Donald Trump’s Tactics

With all that has been written in recent weeks about Donald Trump’s campaign and the start of his transition process, most analysis and forecasting seems to be based on incorrect premises.  No one seems to be looking clearly at either what motivates Trump or his main political tactics.

Making sense of this will be much easier if we assume that Trump is a rational, intelligent, non-psychopathic generally well-meaning human being, equal or better on each of these scores than your average federal-level politician.  If you’re like most people who didn’t support Trump, you probably disagree with at least some part of this.  But try it out for a bit; I think you’ll find that there’s a consistency to it that is lacking in most of the discussion about Trump.

While I will speculate about Trump’s motivations in another post, let’s start with his tactics, which are much more out in the open.

As a campaigner, he recognized early that his skill as a showman — managing people’s attention and feelings — was his greatest asset.  He’s both being good at speaking in a way that makes his audience feel the way he wants them to feel and, even more importantly, understanding the feedback he’s getting from his audience.  He used this combination to convince people to feel good about him and bad about his components.  Beyond that, the campaign was just like any complex game (if an unusually competitive one).  The primary campaign involved divide-and-conquer, plus steering the public conversation about his opponents, in particular about the one or two who were doing the best at any given time.  The outrageousness of his statements not just ensured that he got the most news coverage, but by making outrageous statements about his opponents he would steer the public conversation about them too.

Trump knew that Hillary Clinton would run a much more sophisticated campaign when it came to the standard “ground war” that is part of modern presidential campaigns — fund raisers, get-out-the-vote efforts, local “grass roots” activities, etc.  But he knew that the had far more skill at connecting with voters, both through in-person events and through media old and new.  At a state-by-state level, the contests came down to his communication skills against her organization.  Both of them understood the electoral map well, though Trump had a better understanding that the polls were less meaningful in a campaign which was unprecedented in so many ways, and he pushed himself to give enough attention to every state that had a reasonable chance of being “in play” — standard strategy, not special to Trump.

What about policy?  Realistically, if you think of any recent presidential election, you’ll see that people vote for the person more than they vote for the policies.  Trump just took this to the extreme.

Is this well-meaning?  It neither is nor it isn’t.  While you could argue that getting elected president without working out and presenting your policy positions is cynical, it is only hubristic and not cynical f you have confidence that you can work them out well.  While most presidential candidates have spent their careers building policy positions, I expect that all of them believe that their combination of ideas, perspective, intelligence and ability to build and work with the right team is going to be better for the country than their opponent’s, and that winning the election is a precondition to being able to unleash those benefits, more important than exact policy details or even than keeping election promises.

Back to tactics, four  other Trump tactics are clearly visible.  One is, despite his bold words and expressed hubris, to appear weaker than he is in some areas.  It is likely that this helped him by making Clinton more complacent than she should have been in some of the surprise states (such as Michigan and Pennsylvania).  But is also fits with his showmanship, helping make it possible for a billionaire to present himself as an underdog in a country that likes underdogs.

Another tactic is to avoid being nailed down.  It is unfortunate that this doesn’t have more downside than it does, but it clearly has big upsides, and it makes it far easier for him to say whatever he needs to say to make people feel the way he wants them to.  (This will, of course, become harder as he develops a track record of actions in the political realm, but it seems likely to be a consistent tactic in some areas, especially foreign policy.)

Perhaps the least discussed, but one of his most important tactics, is that beyond the general showman’s manipulation of feelings, Trump also uses a magician’s manipulation of attention.  His particular style is to make things so outrageous they command outsized attention, and to send out conflicting signals (see previous tactic).  This has a few effects.  It made it much less of a downside in the campaign that it was so unclear what his policies will actually be — this should have been a huge concern for voters, but so many other things competed for attention that it was a side note.  It is likely that, as he develops and starts to try to implement policy, he will distract attention away from policies he believes in but are not (at least at the moment introduced) politically expedient.  And at the moment, it makes it hard for us to see which of his political appointments are actually relevant to how he’ll govern (and will still be around for inauguration and beyond).

I will end with one tactic, or rather type of tactic, which is certainly more negative even if it is possible to square with him being well-meaning and mentally well, and that is his tendency towards threats and bullying.  In the campaign this has been visible primarily in words rather than actions, but serious ones, such as threatening libel lawsuits or to send Clinton to jail.  In the business realm he has a history of bullying (in order to underpay) small companies whose services he uses.  In the political realm some kinds of bullying are actually considered appropriate, especially in many cases where the president bullies congress.  But Trump’s track record so far is for his bullying to be very personal, which is worrying, even if he is doing in service of the greater good (or at least his interpretation thereof).

innovation, productivity, wages and employment

Labor productivity and employment have an interesting relationship.   In the long run, increasing labor productivity leads to improved living standards (in the form of a combination of greater prosperity and fewer working hours), since less worker time is needed to produce more output.  During a recession, however, increased labor productivity often simply means less employment, since output isn’t expanding.

Labor productivity can be increased in two ways (not counting “trimming fat” which only works cyclically when labor productivity has previously been reduced by hiring enough to reduce efficiency).  One way is to innovate, to come up with genuinely more efficient methods and technologies.  The other is to invest more in capital, generally meaning technology and equipment.  Often these come together, since technological innovation can improve the options for capital investments — i.e., newer technologies are often more worth buying than the previous generation.

