Trade Matters - John Rosen

Guest Blogger John Rosen is the Executive Director of Marketing Consulting Associates based in Westport, Connecticut.  You can reach him at jrosen@mcaworks.com.

 arod

The Doha round is the ongoing series of multilateral talks sponsored by the World Trade Organization aimed at reducing or eliminating international trade barriers among nations.  It is named after the city of Doha, Quatar – where the talks commenced in 2001.  Ed. Note.

 Trade Matters - John Rosen

Recently, on September 14, we “celebrated” the fourth anniversary of the Lehman Brothers collapse, generally remembered as the critical event in the 2008 financial crisis:  the moment a “banking crisis,” along with a lackluster stock market and a slowing real economy morphed into a full-fledged “Global Financial Crisis,” a frightening Wall Street crash, and the “Great Recession.”  It may well be true that the Lehman collapse was the key, catalytic event.  As mentioned, that is the way it is solidifying in the collective memory.

Economists and policy-makers continue to debate – and will eventually write many theses and books – on the subject of the causes of the crisis that gripped world financial markets in 2008, as well as the run-up and continuing aftermath.  I wish to propose that there was one contributing factor to the crash and aftermath that is significantly overlooked:  the collapse of the Doha Round of trade negotiations on July 29, 2008.  Not the primary, certainly not the only, but just as certainly one contributing factor to the crisis.

To repeat, my thesis is that the collapse of the Doha Round is an overlooked contributing factor to the crash.  Other causes are well-known and documented – the vast, unsustainable bubble in U. S. housing prices preceding the crash, years of “too loose” monetary policy, the subprime debacle, a huge commodities price bubble and subsequent crash, moral hazard, typified by the “Greenspan put,” reinforcement of the “put” by the Bear Stearns bailout in March, 2008, a string of continuing financial institution failures and/or bailouts (Countrywide, Washington Mutual, Merrill Lynch, RBS, AIG, etc.), serious softening of the real economy, disastrous auto sales, etc.  All these, and others, surely fit the definition of “contributing factor” to the financial crisis.  Determining the interrelationships of these factors, as well their relative importance, are subjects best left to professional economists, Ph.D. candidates, finance journalists, and market participants to study for the next several years.  I simply want to be sure that one of the causes that those experts include in their analyses is one which I think is seriously overlooked:  the collapse of the Doha Round of trade negotiations in July of 2008.

So, let’s address this “overlooked contributing factor” premise in two parts:  first, that the Doha Round collapse is overlooked as a key event in that dismal year and, second, the more interesting and presumably more controversial point that the collapse was a contributing factor to the overall financial crisis.

A couple of hours of online research on this topic reveals, as expected, that there are scores of readily-available discussions, Wikipedia entries, more sophisticated and scholarly papers, and timelines regarding the financial crisis.  The timelines are particularly interesting.  Many very detailed and easy-to-access graphic versions exist.  One particularly good one (although it contains and interesting typo, see if you can find it) is from an organization known as DollarDaze.org and is attached.  You will not find any mention of the Doha Round on this otherwise extensive (and colorful) timeline.  Indeed, I could not find a single timeline that included mention of the trade negotiations and their July breakdown.  More detailed, text-only timelines are available online and none, repeat none, include the trade negotiation collapse.  One detailed text-only timeline does, indeed, have an entry for July 30, 2008:  “President signs into law the Housing and Economic Recovery Act (HERA) creating the Federal Housing Finance Agency (FHFA) to regulate Fannie and Freddie.”  Herein lies one of the key premises of this post:  while our leaders and their bureaucrats were running around creating more alphabet-soup agencies to appear to be “doing something,” they were, literally, ignoring something that really could have had a positive impact:  successful negotiation of the trade round.

The New York Times maintains an interactive crisis timeline (http://www.nytimes.com/interactive/2008/09/27/business/economy/20080927_WEEKS_TIMELINE.html), but it begins in September, with the entry, “The credit crisis, which long ago moved beyond its origins in subprime mortgages, began to accelerate in September.”  So, what was causing that acceleration?

There is, of course, a Congressional report, entitled “The Final Report of the Financial Crisis Inquiry Commission,” dated February 16, 2011.  It is 147 pages long.  It is detailed and thorough.  If you search for “Doha,” you find it mentioned not once. Not once.  (You will find 34 entries for “derivatives”).

