Tuesday, 22 July 2014

Graph of the week: The misery index

Recently I came across a new interesting index of economic development measuring the opposite of the usual wealth, prosperity, happiness and income p/c. This one ranks countries in reverse order, it measures their relative "misery" with respect to their unemployment situation, inflation and bank lending - so all the stuff that makes people poor and hence miserable.  

Steve Hanke of the Cato Institute and John Hopkins University, used the data from the Economist Intelligence Unit ranking 89 countries. He applies a very simple methodology: sum of inflation, bank lending and unemployment rates minus year-by-year per capita GDP growth (so as to offset the temporary negative effects of the former variables). He got the intuition from Arthur Okun and Robert Barro who used things like inflation, unemployment and government bond yields to measure relative misery levels in the US during different Presidential administrations.

The first apparent criticism to such an approach is relatively scarce usage of variables to put into the index. Furthermore these are all aggregate and very broad macroeconomic categories, which can send a signal of how the country is doing but fail to distinguish for other institutional characteristics of countries that do make a huge difference with respect to how the adverse event hits the population. For example, losing a job in Spain, Portugal or Greece is arguably not the same as losing a job in Iran or Venezuela. The macro category of high unemployment tells you nothing of the state or the flexibility of the labor market (btw, recall that unemployment rate isn't even the most precise indicator of the labor market) nor does it say anything about the unemployment compensation the unemployed receive. This factor alone biases many countries upwards on the list. 

Perhaps he could have included more stuff (such as what the Legatum's Prosperity Index uses) and weight them all differently, but for the sake of argument let's call it a decent indicator as it does seem to capture the relative levels of temporary misery in many countries. Even if we accept the argument that the aforementioned European countries may be more stable than non-European ones, it's still hard to dispute the fact that many people in these countries feel very miserable at the moment. Finally, taking a glimpse over the index rankings, it does seem to paint a pretty similar picture as many other indexes out there, except in this case the scale is reversed (what's up is bad, what's down is good). 


However by looking at it in greater detail, you can spot some of the apparent biases - like the zero inflation biasing Japan downwards, or the fact that Scandinavian countries (which usually top all the prosperity and happiness based indicators) tend to be quite far from the bottom (and bottom is good here), probably due to unemployment biasing them upwards. And this isn't really realistic. Are the people in China, Malaysia, Panama or Thailand really less miserable than their Scandinavian and Western Europe counter-parts? I doubt it. In these cases the high growth rates of some Asian countries bias them downwards on the index.   

All in all, an interesting indicator, but not really too precise in actually measuring the people's relative misery. In any case I would rather refer to the Economic Freedom Index or the Legatum Prosperity index

Wednesday, 16 July 2014

Beware of leaders who use ideology, they steal the most!

In last week's issue of the Economist there is an excellent piece linking the usage of ideology in political rhetoric and rampant corruption. Kleptocrats like to (need to) use ideology to either justify their political goals or to distract voters from the real issues at stake or from their corrupt activities. 

They use the example of two leaders who enjoy expressing their autocratic power over their respective countries, even though they are formally presiding over democracies. You might have guessed it - they use Russia's Putin and Turkey's Erdogan as examples (in addition to China's corrupt ruling elites). Both of them like to present themselves as leaders which can bring back the glory to their once great nations. They use conservative ideology to establish themselves (albeit unsuccessfully) as moral high-grounds in their countries, while at the same time their cronies continue without any restriction to expropriate their nations' wealth. 

This could easily be any political leader in any country. To the two of them I can - of the top of my head - add dozens of countries and their respective leaders, both current and past. They don't even have to be developing countries' dictatorships. How many times have you seen political elites use moral, religious or nationalist arguments to justify controversial laws and decisions, while at the same time they are directly fueling (and striving upon) bigger and bigger cronyism? I dare you to name a country which didn't have at least one leader that successfully used ideology (left or right) to hide his or her corruption. 