These two methods of improving labor productivity apply to both individual firms and to the economy as a whole, but the dynamics are different.  The level of aggregate investment in capital equipment is heavily influenced by the availability of the capital to invest, which in turn depends of the state of credit and equity markets (which also affects money available to spend on labor, but not by quite as much because labor markets are less efficient).  Innovation spreads in different patterns depending on the type of innovation.  Technological innovation which requires new capital expenditure is obviously tied to capital spending, but technological innovation which requires little capital (or significantly reduces other capital costs), and non-technological innovation (primarily new business processes, organizational methods and marketing strategies) are more driven by cultural adoption patterns, often following roughly a “hockey stick” pattern of slow growth among early adopters, and then much faster adoption after the new innovation becomes well-known and widely accepted.

Innovation which reduces labor costs by more than it increases capital costs changes the appropriate balance between labor spending and capital spending.  More precisely, it reduces demand for labor, so it will reduce some combination of the amount of labor and the cost of labor.  In general, innovation happens at different times in different industries, so except for professions requiring extensive training (where the amount of labor is relatively fixed) the impact tends to be more on the amount of labor used by the affected industry rather than on the cost of labor.  If one set of innovations applies to enough industries to constitute a large portion of the economy, however, it can have a significant effect on the market value of labor.  Recent innovations in information and communication technology are just such a set.

What could be called the beginning of the recent wave of innovation in information and communication technology triggered artificially high investment in the late 1990s, largely due to the well-publicized “Y2K bug” concern.  The investment in the 1990s was inefficient both because of the immaturity of the technologies and because of the necessity of new labor costs to manage the technology (but both were tolerated because of the Y2K bug fear).  Over the past decade, though, the cost-effectiveness of information and communication technology has improved greatly, because of both the greatly reduced cost of the equipment and, even more significantly, because of related non-capital innovation (business processes for managing the technology and a myriad of new ways of using it).  It is because this technology and related innovation is widely deployed and effectively used across nearly all industries that this is exactly the kind of innovation which reduces the overall demand for labor across the economy.  (Electricity and railroads are other examples of this kind of innovation.)

Wages are typically “sticky” in the sense that they rarely go down.  To the extent that wage stickiness has persisted over the last two years, it has resulted in a significantly reduced demand for labor across the economy (often manifest in new types of hours reductions as well as reduced numbers of workers).  While wages for existing jobs are mostly still sticky, many jobs have been replaced with lower-paying jobs, and correspondingly, many workers have needed to switch to jobs with lower wages than they were paid before.

The reduced demand for labor is at least a medium-term change.  Over the next few years, technological progress will continue at a rapid pace and in an overall labor-reducing way.  The capital costs will continue to be high enough to compete with labor (though they will continue to decrease), labor costs for managing the technology will go down, and new ways to derive both new business value and labor cost reductions from technology will be developed.  All of this shifts the balance away from labor spending and towards capital spending.

In other words, relative both to recent history to models that don’t account for this effect, for the same levels of labor productivity growth and overall economic growth we’ll see lower wages and higher unemployment, because more of the money that would have been spent on labor will be spend on capital instead.

leverage, politics and action (predictions for the US banking system)

The banking system in the United States looks considerably worse than it did two weeks ago, as do the prospects for the American and world economies.  Much of the change was predictable, but the interplay between economics, politics and psychology is becoming clearer.

The bill the U.S. Senate just passed, or something similar, looks likely to make it through the House and become law.  The economics of the bill appear to be simply wrong.  And when combined with politics and psychology, it looks likely that the bill will accelerate the problem rather than mitigating or even delaying the impact.

With the amount of leverage in the financial sector, though, no matter how much the bill helps the finances of the banks, it will be small relative to the web of investments that needs to be unwound to get back to a reasonable capital ratio.  Under more normal circumstances, the capital infusion should lead to extra lending to consumers and business of around ten times the increase in capital (based on normal banking leverage).  But these are not normal circumstances, and the first thing banks will do with additional capital is shore up their balance sheets and reduce their dependence on external funding for their operations.  Since it won’t be clear who benefits and by how much, banks won’t start trusting each other as counterparties again.  And since many banks won’t benefit significantly, and interbank lending won’t revive quickly, it won’t stave off bank failures — it will just change which banks fail.

Worse yet, the fact that bold action was taken and was ineffective will destroy faith in the federal government’s ability to deal with the problem.  This will further reduce faith in the medium-term future of the banking system, encouraging bank runs.

What the bill will probably do is make it easier to stuff failing banks into the soon-to-be “big 5” banks — Bank of America, JPMorgan Chase, Citibank and the newly-licensed Goldman Sachs and Morgan Stanley.  The Federal Reserve and the FDIC may display efficiency and competence at consolidating failing banks into these institutions, which might provide some stability.  But there will be two problem with this.

