Wednesday, 31 October 2012

Graph(s) of the week: comparing US Presidential performance

Relating to a graph of the week from two weeks ago, I again turn to the Economist and its interactive feature comparing the performance of past elected Presidents in their failed or successful re-election bids. What is really interesting is that President Obama seems to, on average, have much worse economic results than most other Presidents who failed to be re-elected, particularly in the disposable income category (third graph).

The other two categories (GDP and unemployment) also look disturbing, where Obama's current performance is worse than an average failed re-election bid.

Having all this in mind, it's interesting to see how a lot of economists still think he's the right man for the job (at least according to the partially biased survey described in an earlier post). It is true that the President found himself in the middle of a huge wealth shock to the public and is facing massive develeraging (see second graph) for the whole economy. There is also an important factor of a sluggish recovery from a financial crisis. This is, I think, the main angle for the Obama campaign. If they are able to convince the median voter that the recovery is slow due to a financial crisis shock, they are very likely to get him re-elected. Now this certainly is the case at the moment, but the biggest issue, in my opinion, is the unwillingness to recognize the structural problems the United States is facing (Europe is a similar story). These structural issues can't be solved by short-run stimuli, but via a long-run commitment to reform the system and to adapt to a newly formed technological environment, and accept new patterns of production and labour market specialization.

Keeping this up they will both end up like Japan: a two-decade long hopeless case of close to zero growth, unconventional monetary policy measures with almost no real effect on the economy, similarly ineffective fiscal policy measures, and with an endemic reluctance to reform and adapt. I hear that the Japanese are learning their lesson by now, let's just hope that the United States will do the same before repeating their mistakes. No matter who becomes the President. 

Saturday, 27 October 2012

Is there an optimal size of government?

A recent blog post by Brian Caplan reminded me of a great post by Scott Sumner from a about month ago about the issue of an optimal size of government. He compares the Scandinavian model, which to a narrow conservative mind presents somewhat of a paradox where a large size of government coexists with high levels of economic freedom, to the current US system of relatively smaller government, but decreasing economic (and personal) freedom.

Brian Caplan has the story where he disagrees with Sumner’s distinction between the terms 'size of government' and 'market freedom'. Where Sumner makes an important difference, Caplan thinks market freedom cannot be achieved with a high expenditures to GDP ratio within an economy. Sumner responded to this soon enough, saying that expenditure to GDP ratios "vastly overstate the difference between the Nordic and Singaporean [for example] models. That's why I focus on variables like MTRs [marginal tax rates] and tax complexity, which do a far better job of picking up the extent of market distortion". 
(the discussion continues...)

I agree with Sumner, as I also hold an opinion that efficiency rather than absolute or relative size is a much better and more precise estimate. Efficiency of the government service can tell us much more of its impact on the people’s welfare than its size. This is of course only in the case of Western democracies, since there is a certain institutional threshold beneath which it is futile to discuss the size or efficiency of an extractive state.

Sumner uses the perfect example of efficiency, Scandinavian countries.

Scandinavian countries excel in personal and economic freedom. They top the lists of economic freedom for a long time and are perfect examples of how a favourable formal institutional environment influences the set of informal economic institutions necessary to ignite reforms and create a more dynamic and innovative society. This is the reason behind their success. But there is much more. 

