Synopsis: An article on Jean Tirole’s research about how to promote competitive markets.

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Discussion:

On October 13, 2014, Jean Tirole won the Nobel Prize for his work on regulation. In the hopes of having companies compete fairly, governments try to regulate the firms. Unfortunately, as the governments do not know as much about the firms as the firms do about themselves, the regulation ends up being too heavy handed or too lax. The aim of the regulation is to promote competitive markets.

Jean Tirole, along with Jean-Jacques Laffont, Tirole’s partner until Laffont died in 2004, found a way of overcoming this problem.

Consider a natural monopoly. Because this firm has already spent a sizable amount of money to build a network, other firms would be dissuaded from investing in a second network and thus joining the market, because the subsequent price war if another firm were to join in would “make it hard to recoup the investment”.

This natural monopoly presents regulators with a problem, because they have the ability “gouge consumers and stifle innovation”. However, it is hard for regulators to discern to what extent this is happening.

The root of this problem has to do with a phenomenon called “asymmetric information”, wherein regulators have no idea how much a service provided by a monopoly should cost or how much the firm should be investing. In other words, they have insufficient information about the firm to determine the correct regulations to impose on the natural monopoly.

With this information, regulators have two options. The first option is to “cap prices at some markup to a firm’s costs”. The problem with this is that it does not provide any incentive for firms to be more efficient. The second option is to impose a hard price cap. The problem with this is that firms will pocket the extra gains in efficiency instead of passing the gains down to customers by reducing the prices.

Messrs Tirole and Laffont found that this conundrum is similar to another, more researched, economic problem, called the principal agent problem, where the owners of assets struggle to find incentives for those who manage them to do a good job. Messrs Tirole and Laffont then continued on to borrow ideas from other fields, such as game theory and auction design.

This is their finding: they state that instead of forcing one type of regulation on them (cost-plus contract vs set price), regulators should present firms with a choice between the two. As a result, firms with little opportunity to cut prices will opt for a cost-plus contract, while firms with the ability to innovate and cut prices would choose a set price. Either way, regulators gain valuable information about what type of firm that is, and thus allow the regulators to “negotiate the best deal for customers”.

Mr. Tirole, Mr. Laffont and Mr. Xavier Freixas, a professor at the Universitat Pompeu Fabra in Barcelona, also showed that the best solution is not always the one that results in the lowest prices. For example, a regulator whose primary interest is bringing low costs for consumers might keep reducing the set price, in hopes that the innovative firm might keep reducing the cost of its business. However, a rational firm might stop investing in cost-cutting measures entirely. In this case, the regulator’s best bet is to signal his or her intent to become more lenient with the regulation over time. Mr. Tirole shows how what might seem like regulatory failure to others might actually be a sensible response to this type of hard-to-manage market.

Mr. Tirole’s research does not stop with monopolies. He has also shown how overinvestment in technology could be a tool used by firms to limit competition, as it signals to competitors that it isn’t worth the trouble to compete. More recently, he has written an article with Jean-Charles Robert about how “the interconnectedness of modern financial systems would make it impossible for governments to allow big banks to fail, and that banks, anticipating bail-outs, would behave recklessly.” Regulation can be used to counter this problem by limiting leverage, for example.

Perhaps, his most relevant work is his analysis on “platform” markets, which serve more than one type of customer. An example of this would be a newspaper, whose market consists of both readers and advertisers. In these types of markets, anticompetitive actions may not actually be anticompetitive: a reduction of subscription price might be to attract more advertisers. So, regulation that demands higher subscription prices might actually wreck the two-sided market. Google and Amazon have faced a plethora of these cases.

Net neutrality follows similar arguments. Mr. Tirole suggests that “network owners should be allowed to charge higher access prices to heavy users… to cover the costs they impose on the infrastructure.” However, his research also shows that the network owner could easily abuse this by increasing his position in the consumer market. Mr. Tirole offers no formula for such a problem, but he does highlight the trade-offs in such scenarios.

Key Terms:

1. Natural monopoly: According to Investopedia, this is "a type of monopoly that exists as a result of the high fixed or start-up costs of operating a business in a particular industry". For more about natural monopolies, click here.

2. Cost-plus contracts: If you have a certain cost for the product or service, you are allowed to charge a profit margin as a percentage of that cost. For firms that do not think they can reduce costs, they will opt for this type of regulation as they are guaranteed a certain percentage of profit.

3. Set price: where regulators allow firms to make a certain amount of revenue, and whatever profits they get when they pay off their costs, they can keep the profits. For firms who are innovative and believe that they can reduce their costs of productions, this is the best option, as they can reap higher and higher profits as they pay off their costs.