First, these banks, or at least the three existing deposit-takers, will be increasingly unhealthy underneath.  (They’re probably already pretty bad.)  Second, these banks will start becoming less willing to accept new failed banks into their portfolios.  Goldman (definitely) and Morgan Stanley (probably) will resist from the start, accepting only the best deals.  Within these five, the weakest will accept the least favorable acquisitions, because the weaker the bank the more motivated they will be by the incentives that will be provided.  At least one, and probably two or maybe even three of these banks will end up needing to be rescued themselves.  Such failures are likely to be messy, possibly involving days of closure to halt a run.  Such a closure will really scare business and consumers, trigger a whole new wave of bank runs and failures.

This leaves two critical questions — what’s the time frame for all this, and how bad will the impact on the real economy be?  My guess is that everything described above will happen within the next six months.  As for the impact on the economy, that’s a discussion for another day.

today’s U.S. economy in perspective (before and after Lehman)

In the 1990s, the U.S. economy experienced both rapid GDP growth and rapid productivity growth.  As economic cycle moved towards contraction, the Federal Reserve lowered interest rates, as usual, so as to mitigate the downturn.  Normally, the Fed would have been concerned about keeping interest rates too low for too long because of the risk of stoking inflation, but inflation was mitigated by a number of factors, most notably the continued opening up of the economies of China and India.

Lacking the usual signals and concerns regarding inflation, the Fed kept interest rates low enough for long enough to create an unprecedented climate for borrowing and investing.  With the inherent baseline for interest rates unusually low, it became unusually difficult to earn a given rate of return, so investors needed to become more aggressive to achieve the same results.  And while borrowing was so cheap, many investments became temporarily less risky, because otherwise shaky companies, consumers and investment vehicles could borrow money cheaply to keep them solvent.

The cheap money lasted long enough to reorganize much of the way the financial sector invests.  Leverage, always a factor, became that much more enticing as the cost of borrowing went down.  Investments that were not long ago consider exotic, such as sub-prime mortgages and emerging market debt, because popular choices.  (The rapid growth of Fannie Mae and Freddie Mac exacerbated the problem within the mortgage market by using their extra-low cost of borrowing to dominate the market for mainstream mortgages, pushing banks towards ones that didn’t meet the lending criteria for Fannie and Freddie.)

The availability of ever more powerful computers made increasingly sophisticated risk analysis possible.  In additional to providing a false sense of security, this drove the creation of ever more complex financial instruments, often designed to allow very specific types of risk to be bought or sold.  Many trillions of dollars of new assets types were created and sold.

Between the unprecedented economic conditions and the new types of financial instruments, even the most sophisticated computer models lacked the raw data to make accurate risk assessments.  Meanwhile, shareholders and other investors demanded high returns.  A bank, hedge fund, or other investment entity that underperformed its peers because it took a more conservative investment approach would be punished.  So the whole industry moved towards riskier assets without the ability to make meaningful assessments of the risks.

Inevitably, this brought us back to one of the most classic risks in the economic system — bank runs.  Fundamentally, banks are based on confidence, and backed by a relatively small cushion.  A bank is never too far from a vicious cycle in which reduced confidence causes depositors (and/or other creditors) to pull money out which reduces the cushion, which in turn reduces confidence further.  Given the relatively small percentage of assets kept as a cushion, investment losses or high levels of loan defaults can quickly deplete the cushion enough to start this cycle if new capital is not raised quickly.

Mostly because of deposit insurance, everyday consumer depositors are among the less likely triggers of bank run (in the United States — the weaker deposit insurance in the United Kingdom was a large factor in the Northern Rock bank run).  While investment banks don’t necessarily have the extra risk of short-term liabilities (i.e., deposits that can be withdrawn at any time) against long-term assets (loans they can’t call back in quickly) which retail banks do, they’re still similarly vulnerable.  They have ample short-term liabilities, and selling assets under duress is bound to reduce their value.  So both conventional and investment banks are vulnerable.  Indeed, any highly leveraged investor (which includes hedge funds and many insurance companies) is similarly vulnerable.

When the credit crunch started to bite, it was because banks and other players in the investment community realized that not only are there lots of vulnerable parties, but it’s fiendishly difficult to figure out how vulnerable another party is to a bank run (or equivalent) — risk analysis under these circumstances is inadequate enough when you have all of the data; it’s nearly impossible from just public disclosures.  That caused a drop in interbank lending, with intermittent much larger drops whenever there’s news that makes investors nervous.

As losses continue to climb, and show up in ever more places, more and more parties are vulnerable to the vicious cycle of collapsing confidence and cushion.  Even though the Fed’s policy interest rates are still low, borrowing is difficult and expensive.  The Fed keeps taking further steps to make money more available, but as confidence collapses, money becomes less available to many players throughout the system faster than the Fed can compensate.

What makes the bankruptcy of Lehman Brothers such a significant event in all this?  In addition to being a larger player than Bear Stearns, the Fed reacted differently.  In the case of Bear, the Fed facilitated the sale by effectively guaranteeing the value of $30 billion of Bear’s less liquid assets.  No such action was taken for Lehman.  While it was never realistic to assume that the Fed would (or even could) find ways to prevent the collapse of every large insolvent investment bank, the fact that the Fed allowed Lehman to collapse significantly widened the set of entities that are now perceived as risky.