Apart from a persistently favourable institutional environment in which structural reforms are much easier to do (read an earlier text on the reasons behind Swedish success and quick recovery), they have much more to brag about. Here's from a text by Tim Worstall (I recommend you read the whole thing): 
"My basic starting point is that the social democracies of Scandinavia, the Nordics, are roughly what most people have in mind when they talk about a liberal society. Government takes a large percentage of the total production of the country (up to 50% say) and the uses this to provide public goods, social and welfare services and to redistribute income. 
We're generally told from the right of the political aisle that such societies cannot work. Taxes will be so high that all initiative, all economic growth, will be snuffed out. This clearly isn't true as they're rather nice places to live and they have perfectly standard, if not better than many other European countries, economic growth.
But it's also true that they violate some of the canons of the left side of the political aisle. Capital and corporation taxes are low for example. Sweden doesn't even have an inheritance tax. The basic national income tax rate in Denmark is 3.76%, the top one 15%. The tax systems of all four countries (Denmark, Sweden, Norway and Finland) are more regressive than the tax systems of either the US or UK. Yes, top rates of income tax are higher: but they raise a great deal more money in heavily regressive and high rates of VAT.  
There is no national minimum wage in any of the EU Nordics. Taxation for social spending tends to be bottom up rather than top down. In Denmark, as an example, the social security taxation is set by the commune, a grouping of as few as 10,000 people. The rate might be 25 - 30% added to that national income tax noted above. This is collected and spent locally. Sure, communes will group together to set up services a single commune would not need: specialist hospitals for example. But money and decisions are local, only moving to a higher level when necessary.  
In the American sense this would be like running say, Medicaid from the county level upwards rather than as it does work, from the Federal Government downwards."
Scott Sumner adds more:
"... in America the government schools are almost all local monopolies, whereas Sweden has a 100% universal voucher system allowing students to attend any school they wish. Thus one could argue that the role of government in the US education system is effectively much higher than in Sweden. In general, the Nordic countries are famous for privatizing many government services that are done by the public sector in the US (airports, passenger rail, air traffic control, fire prevention, etc.)

...The US government is presumably the world’s largest, and hence is probably less efficient than smaller governments ... Countries like Switzerland, Sweden and Denmark are not just smaller than the US, they are also more fiscally decentralized. So one definition of “small government” would be government that is highly decentralized.

Another definition might involve the number of regulations with which citizens must grapple. I’d guess that the US has more regulations than any other country in the world, but I am not certain. I do know that our tax system is extremely complex, and this is the main source of frustration that I face when dealing with government ... In contrast, in Sweden the government simply sends you the bill. There are no forms to fill out. I’d much prefer the Swedish system even if tax rates were higher....

Using this approach I’m not sure whether the Nordic governments are all that big, and I’m not sure the US government is all that small. Surprisingly, the Heritage Foundation seems to agree, as they rate the US and Denmark roughly equally in terms of “economic freedom,” despite the fact that ... Denmark’s government is the world’s largest, as a share of GDP."
An "optimal" size of government should be determined by the voters of a country, on local decision-making levels. Politicians can only affect its efficiency, and the efficiency of government institutions. It is in that perspective where politicians fail, and where nations fail

Wednesday, 24 October 2012

Graph of the week: Eurozone nominal wages

FT Alphaville has got a new graph from Credit Suisse:

Source: FT Alphaville; HT: Tyler Cowen
Observe the changes in nominal wages in the pre-crisis decade (grey columns). It reminds me of a graph I've had before in the text on Sweden, where unit labour costs were compared across the Eurozone periphery to Sweden and USA, with respect to German labour costs. The effect on competitiveness was more than clear from that graph. This one shows a similar convergence picture, where Greek, Irish and Spanish nominal wages were adjusting to equate the Eurozone 'average' (there was another similar graph which measured real disposable income for various EU economies).  

Germany, on the other hand, in the same period experienced a significant nominal wage decrease partially as an effect of the unification in the 1990s, but mostly because of their labour market reforms which have ensured a long period of wage moderation. As I've shown in a previous text, this wage moderation was the key in preventing a downturn in the labour market during the current crisis. 

The blue columns represent the current re-adjustment of nominal wages in the periphery, or in layman terms, a reversal of the wage growth from the past 10 years. Was it done too fast? Is it necessary? Was it unsustainable and unrealistic to expect a convergence based on the pre-crisis growth models in the periphery? Maybe, yes, yes.

Monday, 22 October 2012

"Unburdening enterprise"

Today, the Adam Smith Institute published my paper on the deregulation of UK small and medium-sized businesses (SMEs), entitled "Unburdening Enterprise. Reducing regulation for small & medium businesses". 

The paper received coverage in the Financial Times, The Times (both require subscription access), Conservative Home, Politics (where in both, ASI's policy director Sam Bowman wrote good pieces outlining the main proposals of the report), and many others. 

