within the OECD.

Even this is the tip of a very large iceberg. Far more shockingly than AMP’s clumsy mishandling of the optics of “independence,” the utterly corrupted markets for information in nineteenth-century patent medicine markets have been replaced by much subtler corruption that steadily worsens as traditional professional standards give way to the intensifying pursuit of revenue and other institutional imperatives. Driven by various factors, not least academics’ and learned journals’ competition to “publish or perish” and their resulting lack of interest in “null” results and replication, published results are full of bogus findings. As they say in the trade, “if you torture the data enough, it will confess.”

Scholars recently found that only 11 per cent of pre-clinical cancer studies could be replicated.

John Ioannidis, a leading scholar in the field, came to this devastating conclusion: “Overall, not only are most research findings false, but, furthermore, most of the true findings are not useful.” Incredibly, the process by which research then feeds into the proving up of drugs for human use is likewise tangled in similar conflicts. Researchers’ funding depends on the favour of drug companies and widespread suppression of “unsuccessful trials.”

Once drugs are on the market, their marketing is further compromised by conflicts of interest.

And so the dominant treatments for vexing and chronic conditions, from anxiety and depression to the short attention span of children, are marginally efficacious drugs while less easily privatised and possibly more efficacious social cures go largely unfunded and unexplored. This is worst in the United States, which tolerates more advertising and more aggressive drug marketing than other developed countries. One result is the opioid epidemic, which has now given the United States the extraordinary distinction of being the first country since records were kept ever to experience peacetime falls in life expectancy for large socially mainstream demographic groups.

Gary Banks’s list suggested removing restrictions on the ownership of pharmacies, but made no mention of any of this.

Microeconomic reform for the information age

These issues concern the arteries of our information economy. Yet, compared with the set-piece reform talking points driven by business — the state of the budget, over-regulation, restrictive workplace practices and tax — and the obligatory warnings against backsliding on trade protection, they’re largely absent in our reform conversation. They’re nowhere to be found in the endless op-eds and “summits,” where the tall poppies of the Lucky Country bemoan declining productivity growth, and canvass the favours that might be done them while they lament the pervasive lack of leadership.

If we’re to rise to the challenge, we’ll have to ditch all the barracking for “free markets” or “intervention.” When markets work, they do so miraculously by harnessing the information distributed throughout society. Yet they also corrupt information flows wherever one side has better information than another — say, about the shoddy product they’re selling. So solutions to these problems must be pragmatic hybrids of competition and collaboration — accessing and leveraging local knowledge while minimising conflicts of interest throughout the production chain.

Around the Western world “information policy” is mostly stuck in early prototype. Thus, governments issue crude edicts with little care for their effectiveness. In finance, for instance, mandated product disclosure statements for investments cost the economy billions annually, but go virtually unread. Meanwhile, as the scandals about financial “advice” surge from time to time, new regulation is developed. But it always resembles a PR makeover rather than serious policy action.

Some corrupt limbs are jettisoned so the rotten body — the corrupt business model — can live on.

Both investment “advisers” and mortgage brokers are now subject to extensive and costly regulation, including the usual mandatory disclosure of commission payments. But it’s all built around the existing model and its fundamental deception — that they’re “advisers.” Regulation now requires practitioners to provide formal written “advice” to their clients — generally adapted from master scripts spewed forth from software marketed to the industry as “sales technology.” Salespeople still play their well-rehearsed role as their clients’ fiduciaries (though most still lack even a university degree) but now as government-approved professionals.

This fecklessness is reinforced by academia’s disciplinary values. There’s a vast literature on the economics of information. But it’s nigh-on impossible to get these issues into the obligatory formal mathematical models required in academic publishing without ruthless abstraction down to ideal types. This is an unpromising hunting ground for new hybrid institutions in which competition and collaboration would be structured in some new and promising way.

Recall that none of the ideas I cited from the Chicago School came from formal modelling.

Rather, they came from empirical investigation, helpful reframing of problems or institutions, and pragmatic insights, or what a software coder would call “hacks.”

Note that in our discussion of the travesties of regulating financial advisers, we’ve not even got to the main game, which must surely involve surfacing which advisers are providing the best advice and structuring a market that helps consumers find them. One likely prospect would be improving the transparency with which professional reputations are made. But if we simply impose this from the outside, as we’ve done with NAPLAN testing for instance, what’s made transparent will probably be the wrong thing, and even if it isn’t, it will still be vitiated by gaming and buck-passing. Professions and industries must be closely involved in, but should not dominate the building of, standards against which they’ll be judged, while we ensure that those standards represent the interests of users.

We should be asking how we could build institutions to get important information to people in ways they can use. We already know the recent on-time departure rates for airlines, for instance, and the workers’ compensation premiums of firms, which offer a good proxy for workplace safety. What kinds of institutions would build routines to bring this and other relevant information to the attention of those who need it — buyers of airline tickets and prospective employees respectively — when they need it? We could begin without cumbersome regulatory edicts — with groups of industry and user representatives developing disclosure standards — and with governments and other civil society institutions using their convening power to forge greater regard for the collective public good (the standard) so competition between providers is actually in pursuit of something of value. We’d talk and experiment our way to better information flows and better lives. Isn’t this better than ideological barracking for “free markets” or “intervention”?

Wither post-reform renewal?

Meanwhile, the internet is reconfiguring the ecology of public and private goods. Digital artefacts, like language, are potential public goods — available for endless, costless reuse.

You’ve probably heard of the “free-rider problem,” which can kill off improvements like new drugs because the scope for using others’ ideas without paying undercuts the original incentive to develop them. The problem is real enough in some areas, and it’s why governments subsidise research and development and protect intellectual property. But the “free-rider opportunity,” where existing cultural artefacts — like words and ideas — spread for everyone’s benefit, has always been more important. That we’ve never heard the expression is a testament to how biased towards private interests our discourse really is.