What happens next?  The unwinding of Lehman will cause some pain, but will probably not be too dramatic outside of the financial industry.  Many other institutions facing losses will seek to do what Merrill Lynch did and find a buyer, but given how few large financial institutions have healthy balance sheets most will not find one.  There will be more high-profile bankruptcies.  Failures of banks and insurance companies with large numbers of retail customers will be messier.  The Fed will try harder, in those cases, to broker deals that prevent collapse — both to mitigate the impact (psychological as well as economic) on consumers and to reduce the stress on the FDIC’s pool of assets.  But it is highly likely that some failures directly which affect millions of consumers will occur.  Those kinds of failures are likely to impact consumer spending, which will deepen the recession.

The risk of a high-drama freeze-up of the financial system is real, though probably not very likely.  The risk of a deep and memorable recession, however, is high.  And the dollar will weaken, and inflation will rise.  The turmoil may have a permanent impact on the way we think about banks, the stock market, retirement savings and other financial matters.  There are guaranteed to be new challenges for the next president.  But beyond those vague statements, the details are too murky to guess.

the calm before the Olympics

A few months ago, it looked as though China might face major embarrassments in the run-up to the Olympics.  The immediate issue was ethnic violence in Tibet and the government’s heavy-handed response, but it looked as if others might crop up, too.  Several world leaders were considering boycotting the games or at least the opening ceremonies.  China’s choice to be in the spotlight seemed like it could be a tremendous mistake.

It looks very different now.  A massive earthquake, and a government response that was both effective and compassionate (especially when compared to the American government’s response to Hurricane Katrina), brought sympathy and respect.  The section of the Olympic torch relay through Tibet, reduced to one day because of the earthquake, went without a hitch (though with the help of massive security).  Even things in Taiwan have gone well, as a much more mainland-friendly government has come to power and a couple of concrete steps towards better relations have been taken.

But the Olympics are still fraught with huge risks for the Chinese government.  There will be a number of general embarrassments showing how even massive government efforts can’t change some of the ways conditions in China aren’t up to rich-world standards, such as air quality and the prevalence of rabid stray dogs.  While most members of the international press will happily play by the government’s rules, some will bristle at the restrictions placed on covering issues not relating to the Olympics, and report on it.

The biggest risks, though, center around groups of Chinese citizens.  Despite the risk of severe punishments, millions of Chinese participate in many tens of thousands of public protests every year (according to official figures).  There are also large numbers of youth with deeply felt (and government-encouraged) nationalistic passions.

There are four main types of incident to watch for:

The most discussed, but also the least likely, would be a successful public protest in Beijing where it will get the most media attention.  On balance, the massive security efforts will probably succeed in preventing any of these from being major successes, but the government will need to tread a fine line in order to keep these suppressed without being visibly repressive.  Given the massive number of potential organizers who must see this as a once-in-a-lifetime opportunity to have their voices heard, the possibility of a major incident cannot be ruled out.

Probably the most likely type of incident, at least in or around the Olympic venues themselves, would be an outbreak of violent nationalism.  Nationalistic feelings will be stoked by the competition of the games themselves, whether China is exceeding or falling short of expectations.  And many foreigners, ranging from high-ranking government officials to athletes to tourists, might make comments to which ardent nationalists would take offense.  This could include deliberate slights as well as unwittingly patronizing or otherwise insensitive comments.  With the sheer density of Chinese in the area, a reasonable fraction of whom are likely to have strong nationalistic feelings, it is easy to imagine an incident escalating very quickly from a minor brawl into a massive riot.

Another related possibility is an outbreak of violence between anti-government groups and nationalists.  Both groups will be out in force, feeling like they have a lot at stake.  This is most likely to occur a little further away from the Olympics themselves, where security is looser.

The most likely type of incident to inflict real damage on the government would be one that happens outside Beijing, possibly far away (but probably not in Lhasa, where the government will continue to pay close attention).  Anti-government groups may stage a major protest elsewhere in the country, calculating that government resources for suppressing the protest are reduced but that they will still benefit from the media attention.  Such an incident could go as far as a taking over the government apparatus in a city, province or region, and possibly sparking incidents throughout the country.  Massive chaotic change, while not likely, cannot be ruled out.

the high price of oil is part of the solution

High oil prices certainly have a big impact on economies and day-to-day lives.  In the rich world, the cost of transport and some kinds of energy has gone up enough to affect the behavior of both people and companies.  In the poor world, many governments who have been subsidizing fuel to keep prices constant are allowing prices to rise as the subsidies become increasingly unaffordable, putting travel and other luxuries even further out of the reach of many.

Large transfers of wealth also result from high oil prices.  Most of this involves money moving from the rich world to poorer countries, but a lot of the recipients are ill-governed places where the money will benefit only a small fraction of the population.

Some of this will create real problems for people who cannot afford them.  In the rich world, people in affected industries, especially the already struggling airline and car manufacturing industries, will lose jobs — and often the only jobs for which they have technical qualifications.  In some parts of the poor world, people will have trouble affording heating oil, in some cases with dire consequences.

At an economic level, high oil prices have the dual affect of depressing growth (by decreasing disposable income) and helping feed inflation.  Even with the best monetary policy management, this puts pressure on standards of living, at least in the rich world.