Looking at the news reports at the time (on or around July 29, 2008), you will also find occasional mention of the failure of the negotiations, but precious little linkage to the larger, then-developing crisis in finance and the world economy.  The DJIA actually rose about 200 points on each of the ensuing two days; the FTSE and Hong Kong exchanges generally fit the same pattern.  Even the Wall Street Journal editorial page – which generally blames the Smoot-Hawley tariff of 1930 for turning a recession into the global Great Depression (blaming the tariff as well for the demise of civilization as we know it, the rise of Communism, Islamist Terrorism, video games, the Designated Hitter rule, global warming, and just about every other bad thing that has happened in the past eighty years or so) made only this tepid comment in its July 30, 2008 editorial on the topic:  “With economic growth slowing and inflation picking up, a successful Doha Round would have been a welcome growth tonic.”  That’s it.

Clearly, the first part of our premise is correct:  the failure of the Doha Round in late July, 2008 is overlooked.  Or, perhaps “overlooked” is an incorrect description; perhaps it really should be ignored, perhaps it wasn’t a contributing factor, the subject to which we now turn.

Let’s start with a return to Congress.  There is a publication from the Congressional Research Service called “World Trade Organization Negotiations:  The Doha Development Agenda,” dated December 12, 2011 (that is, more than three years after the crisis of 2008).  Here is a representative quote from that report:  “In response to the global economic crisis, the G-20 leading economies have repeatedly called for conclusion of the Doha Round as a way to bolster economic confidence and recovery.”  That’s the point:  if you research hard enough, you can find lots and lots of similar quotes calling for successful regeneration of the talks under the general heading of “In response to the global economic crisis....”  That is, after-the-fact use of the crisis to justify or rationalize calls for reinvigorating the trade talks is widespread, but there are no contemporaneous or after-the-fact analyses blaming the failure of the 2008 talks for the larger financial crisis.

This may be simply opportunism on the part of people like Pascal Lamy:  one can find quotes from him in advance of July, 2008 claiming that a successful conclusion of the talks would be critical in “…ensuring that the financial shock would not deteriorate into a far worse economic recession worldwide.”  You can also find quotes from after the September-October crash claiming that a successful trade negotiation would help restore confidence and the economy.  What I have been unable to find is anyone who has gone on record claiming that the collapse of the trade talks contributed to the crash…only scattered advance warnings and ex post claims that fixing the talks would help restore things.

Amity Shales, in her excellent book, “The Forgotten Man,” expends many pages on the 1930 Smoot-Hawley tariff as a contributing factor to turning a recession into the Great Depression.  Quoting from that book:  “Smoot-Hawley provoked retaliatory protectionist actions by nations all over the globe, depriving the United States of markets and sending the country into a deeper slump.”  Ms. Shales remains a vigorous supporter of Free Trade, but I have been unable to find any public comment from her (there may be one, I just haven’t found it) drawing the direct linkage I am making in this post:  the Doha Round collapsed on July 29, 2008, a time of heightened concern about financial markets and the economy in general.  This was followed by wholesale collapses in world financial markets beginning with the seizure of Fannie and Freddie on September 7.  In the event, Ms. Shales co-authored a WSJ op-ed with Douglas Irwin on August 2, 2008 with the basic premise of “don’t’ despair / not to worry.”

Others – Ben Bernanke in his definitive study and Liaquat Ahamed in a more readable, general audience book, for example – maintain that Smoot-Hawley was of only incidental importance to the Great Depression; that the global disaster was almost wholly caused by terrible monetary policy.  Bernanke has promised to never repeat that mistake.  Ergo, QE3.  As a general audience member who found Ahamed’s book much easier going than Bernanke’s, allow me to posit a monetarist spin on my key point that the failure of the trade talks was important:  The collapse of trade talks implies less trade.  Less trade implies not only a lower level of economic activity but a lower velocity of money.  Which implies that supporting or resurrecting a given level of economic activity will require the Fed to print more money.  Ergo, again, QE3; in this analysis as a direct consequence of the failure of the trade negotiations.

