Welcome to the fourth edition of The Best of the Best in Money and Personal Finance, where every featured post is an Editor’s Pick!  This month, the top selections were based upon entries that came closest to predicting the correct number of per…

btw, here’s a report on a different LSE talk
http://www.economist.com/businessfinance/displaystory.cfm?story_id=13832580

It is good that we both (who seemingly are relatively intelligent people) agree with Rodrik about trade imbalances, and that it is the solution that we may disagree about

I am unsure if I am a very big fan of “just floating exchange rates” as they are prone to volatility. Many large multinationals have enormous funds that can crash small economies if they are rapidly withdrawn, I know there were other problems but look for example at the East Asian Crisis. You also have to remember that the post Bretton woods system with free capital movements have created more financial crisis than any other system (Keynes actually thought about this which is why he suggested the international clearing union and tax on large deficits and surpluses).

In regards to Sweden, I am willing to listen to the alternative, but I am unsure if you can blatantly argue that Sweden developed under free trade when they used extensive protectionism and subsidies (for example in R&D) prior to opening their markets. The entire notion behind infant industry protection is to protect the industry until it is able to compete and then open up, so the fact that some Swedish industries did well might have been as a consequence of the strategies utilized before. It is like arguing that attending University does not add value to your level of salary because you don’t earn anything until after you left university.

The argument that it did not work in some industries (like agriculture) may be absolutely correct. Empirical evidence show that many infant industry strategies fail, but the argument is that very few countries have developed without it. How many countries have developed lately based on completely free trade? You cannot use countries such as China, South Korea, Taiwan, etc as they all have used extensive protectionist strategies.

In regards to the herd effect and profit seeking, the entire notion of capitalism is that it is driven of self-interest and profits. You will always get people who attempt to exploit the system, which is why regulation is so difficult, look at for example Basel II or Sarbanes Oxley. The energy scandal in California, Enron, and the housing bubble are all excellent examples of people exploiting the system. The problem is that people always find innovative ways of exploiting the system, and it is almost impossible for regulators to keep track, and if you ever get to the point where you have regulated every single hole in the system, the industry is so full of regulations that it gets extremely inefficient. The argument loses its strength as efficiency is the entire argument supporting free trade/markets

I worked for one of the biggest investment banks in the world, and it was a mess to get around all the regulation with Sarbanes Oxley (for example), very few in management knew what it was really about and it was extremely inefficient when you tried to comply with the regulation. These are market failures that make the market extremely inefficient, why not look at the systemic reasons for these failures rather than trying to patch it over?

In regards to information asymmetries: One of the biggest problems with the stock market is that it is based upon what people think a company is worth, not what it is actually worth. Information asymmetries and imperfect information is a huge problem, which we will never be able to alleviate, so people make judgments on imperfect information.

But, it seems like we are not so far off after all, I was just a little provoked by your intelligence comment so I had to respond.

I think the behaviour of the “masters of the universe” is a timely reminder that humans are not solely motivated by money. People like Dick Fuld lost most of their fortunes when their banks collapsed, but their overinvestment in their own shares did not stop them from taking stupid risks. (If only they had listened to Monevator’s advice and put their money in index funds!) From my reading on the crisis I get a feeling that there was a risk-enhancing culture in financial markets, partly because investment bankers developed an obsession with league tables. This caused too many people to throw themselves into (for example) subprime mortgages or structured products simply so that they would not lose face in front of their competitors. The idea that they could run a highly profitable business by specialising in their areas of expertise seems to have eluded them.

(The book that especially brought this home to me was Johan Norberg’s A Perfect Storm, which I have read in Swedish and is coming out in English shortly. Norberg is very critical of this culture of irresponsibility but also points out how state intervention worsened the speculation on the American mortgage market. I recommend this book, not least because the author does not claim to have all the answers to prevent the next crisis.)

This is why I think financiers should “get back to basics” and focus relentlessly on profitability in all units of their business and not jump into products that they don’t understand. British banks, to their shame, cross-subsidised consumer credit by ripping their customers off with expensive and unnecessary payment protection insurance (PPI), an abuse which the regulators were too slow in stopping. The latest wheeze is apparently for compulsory payment holidays on personal loans so that interest accumulates and the loan costs more than the APR indicates (sounds just like some of those American subprime mortgages…will no one ever learn?).

If some beneficial fear is to be instilled in the banks, shareholders must lose their shirts if their bank fails to remain solvent. Governments around the world have been too quick to mollycoddle failed banks; there should be more Northern Rocks (outright nationalisation at a very low share price) and fewer HBOSs (government brokering rescue mergers while ignoring competition law, so dragging down otherwise healthy banks). In this case nationalisation is the best way of imposing market discipline, because allowing a significant bank to go bankrupt would cause unacceptable collateral damage.