Both increasing oil supply and reducing oil consumption (not counting reduced economic output) require significant investment.  At the same time, the supply of cheap-to-extract oil is diminishing and the world economy is continuing to grow.  So oil the oil price continues to rise.  For now.

The fact that both supply of and demand for oil are slow to respond to price signals doesn’t mean that they don’t respond at all, though.  Some aspects just take more time.  Some are faster than expected — Americans have, quite suddenly, shifted their automobile purchasing towards more fuel-efficient cars which, for the vast majority of their use, provide the same value while consuming less oil.  Huge investments are being made in both alternative energy sources (including for transport) and in oil extraction, but both of these types of investment generally take years to produce results.  While it is likely that the oil price will continue to rise for another year or two, the law of supply and demand is working, creating exactly the results it inevitably does.

The only potential obstacle to this process is government intervention.  Subsidies and tax breaks which reduce the impact of the price of oil weaken the price signals (including the ill-advised gas-tax holiday suggested by several American presidential candidates), reducing investment in oil reduction.  In the case of poor countries, subsidies primarily benefit the middle class (who use cars and other oil-intensive resources far more), leaving governments with less money to spend on those who need it most (and, again, blunting the price signals).  The good news about this, though, is that the market forces are too large for the likely government intervention to be too effective.

This doesn’t mean governments should do nothing, however.  Governments can be effective by helping those impacted without trying to fight market trends that, in the long run, will reduce dependence on oil (and, at least somewhat, help reduce global warming).  In hard-hit rich world industries, such as airlines and car manufacturers, governments should fund job training for those who will need to find jobs in new industries.  In the poor world, governments would serve the poorest better taking money away from fuel subsidies and spending it on reducing poverty (in the short run, simple income subsidies would address the impact of heating oil and other costs far more cheaply than subsidies do; in the long run, recent successes in anti-poverty programs, most notably Brazil’s Bolsa Familia, provide good models).

The timing of this oil price spike, coinciding with recession and inflation, is unfortunate for many economies, particularly rich-world ones.  (Note that this timing is not entirely coincidental.)  This will contribute to the size of the current recession, and (via both inflation and incomes) will impact short-term on living standards for many in the rich world.  But then when oil prices drop again that will add strength to the economic recovery after the recession.  The economic gains at that point from the reduced price of oil may be less if economies succeed in becoming less oil-centric.  But the more that happens, the more we will reap permanent economic gains from needing less oil.

Perhaps the best news in all this is that it looks like investment in greener energy sources, especially for transport, are currently providing better return than investment in oil extraction.  While there are some negative consequences to be addressed (such as a making coal look more appealing), overall the high price of oil is spurring surprisingly rapid progress towards less oil-intensive transport and energy generally.  Given the current state of green technology, it will not take long for this to provide lasting economic benefits, not to mention environmental ones.  Indeed, for the sake of the planet, it might be a good thing if the price of oil stays high for a while longer.

going for the red medal

China’s leaders are among the world’s most thoughtful. They approach challenges with a pragmatic directness unmatched by any other large country. While far from immune from dirty political squabbles, they often display an impressive unity of purpose. It is with this level of resolve that they are determined to use the Beijing Olympics to improve China’s international image, and in particular to have China be perceived as a respectable, responsible player that should be treated as a full peer to the major Western democracies in international forums.

This was never going to be easy. While none will admit it publicly, many if not most Western politicians would love nothing more than for the Chinese leadership to make some monstrous gaffe which would might weaken China’s international standing.  More significantly, numerous groups within China with one or another anti-government cause to promote see the international spotlight on China as a unique opportunity to make progress.  This may appear as a no-lose time to protest — either the government will be tolerant and the protesters can be bolder than before, or the government will be harsh, which would inspire the international attention these causes crave.

The most prominent challenge comes from Tibet, where China, with its long-term view, is trying to make sure that this colony they control eventually becomes an assimilated province.  Last month’s violence in Tibet, and the government’s provocative choice to route the Olympic torch relay through Tibet may seem to be evidence that China is playing the game badly.  So far, though, it is actually proving the opposite.

China’s response to the initial outbreak of violence in Tibet was swift and harsh.  And it seems to have been very effective.  Within a couple of days Chinese army and police established sufficient control (more or less martial law) to keep Lhasa mostly calm, and elsewhere large organized protests are less likely.  The Western world saw a picture blurred by moral ambiguity — much of the worst violence was committed by Tibetans against ethnic Chinese civilians (who had been encouraged to move there by the Chinese government in an effort to get Tibet to assimilate).  The incident was front-page news in the West, but only for a few days.  Less than a month later, most Western citizens see the continuing small stream of news from Tibet as the kind of international situation they don’t have time to understand properly.  And for Western politicians an international issue with a strong moral imperative but little opportunity for near-term results comes too far down the priority list to organize the kind of coordinated international response that would be required.

Meanwhile, pretty much all governments agree in public that it would be wrong to “politicize” the Olympic games, and Western electorates have largely bought into this concept as well.  This works to China’s advantage, because it encourages Western governments to try to keep otherwise legitimate issues (in particular the Chinese government’s human rights abuses) off the agenda if China has succeeded in associating them with the Olympics.  And while a couple of Western leaders are publicly pondering boycotting the Olympics, more have explicitly promised not to — so if one or two do, it will probably come across as a petty snub rather than a moral statement.

