29/6/18: Multilateralism and the Impossible Policy Trilemmas

"Global governance requires rules, because flexibility and goodwill alone cannot tackle the hardest shared problems. With multilateralism under attack, the narrow path ahead is to determine, on a case-by-case basis, the minimum requirements of effective collective action, and to forge agreement on reforms that fulfill these conditions."

Can Multilateralism Adapt?, Jean Pisani-Ferry.

International Political Trilemma applies to both monetary and fiscal policy dimension by making it impossible for modern societies to combine:

1. Monetary sovereignty in the form of free capital mobility, with international political stability and political autonomy of democratic systems. In simple terms, free capital mobility means that capital flows will reflect economic and demographic conditions prevailing in the specific society. If these conditions deteriorate, triggering capital outflows (perhaps due to monetary accommodation response to ageing population), the society can respond either through imposing capital controls (preserving its standing in international political institutions, and allowing its democratic institutions to remain robust) or it can pursue non0-democratic suppression of its own population (allowing capital to flow out of the economy and not imposing cost of resulting economic decline onto international partners). Alternatively, the country can continue allowing outflow of capital and retain democracy by blaming the external shocks and restricting its engagement with international political institutions.
2. Fiscal sovereignty in the form of free capital mobility, international political stability and autonomous fiscal policy. In simple terms, the above monetary sovereignty simply transfers democratic autonomy failure to fiscal policy failure.

To my students at TCD and MIIS, these are familiar from the following summary charts:

For more academically inclined readers, here is my paper summarising these Trilemmas and putting them into the context of the euro area harmonisation: Gurdgiev, Constantin, Euro After the Crisis: Key Challenges and Resolution Options (May 30, 2016). Prepared for: GUE/NGL Group, European Parliament, October 2015: https://ssrn.com/abstract=2786660.

It is, generally, not hard to find examples of the two trilemmas presence in a range of historical shocks in the past. More recent examples, however, are harder to come by due to time lags required to see these trilemmas in action. Pisani-Ferry's quote above hints at such.

During the 1990s, "After an eight-decade-long hiatus, the global economy was being reunified. Economic openness was the order of the day. ...The message was clear: globalization was not just about liberalizing flows of goods, services and capital but about establishing the rules and institutions required to steer markets, foster cooperation, and deliver global public goods."

As Pisano-Ferry argues, today, "Despite a decade of talks, the global trade negotiations launched in 2001 have gotten nowhere. The Internet has become fragmented and could break up further. Financial regionalism is on the rise. The global effort to combat climate change rests on a collection of non-binding agreements, from which the United States has withdrawn...  The very principles of multilateralism, a key pillar of global governance, seem to have become a relic from a distant past."

"...let’s face it: today’s problems did not start with Trump." In fact, the problems started with the above trilemmas. Or put differently, the problems are not an outrun of bad policies or choices, but the natural result of the impossibility of combining the conflicting policies objectives and institutions. "There is no shortage of explanations. An important one is that many participants in the international system are having second thoughts about globalization. A widespread perception in advanced countries is that the rents from technological innovation are being eroded precipitously... A second explanation is that the US strategy toward Russia and China has failed... neither Russia nor China has converged politically... Third, the US is unsure that a rules-based system offers the best framework to manage its rivalry with China. [and]... Finally, global rules look increasingly outdated. Whereas some of their underlying principles – starting with the simple idea that issues are addressed multilaterally rather than bilaterally – are as strong as ever, others were conceived for a world that no longer exists. Established trade negotiation practices make little sense in a world of global value chains and sophisticated services. And categorizing countries by their development level is losing its usefulness, given that some of them combine first-class global companies and pockets of economic backwardness."

In simple terms, the world became more complex and more fragile because we tried to make it less complex and more centralized (hegemonic positioning of the U.S. in Bretton Woods setting), while making it also more multilateral (through financial, economic, trade and human capital integration).