When it comes to sharing, the vested interests driving public debate are vastly more preoccupied with preventing it from undermining private profit than with optimising the immense and increasing opportunities and advantages it offers.

Be that as it may, with the advent of the internet, the free-rider opportunity is burgeoning as a slew of new public goods are privately provided. They include open-source software, blogs and Wikipedia, where people generate digital artefacts to satisfy their own desires and then throw them open for digital sharing to work its magic. And public goods privately provided for profit are also burgeoning.

Google and Facebook could have marketed their products behind a paywall to monetise more of the value they generated. But in those cases, as with so many others, the free-rider opportunity afforded by the internet now so overwhelms the free-rider problem that monetising a small fraction of a public good via advertising has made their owners vastly richer than they’d have been if they’d obsessed about free riders, as our policy debate does, and provided their services as private goods for a fee.

The internet has certainly given the entrepreneurs of the world plenty to be getting on with.

Government policy-makers not so much. I’ve suggested a whole class of digital public goods delivered by public–private partnership, and as chair of Innovation Australia I presented them to scores of officers senior and junior from the federal Departments of Innovation, Treasury and Communications. We’ve had a major innovation statement since then in which I participated at senior levels. No one disagreed with the ideas. Several found them exciting or inspiring. But they never took hold — even to be ultimately rejected further up the line. In the jaded discourse of our post-reform world, they could never be more than innocent entertainment. It’s so much easier just turning out the same old, same old.

Back to where we started

Since before the finance industry royal commission was announced, the Productivity Commission has been conducting a major inquiry into intensifying competition in finance. My submission proposed a small “hack” that could make a big difference: a slight gloss on an old idea of “competitive neutrality.”

Indeed, my proposal “completes” the idea of competitive neutrality, putting it on an ideological level playing field, as it were. Since we’ve taken so seriously the idea that, if they compete with private firms, government enterprises should compete on a “level playing field,” shouldn’t we also take the converse idea seriously — that where governments have substantial investments in providing services exclusively to some group, they should provide them on an unsubsidised basis to all comers?

This would see governments opening up the superannuation services they provide for their employees to all comers. It would also see the utility banking products central banks provide to commercial banks — products like savings and payment accounts with the government — opened up to the general public online.

The PC’s draft report on finance dealt with competitive neutrality in banking with the silence of a holy order. With others taking interest — from Martin Wolf to the Greens (who adopted it, quickly topped and tailed for political consumption) — the PC’s final report broke its silence.

Not to engage with the issues, but to shoo them away. They think it’s a bad idea. And here’s the thing. Maybe they’re right. Policy is a difficult game with more moving parts than anyone can feel confident about.

But if we’re to get even a glimmering that we’re reasoning our way to a decision rather than having our prejudices do all the work, the PC needs to weigh the pros and cons conscientiously.

But that’s not how the game has worked in Australian economic debate for a long while.

Instead, the PC points to some untoward possibilities. It doesn’t suggest how likely they are, how bad they’d be or what might be done if they happened. Nor does it weigh those concerns against possible benefits.

Rather than engage with a new idea that goes (however slightly) against the grain, it simply gainsays it as John Cleese does in Monty Python’s classic argument sketch. My proposal got the five-minute argument. But we’ve been getting the full half hour for decades.

As Thomas Paine once observed, “We have it in our power to begin the world over again.” There’s certainly lots to be thought about after the good, the bad and the ugly of thirty-odd years of reform and economic and social development in the age of the internet. But when the royal commission hands down its report and the vested interests of finance are at their weakest point, the intellectual work to get us beyond a bit more tinkering won’t have been done.

Nothing ventured, nothing gained

Nicholas Gruen is CEO of Lateral Economics.

Liberals, nationalists and the struggle for Germany

A surge of populist sentiment is part of a broader shift in international politics

Gideon Rachman

In 1989, the chant “we are the people” excited people all over the world. It was the slogan of the popular demonstrations in East Germany that brought down the Berlin Wall and ended the cold war.

Almost 30 years later the same chant is once again being heard on the streets of eastern Germany — but in a new and disturbing context. It has become the rallying cry for anti-immigration demonstrators, linked to the far-right.

In Chemnitz, a small town in eastern Germany that has become the flashpoint for the protests, one retired teacher and demonstrator explained to me last Thursday: “I was on the frontline in 1989 and it’s exactly the same spirit today. The same deep anger against the government.” Another retiree recalled that in 1989 the East German government had called the demonstrators “an out-of-control mob” and added, “the Merkel government is using exactly the same language now”.

These comparisons between the democratic revolution of 1989 and today’s anti-migrant rallies will strike many as grotesque. Mainstream German politicians are instead warning of similarities with the 1930s, pointing to the fact that some demonstrators have given Nazi salutes on the streets. But the 1989 parallel is thought-provoking in one important respect.

The upheaval in East Germany was triggered by profound changes outside the country — above all in the Soviet Union. In a similar fashion, the current surge of nationalist and populist sentiment in Germany is part of a broader shift in international politics.

In 1989, the rise of a reformist leader of the Soviet Union, Mikhail Gorbachev, fatally undermined the East German government, which was essentially a Soviet client. Today, a German government once again feels shaken by a fundamental change in the politics of the country that it has traditionally looked to for leadership — except that this time the change has taken place in Washington, not Moscow.

The great influx of more than 1m refugees and migrants into Germany took place largely in 2015. Donald Trump was elected president of the US a year later. Just as in 1989 Mr Gorbachev was widely assumed to be in sympathy with pro-democracy demonstrators in East Germany, so now Mr Trump is in sympathy with Germany’s anti-migrant movement and with broader nationalist forces across Europe.