So, so far, China is playing the game skillfully.  The violence in Lhasa resulted in very little censure or bad publicity given the scale of the violence.  And the response from the West is varied and uncoordinated.  Without a very big incident, Western governments couldn’t now muster a coherent response without at least some of them losing face.

And yet, it seems likely that China has underestimated the scale of the challenge.  China has oppressed its people in many ways, and there are limited outlets for the Chinese people to express their discontents.  There are millions of activists and potential activists now making plans for how to use the attention the Olympics will bring to have their voices heard.  The government will succeed in thwarting the vast majority of those plans.  But it seems likely that a few slip through the net.  Whether they come in the form of roadblocks, large publicity stunts, or outright violence, China’s potential protesters will find ways to create situations to which there is no good response on the part of the Chinese government.  And a couple of effective protests would likely inspire others.  It is just possible (though probably, on balance, unlikely) that this will start a chain reaction.  And even if it doesn’t, it is likely that the Chinese government will end up (due to either miscalculation or lack of choice) seriously embarrassing itself.  What would happen next will depend a lot on exactly how those incidents are perceived by the rest of the world, and whether the rest of the world can bring enough moral clarity to the situation to coordinate an effective response.

The most likely political outcome of the Olympics is for there to be two or three more incidents like what happened in Tibet last month — ones where the Chinese government loses some face, but the government and the system emerge fundamentally unscathed.  It is also conceivable (but unlikely) that China will implode as a direct result of the Olympics.  Another distinct possibility is that some of the severe weaknesses in the Chinese system will be exposed, forcing more changes than look possible today.  The international response will be critical to a good outcome.  But even more important will be a large dose of luck.

a brief analysis of the American mortgage crisis and housing bubble, and how to respond to it

Perhaps the worst thing about the current mess with subprime mortgages in the United States is the timing relative to the political cycle.  With an unusually wide-open presidential race getting into full swing, and with a party recently gaining congressional power wanting to prove itself quickly, politicians are competing to been seen to be doing something.  So level-headed long-term thinking is in particularly short supply.  Unfortunately, policy decisions made under such conditions are highly likely to have unintended consequences.

To determine what a rational response would look like, it is necessary first to understand the situation.

What is the “crisis”?

What, precisely, is going on that constitutes a mortgage “crisis”?  There are four main components: large numbers of foreclosures, sudden changes in lending criteria that make it much harder for buyers to find financing, major changes to the conditions in credit markets (especially for mortgage-related financial instruments) and broader impact on the American (and world) economy.

What impact is the crisis having?  The first category of impact is the direct impact on those who experience foreclosure.  Obviously, the personal impact on these people and families is great.  They become poorer both in direct monetary terms and in terms of the reduced purchasing power from degraded credit.  Some fraction of them (especially those who are unemployed) will have trouble finding homes to rent and/or will be otherwise pushed into poverty.

The second category of impact is the impact on people trying to finance home purchases over the coming months and years.  These people will have a much harder time.  For many, this will simply mean that they will stay, or become, renters rather than home owners.

The third category is the impact on the housing market.  There has long been ample evidence of a housing bubble, but large numbers of foreclosures and more difficult borrowing could make the correction in housing prices much more sudden.  This has a vicious-cycle component, because the difficulty of selling a home at a good price will make it more likely for owners to default rather than sell.

There is other impact on investors and on the economy in general, but I won’t get into that here.

How did this happen?

Mortgage lending has changed greatly in recent years.  Not that long ago, nearly all mortgages had the same payment every month for the entire duration of the mortgage, and you expected to keep the same mortgage until you either paid it off or sold the home.  A large down payment was required.  Even though most buyers could expect to see both their incomes rise and the house value rise over the duration of the mortgage, the calculations were entirely based on what you could afford to borrow as of the initiation of the mortgage.

Over the past few years, things changed.  Governments encouraged an easing of lending criteria to make it possible for more people to buy homes.  Financial instruments got a lot more sophisticated, enabling lenders not just to sell mortgages to investors, but to sell very specific elements of default risk, making it much easier to find investors to cover the risk of default for mortgages that were more of a stretch for the borrower.  On top of that, the Federal Reserve and other central banks kept interest rates unusually low for several years, driving many investors to seek riskier investments in order to get higher returns.

So it became easier to buy a house — whether or not you could afford it in the long term.  This effectively increased demand for housing, driving up prices.  Enough people made significant profits from their homes that simply becoming a home owner was increasingly perceived as key step to accumulating wealth.  In American culture, buying a home became known as something that financially prudent people did — almost regardless of the fundamentals of the investment.  And having interest rates and/or payments that went up in a couple of years wasn’t seen as a problem, since you could simply refinance when the introductory period expired.

All of which explains both how there came to be a housing bubble (the full extent of which is still mostly unacknowledged) and how both lenders and borrowers decided to engage in mortgages that would have been considered implausibly imprudent a few years ago.