Pisano-Ferry offers a 50,000 feet level view on the solution to the problems: "the solution is neither to cultivate the nostalgia of yesterday’s order nor to place hope in loose, ineffective forms of international cooperation. International collective action requires rules... The narrow path ahead is to determine, on a case-by-case basis, the minimum requirements of effective collective action, and to forge agreement on reforms that fulfill these conditions." In other words, one cannot tackle trijemmas directly (correct view), but one can defuse them by limiting each node of the desired policies. E.g. less democracy here - to offset pressure from demographic of ageing, less capital mobility there - to reduce the speed of capital flows across the borders and lower volatility of financialized investment, less fiscal sovereignty - to provide better buffers for shocks arising in financial and economic systems, and less international institutions - to allow for more flexible rebalancing of monetary, trade and fiscal policies.

The problem with this is it requires for the hegemony (the U.S.) to put a hard stop to imposing its preferred solutions onto the rest of the world and international institutions. Or, put differently, the hegemony must stop being a hegemony. Good luck squaring that with American vision of the world a-la Rome 4.0.

17/1/17: Economics of Blockchain

One of the first systemic papers on economic of blockchain, via NBER (http://www.nber.org/papers/w22952) by Christian Catalini and Joshua S. Gans, NBER Working Paper No. 22952 (December 2016).

In basic terms, the authors see blockchain technology and cryptocurrencies influencing the rate and direction of innovation through two channels:

1. Reducing the cost of verification; and 
2. Reducing the cost of networking.

Per authors, for any "exchange to be executed, key attributes of a transaction need to be verified by the parties involved at multiple points in time. Blockchain technology, by allowing market participants to perform costless verification, lowers the costs of auditing transaction information, and allows new marketplaces to emerge. Furthermore, when a distributed ledger is combined with a native cryptographic token (as in Bitcoin), marketplaces can be bootstrapped without the need of
traditional trusted intermediaries, lowering the cost of networking. This challenges existing
revenue models and incumbents's market power, and opens opportunities for novel approaches to
regulation, auctions and the provision of public goods, software, identity and reputation systems."

A bit more granularly, per authors,

• "Because of how it provides incentives for maintaining a ledger in a fully decentralized way, Bitcoin is also the first example of how an open protocol can be used to implement a marketplace without the need of a central actor." In other words, key feature of cryptocurrencies and blockchain is that it removes the need to create a central verification authority / intermediary / regulator or repository of data. The result is more than the cost reduction (focus of the Catalini and Gans paper), but the redistribution of market power away from intermediaries to the agents of supply and demand. In other words, a direct streamlining of the market away from third parties power toward the direct power for economic agents.
• "Furthermore, as the core protocol is extended (e.g. by adding the ability to store documents through a distributed ledger-storage system), as we will see the market enabled by a cryptocurrency becomes a  flexible, permission-less development platform for novel applications." Agin, while one might focus on reductions in the direct costs of innovation in that context, one cannot ignore the simple fact that blockchain is resulting in reduced non-cost barriers to innovation, further reducing monopolistic market power (especially of intermediaries and regulators) and diffusing that power to innovators.

So what are the implications of this view of economics of blockchain? "Whereas the utopian view has argued that blockchain technology will affect every market by reducing the need for intermediation, we argue that it is more likely to change the scope of intermediation both on the intensive margin of transactions (e.g., by reducing costs and possibly influencing market structure) as well as on the extensive one (e.g., by allowing for new types of marketplaces)." So far, reasonable. Intermediation will not disappear as such - there will always be need for some analytics, pricing, management etc of data, contracts and so on, even with blockchain ledgers in place. However, the authors are missing a major point: blockchain ledgers are opening possibility to fully automated direct data analytics and AI deployment on the transactions ledgers. In other words, traditional forms of intermediation (for example in the context of insurance contract transactions, those involving data collection, data preparation, risk underwriting, contract pricing, contract enforcement, contract payments across premia and payouts, etc) all can be automated and supported by live data-based analytics engine(s) operating on blockchain ledgers. If so, the argument that the utopian view won't materialise is questionable.