Here's a passage from the text:
"Every country has its charlatans and rogues, be they light-fingered British MPs or pork-happy American congressmen. Many, whether Latin American strongmen or African kleptocrats, claim to serve their people. Hardly any admit to thieving. But there is something especially grating about leaders who push moralistic causes, thus inviting judgment of their own behaviour, while overseeing scams. Casual observers may wonder why citizens put up with the hypocrisy—and how their rulers look at themselves in the mirror." 
Whenever you hear of such examples, the economic voting part of the story is always the same: such leaders tend to lose in urban centers but win in rural ones. They lack in support among educated voters, but gain among poorly educated ones. So you get a situation that the rural, uneducated population, usually of lower incomes on average, tend to vote for the conservative party (or some national-socialist variety of it), since they tend to favor ideological issues over economic ones. The propaganda makes them believe that national unity is what's important for their country's progress. It's not. It never was. 

The ideological issues tend to range from country to country; it can be the sorrow over the destiny of a once great nation (a common argument for our two protagonists), it can be religious issues, foreigners taking domestic jobs (which triggers an anti-immigration movement), foreign companies extracting profits from the domestic population (which triggers the protectionist argument), and it can even be gay rights. Everything is more important than the people's economic misery. Especially in times of prolonged crises when the people psychologically tend to be more open to radical ideasideology triumphs over economic reason

And the result is obviously that radical ideas get more political clout. In more democratic countries this gives unexpected power to certain extremist parties, but in more autocratic countries (regardless of their de jure definition) the elites on top don't miss an opportunity to use this anger of the people to their benefit. The people no longer blame the elites for the fact that they haven't allowed any of the economic benefits during the good periods to be shared among the people. Their leaders' propaganda makes them blame globalization, "neoliberalism", the Western elites expropriation of their countries' wealth (which results in nationalization of some former public companies), or even the Western culture that seems to have shattered the domestic cultural values and led to greed and lack of social trust (arguably the most ridiculous argument). 

But regardless of how ridiculous the arguments tend to be, they work! People 'buy' it. The leaders succeed in increasing their support - unless some random event messes things up, such as the Tahrir square protests did to Erdogan. And interestingly enough it actually comes down to such random events to disrupt the power of the mighty autocrats. The protests of last summer haven't yielded any real effects (in none of the countries did they change their corrupt leadership). But they've certainly destabilized their power. For those countries only time will tell of how much longer will the voters 'buy' these arguments, and will they finally vote by their pockets instead of their propaganda-evoked emotions.

Friday, 11 July 2014

Graph(s) of the week: What is specialization?

According to the classical international trade theories of Adam Smith and David Ricardo countries specialize in producing those goods and services in which they have a comparative advantage. Comparative advantage simply means that some countries can produce certain goods more efficiently (at a lower cost) than others. Be it geography, climate, or the presence of certain key resources (land, raw materials, oil, quality labor, capital), each of these may carry a potential advantage making one country relatively better than other countries at producing a particular good. 

Relative is the key word here as comparative advantage doesn't imply absolute advantage. Some countries can probably produce all goods better than other countries, but this doesn't mean they have to. They can specialize in what they do best (with respect to all other countries) and leave the production of things they are relatively less good at to other countries and import it from them at a lower cost. 

Countries such as the US, Germany or Japan can probably produce any good in the world. But is it better for the US to allocate its resources into e.g. production of clothes and shoes instead of allocating their resources more efficiently into production of computers? They can specialize in producing computers (in which they are, by assumption, the best in the world at), and import clothes and shoes from Mexico, which specializes in precisely these types of goods (see map below). Of course this doesn't imply that the US should have no textile manufacturers nor that Mexico shouldn't produce computers (after all in a globalized world everything is being produced everywhere), it's just a question of opportunity cost of allocating resources into less productive areas vs the more productive ones

Anyway the theories of comparative advantage and specialization are the central explanations as to why countries trade and why trade is always good and beneficial for everyone involved. Especially the consumers (both parts of the trade equation: exports AND imports).