In a series of tweets and snide remarks, the US president has made it clear that he regards Chancellor Angela Merkel’s refugee policies as disastrous and that he both expects and welcomes political upheaval in Germany. Mr Trump’s preferences are so clear that Sigmar Gabriel, who was Germany’s foreign minister until earlier this year, accused the US of seeking “regime change”.

But the 1989 parallels should not be pushed too far. The panic that gripped the East German politburo back then has no counterpart in today’s Berlin. Government ministers are concerned by events in Chemnitz. But nobody has any fear of being swept from power.

Nonetheless, events in Chemnitz are the rough edge of a broader shift in German politics. The official opposition in the German parliament is now the Alternative for Deutschland, a populist, anti-migrant party. Some of its leading figures encourage extra-parliamentary action and vigilante justice.

When support for the far-right was at less than 5 per cent, German authorities had no difficulty in monitoring and repressing it. But government officials now reckon that in areas such as Chemnitz about 25 per cent of the population supports or sympathises with the AfD. This has created anxiety about support for the far-right in the police and other arms of the state.

The rise of the AfD and the visible anger on the streets of Germany has contributed to the sense that an era is coming to a close. Ms Merkel struggled for many months to put together a coalition government. Even some supporters describe her as exhausted and shaken by the hatred she encountered in eastern Germany during the last election.

The challenges to Ms Merkel also now come from within the EU, which Germany has long nurtured as a bastion of liberal values. The entrance of nationalists and populists into government in Italy, Hungary, Poland and Austria means that Germany’s nationalists are part of a broader European backlash against liberal orthodoxy.

When Ms Merkel looks around the EU council table, she now sees a number of ideological foes. The most articulate of these is Viktor Orban, the prime minister of Hungary. He was a leader of the country’s anti-communist, pro-democracy movement in 1989 but now champions the new style of nationalist authoritarianism that places anti-refugee sentiment at the very centre of politics. Mr Orban said recently: “In 1990, we saw Europe as the future. Now we are the future of Europe.”

The Berlin political establishment has no intention of ceding the future of Europe to nationalists like Mr Orban and the AfD. But German officials and politicians know that they are once again in a fight.

In 1989, liberal and nationalist causes were allied in the struggle for democracy in eastern Europe. Now the two ideologies are opposed. The battle between liberalism and nationalism is being waged internationally. It is also unfolding on the streets of small towns in Germany.

Beyond Secular Stagnation

Joseph E. Stiglitz  

Wall Street Bull The Fearless Girl

NEW YORK – As Larry Summers rightly points out, the term “secular stagnation” became popular as World War II was drawing to a close. Alvin Hansen (and many others) worried that, without the stimulation provided by the war, the economy would return to recession or depression. There was, it seemed, a fundamental malady.

But it didn’t happen. How did Hansen and others get it so wrong? Like some modern-day secular stagnation advocates, there were deep flaws in the underlying micro- and macroeconomic analysis – most importantly, in the analysis of the causes of the Great Depression itself.

As Bruce Greenwald and I (with our co-authors) have argued, high growth in agricultural productivity (combined with high global production) drove down crop prices – in some cases by 75% – in the first three years of the Depression alone. Incomes in the country’s major economic sector plummeted by around half. The crisis in agriculture led to a decrease in demand for urban goods and thus to an economy-wide downturn.

WWII, however, provided more than just a fiscal stimulus; it brought about a structural transformation, as the war effort moved large numbers of people from rural areas to urban centers and retrained them with the skills needed for a manufacturing economy, a process which continued with the GI bill. Moreover, the way the war was funded left households with strong balance sheets and pent-up demand once peace returned.

An analogous structural transformation, this time not from agriculture to manufacturing, but from manufacturing-led growth to services-led growth, compounded by the need to adjust to globalization, marked the economy in the years before the 2008 crisis. But this time, mismanagement of the financial sector had loaded huge debts onto households. This time, unlike the end of the WWII, there was cause for worry.

As Summers well knows, I published a widely cited commentary in The New York Times on November 29, 2008, entitled “A $1 Trillion Answer.” In it, I called for a much stronger stimulus package than the one President Barack Obama eventually proposed. And that was in November.

By January and February 2009, it was clear that the downturn was greater and a larger stimulus was needed. In that Times commentary, and later more extensively in my book Freefall, I pointed out that the size of the stimulus that was needed would depend both on its design and economic conditions. If the banks couldn’t be induced to restore lending, or if states cut back their own spending, more would be required.

Indeed, I publicly advocated linking stimulus spending to such contingencies – creating an automatic stabilizer. As it turned out, the banks weren’t forced to expand lending to small and medium-size businesses; they cut it drastically. States, too, slashed spending. Obviously, an even larger stimulus in dollar terms would be needed if it was poorly designed, with large parts frittered away in less cost-effective tax cuts, which is what happened.

It should be clear, though, that there is nothing natural or inevitable about secular stagnation in the level of aggregate demand at zero interest rates. In 2008, demand was also depressed by the huge increases in inequality that had occurred over the preceding quarter-century.

Mismanaged globalization and financialization, as well as tax cuts for the rich – including the cut in capital-gains tax (overwhelmingly benefiting those at the very top) during the Clinton and Bush administrations – were major causes of accelerating concentration of income and wealth.

Inadequate financial regulation left Americans vulnerable to predatory banking behavior and saddled with enormous debts. There were thus other ways of increasing aggregate demand besides fiscal stimulus: doing more to induce lending, to help homeowners, to restructure mortgage debt, and to redress existing inequalities.

Policies are always conceived and enacted under uncertainty. But some things are more predictable than others. As Summers again knows full well, when Peter Orszag, the head of the Office of Management and Budget at the beginning of Obama’s first administration, and I analyzed the risks of mortgage lender Fannie Mae in 2002, we said that its lending practices at that time were safe. We did not say that no matter what it did, there was no risk.