Let me conclude with a few facts and a restatement of my premise, simply to avoid any miscommunication.  First, the buildup to the crash in September-October, 2008 was years in the making and had multiple, interrelated causes.  Second, the DJIA peaked at a little over 14,000 in October, 2007, a year before the crash.  It had settled into a range of 11,000 to 13,000 for several months by the time in question, July of 2008.  This indicates that markets, at least, were betting that the worst was over…but they were watching very closely.  Our premise is that the failure of the trade talks in July contributed to a general level of uncertainty and steadily increasing inventory of bad news leading to the September crash.  As noted, the failure of the Doha Round in July did not spark a huge stock sell-off, quite the contrary.  Stocks didn’t start really crashing until September.  What did crash quite concurrently with the Doha talks was the price of commodities.  Oil prices hit their $147 peak (WTI) in that very same July and began their rapid, scary crash down to under $40 by January.  Less trade most certainly does imply less demand for oil, and commodity speculators might certainly want to head for the hills…in response to a trade talks impasse, 30-40 days before everyone else (equity speculators) realizes that the game is up.

Finally, the Doha Round of negotiations has been resurrected, but the outlook is “unclear.”  All sorts of commentators, politicians, bureaucrats, economists, etc., continue to stress the importance of a successful conclusion to this round as a means of re-establishing business confidence and generally resurrecting the world economy.  (See “In response…” above). If it’s so important, now, to complete this round, using the trade agreement to re-establish sustainable global economic growth and prosperity, shouldn’t its failure in July, 2008, be considered at least one contributing factor to the September, 2008 financial crisis?

After the Hurricane

Perhaps your attention has drifted over to football, but the aftermath of hurricane Isaac has given way to another national sport.  Isaac was the category-1 storm that just pummeled New Orleans and neighboring areas. Isaac landed close to the spot where Category-5 hurricane Katrina landed, back in 2005.  We now know that Isaac’s destruction and havoc – and especially the rainfall - was higher than what was expected.  Many were apparently unprepared for the storm’s intensity– as was evident after the fact, even though they had taken the seeming necessary recommended precautions.  Put simply, it seems many people were unpleasantly surprised by Isaac –despite having received and acted on the advance warnings provided by the authorities.

Predictably, the chorus of complaints impugning the hurricane scale rankings has surfaced.  And with the outcry one hears calls for revising the hurricane warning scales – presumably, in a direction that will convey better information.  Even the New York Times joined the fray – hosting a “debate” on the matter titled “How Could the Storm Ratings be Improved?” I argue that to replace the current system with a more complex one is inappropriate.  And I argue in fact, that to advocate replacing the scale is to call attention to the wrong issue. 

The by now familiar hurricane scale is the Saffir-Simpson scale – a 5-point category ordering originally created by Howard Safir.  The scale was later enhanced and popularized by Robert H. Simpson of the National Hurricane Center.  It was an effort at prediction in a manner intended to inform decisions both by individuals and by cities, states and regions.

Mr. Saffir’s ordering was a storm-destruction ranking system keyed primarily on wind speed.  To be considered a Category 1 hurricane, the system’s wind speed must clock within the 74-95 mph range.  At the other extreme are Category 5 monster cyclones where wind speed exceeds 155 miles per hour.  Three other thresholds between 74 and 155 mph winds separate Category 2-4 hurricanes. 

Although it might seem somewhat obvious, the beauty of Mr. Saffir’s innovation was not only in establishing the threshold (thereby creating the categories) but also in associating each category with the damage the winds may cause.  To formally do this he examined historical data.  He documented the positive relationship between wind-speed and property and other physical damage.  Thus, trees and unanchored mobile homes receive the primary damage in a Category 1 storm whereas – at the other end of the scale – a Category 5, involves the complete failure of roofs and some structures.  The other three descriptions of destruction were then matched with the sustained wind speeds that would produce the corresponding damage.  What follows then is to recognize that past is prologue. 

What Mr. Safir and Mr. Simpson created was a model, a simplification of a real event intended to convey decision-making information (material destruction) based on a particular, distinctive attribute – like wind-velocity.  By design, because it is an abstraction of reality, it will (practically) always be mistaken.  To expect a model to perfectly convey as much information as the actual event it aims to describe is a mistake.  Jorge Luis Borges most elegantly captured this fallacy in his Exactitude in Science.  As an aside, it’s worth noting that this beautiful story stands to be one of the most influential (in my opinion), if not the most influential, in the history of the written word given the number of words expended (it has less than 150 words).  Borges tells of a map-making competition where different generations of cartographers aimed to surpass the previous generation by building more and more accurate maps in the pursuit of the perfect map.  They ended the map competition by building a map that replicated the world.  A map that was useless. 