With this in mind Time magazine brings a few maps showing the main exports (by group of products) of each world economy, which paint a very interesting picture of the different types of goods countries specialize in. Bear in mind the map shows the group of products that bring in the most money to a particular country (so it's not the only good they produce, but the most profitable one). We can easily say that this is the type of good that each of these countries "specialize" in. 




Compare Africa to Europe. Africans only export unrefined raw materials or unprocessed food. Europe and America use these goods and build them into actual stuff (and actual food). What is also interesting about Africa is the extent to how rich in resources this continent is. Of all the oil exporters out there it seems that only in African countries the population receives absolutely no benefit from it. Not to mention the gold and diamond exporters. Based on resources alone, Africa should have been very rich by now. Or is it precisely because of such relative wealth in resources that makes them stuck in a low-development trap? The so-called natural resource curse




These maps give us a very good insight into the level of development each economy is in. Richer countries produce and export heavy machinery and electronics (capital goods), while poorer countries produce and export raw materials, metals, minerals or food (with obviously a few outliers). And there's also a special category: oil. Oil producers are both rich and poor countries. The difference here is simply institutional: how are the countries' elites (owners over the key export resource - politicians in some countries, entrepreneurs in others) using the money from these vast exports of oil: do they grab the profits for themselves by nationalizing the oil industry (Libya, Venezuela, Russia, etc.) or are the oil revenues shared with the majority of the population in ensuring higher living standards and better quality of life (Norway, Qatar, Emirates, Kuwait etc.)?

In conclusion, I feel that the export specialization story may offer a good proxy (or a good instrumental variable) for defining whether a country is rich or poor. 

Monday, 7 July 2014

Political economy of debts and deficits (4): Hypotheses explaining debt accumulation

The fourth (and final) part of the PE of debts and deficits closes with the last three hypotheses explaining debt accumulation in the past 40 years in many industrial economies. In the end it includes the suggested literature used in all four posts: Intro, Theory, Hypotheses pt 1.

4. Models of distributional conflicts

Theories about distributional conflicts suggest that delays in addressing the deficit issue reflect war of attrition among parties that cannot agree on the distribution of the fiscal burden required for consolidation. Such situations could occur particularly in weak coalition governments that do not share the same distributional agenda.

For example, when an external shock influences the government budget so as to increase the deficit, the social planner government (a standard benchmark assumption in political economy models) would immediately choose to close it either via revenue increases or spending cuts (he would enact a stabilization effect), but a coalition government would engage into a series of trade-offs between what is the optimal policy response: which group(s) should bear a higher burden in terms of spending cuts and/or tax hikes? Each coalition member will attempt to protect the interests of their own voter group (their ideological or economic “constituency”). Naturally the party which caves in to the pressure will be the looser (in terms of both reputation and voter support). No one wants to accept such a position.

In such cases, parties might postpone the decision to address debt until a crisis finally forces them to act. The more unequal is the distribution of stabilization costs among social groups the later is the expected time of stabilization (the policy reaction).

Here again political stability comes to the fore, as empirical research suggests that more durable governments are more prone to be fiscally conservative. These models tend to have the highest empirical support for their underlying assumptions, since it can indeed be verified that unstable, coalition governments on average result in larger deficits and higher debt levels.

5. Models of geographically dispersed interests

Models of geographically dispersed interests are a realization of the common pool problem where the groups are geographically dispersed rather than socio-economically. These are typical pork-barrel spending models, where in majoritarian political systems political representatives (Congressmen) overestimate the benefits of public projects in their own districts (constituencies) relative to the costs of financing which are distributed nation-wide. The total effect will be an oversupply of local public goods (“bridges to nowhere”).

Such models don’t explain the deficit problem directly, but they do explain the overinflated size of government spending which indirectly increases the deficit. However empirically local pork-barrel spending only marginally affects the national budget, but this does differ from country to country, depending on the level of centralization. In general such models don’t explain the accumulation of debt so much as they do the increase of inefficient spending and potential local government corruption.