And what Fannie Mae did later in the decade mattered very much. It changed its lending practices to resemble more closely those of the private sector, with predictable consequences. (Even then, notwithstanding the right-wing canard blaming Fannie Mae and the other government-sponsored lender, Freddie Mac, it was private-sector lending, especially by the big banks, that underlay the financial crisis.)

But what was predictable and predicted was the manner in which under-regulated derivatives could inflame the crisis. The Financial Crisis Inquiry Commission put the blame squarely on the derivatives market as one of the three central factors driving the events of late 2008 and 2009. Earlier in President Bill Clinton’s administration, we had discussed the dangers of these fast-multiplying and risky financial products. They should have been reined in, but the Commodity Futures Modernization Act of 2000 prevented the regulation of derivatives.

There is no reason economists should agree about what is politically possible. What they can and should agree about is what would have happened if…

Here are the essentials: We would have had a stronger recovery if we had had a bigger and better-designed stimulus. We would have had stronger aggregate demand if we had done more to address inequality, and if we had not pursued policies that increased it. And we would have had a more stable financial sector if we had regulated it better.

These are the lessons that we should keep in mind as we prepare for the next economic downturn.

Joseph E. Stiglitz, a Nobel laureate in economics, is University Professor at Columbia University and Chief Economist at the Roosevelt Institute. His most recent book is Globalization and Its Discontents Revisited: Anti-Globalization in the Era of Trump.

China is Losing the New Cold War

Minxin Pei

Chinese military marching

HONG KONG – When the Soviet Union imploded in 1991, the Communist Party of China (CPC) became obsessed with understanding why. The government think tanks entrusted with this task heaped plenty of blame on Mikhail Gorbachev, the reformist leader who was simply not ruthless enough to hold the Soviet Union together. But Chinese leaders also highlighted other important factors, not all of which China’s leaders seem to be heeding today.

To be sure, the CPC has undoubtedly taken to heart the first key lesson: strong economic performance is essential to political legitimacy. And the CPC’s single-minded focus on spurring GDP growth over the last few decades has delivered an “economic miracle,” with nominal per capita income skyrocketing from $333 in 1991 to $7,329 last year. This is the single most important reason why the CPC has retained power.

But overseeing a faltering economy was hardly the only mistake Soviet leaders made. They were also drawn into a costly and unwinnable arms race with the United States, and fell victim to imperial overreach, throwing money and resources at regimes with little strategic value and long track records of chronic economic mismanagement. As China enters a new “cold war” with the US, the CPC seems to be at risk of repeating the same catastrophic blunders.

At first glance, it may not seem that China is really engaged in an arms race with the US. After all, China’s official defense budget for this year – at roughly $175 billion – amounts to just one-quarter of the $700 billion budget approved by the US Congress. But China’s actual military spending is estimated to be much higher than the official budget: according to the Stockholm International Peace Research Institute, China spent some $228 billion on its military last year, roughly 150% of the official figure of $151 billion.

In any case, the issue is not the amount of money China spends on guns per se, but rather the consistent rise in military expenditure, which implies that the country is prepared to engage in a long-term war of attrition with the US. Yet China’s economy is not equipped to generate sufficient resources to support the level of spending that victory on this front would require.

If China had a sustainable growth model underpinning a highly efficient economy, it might be able to afford a moderate arms race with the US. But it has neither.

On the macro level, China’s growth is likely to continue to decelerate, owing to rapid population aging, high debt levels, maturity mismatches, and the escalating trade war that the US has initiated. All of this will drain the CPC’s limited resources. For example, as the old-age dependency ratio rises, so will health-care and pension costs.

Moreover, while the Chinese economy may be far more efficient than the Soviet economy was, it is nowhere near as efficient as that of the US. The main reason for this is the enduring clout of China’s state-owned enterprises (SOEs), which consume half of the country’s total bank credit, but contribute only 20% of value-added and employment.

The problem for the CPC is that SOEs play a vital role in sustaining one-party rule, as they are used both to reward loyalists and to facilitate government intervention on behalf of official macroeconomic targets. Dismantling these bloated and inefficient firms would thus amount to political suicide. Yet protecting them may merely delay the inevitable, because the longer they are allowed to suck scarce resources out of the economy, the more unaffordable an arms race with the US will become – and the greater the challenge to the CPC’s authority will become.

The second lesson that China’s leaders have failed to appreciate adequately is the need to avoid imperial overreach. About a decade ago, with massive trade surpluses bringing in a surfeit of hard currency, the Chinese government began to take on costly overseas commitments and subsidize deadbeat “allies.”

Exhibit A is the much-touted Belt and Road Initiative (BRI), a $1 trillion program focused on the debt-financed construction of infrastructure in developing countries. Despite early signs of trouble – which, together with the Soviet Union’s experience, should give the CPC pause – China seems to be determined to push ahead with the BRI, which the country’s leaders have established as a pillar of their new “grand strategy.”

An even more egregious example of imperial overreach is China’s generous aid to countries – from Cambodia to Venezuela to Russia – that offer little in return. According to AidData at the College of William and Mary, from 2000 to 2014, Cambodia, Cameroon, Côte d’Ivoire, Cuba, Ethiopia, and Zimbabwe together received $24.4 billion in Chinese grants or heavily subsidized loans. Over the same period, Angola, Laos, Pakistan, Russia, Turkmenistan, and Venezuela received $98.2 billion.

Now, China has pledged to provide $62 billion in loans for the “China-Pakistan Economic Corridor.” That program will help Pakistan confront its looming balance-of-payments crisis; but it will also drain the Chinese government’s coffers at a time when trade protectionism threatens their replenishment.

Like the Soviet Union, China is paying through the nose for a few friends, gaining only limited benefits while becoming increasingly entrenched in an unsustainable arms race. The Sino-American Cold War has barely started, yet China is already on track to lose.

Minxin Pei is a professor of government at Claremont McKenna College and the author of China’s Crony Capitalism.

