1) Cutting spending and raising taxes is a risky formula. It doesn’t have a great track record;

2) Trying to take more from rich people has its limits. Higher and higher income taxes or even wealth taxes create incentive to find tax havens and avoid productive work or capital allocation;

3) Cutting spending is better than raising taxes;

4) Less spending +more growth.

He provides data to back up each point and links to a larger article he recently wrote for The Weekly Standard.

Pethokoukis makes some excellent points and I am largely in agreement (although he brings to bear some strawmen in the longer piece), particularly on the need for economic growth, rather than broad tax increases, to increase revenues to service the budget.  What struck me, though, was that he never really addresses the friction that makes any trimming of spending, particularly around entitlements, difficult if not impossible–Politics.

Cutting spending comes down to politics–nothing more. I am not sure to what extent we have the political environment in the US to implement the kind of cuts that Pethokoukis, and others such as Rep. Paul Ryan, suggest.

Certainly the overall mood in the electorate supports dealing with the deficit and spending, but when polled on individual entitlements and government programs that consensus and support quickly evaporates. This means that even if Congressional leaders and the President may want to implement a plan to cut spending the overall initiative could easily be scuttled by individual politicians protecting their electoral chances with constituents by voting against or killing specific cost-reduction measures.

Unless someone is forcing the US to cut spending as is the case in Greece–and, therefore, providing political cover for individual politicians–it is hard to imagine progress on this front in the near term.

As he eloquently demonstrates, the old terms of First World and Third World really no longer apply. Rather, the majority of the world is either highly developed or moving significantly in that direction. However, there is a portion of the world—about 1 billion people—whose countries are on the outside looking in when it comes to economic development. Collier’s work, and this book, offers an explanation as to why the countries that make up the bottom billion have failed to develop and what can be done about it. Books of this nature typically stake out a position along one of the ideological poles and hammers away at the other pole for three-hundred pages or so—Aid is bad and does nothing but fill the coffers of corrupt leaders and make the population dependent and lazy! Capitalism is the enemy! Rich countries use their power to exploit the labor and resources of these countries for profit, therefore protectionism and transfers of wealth from the developed world are needed! As it so often does, the truth can be found in the middle.

Collier lays out various “traps” that countries can find themselves in–conflict, resources, geography, and governance–all of which provide extensive barriers to economic development. All of these have been hypothesized by others, but Collier & Co. tease out the specific ways that these traps work. For example, while landlocked countries generally find themselves without realistic alternatives to growth there does appear a way out–development by their neighbors (particularly in terms of infrastructure) leads to increased growth for the landlocked country. Understanding that geography is a powerful variable, but does not equate to fate, leads to various policy prescriptions that can credibly be applied to these particular cases. It also highlights the friction that is politics. Collier acknowledges the powerful role of politics in both his explanations and his prescriptions for the least developed nations. Countries and leaders are generally self-interested, and this makes political solutions difficult to come by when dealing with the poorest countries in the world. Collier has a few ideas, some of which have been adopted by leading countries and organizations. However, it is too early to tell if they have the kind of effect he hopes they will.

My one complaint is that Collier does not provide a graphical summary of the numerous hypotheses that he confirms and nullifies. Nor does he provide a summary guide to the additional theories and mechanisms that he proposes. The book is stuffed with propositions and results that after a while it was hard to remember just what was proven and falsified, what mechanisms Collier suggested that may explain the peculiar relationship between, say, aid and coups. Now, I read the Kindle version, so maybe such graphics were available in the dead-tree version.

Overall, Collier’s book was well worth my time. I am excited to read his follow up, War, Guns and Votes, but it will have to wait as I’ve got a few others ahead of it in the queue.

It is a lucrative business that has drawn financiers from the Somali diaspora and other nations—and now the gangs in Haradheere have set up an exchange to manage their investments.

[...] “Four months ago, during the monsoon rains, we decided to set up this stock exchange. We started with 15 ‘maritime companies’ and now we are hosting 72. Ten of them have so far been successful at hijacking,” Mohammed said. “The shares are open to all and everybody can take part, whether personally at sea or on land by providing cash, weapons or useful materials … we’ve made piracy a community activity.”
[...] “The district gets a percentage of every ransom from ships that have been released, and that goes on public infrastructure, including our hospital and our public schools.”

One commenter noted that the enterprise could not last without formal legal structures to provide proper oversight.  Chirol responded that “those structures essentially exist in Somalia, they are just “informal” according to us since they are illegal by our standards and not government run. But such mechanisms do exist.”

My question is, do they really exist? Theoretically, you have repeated interactions which discourage cheating in the short run as well as a community that could possibly impose reputational costs on particular actors, but these are not efficient mechanisms for compliance and trust. Whose is responsible for monitoring? Who pays those costs? If it is individual actors the transaction costs are sure to be quite high and, moreover, inefficient and ineffective. You need a (presumably) neutral body that can write, monitor, and enforce rules and regulations that act as the foundation for the entire investment process. The pirates themselves are not exactly a neutral party, and as they are effectively running the exchange it should create all kinds of perverse incentives and issues in the long run. In either case, it is a fascinating development.

By delaying payment Dubai has not only created serious doubts about its dedication and ability to repay its loans, but also the credit worthiness and risk-level for other sovereigns.  The price to insure against debt-default by Dubai more than doubled (from $300M to $675M).  Additionally, the price of default insurance rose in general for many sovereigns, including Bulgaria, Abu Dhabi, Hungary, the U.K. and the U.S. (see graphic below).

Graphic Credit: The Wall Street Journal

It’s unclear at this point to what extent concerns for default (or an actual default) by Dubai would act as a contagion, setting off another global financial crisis.  On Friday, global markets took a significant hit based largely on investor reaction to the payment delay.  U.S. and Asian markets took the biggest hits, with European markets managing to close higher on the on the day.

At first glance, the sell-off for firms linked to Dubai World was contained on Friday. Additionally, the amount of risk at stake in this case is minuscule compared to the financial crises of a year ago. The Financial Times notes:

Credit Suisse, for example, assumes that European banks account for half of Dubai’s debt, estimated at about $80bn. If they lost 50 per cent on their exposure, bad loan provisions would rise by 5 per cent next year, equivalent to a €5bn after-tax hit. Compared with the $1,700bn of toxic assets European and US banks have wiped out in the credit crisis, that is a drop in the Burj Al Arab swimming pool.

It would appear at first blush that, financial speaking, there isn’t a great threat of a Dubai default leading to a global financial meltdown (however, I have not seen data on the holders of credit default swaps [cds] and to what extent they’ve assumed too much risk, as AIG did last year). However, I do wonder about the other major variable in financial crises–the psychological risk. Financial crises are the result of both economic and psychological variables interacting in dangerous ways (namely, a positive feedback loop where negative economic conditions feed into negative views on the market which leads to actions that increase negative economics conditions which feed into negative views on the market, etc, etc). As Mark Gongloff notes:

Every episode of sovereign worry raises market fears of contagion, “reminders that pockets of post-credit-excesses are intact and destabilizing,” Gluskin Sheff chief economist David Rosenberg told clients on Friday.

To me, that is the real risk. With states’ balance sheets in total disarray around the globe, investors will not long for worrisome indicators and troublesome cases to analyze (think of the conditions that facilitate brush fires).

We’ll see to what extent this scenario plays out in the coming days. Would love to hear feedback from sovereign debt specialists and global finance experts.