6. Models emphasizing the role of budget institutions

The last and recently most popular stream of literature has focused on the effects of different institutional characteristic of government and budgetary procedures on budget outcomes.

Budgetary procedures (or budgetary institutions) represent all the rules and regulations according to which budgets are drafted, approved and implemented. Since they tend to vary between countries they could provide an explanation for varying fiscal policy outcomes. They can have an influence on policy outcomes if they are more difficult to change than the budget law itself. If a country has enforceable and transparent fiscal rules and conducts fiscal policy according to these rules instead of discretion, it will generally exhibit lower deficits and lower public debt levels.

Empirical research suggests that budgetary procedures that give larger authority to Prime Ministers or Ministers of finance do better in terms of lower deficits and debts than systems with more dispersed authority. Furthermore procedures that increase transparency also lead to more prudent fiscal policies.

In terms of electoral institutions Persson and Tabellini (2000) find that majoritarian electoral systems (the two-party US or UK system) are more fiscally conservative than proportional systems (European electoral systems). This can however be linked to the persistence of strong, centralized governments on one hand and weak coalition governments on the other hand. The hypotheses above clearly explain why such weak coalition governments are more fiscally irresponsible than one-party governments. Persson and Tabellini (2000) also find that presidential systems tend to be less fiscally wasteful and have lower deficits and lower budgets in general than parliamentary systems. This can be explained via the relative agenda-setting power given to the President, which isn’t a characteristic of parliamentary systems. In addition parliamentary systems are also more prone to coalitions and the common-pool problem.

If we accept the assumption that policy outcomes are influenced by politico-institutional variables then in order to improve policy making one has to intervene at an institutional level. One can either change budgetary formation legislation via implementing new fiscal rules, or by changing electoral laws so as to increase political accountability and decrease the incentives for wastefulness.

One of the most commonly advocated reforms of the budget process is the introduction of a balanced budget law, or more generally, regulations which limit the discretion of governments in running deficits. A potential cost of such strict rules is the loss of flexibility in reacting to exogenous shocks. This can be averted by introducing a cyclically adjusted budget rule. However , as mentioned above, in each case politicians will rather cut investment spending or hit at social groups with lack of political power rather than to undermine their support groups.

However, most of these results linking various electoral or budgetary rules to government size and consequently debts and deficits need to be taken with a pinch of salt. The direction of causality can be reversed. Perhaps countries which tend to be fiscally irresponsible design these types of institutions. In addition most of the empirical findings of institutional hypothesis model bound down to the essential differences between an Anglo-Saxon laissez-fair economic model and the European welfare state economic model. Perhaps the difference in debt levels and government size lie in other factors like voter preferences, culture, or some historical trails, and not just mere differences in electoral institutions.

Literature

For those more interested in the topic I recommend the following literature.

Alesina, A. and G. Tabellini (1990) A positive theory of fiscal deficits and government debt. Review of Economic Studies 57, no. 3: 403-414.
Alesina, A. and R. Perotti (1994) “The Political Economy of Budget Deficits”.
Alesina, A. and R. Perotti (1996) “Budget Deficits and Budget Institutions”.
Alesina, A. and N. Roubini (1997) Political Cycles and the Macroeconomy. MIT Press.
Brennan, G., and Buchanan, J. (1980) The Power to Tax: Analytical Foundations of a Fiscal Constitution. Cambridge University Press.
Hibbs (1977) “Political Parties and Macroeconomic Policy” American Political Science Review, Volume 71, Issue 4 (Dec., 1977), 1467-1487
Mueller (2009) Public Choice III. Cambridge University Press.
Nordhaus (1975) “The Political Business Cycle” Review of Economic Studies 42, 169–90.
Olson, Mancur (1971) Theory of Collective Action. Harvard University Press
Peltzman, Sam (1994) “Voters as Fiscal Conservatives“ Quarterly Journal of Economics, 108(2), 327-61.
Persson, T. and L. Svensson (1989) “Why a Stubborn Conservative Would Run a Deficit: Policy with Time-Inconsistent Preferences”. Quarterly Journal of Economics 104(2): 325-45
Persson, T. and G. Tabelini (1990) Macroeconomic Policy, Credibility and Politics. London: Harwood.
Persson, T. and G. Tabellini (2000) Political Economics. Explaining Economic Policy. MIT Press.
Rogoff, K. (1990). Equilibrium Political Budget Cycles. American Economic Review, 80(1). 21-36.

