A Scientist for Every Issue

What sparked my interest in economic history was actually a book which had very little to do with the past. It was ‘The Cult of Statistical Significance’ by Steven Ziliak and Deirdre McCloskey.  The book was, as you have probably guessed about statistics; furthermore the authors argued that statistics was having a negative effect on the way that economists undertook research. They argued that economists liked to appear scientific and one of the ways to do so was to use statistical significance. A clean cut, simple procedure that gives a right or wrong answer appeals because it seems to offer a degree of certainty to a researcher’s findings. Does smoking lead to an increase in the use of other drugs? Do a t-test and you have your answer. However what exactly does the test of statistical significance prove? The answer, to the authors, was not much.

I am not going to talk more about this debate here (as it is quite technical, divisive and will likely bore the pants off anyone that isn’t interested in doing research in the social and natural sciences). One of the points that I did take away and thought would be interesting to talk about, was that economists can benefit from grounding their work in a wider context.

How to Build a Discipline from the Ground Up

This is where economic history can really play a part. Firstly modern neoclassical economics, the stuff that gives us supply and demand diagrams and the toolkit for how a central bank should be run, is based on a number of key assumptions about the nature of the world. Many of the debates on these assumptions happened over a hundred years ago.

Take for example the theory of value. What should the price of a good be? Should it be decided by how much of each input goes into its production?  Or should it be decided by how much use that people get out of it? Why don’t we just let the market decide and take that as its value? If the first case is true then is the value of the internet, which as a service is very cheap to provide for each user, valueless? Likewise if we use the third option and let the market decide then the internet is still pretty cheap. However, people clearly get a lot out of the internet. It has created a great deal of what economists call consumer surplus; that is what consumers get in value above and beyond the price they pay.

Trial and error, a 10000 year experiment

Secondly it allows us to enrich many of the theories we have to explain the world as it is today. I am currently reading another book (this is the last I will mention I promise!) called ‘Structure and change in economic history’ by Douglas North. In the book he attempts to create a theory which can explain why economies over time fair well and poorly.

For example, we can explain why humans moved from a hunter gatherer society to organised agriculture. For the first million and a half or so years of our history humans occupied a very small area of the globe. There was a lot of space and so as our population grew there was little pressure on hunting resources as new groups or clans could simple move into territory unoccupied by other humans. However, as the world began to be filled up the amount of free space decreased. This caused a decline in the marginal benefit of hunting as there were fewer animals to go around, and there was no incentive for tribes to not exploit all of the animals that surrounded them. If they decided to not hunt a herd or buffalo, some other tribe would. Hunting suffered from what the tragedy of the commons. At some point, the marginal productivity of hunting must have fallen below that of agriculture. When this happened it became in the interest of tribes to start farming, as extra hunters had very little effect on how much game a tribe would catch. Over time agriculture became more and more productive (from breeding crops, improving techniques etc.) and eventually replaced hunting as the main form of food production.

There are no ways of testing such a theory, but it is interesting none the less. It also demonstrates how central property rights and natural resources, two items usually omitted from modern economical analysis, can be in examining the nature of the world.

Unless you have been living in a hole for the last year then you have probably heard that the European financial system is in a bit of a mess. Put simply, the countries of the Euro-zone have borrowed quite a lot of money. Some of the people that governments have borrowed this money off of have become less than convinced that the euro-zone countries pay it back. As a result debt holders have been selling a lot more than buying, which has forced the price/value of these loans down and interest rates up. All-in-all, not too pretty.

The question most people are asking, is how likely is it that the cost of debt gets so high for a country (say Italy), that it will have no choice but to default on its debt. This is a very hard question to answer.

So turning to the other side of the story, what happens if a country defaults? I thought it would be interesting to take a look back at one of the more colourful periods in financial history, the Spanish Bankruptcies.

A little History

In 1492, Rodrigo de Triana became the first European to set sight on the Americas in almost 500 years. Few at the time would have thought that the sighting of land sailor on la Pinta, one of three ships in the expedition led by Christopher Columbus, would transform the shape of Europe. The ships had been sent to discover a trade route around the east of the globe to the orient. The goal was to ship spices, which were extremely valuable is Europe at the time from the east, thus making a fortune. The Portuguese would get the spice route as it later became known but the Spanish got a lot more.

It became apparent, over the next few decades that the Americas were extremely rich. Areas that now include Mexico, Peru and Bolivia had huge reserves of gold and silver. At Potosi, there was a mountain which contained the largest reserve of silver ever found. So large in fact that it is still being mined to this day. The value of gold and silver was particularly important in the 16^th century as it was literally used as currency. The influx of gold and silver made the Spanish exceedingly rich, unfortunately this didn’t last.