How central banks distort the predictive power of the yield curve

Gaps between long- and short-term bonds may flatten for financial not economic reasons

Megan Greene

As the Federal Reserve raises interest rates during an economic recovery, the short end of the yield curve goes up. But the central bank has little control over longer-term rates © AFP

I have a bet with some colleagues that we will see the yield curve invert before the end of next year. This hardly seems a bold call given that the gap between two-year and 10-year Treasury yields narrowed to below 20 basis points last week to a post-financial crisis low. So I’m going to propose another question on an even thornier issue — if the yield curve inverts, will we actually care?

In theory, we should. The yield curve charts the difference in compensation that investors receive for holding debt of different maturities. It usually slopes upwards to the right, to reward investors for locking up their money for longer. But if investors think the economy is about to go into recession, they demand a higher premium for holding short-term bonds than longer-term debt and the curve is inverted.

Yield curves have been better than most economists at predicting US recessions, although there is some debate about which part of the curve to use. Investors typically focus on the gap between two- and 10-year yields, while academics favour the spread between three-month bills and 10-year notes.

A paper from Federal Reserve board researchers suggests that a spread of short-term interest rates may be best. All three metrics turned negative a year or two before each of the seven US recessions since the 1970s. You can argue that one curve is better than another, but all of them put us economists to shame. As the Fed lifts interest rates during an economic recovery, the short end of the yield curve goes up. But the central bank has little control over longer-term rates. Those are determined by expectations for short-term rates, inflation and the “term premium”, the bonus investors demand for the risk of holding an asset for a longer period. If the economy seems to be faltering, investors expect inflation to ease and so longer-term yields fall.

While the yield curve has a successful record predicting downturns, seven recessions is not a huge sample size. Some economists argue that policy shifts and structural changes mean the yield curve’s signal is now distorted. The US Treasury is currently borrowing more money to finance predicted big budget deficits and it has mainly done so with short-term debt. That increase in supply has pushed the price of bills and short notes down and their yields up (bond prices and yields move inversely).

At the same time, global quantitative easing has created a seemingly insatiable demand for five- to 10-year Treasuries, pushing down yields. This means that the yield curve may be flattening for financial rather than economic reasons. Meanwhile, expectations for the neutral rate (when real gross domestic product grows at trend while inflation remains stable), inflation and term premia have been consistently lower than before the financial crisis. That means longer rates have been lower, making it easier for the yield curve to invert as short rates continue to rise.

Finally, deflation fears have made long-term bonds a useful hedge for equity investors concerned about a stock price correction. That also boosts demand and represses long yields.

All of these factors make it easier for the yield curve to invert, but none seems to reflect particular concerns about the economy. An inversion this time need not necessarily indicate a recession is nigh. I am sympathetic to the arguments that this time is different, but reluctantly so. Do not forget that in 2006, then-Fed chair Ben Bernanke insisted the yield curve’s signal was being distorted by structural factors, two years before the 2008 crash.

It may not matter whether the yield curve’s predictive powers are distorted. If the markets, companies and individuals believe an inverted yield curve means there will be a recession, they will behave accordingly. An economic downturn will then become a self-fulfilling prophecy — and I will win my bet.

The writer is global chief economist at Manulife Asset Management

America’s Global Engagement

The myth of disengagement derives from American rhetoric and not American actions.

By George Friedman

I am writing this from Budapest, where Corvinus University has been kind enough to invite me to be a distinguished international fellow. (Having been a university instructor decades ago, I can confidently say being a distinguished international fellow is much nicer.) Since arriving in Budapest, I have been repeatedly asked why the United States is disengaging from the world. I have heard this said by some Americans as well, but my response is always the same: The United States continues to be deeply engaged in the world, and the myth of disengagement derives from American rhetoric and not American actions.

Take the renegotiation of NAFTA for example. The United States is involved in discussions with Mexico and Canada over the future of continental trade. Lest this be regarded as a trivial relationship, the total population of North America is about 500 million, roughly the same as the European Union. The combined gross domestic product of these three countries is roughly that of the combined GDP of EU members. So the redefinition of this trade relationship is as complex and difficult as such a negotiation would be in Europe.

The United States is also trying to redefine its trade relationship with China. It recently imposed tariffs on a large number of Chinese imports to the U.S., arguing that China has engaged in unfair trade practices through currency manipulation, barriers to U.S. exports and so on. China has responded with tariffs of its own.

Meanwhile, the United States remains on alert over North Korea. The North Koreans appear to be backing away from commitments to denuclearize, and the possibility that this will extend to deploying intercontinental ballistic missiles capable of striking the United States has not evaporated. U.S. aircraft remain poised on Guam, approximately 30,000 U.S. troops are deployed in South Korea, and naval assets are available. War is not near, but it is still possible, and more talks are being considered.

At the same time, U.S. vessels are periodically conducting freedom of navigation operations in the South China Sea to challenge Chinese territorial claims. The U.S. has also backed Australia and New Zealand’s attempts to limit China’s economic leverage over South Pacific island nations like Tonga.

This is part of a broader attempt to limit Chinese power in the region that also includes the Quadrilateral Security Dialogue, an alliance that lays the groundwork for cooperation between Japan, Australia, India and the U.S. In the past, the four nations have conducted, in different configurations, naval exercises in the Western Pacific, and the United States, Japan and Australia seem to want to formalize the military aspect of the alliance. (India is prepared to cooperate on an ad hoc basis, but not as part of a formal military alliance.) U.S. Secretary of Defense James Mattis is visiting India this week, and talks on the Quad are likely to take place. In addition, the United States and Vietnam have taken significant steps to coordinate their military and security efforts, focusing on China.