Wednesday, 2 July 2014

Political economy of debts and deficits (3): Hypotheses explaining debt accumulation

Continuing with the overview of the politics behind debt and deficits, in this post I present the dominant hypotheses aimed at explaining the vast debt accumulation on the past 40 years in many industrial economies. 

The debt dynamics in the past few decades has prompted a new stream of research that focused on political economy of public deficits and debt. A useful overview of this literature can be found in two papers by Alberto Alesina and Roberto Perotti (1994) "The Political Economy of Budget Deficits", and Alesina and Perotti (1996) "Budget Deficits and Budget Institutions".

The following six groups of models (presented in the above-mentioned papers) try to explain the political economy of the budget process:
  1. Models that focus on opportunistic behavior of policy-makers and the naivety of voters, who are subject to fiscal illusion; 
  2. Models of intergenerational redistribution; 
  3. Models of the public debt as a strategic variable; 
  4. Models of distributional conflicts; 
  5. Models of geographically dispersed interests; and 
  6. Models emphasizing the role of budget institutions. 
1. Models of opportunistic behavior and the fiscal illusion

The theory of opportunistic behavior of politicians and voters suffering from illusion suggests that politicians are inclined to increase spending more than taxes close to election time, so as to cure favors with voters who do not understand that increased taxation would have to follow. Voters overestimate the benefits of current expenditures and underestimate future tax burdens. Opportunistic politicians who seek to be elected will take advantage of this by running deficits in pre-election time to boost output and please the voters.

This is linked to models of political business cycles (originally presented in Nordhaus, 1975), where politicians will tend to create expansions before the elections (deficits spending to increase GDP growth above normal and lower unemployment) only to see a recession coming immediately after as an effect of tightening monetary and fiscal policy. Incumbents are reappointed if growth is high and unemployment is low in the election year. Voters are retrospective (backward looking) and highly discount the past (meaning that recent events are more important to them than past events – in other words, they will react more to events that happened in the election year than in the beginning of the incumbent’s mandate, 4 years ago). An empirical implication is that election years should be characterized by above normal growth and below normal unemployment with a moderate increase of inflation, whereas after the election the opposite will occur. The long term effect is higher debt and possibly higher inflation. However empirical evidence has failed to find any substantial support for this kind of behavior in the economy vis-à-vis the electoral cycle. A famous paper is Peltzman’s (1992) “Voters as fiscal conservatives” where he found that US voters tend to punish politicians which engage into deficit spending.

The traditional opportunistic models were later expanded by introducing rational expectations (Rogoff, 1990; Persson & Tabellini, 1990), where voters are no longer retrospective but forward-looking, and have introduced the government competence parameter (thus introducing the adverse selection problem).

Opportunistic models have also been contrasted with the so-called partisan models (Hibbs, 1977) where it is said that unemployment is persistently higher with right-wing parties in power and lower for left-wing ones, while inflation is permanently higher under left-wing governments and lower for right-wing ones.

One possible weakness of this theory is that voters aren't always retrospective, and don't always underestimate the tax implications of spending decisions (i.e. they don't always succumb to the fiscal illusion, over time they learn and accommodate). However empirically it has been shown in many economic voting models that voters are in fact much more retrospective (past-performance oriented) than prospective (expectations of future performance), and far more myopic, leading them to persistently succumb to the fiscal illusion and overestimate deficit-spending in good economic times.

