SESSION # 2. THURSDAY, FEBRUARY 12
International Political Economy – Leiden University
 Innovation & the credit market (continued)
 Inflation expectations & long-term interest rates
 Governance, property rights & the credit market (introduction)
 Innovation & the credit market
Because the second 1500-word assignment will be on innovation –The Political Economy of Innovation– we need to discuss a number of issues in more detail. First, let me mention a couple of interesting "Schumpeterian" cases.
1a. New sources of energy: what’s at stake?
- Norway. The investment policy of the Norwegian government pension fund, managed by Norges Bank Investment Management, aims at “socially responsible investment”. As part of NBIM’s corporate governance work on environmental issues, NBIM focuses on policy positions taken by energy related companies in regards to possible U.S. climate policy. In January, NBIM praised the position taken by the Edison Electric Institute (EEI), which has adopted an updated climate change framework calling for an 80 percent reduction of carbon emissions by 2050, from current levels. Beyond the very deep, long-range emission reduction target for 2050, the EEI document states that near-term targets should be guided by efforts on energy efficiency, renewable energy and, to some extent, new nuclear. REMEMBER: THE NORWEGIANS ARE INVESTORS IN THESE COMPANIES!!!! In 2007, the sold their $400 million-position in Wal-Mart shares, because of ethical concerns over the company’s labor policies. NBIM does not invest in companies involved in the manufacturing of landmines, cluster bombs, atomic weapons, etc. [Norges Bank]
1b. On energy & innovation, see Thomas Friedman. Hot, Flat and Crowded: Why We Need a Green Revolution — and How It Can Renew America (Nueva York: Farrar, Straus & Giroux, 2008) [Chapter 1][Video] [Bjorn Lomborg: "A Chilling View of Warming", The Wall Street Journal]
1c. The Zayed Future Energy Prize. In 2008 the Crown Prince of Abu Dhabi announced The Zayed Future Energy Prize [info] to be awarded to individuals, companies, organizations or NGOs that have made significant contributions in the global response to the future of energy. The aim of the prize is to inspire the next generation of global energy innovators. 2009 winner: Dipal Barua. “The first annual Abu Dhabi based Zayed Future Energy Prize, worth USD 1.5 million, was awarded to the Founding Manager Director of Grameen Shakti, Dipal C. Barua, for his work in financing and installing over 200 thousand solar panels that have electrified the homes of approximately 2 million people in rural Bangladesh. Grameen Shakti, or “Village Energy,” was founded as a non-profit in 1996 as a sister organization of the Nobel Peace Prize winning microfinance institution Grameen Bank. Grameen Shakti’s website says that their solar power program “really took off the ground when rural clients realized (solar panels) are more cost effective than other conventional sources of energy such as kerosene and provide more utilities.” Grameen Shakti hopes to implement 1 million solar panels by 2015”.
1.b The Kindle 2.0
The New York Times is blogging the Kindle 2.0 launch. What kind of innovation is this?
[QUESTION. Is the Kindle a new product, or is it rather a new way to sell an existing product?]
- Schumpeter's views on innovation and the credit market. Fore more info on Schumpeter, see Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007 [web] [prologue]. I've written a review, but it's in Spanish! From McCraw's book: "The core ethos of capitalism looks constantly ahead and relies on credit in launching new ventures. From the Latin root credo —'I believe'— credit represents a wager on a better future ... In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations" (p. 7). Initially, the emergence of innovative entrepreneurs pushes interest rates higher, as demand for credit shifts upward.
[DIAGRAM. IN THE CREDIT MARKET, THE DEMAND SCHEDULE SHITS UPWARD, AS ENTREPRENEURS DEMAND MORE CREDIT AT EACH LEVEL OF THE INTEREST RATE. The result is a higher level of interest rates].
Now, Schumpeter also praised financial innovation — up to a point. In the case of railroads in the second half of the XIXth century, or the automobile industry in the 1920s, he states that “credit creation” in the form of overdrafts and car loans [i.e credit creation on a large scale] made it possible to finance these innovations:
[DIAGRAM. IN THE CREDIT MARKET, THE SUPPLY SCHEDULE SHIFTS DOWNWARD, AS MORE LOANABLE RESOURCES ARE MADE AVAILABLE. Note that the net result is a stable interest rate and more credit! This is the kind of results you want!]
But then Schumpeter adds: “Some of that lending was granted with almost unbelievable freedom and carelessness”. Does that ring a bell? Schumpeter made a distinction between productive & non-productive financial instruments (*). When bankers create financial instruments to “play amongst themselves”, then the risk of a bubble increases dramatically. But is it possible to really make that distinction?
[DEBATE! WERE SUB-PRIME LOANS A “SCHUMPETERIAN” INNOVATION?]