The paper is worth reading, for it is one of the early attempts to create some theoretical framework around blockchain systems. Alas, my gut feeling is that the authors are failing to fully understand the depth of the blockchain technology. 

24/10/16: Hacktivism on the rise? Welcome to the well-predicted future

Given a rising prevalence and impact of the cyber attacks in recent weeks, here are some slides from my February 2016 course notes on ERM with warnings about the same back at the end 2015 - start of 2016:

22/101/16: Cashless Society: Efficiency 1 : Privacy 0

My comments on the dangers associated with the idea of the 'cashless society' where traditional money is replaced by fully captured (by data flows) and de-privatized electronic accounts: http://www.gold-eagle.com/article/cashless-society-%E2%80%93-risks-posed-war-cash.

22/10/16: Watering Down Budget 2017 Promises?

My article on the Irish Finance Bill for Budget 2017 is now available on Sunday Business Post website: https://www.businesspost.ie/opinion/constantin-gurdgiev-2-key-budget-promises-watered-finance-bill-367627.

26/6/16: Black Swan ain't Brexit... but

There is a lot of froth in the media opinionating on Brexit vote. And there is a lot of nonsense.

One clearly cannot deal with all of it, so I am going to occasionally dip into the topic with some comments. These are not systemic in any way.

Let's take the myth of Brexit being a 'Black Swan'. This goes along the lines: lack of UK and European leaders' preparedness to the Brexit referendum outcome can be explained by the nature of the outcome being a 'Black Swan' event.

The theory of 'Black Swan' events was introduced by Nassin Taleb in his book “Black Swan
Theory”. There are three defining characteristics of such an event:

1. The event can be explained ex post its occurrence as either predictable or expected;
2. The event has an extremely large impact (cost or benefit); and
3. The event (ex ante its occurrence) is unexpected or not probable.

Let's take a look at the Brexit vote in terms of the above three characteristics.

Analysis post-event shows that Brexit does indeed conform with point 1, but only partially. There is a lot of noise around various explanations for the vote being advanced, with analysis reaching across the following major arguments:

• 'Dumb' or 'poor' or 'uneducated' or 'older' people voted for Brexit
• People were swayed to vote for Brexit by manipulative populists (which is an iteration of the first bullet point)
• People wanted to punish elites for (insert any reason here)
• Protests vote (same as bullet point above)
• People voted to 'regain their country from EU' 
• Brits never liked being in the EU, and so on

The multiplicity of often overlapping reasons for Brexit vote outcome does imply significant complexity of causes and roots for voters preferences, but, in general, 'easy' explanations are being advanced in the wake of the vote. They are neither correct, nor wrong, which means that point 1 is neither violated nor confirmed: loads of explanations being given ex post, loads of predictions were issued ex ante.

The Brexit event is likely to have a significant impact. Short term impact is likely to be extremely large, albeit medium and longer term impacts are likely to be more modest. The reasons for this (not an exhaustive list) include: 

• Likely overshooting in risk valuations in the short run;
• Increased uncertainty in the short run that will be ameliorated by subsequent policy choices, actions and information flows; 
• Starting of resolution process with the EU which is likely to be associated with more intransigence vis-a-vis the UK on the EU behalf at the start, gradually converging to more pragmatic and cooperative solutions over time (what we call moving along expectations curve); 
• Pre-vote pricing in the markets that resulted in a rather significant over-pricing of the probability of 'Remain' vote, warranting a large correction to the downside post the vote (irrespective of which way the vote would have gone); 
• Post-vote vacillations and debates in the UK as to the legal outrun of the vote; and 
• The nature of the EU institutions and their extent in determining economic and social outcomes (the degree of integration that requires unwinding in the case of the Brexit)

These expected impacts were visible pre-vote and, in fact, have been severely overhyped in media and official analysis. Remember all the warnings of economic, social and political armageddon that the Leave vote was expected to generate. These were voiced in a number of speeches, articles, advertorials and campaigns by the Bremainers. 