The crucial problem with the theory is the failure to explain the cross-country differences. How come in some countries voters persistently suffer under the fiscal illusion while in others they don't? Are they smarter or better informed? Not likely. Different tax systems and different fiscal rules can explain the cross-country differences. This also implies that opportunist behavior of politicians and voter fiscal illusion aren't the only reasons behind high debt. They can perhaps explain it to some extent but different institutional settings are much more precise in explaining why some countries will face high debts and deficits and why others will not.

2. Models of intergenerational redistribution

The models of intergenerational re-distribution start from the fact that only the currently living people vote. The current generation can be selfish and leave debt to new generations without any repercussions against high debts. The only constraining factor for the selfish generation is the increased risk of default, which might affect their pension plans. For example, if the current generation is reckless and doesn't punish politicians which accumulate unsustainable debt levels, by the time they become retired the risk of government default will affect their pensions (either via austerity measures or via a literal default where the government simply won’t have any more money to service its existing liabilities).

In conventional macroeconomics, debt and pay-as-you-go social security are identical policies. Preferences for social security depend on age-earning profiles and the population growth rate, as well as intergenerational altruism. The degree of altruism varies across households. Richer households leave money for their future generations (they bequest) while poorer households are unable to do so – we can call them bequest-constrained. Voters from richer households are concerned only with the general equilibrium effects of fiscal policy and deficits and not how it redistributes across generations. But the bequest-constrained voters favor a budget deficit, because it allows them to do something they cannot do privately: redistribute resources toward themselves. In a median voter equilibrium, the size of the budget deficit depends on the efficiency effects and the number of bequest-constrained voters (from poorer households).

The politicians seize this opportunity and act to only increase the borrowing category to finance their deficits and rising government spending. Taxes are not a viable option since they risk no re-election, while cutting spending is arguably even worse for the politicians as this directly affects particular groups which could, as an effect, lower their support for the incumbent party.

However this too fails to explain the cross-country heterogeneity. In addition high public debts have often been both accumulated and sharply reduced during a lifetime of a single generation.

3. Models of the public debt as a strategic variable

In case of strong conflicts between two main political parties, public debt might become a strategic variable in the sense that one party might amass debt to constrain the actions of the other party.

This model (coined by Alesina and Tabellini, 1990) was applied primarily to US politics, characterized by a polarized electorate which is faced with only two viable options for holding office. In this model, we need to assume the existence of two parties with different preferences over public spending. The "defense" party (Republicans) runs large deficits during its term in office to prevent the "welfare" party (Democrats) from increasing spending when it comes to the power. The larger polarization between the parties about the composition of government spending, the stronger might be the incentive to leave high debt to successors to deal with it. These effects might become stronger with the increased instability of governments. For example, Alesina and Tabellini suggest that more frequent changes of governments in OECD countries since early 1970s were one of the reasons for debt expansion (see Alesina and Tabellini (1990) "A Positive Theory of budget Deficits and Government Debt", Review of Economic Studies 57, pp. 403-14)

A similar model (Persson and Svensson, 1989“Why a Stubborn Conservative Would Run a Deficit: Policy with Time-Inconsistent Preferences”) is when the two parties are in disagreement not in the composition of spending but in size of spending. This model predicts that only the low spending party increases debt since by lowering taxes and issuing debt the low spender constrains future spending. The new party in power must amount to lowering the debt burden due to a costly threat of default.

There is also the following conundrum: parties can use debt strategically to win elections. If we assume that the left wing party is more prone to a default since it’s mostly the upper classes and the banks which are debt holders, the right wing party can increase debt so as to make more people debt holders, and as a result the left would lose support.

This hypothesis can explain the rising debt levels that started since the 70-ies as it is in this period that most Western governments experienced more frequent changes of governments in power. In addition by using political polarization as an explanatory variable we can also explain why in some countries debt levels are higher while in others they’re not.

Furthermore empirical evidence has found support for the Persson and Svensson model, where right wing governments issue more debt when facing a probability of a defeat (e.g. the Reagan deficit effects on the Clinton government), while left wing governments do the opposite.

In the next and final blog post on this topic, the final three hypothesis will be presented along with some concluding remarks and a short literature overview for those more interested in the topic.