4. Anticompetitive: This is where a player behaves in a way that tries to eliminate other competition from the market.

Context:

1. The assumption behind this article, and behind Mr. Tirole’s work, is that all firms must be regulated in some way. Why is this?
a. To reduce the amount of asymmetrical information between buyers and sellers
b. To protect the environment
c. To encourage competition
d. To curb monopolies
e. For public safety, e.g. restrictions on the selling of drugs, restrictions on the selling of cigarettes and alcohol to minors, restrictions on the amount of radiation cell phones can have
f. Worker safety, e.g. minimum wage, maximum working days

2. What is the problem with asymmetric information? There are two main problems:
a. The firm will charge unfair prices to consumers for what may be necessary goods
b. As the firm has no competition, it will not strive to innovate and reduce its costs of production.

3. In the sixth paragraph, the author discusses the idea of agency, and how owners of assets struggle to find incentives for those who manage them to do a good job. This is called the principal agent problem. Take this example: You own a house in London and you have someone managing the house. Each week, he calls up with complaints about a broken tap or a broken air conditioner, and you must pay out of your own pocket to fix these problems. How can you be sure that the manager is not making this up and pocketing the extra money being sent? In other words, how can you incentivise such managers to do a good job managing this? This is the principal agent problem.

4. In the paragraph before the “competitive hedge” subtitle, the author mentions the idea of moral hazard, where the idea is that if banks believe they will be rescued, they will act recklessly. This is exactly what happened in the global financial crisis. It is important to not rescue all banks so that they do  not become reckless, but it is important to rescue some so that the whole banking system does not fail. In March 2008, Bear Stearns, a bank in the USA, failed and was saved by JP Morgan. However, in September of the same year, the Lehman brothers failed, but were not bailed out. How do you strike a balance between bail-outs and not? It is a real challenge. Some people believe that the Federal Reserve had struck the wrong balance in 2008. There is no clear dividing line that dictates what the ratio of bail-outs to not should be. One reason for this might be that bail-out situations occur rarely and are never similar to each other.

5. In the same paragraph as the moral hazard one, the author mentions limiting leverage. This is where banks reduce the ratio of borrowing to shareholders’ capital. It all has to do with the capital adequacy ratio. More about this can be read here.

Synopsis: Are on-off capital controls really a good idea?

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Discussion:

This article discusses the flaws with having on-off capital controls. Capital controls (defined in ‘Key Terms’) are, and have been, a big debating point. Currently, Russia is trying to soften the blow of the oil price’s plunge on the rouble by “imposing limits on currency conversions”, and Iceland is easing the restrictions on its capital controls after the financial crisis.

For a long time, capital controls were frowned upon, until 2012, when the IMF gave its stamp of approval, saying that it is okay “under certain circumstances”. Many argue that the problem with capital controls is that it “breeds inefficiency”, i.e. those who have excess savings cannot give it to those who need the money for investment. It is, they argue, a form of allocative inefficiency.

In the 1990s, when Mexico and Asia were faced with a sudden influx of cash, they realised that this influx led to uncontrollably high exchange rates and asset prices. Furthermore, when it finally exited these economies, it damaged financial stability.

Now, there is general consensus that capital controls are needed, and that they should be “targeted and limited”, such as having minimum stay requirements or taxes on short-term borrowing. Additionally, many believe that capital controls should be counter-cyclical, which is to say that when there is an influx of cash, controls should be tightened, but when there is an exodus of it, controls should be loosened.

While this solution may seem neat and tidy at first, there are three major underlying problems with it.

The first is that many can find ways around capital controls. One example of this is in China, which has very stringent controls, and little tolerance for short-term borrowing. Yet, the Bank for International Settlements (BIS) has found that, in June, international bank lending to China has reached $1.1tn. This is because many investors are sneaking around capital control laws by issuing debt via foreign subsidiaries, and thus, loans are being disguised as FDI. This point is explained in more detail in ‘Context’. Furthermore, as the amount of FDI going into China is already extremely high, it is not hard for firms to disguise loans as FDI; nobody will notice.

The second biggest flaw with counter-cyclical capital controls, i.e. on-off capital controls, is that it ignores the revealed preference of the countries. Records have shown that many economies prefer easing barriers to outflows.

Joshua Aizenman of the University of Southern California and Gurnain Kaur Pasricha of the Bank of Canada (quoted in the article) have studied 664 cases of changes in capital flows and have found that governments much prefer easing restrictions on outflows, which happened 274 times, substantially more than any other type of change. While, in theory, easing restrictions on outflows has the same effect as blocking inflows (net inflows decline), the former shows confidence in the economy through a looser leash on the economy.