Given that, it’s no surprise that many people ended up with mortgages that they wouldn’t be able to afford as soon as house prices stopped rising or interest rates started to climb.  Both of those have happened.  And, in the nature of credit, when things deteriorate, they deteriorate rapidly.  A borrower in financial stress has their credit downgraded, making it hard for them to refinance or otherwise borrow money to relieve their financial stress.  So a borrower with a perfect payment record but little room for error can quickly end up in default and then foreclosure if their payments go up (or their income goes down).  So with interest rates starting to climb and housing prices weakening, we’re seeing lots of defaults and foreclosures, with many more expected.

How unusual is this?

In general, when a borrower defaults, and a home is foreclosed, it may be a personal tragedy for the individuals involved, but it’s not something that merits a government response.  Capitalism is messy.  Buyers and borrowers sometimes make bad decisions.  When they do, they face the consequences.

There are some borrowers who were victims of outright fraud.  Some mortgage documents were designed to hide the changes to monthly payments over time, or were structured in ways that designed to lead to foreclosure.  Mortgage salespeople and brokers were sometimes compensated more for loan arrangements that were not in the buyer’s interests, and therefore had incentives to mislead.  Where there has been provable fraud, the perpetrators should be punished and the victims compensated.  But this is a small part of the picture, and there’s nothing particularly new about it.

But there are things about this that are unprecedented.  In terms of the crisis itself, three things that are unusual.  One is the scale of the problem — many are currently estimating about half a million subprime foreclosures in the next year, and experts expect that the problems will extend well beyond just subprime borrowers.  The second is that there are an unusually high number of new borrowers in trouble, many of whom are inexperienced with financial documents and therefore more easily mislead.  The third is that many of the new borrowers are poor enough that the consequences for them may be especially harsh, to the point where finding housing of any kind may become problematic.

Dealing with the crisis itself

Responding to the humanitarian impact is, or at least should be, closely related to the overall way the government handles poverty, rather than being about protecting people from foreclosure.  There’s no inherent reason why people should own their homes, and there are potentially serious negative effects of preventing foreclosures that make economic sense (see next section).

While Americans tend to be ambivalent about helping the poor, and the American welfare system is weak for a wealthy country, if there are hundreds of thousands of foreclosures it will get the attention of both politicians and the media.  But the fact that this is all happening at once doesn’t really change the fact that this is a problem with how America handles poverty, not with the particular situation at hand.  Ideally this would inspire a fresh effort to revamp the welfare system to be better at both addressing humanitarian issues (health, housing and food) and at providing paths out of poverty.  More likely, however, the government will choose to give money on a one-time basis to people who meet a specific set of criteria — an approach that is likely to be neither fair nor effective.

In addition to the humanitarian impact, the impact on the housing market could be severe, and might merit a response to try to reduce the downward spiral that the interplay between falling prices and credit problems will cause.  But there are conflicting indicators here.  The problem was caused by credit that was issued too easily, but the only thing which would help the housing market situation would be to make credit easier to get.  So there’s not too much the government can do here.  It is possible that there might be categories of borrower that are less risky but underserved by the market under current conditions, and if so, the government could use the government-sponsored mortgage lenders to help make credit available to those borrowers.  But even if there is something that can be done along these lines, it will be small relative to the scale of the issue.

What not to do

Politicians will find it tempting to use government money to prevent foreclosures, either by helping borrowers directly or by subsidizing refinanced mortgages.  Doing this, however, would strongly encourage similar crises in the future.  If a government bailout is likely, the effective risk of a mortgage is much lower.  So lenders will be encouraged to issue such mortgages — especially to the weakest borrowers who pay the highest interest rates.  So the cycle would just repeat itself.

Another tempting response is to “protect” the poor by making it illegal for lenders to issue mortgages to borrowers who cannot afford them.  Aside from predatory mortgages, the reality is that so long as it is clear that the lender will lose money if the borrower defaults, when the risk of default is too high the mortgage won’t be issued anyway.  If the government acts to restrict credit to poor people, it will make it harder for them to escape poverty.  While the recent excesses (caused by overly cheap credit and therefore overly high risk tolerance on the part of lenders) were problematic, allowing some creativity on the part of lenders can be a significant help to poor people looking for mortgage products that will help them into a better home and out of poverty.

Preventing/mitigating future crises

Both the Federal Reserve and the government should take a hard look at the overall economic drivers, especially the impact of monetary policy on credit markets and asset prices.  But aside from that, what can be done to prevent a situation where large numbers of borrowers are tempted into mortgages (or other credit) they cannot afford?  As mentioned above, too much regulation will make it worse for poor people by making it artificially hard for them to buy homes.

There are indeed some “predatory” mortgages — designed specifically to take advantage of naive lenders.  Obviously, cracking down on those is desirable.  Similarly, there may be certain mortgage structures which, which not explicitly predatory, are highly likely to be problematic for the borrower — with careful and level-headed analysis, these should be identified and prohibited as well.

Beyond that, the other thing the government can do is help make sure the borrower has good information, through borrower education and disclosure requirements.