So, per second point, the event was ex ante expected to generate huge impacts and these potential impacts were flagged well in advance of the vote.

The third ingredient for making of a 'Black Swan' is unpredictable (or low predictability) nature of the event. Here, the entire thesis of Brexit as a 'Black Swan' collapses. 

Let me start with an illustration: about 18 hours before the results were announced, I repeated my view (proven to be erroneous in the end) that 'Remain' will shade the vote by roughly 52% to 48%. As far as I am aware, no analyst or media outfit or /predictions market' (aka betting shop) put probability of 'Leave' at less than 30 percent. 

Now, 30 percent is not unpredictable / unexpected outcome. It is, instead, an unlikely, but possible, event. 

Let's do a mental exercise: you are offered by your stock broker an investment product that risks losing 30% of our pension money (say EUR100,000) with probability of 30%. Your expected loss is EUR9,000 is not a 'Black Swan' or an improbable high impact event, but instead a rather possible high impact event. Conditional (on loss materialising) impact here is, however, EUR30,000 loss. Now, consider a risk of losing 90% of your pension money with a probability of 10%. Your expected loss is the same, but low probability of a loss makes it a rather unexpected high impact event, as conditional impact of a loss here is EUR90,000 - three times the size of the conditional loss in the first case. 

The latter case is not Brexit, but is a Black Swan, the former case is Brexit-like and is not a Black Swan event. 

Besides the discussion of whether Brexit was a Black Swan event or not, however, the conditional loss (conditional on loss materialising) in the above examples shows that, however low the probability of a loss might be, once conditional loss becomes sizeable enough, the risk assessment and management of the event that can result in such a loss is required. In other words, whether or not Brexit was probable ex ante the vote (and it was quite probable), any risk management in preparation of the vote should have included full evaluation of responses to such a loss materialising. 

It is now painfully clear (see EU case here: http://arstechnica.co.uk/tech-policy/2016/06/brexit-in-brussels-junckers-mic-drop-and-political-brexploitation/, see Irish case here: http://www.irishtimes.com/news/politics/government-publishes-brexit-contingency-plan-1.2698260) that prudent risk management procedures were not followed by the EU and the Irish State. There is no serious contingency plan. No serious road map. No serious impact assessment. No serious readiness to deploy policy responses. No serious proposals for dealing with the vote outcome.

Even if Brexit vote was a Black Swan (although it was not), European institutions should have been prepared to face the aftermath of the vote. This is especially warranted, given the hysteria whipped up by the 'Remain' campaigners as to the potential fallouts from the 'Leave' vote prior to the referendum. In fact, the EU and national institutions should have been prepared even more so because of the severely disruptive nature of Black Swan events, not despite the event being (in their post-vote minds) a Black Swan.

27/4/16: MIIS Team Comes Second in 2015-2016 The Economist MBA Case Competition

Well done to our MBA students at MIIS (http://www.miis.edu/) on taking the second place in The Economist MBA case competition: Real Vision Investment Case Study. See the details of the case study here: http://www.economist.com/whichmba/mba-case-studies/case-study-competition-2016. The winners were from Ryerson University. Our students second place project is described here: http://www.economist.com/whichmba/mba-case-studies/case-study-competition-2016/middlebury-institute-international-studies. Awesome result!

This comes on foot of 2015 win by MIIS team in The Economist MBA case competition: Muddy Waters Investment Competition, the details of which are available here: http://www.economist.com/whichmba/mba-case-studies/mba-case-competition-2014-15.

Which, of course, attests not only to the brilliance of students, but also to the consistently top quality of the programme.