In South Asia, the United States is engaged in negotiations with the Taliban to bring the 17-year war in Afghanistan to some sort of conclusion. There have been secret talks in the past, but the current negotiations are quite open and coincide with a repositioning of U.S. troops away from offensive operations. These talks are complex and will inevitably involve Pakistan. Not incidentally, Mattis will also be visiting Pakistan this week.

To the west, the United States is trying to refine a strategy on Iran. Owing to the U.S. failure to pacify Iraq, the Iranians have a powerful hand there, as well as in Syria, Lebanon and Yemen. The spread of Iranian power is of greater significance than Iran’s nuclear program, as it is a far more immediate threat. The U.S. is increasing its support for anti-Iranian forces in Iraq, as well as for Kurdish groups in Iran and Iraq. The U.S. is tangled in relations with Israel, which is challenging Iran in Syria, and with the Saudis and United Arab Emirates, both of which are involved in Yemen. The situation is made even more complicated by the weakening of the Iranian economy and the rise of some degree of public opposition in Iran.

Then there’s the United States’ relationship with Turkey. Turkey is attempting to play the U.S. and Russia against each other, and threatening to limit its relations with Washington in favor of Moscow. Given the long history of tensions between Turkey and Russia, and the fact that in any entente with Moscow Ankara would be the weaker player, the U.S. tends to disregard this. Nevertheless, the U.S. hit the Turks with new tariffs on exports a few weeks ago, at a time the Turkish currency was in decline. The U.S. is now using tariffs as a tool to shape political relations, but Turkey has not yet taken steps to break with the United States.

In Europe, the U.S. has stationed troops, aircraft and other assets in Poland and Romania. The likelihood of a Russian attack is low; the Russians have retreated to the Ukrainian border in the south, and they know that an attack in the north would rapidly involve U.S. forces. Those forces may be insufficient to stop a full-blooded Russian attack, but they are part of a strategy Washington also deployed during the Cold War. The U.S. had a brigade in West Berlin that wasn’t large enough to stop a Russian assault, but the Russians understood that attacking and killing American troops would bring a massive and unpleasant response.

This list of very current activities demonstrates that the U.S. is far from disengaged in the world. But it is disengaged from Germany and Western Europe simply because no U.S. interest is threatened there at this time, and these countries and NATO won’t or can’t provide substantial and strategically significant support for major U.S. interests in the Pacific. Despite U.S. engagement in Poland and Romania, the European perception is, as I will put it frankly, that if the U.S. is not engaged with France and Germany, it is not engaged in the world. This is because France and Germany think of themselves as the center of the world. This is an unkind and perhaps unfair statement, but it helps to explain this strange Western European idea of American disengagement.

It is also important to note that many of these engagements are simply a continuation of older policies. The North Korean nuclear issue dates back to the Clinton administration, which had same red lines. The Quad alliance originated in the George W. Bush administration. The relationship with Vietnam and India has been evolving through many administrations, and negotiations with the Taliban have been ongoing at least since the Obama administration. The deployment along the Russian frontier was started under George W. Bush and increased under Obama, and the crisis in U.S.-Turkish relations goes back at least to the 2016 failed coup. There are a few new developments, however – namely the use of tariffs, the NAFTA negotiations, and the need to limit Iranian expansion.

There is certainly a political battle between factions in the United States, and the atmosphere is tense. But it is noteworthy that regardless of what some might think, U.S. foreign policy has had far more continuity than disruption. The atmosphere has certainly shifted, and U.S. strategy has merely evolved. Geopolitics dictates that nations are driven in their major relations by necessity, and that has held true for the U.S.

There has long been a vast divergence between the rhetoric of politicians and American reality. The U.S. has always been difficult for many Europeans and others to understand. But then, Americans are frequently baffled by America as well. But for all the storms and stresses, the U.S. remains deeply engaged in the world. We can agree or disagree with particular actions, but the idea of disengagement has no basis in reality.

Is the U.S. Headed for Another Mortgage Crisis?


Ten years after the mortgage-fueled Great Recession, several of the market and structural components remain in place that could set the environment for the next crisis. In her latest research, Wharton management professor Natalya Vinokurova takes a historical look at the development of mortgage-backed securities and finds fascinating parallels to the present day. She spoke to Knowledge@Wharton about her papers, “Failure to Learn from Failure: The 2008 Mortgage Crisis as a Déjà vu of the Mortgage Meltdown of 1994” and “How Mortgage-Backed Securities Became Bonds: The Emergence, Evolution, and Acceptance of Mortgage-Backed Securities in the United States, 1960–1987,” and why one should heed the warnings of history.

An edited transcript of the conversation follows.

Knowledge@Wharton: The inspiration for this research goes back to the introduction of mortgage-backed securities. Can you tell us about that?

Natalya Vinokurova: One of the things many people do not realize is this last mortgage-backed securities market got started in the 1970s. Specifically, the goal was very much to find funding for the baby boomers as they were buying houses. What’s interesting about the market is that for the first 15 years or so of mortgage-backed securities being around, bond investors did not believe that these were bonds. The big project was convincing bond investors that they could treat mortgage-backed securities as bonds. One of my papers on this topic looks at the process by which mortgage-backed securities issuers convinced bond investors that these were, in fact, bonds.

Knowledge@Wharton: What did they do?

Vinokurova: Mortgage-backed securities and bonds are different on a number of dimensions.

The dimension that bond investors were most concerned about in the 1970s and early 1980s was prepayment risk, with the idea being that mortgage-backed securities are bundles of mortgages. Your average borrower can repay his or her mortgage at any time. Most of the time, these borrowers would not incur a penalty. As an investor, this meant that if you were buying a security backed by 30-year mortgages, there was a very small chance that the security would still be around 30 years out. It could have been repaid in seven years, 12 years. There was a lot of uncertainty about when these mortgages would actually be repaid. As a bond investor, somebody’s trying to sell you something and they can’t even tell you how long this thing is going to be around. Obviously, bond investors pushed back.