. Alan Greenspan seems to think so. In his 2007 autobiography, Alan Greenspan —a self-delcared Schumpeter fan—had only positive things to say about sub-prime lending: “The gains [he is referring to the percentage of households who own their house] were especially dramatic among Hispanics and blacks, as increasing affluence as well as government encouragement of subprime mortgage programs enabled many members of minority groups to become first-time home buyers” (The Age of Turbulence. Adventures in a New World. New York: Penguin, 2007, pp. 229-230) [info].
. Any ideas?
. Obviously, Greenspan got that one wrong… Warren Buffet, the great investor, had by that time issued his famous warning: “Derivatives are financial weapons of mass destruction”.
. In 2004, Charles G. Leathers & J. Patrick Raines published a brilliant paper: "The Schumpeterian role of financial innovations in the New Economy's business cycle", Cambridge Journal of Economics, 2004 28 (5): 667-681. According to Leathers and Raines, Schumpeter made a crucial distinction between productive and unproductive financial innovations (the latter are created by banks for speculative purposes). As early as 2004, they wrote that Alan Greenspans's optimism was completely misplaced. Bingo!
- Schumpeter on monopolies. You may remember that one of the key ingredients of Schumpeter’s theory of innovation is the incentive played by the ambition of some entrepreneurs to become monopolists
[DEBATE! Do you remember the litigation that took place between Microsoft and the European Union? How can one relate it to Schumpeter’s theory of innovation? What was Microsoft's chief argument?]
. Clue: bureaucratic meddling creates risks to the whole economy, as it would stifle innovation. Schumpeter thought that monopolists would not be able to keep their privileged position for too long: new competitors would sooner or later emerge!
[QUESTION. Did new competitors emerge?]
. Clue: Google, Linux.
- Schumpeter & Keynes (very briefly). Who’s the leading dead economist nowadays? Keynes.
In times of crisis & depression, when everybody wants to get out of debt and sell assets at the same time, somebody has to take the other side of those trades in order to counter the downward spiral. And that "somebody" is?
[QUESTION. And that "somebody" is?]
. Clue: the State, the government.
. Schumpeter: innovation in a downturn. Innovation provides the solution. Innovation itself stimulates demand, as prices tend to drop, thereby stimulating demand. On that point, see the Financial Times interview of Dave Willis, founder of Whitford, one of the world’s top non-stick coating makers (Teflon, etc). "Is he worried about the global downturn?" Were it not for his FATE IN NEW PRODUCTS, he would be. Says Mr. Willis: "Because of Eterna –a new pan coating- and the coatings we think we can derive from it, I am optimistic we can find $8-$9m of new sales and achieve a growth in revenues of perhaps 8-10 per cent over the year". Plus, he hopes that many of his products will prove attractive to companies and consumers looking to save money. For example, his industrial coatings help to maintain existing equipment; and his durable non-stick frying pans may appeal to households that want to spend less on eating out”. [Peter Marsh: “Entrepreneurship: Turn up the heat in a tough market”, Financial Times].
. Schumpeter on Keynes' exagerated pessimism. Keynes, Schumpeter thought, was too pessimistic about human creativity. As soon as 1919 (The Economic Consequences of Peace), the English economist thought that humans had reached the end of their creative potential. Schumpeter was stunned to note that Keynes’ great 1936 book, the Generaly Theory, did not contain a single mention of a firm or an entrepreneur. Obviously, the Austrian was right on that score. In the long run, innovation would always prevail.
. Keynes on the "long run". To Schumpeter's views, Keynes famously responded ... WHAT ????? “In the long run where all dead”. And here, of course, he was also right.
[DEBATE! Can we have it both ways? Schumpeter for normal times, Keynes for depressions?]
 Inflation expectations & long-term interest rates
Not the most exciting of topics, I admit. Nonetheless, it is of critical importance. Only if we understand the dynamics of inflation expectations can we pretend to understand the way the Federal Reserve & the ECB work. Inflation expectations are a key element of the dynamics of the credit market and long-term interest rates. The best way to understand is through an example.
. Scenario: Mexico 1994. The Zapatista movement enters the politica scene; the leading presidential candidate is assassinated; the US Federal Reserva raises short-term interest rates; some Mexican banks fail. Can we expect the Mexican government to react in panic, printing lots and lots of money?
. Changes in the demand schedule in response to the new information. If people expect prices to rise, they would expect to see their income rise, at least in nominal terms, as prices and wages adjust upwards.
[QUESTION. IN SUCH A SCENARIO, WOULD YOU BE WILLING TO DEMAND MORE OR LESS CREDIT, AT A FIXED RATE OF INTEREST?]
[DIAGRAM. Increasing inflation expectations lead to MORE demand for credit at each level of the interest rate, as more income is expected to pay fixed interest costs]
. Changes in the supply of loanable resources. If you have funds to lend at a fixed interest rate, you expect to get paid back in a currency that is worth less (in terms of purchasing power).
[QUESTION. IN SUCH A SCENARIO, WILL THOSE WHO SUPPLY LOANABLE RESOURCES BE WILLING TO SUPPLY MORE OR LESS CREDIT?]