Beyond this (and a regulatory action against asset bubbles) I don’t have any ideas for how to deal with the cultural problems and herd mentality of the financial markets, so I am open to suggestions.

On trade imbalances, I entirely agree with your points. Borrowing to consume rather than invest is always economically unhealthy. What I was arguing is that the trade deficit would have been smaller had China allowed its currency to appreciate. In fact, the problems caused by trade imbalances are one very good reason to retain floating currencies rather than listen to the hardcore libertarians (like Ayn Rand) and Austrian economists who advocate a return to the gold standard.

On the history of protectionism, I do know that Sweden was very mercantilist in the eighteenth and early nineteenth centuries, as I have read up on this (which was why I used Sweden as an example). The point is that Sweden remained a poor country until tariffs were cut. Large countries like Germany and the USA could get away with protectionism because they had large domestic markets that allowed industries to develop sufficient scale; smaller countries such as Sweden could only industrialise by being open to the global market. If you look at Angus Maddison’s growth figures it is striking that the Nordic countries were the great economic success story of Europe from the second half of the nineteenth century.

It is true that Sweden introduced agricultural tariffs in the 1880s (though my dissertation research indicates that they did little to stop rural emigration, and farmers still struggled economically). But by that point industrialisation had taken hold, so Sweden’s industrial “infancy” happened in the context of a free trade policy. Denmark resisted the European trend towards agricultural protectionism and managed to do very well out of specialisation (bacon and butter), which in turn stimulated much of Denmark’s early industrialisation through food processing – as well as the development of the financial sector with rural credit cooperatives.

I have heard of Ha-Joon Chang’s book – one of my lecturers praised it – but I’m sceptical of his conclusions for the simple reason that he only shows correlation between protectionist policies and industrialisation. Moreover, protectionism was the norm for centuries without contributing notably to economic development. In many ways the (re-)introduction of tariffs in the late nineteenth century was a reaction to falling transaction costs, most dramatically in transatlantic shipping. Niall Ferguson has argued that the fall in transport costs outweighed or at least equalled the increase in transaction costs caused by tariffs.

I must admit that I get slightly provoked when you refer to people’s intelligence and clearly need to read up on these topics yourself. I would rather appreciate it if you could welcome that people are questioning the behavior of the herd and approach things from a different perspective, it was in fact the herd that got us into this mess in the first place.

In regards to the trade imbalances issue, many of the leading economist and commentators, such as Rodrik, Wade, and even Financial Times’ own Martin Wolf argue that the trade imbalances are the root to this mess, so I assume that it is a point you should at least take seriously.

I am not criticizing you for taking a different perspective, in fact, I think that it is healthy, I just think that you could have spare us for the intelligence comment and rather ask yourself why “intelligent people think the credit crunch is an indictment of “neo-liberal” globalization”.

If the external deficit remains constant (or rises) and the fiscal deficit falls, there must be an offsetting increase in private indebtedness. In other words, normal people take upon increasing amount of risk. The problem is that the majority of these loans does not increase assets, but rather facilitate for increased consumption or pay for (and get lost in) bubbles. The financial crisis is thus a consequence of a bigger and more systemic flaw in the system.

Re: Safeguarding via trade barriers, the whole subject gets even murkier when you consider the extension to ’safeguard’ people/workers in the producing country, rather than the consumer country.

Besides the dubious morality/paternalism of this approach and the issues Rodrik to his credit did raise (i.e. two different country’s populations having different needs), alleged problems occurring ‘out of sight’ are even more hijack-able by domestic special interest groups, weird alliances of well-meaning students worried about social/environmental harm with rigidly conformist unions wanting to ratchet down the status quo, and so on.

I’d like to see all such special interest lobbying required to product a bill of cost to the producing country of boycotting their produce as part of any serious campaign.

To be clear I’m not arguing here for a world based around six-year olds in developing countries losing limbs in stitching machines so we can have cheap trainers. I understand how lucky we are and I’d prefer they were, too. I’m partly arguing as to what ends that world soonest – and for me that’s such countries getting rich enough for their populations to afford to have the choice. It also happens to benefit world output best (Ricardo etc).

The Nordic bank is interesting – will read The Economist when I get some time.

As for trade barriers to “safeguard” society, this shows the confusion of free trade with unregulated markets. The most powerful moral argument for free trade is that it is non-discriminatory. People should not be penalised for choosing to buy imported goods or services, but VAT (for example) is perfectly acceptable as a tax because it falls equally on all consumption. All arguments that tarriffs are needed to protect people from “evil market forces” are based on the assumption that individuals cannot be trusted to make decisions in their own interest. Protectionist arguments are debunked much more effectively than I can do here in Johan Norberg’s book In Defence of Global Capitalism: http://tinyurl.com/indefence

Sorry about the length of my comments but your post was very thought-provoking!