One of the interesting things about my research is I get to go back and look at the various mortgage-backed securities that issuers tried to sell to bond investors. I documented at least seven or eight different types of mortgage-backed securities, and that’s just what was offered to the public. I have no way of tracking the many private experiments.

Knowledge@Wharton: How did market participants come to accept these mortgage-backed securities as being like bonds?

Vinokurova: An important step in the acceptance of mortgage-backed securities as bonds was developing tools that bond investors believed would manage prepayment risk. The tools that won the game, which were introduced in 1983 in a public security called the collateralized mortgage obligation, was tranching. The idea behind tranching is that you can slice investors into different classes. Tranche is the French word for “slice.” Each of these slices of investors would theoretically be exposed to different levels of risk. You had the junior tranches, which were supposed to absorb the risk. The senior tranches were protected by the fact that you had the junior tranches as part of the security.
The security that started it all only had three tranches. By the early 1990s, you had securities with something like 68 tranches…. But the precursor for this flourishing of all these tranches was when Freddie Mac issued the collateralized mortgage obligation in 1983. It was the first publicly issued security that used tranching. Bond investors said, “We now believe you,” because each of these tranches was given a ballpark range of repayment. If you were a pension fund looking for longer-term securities, you knew that the security you were buying would be safe from prepayment risk for the first five, seven, however many years you needed.

Knowledge@Wharton: Now we get into the 2000s and the financial crisis. You found that past experience didn’t play very much of a role in what happened next, correct?

Vinokurova: In the early 1990s, the Fed undertook a series of interest rate cuts, so just about every mortgage borrower in the United States had an opportunity to refinance their mortgage. The reason they had this opportunity is because the bond investors’ capital flowed into the mortgage market. Prior to the bond investors believing that mortgage-backed securities were bonds, you had these concerns about insufficient financial capital flowing to the mortgage market. Once the bond investors believed these things were bonds, once they believed that tranching would work, just about enough money flowed into this market to enable as many people to refinance as wanted to. You had 70% of all borrowers repaying their loans in some securities. 
What that meant was no matter how well the tranching of prepayment risk was structured and how much fancy math went into it, at the end of the day, the junior tranches disappeared. They were kind of overwhelmed by the risk. The senior tranches found themselves vulnerable. If you were a pension fund investor who was comfortably sitting in the knowledge that whatever it was you owned would not be repaid for the next five years, you found yourself in the same boat as the junior tranches.

What I argue in the paper is the series of events — starting with the faith and the efficacy of tranching, leading to the influx of bond investor capital into the mortgage market, leading to this self-destructive loop — is exactly predictive of the events of 2008. Moreover, what’s interesting about the meltdown of tranching for prepayment risk is that it is what encouraged people to invest in subprime mortgages because some of these subprime mortgages had prepayment penalties, which prevented the borrowers from refinancing. In a way, the movement towards these nongovernment-backed, mortgage-backed securities with default risk was driven by the fact that they were seen as being a safer bet.
Knowledge@Wharton: What were the most surprising conclusions in terms of how market participants reacted to this?

Vinokurova: One of the reasons why people did not update their beliefs about whether mortgage-backed securities were bonds was because people constructed narratives that were very specific to the crisis. The early 1990s events were variously called “the meltdown” and “the mayhem” of the mortgage market. But the explanation that got constructed for the mayhem had to do with the fact that mortgage lenders lowered the fees associated with refinancing. Instead of blaming the use of tranching for what happened, instead of seeing the systematic causes of the events of the 1990s, the market participants settled for this very local explanation.

I think we see something similar with the 2008 crisis, where instead of looking for structural causes, what we see is a search for this very specific explanation.

Knowledge@Wharton: Why do you think people want that very specific explanation? Is it because that seems easier to fix than a structural problem?

Vinokurova: I think it’s a combination of that. It’s also a combination of the fact that people have a lot of time pressure. People in these jobs, whether they be investors, rating agencies, investment bankers, are all working with time pressure. Frankly, most of them do not last in their jobs for long enough to remember the previous cycle, and the ones who do kind of partitioned their experience. I didn’t really find anybody trying to look for these global lessons.

I think one way in which the failure to look is evident — and this is something I found surprising — is if you examine the arguments in the 1970s in favor of developing these mortgage-backed securities, there is absolutely no reference to the prior U.S. markets in which mortgage-backed securities played a part. One such market developed in the 1870s. Another such market developed in the 1920s. Even as these markets have certain parallels to what happened post-1970s, once the securities were introduced, you don’t see any of these actors making specific appeals to these prior experiences. As they don’t remember the history, they literally repeat it.

For instance, some of the names of the mortgage-backed securities issued in the 1970s are exactly the same names that were used in the 1920s. In 1975, Freddie Mac issued something that was a precursor to the collateralized mortgage obligation, a security that they called a guaranteed mortgage certificate, which is exactly the name that was used in the 1920s by mortgage insurance companies issuing mortgage-backed securities. The parallel does not end there because what happened in the 1920s as part of the mortgage crisis was these mortgage insurance companies went bankrupt, and this is very much what happened to AIG in 2008. The history literally repeats itself.

Knowledge@Wharton: Is there a way to build institutional memory into the system?

Vinokurova: Absolutely. I think a good analogy here is the Food and Drug Administration. This is an entity that tries to force memory. If your drug failed to do certain things or it poisoned people in the 1960s, you can’t reissue it and say, “Oh, let’s do this again.”