The third point against counter-cyclical capital flows is that there is little relationship between capital controls and inflation or growth, i.e., they are not counter-cyclical. During the global financial crisis, in fact, some countries such as China and Indonesia loosened restrictions as their economy boomed, which is not counter-cyclical at all.

Furthermore, in 2009, Brazil tried increasing capital controls to slow down the real’s appreciation, by imposing taxes on debt and equity flows. In fact, the real appreciated at the same pace as before the capital controls were in place. Instead, as seen by the sudden increase in FDI, investors just found other ways to get the money past the barriers.

In all, while in theory counter-cyclical capital controls seem like a good idea, it is not so.

Key terms:

Capital flows: This is the flow of capital in and out of a country by investors investing in assets. For example, if the British economy is doing very well, investors in America would want to buy assets, e.g. houses, by trading in USD for GBP. This is an influx of capital. When the British economy is not doing as well, the American investors would sell the houses and trade GBP back for USD, which is called an outflow.

Context:

1. In 2012, the IMF gave its approval for capital controls under the correct situation. Before that, during the Asian Financial Crisis, the IMF had aided the damaged economies by giving them loans, under conditions that government spending decreases, taxes increase, etc., and that there were no capital controls. Malaysia’s Prime Minister at the time, Mahathir bin Mohamad, had disregarded the IMF’s terms, and imposed capital controls anyway to protect its economy. The result was that Malaysia recovered at around the same time the other countries did, but the Malaysian economy suffered much more during the Asian Financial Crisis. People who support capital controls often cite this argument.

2. What does the phrase “issuing debt via foreign subsidiaries” mean? First of all, a subsidiary is a company that is either partially (50%+) or fully owned by another company. With that in mind, this phrase can be best described by the diagram below:

In this diagram, we can see that a subsidiary is offshore, i.e. outside the country. In this example, the country is China. The foreign subsidiary borrows from a foreign bank, which has much lower interest rates than China does, and gives the money to the holding company as an equity investment. An equity investment is a type of FDI where the subsidiary purchases an asset from the holding company, such as a factory or a machine. China does not like domestic companies borrowing money from other countries under the fear that, especially because the loans are usually short-term, they will not be able to pay back. China does not mind FDI, as it is in the form of equity investment. So, cash comes in from the subsidiary as FDI but is actually a loan. As pointed out in the article, the holding company must find a way to return all the money to the subsidiary plus interest, so that the subsidiary can return the money to the foreign bank. That is a large challenge.

Synopsis: What problems the EU will face with QE, when it will happen, and how it might come about.

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Discussion:

This article discusses the likelihood of QE in the Eurozone, the necessity of QE, the problems it could face and the manner in which it would happen.

The Eurozone has faced persistent lowflation (which, for the countries in the periphery, means actual deflation). Hence, there has been a push from many countries for QE – “creating money to buy fiscal assets”.  The ECB faces strong opposition from Germany, whose nightmares about hyperinflation eclipse the need for QE to put a stop to sliding inflation.

Both core and headline inflation are slipping lower and lower – substantially lower than the ECB’s 2% target. The all in oil prices itself is a welcome relief for many countries, where the decrease in oil prices reduces their own costs of production. However, if the lower costs of production make people expect deflation (or even lower inflation), deflation will happen, true to its self-fulfilling nature.

Lowflation is equally as harmful as deflation, where the latter means an increase in the real value of debt (debt is in nominal terms), and the former means prices rising slower than what the government expected when they first borrowed money.

As the ECB can no longer decrease the interest rates (it is currently at 0.05%), they must try to expand their own balance sheet by buying sovereign bonds. They plan on expanding it by 1tn euros, although when this will happen is unknown.

Past attempts at increasing their balance sheet and pumping money into their economy was as not fruitful as the ECB had hoped – only 212bn euros of the 400bn euros was borrowed by banks from 2011-2012. One potential reason for this is that banks were not willing to borrow money during a stagnant economy.

Because Germany has its own reservations about the ECB’s buying sovereign bonds, the ECB is also buying covered bonds and asset0backed securities, neither of which is big enough to absorb the whole of the QE needed.

The ECB also has the option of borrowing corporate bonds, but even that market is not substantial.

The ECB, therefore, must buy public debt.

Whenever the ECB may enact QE, the program is unlikely to surpass 500mn euros, which may or may not be sufficient to aid the economy.

Context:

This post about the ECB and QE by Ambrosse Evans-Pritchard discusses similar things, and hence, is worth reading. Both articles reach a similar conclusion that the scale of QE the ECB plans to do is insufficient.