If you haven’t done it before (or even if you have), selecting and understanding a mortgage, and analyzing how much you can afford, are complex tasks.  The federal government could produce and distribute information (in a variety of languages) that could make this much easier for new borrowers, and could certify and subsidize classes on mortgage borrowing.  This information is, of course, already available in many places, but it is too difficult for a borrower today to know which sources of information are balanced and accurate.  The information should be practical, easy to apply but not too prescriptive, and available in a wide variety of languages.  If done well, it could make it much harder for a mortgage seller (typically paid on commission) to become the primary source of information for a borrower — something particularly likely to happen for less sophisticated borrowers.

Improved disclosure requirements could also help.  The government already has some standards for how information about payments and costs of borrowing are presented, but these haven’t kept up with the increasing complexity of mortgages.  Also, if brokers were required to disclose discrepancies in commissions between different mortgage products they sell, it would encourage borrowers to be skeptical of mortgage products with higher commissions.  After this worked its way through the system, it would result in more sales being based on the differences between the mortgages themselves rather than their commission structures.
Capitalism creates losers as well as winners, and general economic policy errors create problems in unexpected places.  When it comes to specific areas like mortgages, many kinds of government intervention end up doing more harm than good, especially when they become highly political issues.  But helping ensuring both sides have good information and prohibiting transactions that clearly harm the less savvy party are among the few ways the government actually can help.

very dark shades of gray

The world can (usually) agree that a government that murders lots of people is bad.  It is about as black and white as gets (which is still pretty gray).  While there are some who still won’t call what’s going on in Darfur genocide, it is clear enough that there are widespread calls for forced intervention (though, sadly, no action as yet).  There is consensus in the international community that we should have intervened in Rwanda.  And, despite a few detractors, intervention in the Balkans is pretty widely regarded to have been a good move.

The world is pretty clear that bad policy is not a reason for forced intervention, regardless of the scale of death and suffering that it causes.  In the last couple of years, since the generosity of Westerners regarding AIDS treatment has improved, bad AIDS policy on the part of the South African government has caused hundreds of thousands of preventable deaths.  But clearly, the only intervention considered there is diplomacy and aid, and perhaps a little propaganda.

By most measures, today’s worst government is that of Zimbabwe.  Depending on what you assume the baseline is, it is is likely that its misrule has cost millions of lives, even though it is responsible for relatively few direct murders.

While there are plenty of calls for increased sanctions against Zimbabwe, and stronger international condemnation, there are almost no calls for forced intervention there — even though the humanitarian costs, in terms of both death and suffering, are probably rather larger than in Darfur.

The fact that there’s not more international pressure is a function of political weakness on the parts of the powers (African and otherwise) that ought to be applying the pressure.  But the fact that the option of intervention is not in any serious way on the table is a function of international norms and views about sovereignty.

The role of sovereignty in the international community is changing, and it will be necessary to modernize the concept.  Respecting sovereignty is often discussed as a moral issue, but this is surely not correct.  It is true that lacking international consensus, “strong” sovereignty helps prevent a perpetual state of war.  But as power becomes increasingly globalized, and the technology for oppression increases, the cover that sovereignty provides is bought, sold and co-opted too easily.  And while this issue is nothing new, there is nothing morally right about protecting the sovereignty of a government that oppresses, impoverishes, tortures, displaces and, when convenient, kills its people.

nuclear proliferation and trust

Optimism regarding the latest negotiations with North Korea regarding nuclear weapons is worse than misplaced. The West’s current strategy for nuclear nonproliferation is founded on premises that are flawed, leading to counterproductive actions.

One of the key premises is that nuclear inspections can be effective even if relations between the inspectors and the inspected are still fundamentally adversarial. The two examples of countries where inspections have worked — Libya and South Africa — are both examples of countries highly motivated to become accepted members of the international community, and giving up nuclear weapons was key for both (especially Libya) in achieving such acceptance.

Despite all the talk of safeguards and the current agreement’s much more quid pro quo-oriented structure, negotiators continue to grossly overvalue the statements and promises made by the North Korean regime, despite a consistent history of deception and reneging. In a few months, if not sooner, this round will prove to be just more talk.

The logic behind the current approach to North Korea appears to be that since there are no medium-term outcomes that are both plausible and acceptable to the interested powers, the best strategy is to nudge things in the right general direction in the short-term and hope that a creative solution can emerge in the future. The problem is that, ironically, almost any change available to the nonproliferation negotiators at this point is a change in the wrong direction. Prior to the latest talks, North Korea looked to be in an economic bind. Almost any agreement is likely to give it more room to maneuver, which is likely to mean more secret nuclear weapons work.

A functional non-proliferation strategy requires a viable path from the current situation to the target country not having nuclear weapons. At each step along the path, it is vital that each party perceive that it is in its self-interest to take the next step. This means that other paths must look less attractive. In a relationship lacking even basic trust, it is highly unlikely that a country that has or believes it soon will have viable nuclear weapons will take meaningful steps towards giving them up.

So the problem to solve is the problem of trust. This is complicated by the fact that in the long run trust generally goes along with economic integration, but in the short run that same economic integration generally makes it easier to acquire the resources and know-how to produce nuclear weapons.

I don’t have answers here, but I don’t think the problem is necessarily unsolvable. Addressing the question of how to build trust and encourage integration on the part of aspiring nuclear powers would be far more effective than trying to decide on next steps without a coherent plan.