In my research, I take the prospectuses — the documents explaining what the securities are and what they should do — as almost a fossil record because that’s my way of reconstructing what these securities did. Just locating these documents is surprisingly difficult. This is even the case within the firms that pioneered these securities. For instance, I contacted Citibank or Citigroup, which bought Salomon Brothers on the merger path a while ago, and I asked them for prospectuses of some of the securities that were pioneered by the Salomon Brothers in the 1980s. The reply I got was one, they couldn’t give me access to their archives because I wasn’t a client; and two, they do not keep their prospectus records in the archive for longer than three months. Now, we are talking about securities with 30-year maturity. The fact that we live in a regulatory environment where an issuer or an underwriter of a security can discard what is effectively the contract between them and the investors seems very surprising.

Knowledge@Wharton: Does there need to be more regulation requiring that this type of documentation be kept?

Vinokurova: Unfortunately for the mortgage industry in the United States, the problem runs deeper than the regulation of documentation. I can think of no other country in the world where you have these fly-by-night mortgage originators that disappear after every bust. And there are trade-offs in terms of wanting more people to have access to credit. We want the credit to be cheaper. But it seems that in designing the system, the access to credit considerations perhaps get prioritized ahead of the safety of the system.
Knowledge@Wharton: There was a lot of finger-pointing during and after the crisis to assign blame. One of the interesting things about your paper is that you find that while people may want to ascribe animus to some of these market participants, that wasn’t necessarily the case.

Vinokurova: Right. The perspective from which I approach my research is to imagine the best-intentioned actor in the system. Imagine somebody at Citigroup who is trying to learn from the 1970s. We are not going to make them learn from the 1920s, but they are trying to learn or build on the knowledge that Citigroup accumulated. At some point in tracking down these various people, you would have to go on the circuitous path of locating the people you would learn from. So, there are systematic problems that do not get addressed. In a way, I feel like the incentives narrative is not helpful. This is not to say that there wasn’t fraud, that there wasn’t ill will, but the system has structural problems. The fact that we repeat mortgaged-backed securities markets every 50 years suggests to me that it takes everybody to die who remembered what it was like, and then we try again.

Knowledge@Wharton: As we’re coming up on 10 years since the start of the Great Recession, there has been a lot of talk about what will cause the next crisis and when. Do you see any warning signs? Are there changes we could make to protect against that?

Vinokurova: I think that house price inflation is an incredibly potent signal of us being in a bubble, of us being on the verge of a crisis. I think the quantitative easing, which is effectively creating liquidity by printing money, has been shown by folks like Markus Brunnermeier at Princeton to bring about crises. When you have too much money chasing too few attractive options, you end up in the bubble. And the bubble will have to burst.
In terms of what we know about righting financial crises, a lot of it is not rocket science. The banks are too big. The banks that were too big to fail 10 years ago are even bigger now. The Consumer Financial Protection Bureau has been rendered ineffective by the current changes, and Dodd-Frank has been rolled back. It was a set of regulations that people didn’t think were strong enough to remedy what we saw happen. I think there are things that can be done, but it’s not clear that the current administration is interested in pursuing these paths.

Knowledge@Wharton: If you had control, what would you do?

Vinokurova: What I would do is further restrain the leverage of the banks. Banking used to be a boring 9-to-5 job. It needs to go back to being a boring 9-to-5 job.

Knowledge@Wharton: What’s next for this research?

Vinokurova: I’m interested in the structural parameters of the system. One of the projects that I just submitted to a journal looks at the history of mortgage ownership recording. One of the very interesting things that came out of the 2008 crisis is that it turned out that, in many cases, banks didn’t know who owned what loan. In my research, I trace the development of that system that keeps track of land ownership recording and mortgage ownership recording to the 1630s. That allows me to say, “Look, these are structural problems. They have been around through these multiple generations of reform.” I feel like one of the challenges reformers often face is that they think they are the first people who tried to reform the system, and I feel like learning from the people who came before them would actually be helpful.

The Chinese Profits Puzzle

Threats to Chinese growth are multiplying but some big companies are still posting their best results in years. What’s going on?

By Nathaniel Taplin

What Chinese growth slowdown? Some of China’s biggest companies, particularly its banks, have been posting their best earnings growth in years, despite all the gloom around a trade fight with the U.S. and rising bond defaults.

The buoyant results don’t mean all is well for the world’s second-largest economy. 
Chinese listed companies’ average earnings per share have slowed from peak double-digit growth rates in late 2016, but were still 8% higher in the first half, according to Wind Info. That, though, mostly reflects the health of state-owned firms: the top three Chinese sectors by market capitalization—finance, industrials and materials—are heavily backed by Beijing.

The government has given two huge shots in the arm to the country’s biggest public companies in the last 18 months—largely at the expense of non-state-owned companies, largely at the expense of the non-state-owned companies, often unlisted, which account for about two-thirds of economic output.

Forced factory closures in heavy industry, aimed at cutting overcapacity, have hit small, private businesses hard. But they have helped boost profits at listed state-owned competitors like Baoshan Iron & Steel Co, which have gained both market share and pricing power. Healthier balance sheets for the likes of Baoshan have in turn helped the state-owned banks which hold their debt: State-owned industrial companies’ profits as a whole were five times as large as their interest payments by mid-2018, up from just three times in early 2017.

Beijing’s crackdown on shadow finance has given an additional boost for the big state-owned banks—and another slap in the face for small, private firms, which often have trouble securing bank loans at reasonable rates through official channels.

As shadow bank lending evaporated in early 2018, weighted average lending rates for traditional bank loans hit nearly 6%, their highest since mid-2015. With deposit rates still low and wholesale funding costs drifting down, bank profits have roared back: Their average earnings per share rose over 4% on the year in early 2018, according to Wind, the best performance since 2014. Meantime, the private sector’s financing problems have worsened: Private industrial firms’ profits were equivalent to nine times interest payments in late 2017, but had shrunk to just seven times by mid-2018.

Chinese stock markets now look cheap on the fundamentals, but better finances for state-owned companies have come at a steep cost for the economy as a whole—by crimping the more vibrant private sector. That bill is still likely to come due in the form of significantly slower growth in the quarters ahead.