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July 14, 2011

Pareto

Evidence for Greenspan (now Bernanke) Put?

Post 2007 crash, we saw Alan Greenspan descend from being the world’s best central banker to being perhaps one of the worst. If Liaquat Ahmed were to do a sequel of the Lords of Finance, it would surely feature how Greenspan got it so wrong.

Swiss National Bank economist PAMELA HALL looks at another legacy of Greenspan (Is there any evidence of a Greenspan put? SNB WP 2011-6). Based on Greenspan ideology, Fed did not intervene during asset bubble build up, but intervenes aggressively when the bubble bursts. Markets call it the Greenspan Put as Fed will always cut rates when there is a financial problem.

Hall looks at whether Greenspan Put is empirically valid. She argues that there is evidence of this Put option and markets are right in believing that Fed will bail it out each time they land in trouble. She looks at Fed policy in the last 20 years and finds this evidence is consistent in each bubble burst since 1987, when Greenspan managed his first crisis.

Thanks to the Greenspan force, this ideology became mainstream and we now have Bernanke Put, Trichet Put and King Put as well. This obviously has dangerous ramifications as players can keep piling on the risks assuming central banks will take care of them in case of a fallout.

How Vernon Smith has helped us understand Adam Smith better

MARIA PIA PAGANELLI of Yeshiva University in a paper (The Same Face of the Two Smiths: Adam Smith and Vernon Smith) connects the two Smiths.

She asserts that most economics is based on rationality and self-interest. However this is not always the case as we see humans valuing cooperation and fairness tool. Adam Smith’s The Theory of Moral Sentiments was based on these ideas. Smith said that there are other things that the humans value — sympathy, and an innate desire to be both praised and praiseworthy.

Vernon Smith took these ideas forward and demonstrated via experiments all around the world that people did value cooperation and fair-play, and were sympathetic to others. This led to people either monitoring and giving punishment for non-cooperative behaviors or following internalised rules of conduct that promote fair and cooperative behaviors. For instance, using undergraduate subjects from the University of Arizona, even with double blind procedures, 29 per cent of second movers choose $25 for self and $15 for other, over $40 for self and $0 for other, after the first movers have forgone $10 for self and $10 for other. Additionally, cooperation and fairness are also observable in many foraging societies across the globe, although in different forms from the ones observed in industrialised countries.

Gulf countries implementing a monetary union — lessons fom Euro

It is ironical that Gulf economies are opting for a monetary union when the Euro experiment has turned sour. In December 2009, Saudi Arabia, Kuwait, Bahrain and Qatar decided to form a monetary union, followed by Oman and the UAE.  UAE has reservations over choice of Riyadh as the base for the new central bank and Oman could not meet the union’s prerequisites.

JOHN WHITTAKER of Lancaster University looks at this new union and points to lessons from Euro (The Gulf Currency: Lessons from the Euro). He points GMU would be much smaller than EMU and barring Bahrain, have fiscal and current account surpluses. But then this is mainly because of oil resources. Again like the Euro, there are major political reasons for GMU to succeed. In EMU Germany is the centre and GMU it is going to be Saudi.

The author then looks at how the transition would be made and debates whether the common currency should be pegged or allowed to float. He says it should move towards free float to give credibility to the new arrangement.

This will be an interesting experiment for sure. The linkage of this union to world oil markets is going to be significant. Any problems in former could lead to problems in latter.

Is New Economic Geography (or Krugman) right?

In his New Economic Geography (NEG) theory, Paul Krugman showed how economies of scale along with falling transportation costs can trigger a self-reinforcing process whereby a growing urban population gives rise to more large-scale production, higher real wages and a more diversified supply of goods.

JESSIE HANDBURY and DAVID WEINSTEIN of Columbia University explore the idea whether large cites lead to lower prices and more varieties (Is New Economic Geography Right? Evidence from Price Data).

The paper says that both NEG and Krugman are right. Larger cities lead to lower costs and more varieties. For example, residents of New York (population 9.3 million) can choose between 97,000 different types of groceries, whereas residents of Des Moines (population 456,000) only have access to 32,000 varieties. Further, a household that moved from Des Moines to New York and purchased goods from the same type of stores in the same types of neighborhoods in the two cities would realise a 9 percent drop in the overall cost of its grocery purchases.

One often cribs how costly India’s metros are compared to other towns. The above paper turns the whole thing upside down. Surely one gets more varieties in metros compared to smaller cities. Would adjusting for this high variety lead to lower grocery inflation in India’s metros as well?


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