What would you buy with all the gold in the world?

By the time the Spanish had begun to realise the extent of their new-found wealth a new family had come to power, the Habsburgs. The Habsburgs were extremely ambitious and used their money to finance a large number of wars in order to consolidate and expand their power. They fought for control of Italy, they fought against France and later they fought against protestants in the form of the Dutch, the English and later still many Germans. They didn’t just fight. They donated huge amounts to the catholic church, building the Vatican in its current form. They even built a brand new city from the ground up, which would become their capital, Madrid.

One of the problems they faced was that while the government had a lot of money to spend, by spending it they increase the supply of money in their own lands and inevitably throughout Europe. The rate at which the money supply grew was like nothing Europe had ever seen. Not only that but it grew far faster than the Spanish economy, causing a huge amount of inflation. This impoverished the lower and middle classes and the domestic economy stagnated.

The well dries up

By 1557 Spain’s finances were extremely overstretched and the Spanish were forced to declare a state bankruptcy. This caused chaos in the European financial system of the day. It bankrupted a large part of the Fugger family which had been the Habsburgs main financiers. At the same time the Spanish crown began to borrow large amounts of money, largely from the Genoese (ironically Columbus was born in Genoa).

Continued borrowing and debt led to more bankruptcies in 1576 and in 1596. They lost the great bulk of their European possessions outside of Spain itself and the financial mismanagement in the 16^th century set the stage for the perennial decline of the Spanish Empire over the next two hundred years.

I am not saying that the west is going to go bankrupt. The two situations are not very comparable. It was fiscal mismanagement, a high growth in the money supply and overspending on foreign wars that caused the Spanish Empire to decline. It’s worth not forgetting just how bad, bad economic policies can be.

Essentially the lovely people over at The Economist publish a chart every day on pretty much everything. Not only are they extremely shiny, they are also usually both topical and interesting. They even have an advent calender!

So apart from all of the eye candy, just why are graphs so awesome? I think they allow you to summarize a huge amount of what’s going on in just a small area. Not only that but they can be great tools on which to frame a discussion. Here are some charts that I found particularly interesting:

1. European Borrowing and Lending

This graph shows how much banks have been able to raise in the bond markets. Put simply, how much extra cash they have managed to get invested into their business. Investors in exchange for providing this money now, get a rate of return on what is called a bond. The graph firstly shows that banks are having major issues in getting more cash, which they need to meet the new Basel Rules*. Secondly it shows that investors are unwilling to issue these bonds unless they are covered. A covered bond is a bond which is linked to an asset proportional in value to the bond issued. So if the bank cannot pay the bond interest then the investors can take control of the asset to get their money back. Fundamentally this graph shows just how little liquidity and how much paranoia is driving the behaviour of European banks.

*(Basel 3 is the latest set of guidelines issued for global banking. Passed after the financial crisis they required banks to keep a far greater proportion of their assets as cash, the kind of money you carry around in your pocket everyday, as opposed to investments, say mortgages)

2. Bribery and Corruption

This graph shows perceived corruption within the public sector on the Y-axis against a survey-based score for how likely private companies are to engage in bribery on the X-axis. A higher score suggests bribery is less common. It is worth noting that the companies Bribe Payers Index is the likelihood of companies using bribes when doing business in foreign countries. There are some interesting results here. Italy and Turkey rank as the most corrupt amongst the OECD (developed) countries. Hong Kong has one of the least corrupt administrations in the world, despite being part of the China which ranks quite poorly on this scale. Perhaps unsurprisingly the Russian oligarchy is bringing up the rear amongst the major economies.

3. Dangerous Places

When it comes to crime it is often very difficult to make comparisons between countries, partly because the chance of a crime being reported differs greatly across cultures. One of the better measures to get around thus problem are murder rates, as murders tend to be reported. It seems that less developed countries have higher murder rates. Rather surprisingly while Mexico hasn’t topped the chart, they didn’t even make the top ten. Afghanistan has a lower homicide rate than the USA. Quite whether this makes Afghanistan a safer country would be hard to believe.

http://www.zerohedge.com/news/charting-fundamental-cash-supply-demand-dilemma-europe

http://www.economist.com/blogs/dailychart/2011/11/bribe-payers-index

http://www.economist.com/blogs/dailychart/2011/10/homicide-rates

Disclaimer: All of the charts here are reproductions from the websites linked above.