[DIAGRAM. Increasing inflation expectations lead to LESS supply of loanable resources at each level of the interest rate, as lenders are paid back in a currency that is worth less in purchasing power terms].
[DIAGRAM. THE NET RESULT. The net result of an increase in inflation expectations is ALWAYS the same: LONG-TERM interest rates go up! Note that there is NO INCREASE IN THE AMOUNT OF CREDIT!]
. An interesting commentary by an always interesting author, James Madison: “Those who are creditors and those who are debtors, have always formed distinct interests in society” (Federalist No. 10.)
. Let me stress again the importance of this very simple case. In Mexico, the political, economic and social consequences of the high inflation were such that steps were taken to make the central bank independent from the executive. The reward came in late October 2008, as the financial crisis was deepening. The Federal Reserve extended a so-called SWAP agreement to Banco de México (and to the central bank of Brazil as well). More on that soon. In the UK, a fantastic move by Tony Blair & Gordon Brown in 1997. Against all expectations, they declared that the Bank of England would be made independent from the government.
[QUESTION. WHAT HAPPENED TO LONG-TERM INTEREST RATES in the London credit market?]
. They fell sharply, even though, on that very day, the BoE raised short-term interest rates!
[DEBATE & DIAGRAM: THE POSSIBILITY OF DEFLATION. How would credit markets react to news that would sharply increase the probability of a sharp DECLINE in the overall price level?]
[WHAT WOULD THOSE WHO DEMAND CREDIT DO?]
[WHAT WOULD THOSE WHO SUPPLY LOANABLE RESOURCES DO?]
[WHAT IS THE END RESULT?]
[DEBATE! Inflation expectations today! What elements would suggest to market participants that the price level will increase –or decrease- over the foreseeable future?? Suggestions: commodity markets, exchange rates, money supply, policy measures. Ireland to cut wages of public servants!]
 Governance, property rights & the credit market (introduction)
The best way to start looking at this crucial issue is to start with the writings of Peruvian economist Hernando de Soto. In 2000, de Soto published his book The Mystery of Capital [info] in which he summed up his research in the field of … slum economics. What did De Soto find inside Peruvian slums in the 1980s? Drug dealers & criminals, but also … entrepreneurs in need for credit! De Soto’s key finding: slum entrepreneurs may physically possess a given piece of land, but they lack formal property rights to it. Suppose that this room here is a part of a slum, and that I am in possession of it. Say that I am an entrepreneur in need for capital: I sell hats made by my family. I need to invest in equipment!
[QUESTION. How much credit can I get if I pledge my POSSESSION as COLLATERAL? To put it slightly differently, how much more credit would I be able to get if, instead of the simple possession, I could show a FORMAL TITLE TO THE PROPERTY OF THE PIECE OF LAND? Please reason in terms to the size of the credit market].
In the first case, the supply of loanable resources would be limited to people that actually know me & trust me: my cousins, my uncle, etc. In the second case, many more people would be attracted by the investment. [Hernando de Soto’s biography; website].
[DIAGRAM. Supply & Demand for credit in slums: show the supply of loanable resources much greater with legal property rights than with legal possession].
This is Hernando de Soto’s key finding: with official, tradable and liquid property rights, entrepreneurs can get credit on a much larger scale than with just physical possession. Moreover, such rights give you access to the formal judicial system in case of litigation. De Soto is now a super-star in the economics of slums (I wouldn’t be surprised if he’d be awarded the Nobel Prize in Economics one day; in 2004 the Cato Institute’s Milton Friedman Prize was awarded to the Peruvian economist). De Soto has now extended his work to a number of cities with big slums, like Cairo, Mexico City, Jakarta, Manila, etc. He estimates that the potential increase in the supply of loanable resources could reach … $10 TRILLION, which at the time of writing (2000) was about the size of US GDP.
[DEBATE! What would a person like Hernando de Soto think about MICRO-CREDIT; Muhammad Yunus, winner of the 2005 Nobel Peace Prize; princess Máxima; etc.]
. Clue: the foundation of Cisco Systems! Cisco Systems founders Len Bosack and his then-wife, Sandra Lerner, are credited with making major design enhancements to one of the technologies that makes the Internet possible—the router. Bosack, Lerner, and the Stanford colleagues who helped them didn’t invent the first router. That credit goes to William Yeager, a Stanford Medical School engineer, who wrote the software to drive a specialized computer controlled by an Internetwork Operating System (IOS). Bosack and his group took the original router code, enhanced the design, and capitalized on it, creating the first commercially successful router. [Note the difference between the inventor and the entrepreneur].
[QUESTION. HOW DID BOSACK & LERNER FIND CREDIT?]
Answer: by mortgaging their house! [Leonard Bosack]. So there you have it. The great thing about micro-credit is that it highlights the tremendous capabilities of poor people in terms of entrepreneurship. The problem, at least from De Soto's perspective, is that it fails to provide and answer to the problem of scale. By definition, micro-credit cannot take you very far. To create the Cisco Systems of the developing world, much more will need to be done in terms of creating and protecting property rights.