In threshold setting – which is at the core of the Safir-Simpson method and other ordered scale warning systems – there can be two types of errors.  Suppose that the authorities announce a Category 1 storm (and to keep it simple, assume there are only two levels).  When the cyclone finally arrives we find the property damage ends up being what would normally be associated with a Category 2 hurricane (for sake of argument) – an unpleasant mistake.  On the other hand, suppose the authorities announce a Category 2 hurricane – and when the winds are quieted we find material damage of Category 1 magnitude.  The error, this time, is a more welcome one.   In principle, we could move the thresholds to try to maximize the “welcome” error.  Lower the wind-speed threshold to 80 miles per hour.  Thus, any storm with winds between 75 and 79 miles per hour will be a Category 1 and now anything above 80 and 110 is a Category 2.  But moving the thresholds we encounter several unintended consequences. We would reduce the chances of incurring the unpleasant mistake and enhance the chances of the welcome mistake. But over time since everything is going to be a Category 2 hurricane – any information contained in the warning is lost – it becomes meaningless – like Borges’ map. Think about it – why not avoid unpleasant mistakes at all by eliminating the various categories and only have 1 category.  In this case you can only be pleasantly surprised. 

So what is being left out in the map-building – the Saffir-Simpson scale – and thereby a potential source of error?  There is more to a hurricane’s damage potential that high winds.  The storm surge is wall of water at the leading edge of a storm – is especially destructive in low lying areas.  The rainfall associated with storms presents flooding threats – especially in regions with saturated soils or already swollen rivers.  Two other things (at least) surge and rainfall in addition to a cyclone’s wind speed are associated with the ultimate concern material damage.  The association between these three measurable features of a cyclone and material damage – aside from being positive – is different and distinct.  Thus, relying on one aspect of a hurricane wind-speed to categorize them in a manner that tells us how much damage to expect will imperfectly capture the association between the other aspects as well – practically guaranteeing a source of error.

Will a more complex model – perhaps one that combines wind-speed, surge and rainfall - do better?  Not likely – error and therefore judgment cannot be avoided.

Thus, a model builder has to tradeoff error and accuracy.  How much error?  Alan Alda’s character in Nothing but the Truth arguing a point of law set forth the parameters: “is this mistake like wearing white after labor day or is it like invading Russia in winter?”   Scale constructors often opt to minimize errors – and associated costs of errors. And to educate the population – so that we understand the nature of the underlying decision-making model and thereby take its efficacy into account into our own decision-making and importantly, ex post performance appraisal.

Arod

arodriguez@newhaven.edu

Dr. Mongeon's talk at CoB Research Forum, Fall 2012

On Wednesday, September12, 2012 from 12:30-1:30pm, in Maxcy 124

The College of Business is hosting a talk by

 Dr. Kevin Mongeon

Of the Department of Economics and the Department of Sports Management

Of the University of New Haven

Kevin’s professional and scholarly work - is on the hockey version of sabermetrics.  Sabermetrics, popularized by Michael Lewis’ book: Moneyball (and the recent movie) – is all about the quantitative appraisal of baseball skills. Reliance on statistics to inform decision-making instead of the `old-school’ subjective appraisals of talent, skills and other elements of the game revolutionized baseball.  The same sabermetrics-grounded methods are exerting its influence in all other sports – hockey being an especially fertile area.  

Here are three articles on Kevin and hockey metrics:

The Globe and Mail: http://www.theglobeandmail.com/sports/hockey/the-moneypuck-revolution/article2178766/

The New York Times: http://www.nytimes.com/2012/01/22/sports/hockey/flying-fists-dont-add-up-to-victories.html?_r=1

The Edmonton Journal: http://blogs.edmontonjournal.com/2011/11/04/what-will-come-after-corsi-plusminus-heres-one-promising-new-plusminus-system/

The paper Dr. Mongeon is presenting on Wednesday is titled:

“Economics and Existence of Rationally Biased Officiating”

Abstract

A stochastic decision model motivates an innovative econometric identification strategy that provides evidence that referees exhibit explicit forms of penalty calling “biases”.  However, this behavior is interpreted as rational in the context of both supplying game characteristics demanded by fans and favorable to leagues, and for self-preservation.  Penalty calling favors home teams while attempting to keep games close and balancing penalty calls between competing teams in order to promote a perception of fairness.  Short of constraining referees to act irrationally or leagues countering their own self-interest, bias mitigation through separating the officiating industry from league ownership is one policy option.

A light lunch will be served

For more information: dfraioli@newhaven.edu