Here is a blog post I wrote for the ASI to sum up the report. I will quote it in full: 

"Regulatory confinements very often result in wrong policy perceptions and adverse policy conclusions. In an attempt to create a safer environment they impose a number of rules, procedures, and amendments to these rules that eventually end up stifling companies and diverting their resources away from productive activities. This is particularly endangering for small and medium-sized businesses (SMEs), considered to be the drivers of growth in an economy.

Small and medium-sized businesses make up an integral part of the private sector. The recovery depends on them to create jobs and replace public sector spending. But we cannot expect them to flourish under current regulatory and tax conditions. The focus of the ASI’s new report Unburdening Enterprise was to identify the most cumbersome and harmful regulations, taxes, and other barriers to growth and to offer possible solutions to relieve the businesses of these burdens. Having undergone a range of surveys among businesses, several constraints were recognized, including employer’s national insurance contributions being too high, problems with access to finance, regulatory compliance costs, hiring obstacles, fear of employment tribunal, and a lack of confidence due to the uncertainty regarding the unfolding of the recession.

With the UK experiencing deteriorating productivity, keeping on inefficient workers subject to employment law protection is a policy that will keep productivity low for quite some time. Low productivity is a sign of an economy stuck in a structural shock (bad equilibrium). Domestic competitiveness is deteriorating, making domestic businesses inflexible in adapting to market conditions. This will only make them more prone to failure.

It these times of uncertainty and lack of confidence, government subsidies to businesses in favoured industries won’t create an incentive to invest or hire more. Just like the banks, the businesses choose to hoard cash since they are uncertain on the future returns on their investments. On the other hand, the private sector is currently engaged in a massive deleveraging process. Introducing subsidies and stimuli will only shift the resources from making profits on their regular markets onto making favours on the political market in order to attract the subsidies. Cutting costs creates a completely different incentive – it gives the business an incentive to use its resources more efficiently and to transfer them into more production or more hiring. 

This report aimed to show how decreasing costs for businesses is a much wiser, cheaper and efficient policy than a subsidy or a fiscal stimulus, as it creates economically better incentives for businesses. It is particularly important to create a healthy, competitive, market environment where firms compete for customers rather than political or bureaucratic favours. Otherwise, we are dangerously close to a system of crony capitalism where political signals rather than consumer demand drive the incentives of the private sector.

The plea for less regulation doesn’t imply removing all regulation since SMEs need a sense of reliability and guarantee in order to be considered a credible borrower. Deregulation is a call for reducing and removing all those regulative, administrative, and legal burdens that exemplify adverse use of resources and constrain a business in its growth and development.

The report’s main proposals include:
  • Abolish employers’ National Insurance contributions. This proposal has a potential of creating a minimum of 500,000 jobs by relaxing the tax burden on employment.
  • Reverse the 5.6% increase in business rates from April 2012 to free up funds for businesses.
  • Substantially reduce costs for the SMEs by removing all unnecessary administrational burdens. The government should continue with its deregulatory agenda demanding higher efficiency from all departments.
  • Simplify the regulatory system for SMEs in order to remove the necessity of hiring lawyers and accountants to help them comply with regulatory standards. Simplification should benefit all UK SMEs.
  • Put a stop to all new regulation coming in from EU that targets SMEs. This will save them a total of £100bn per year (£23,000 per business) – enough to hire an additional employee or invest into new capital creation and production.
  • Make it easier for employers to fire employees for misconduct. This will make it more attractive for employers to hire, and will increase labour market flexibility.
  • Encourage businesses to take more temporary, zero-hour and fixed term employees. Introduce the option of self-employment for SMEs. It saves money, increases job creation and channels resources into profit-making opportunities.
  • Remove the minimum wage to create youth jobs.
  • Encourage private sector solutions to help businesses chase late payments and increase their availability to credit."

Saturday, 20 October 2012

Confirmation bias

From Wikipedia:
"Confirmation bias is a tendency of people to favor information that confirms their beliefs or hypotheses. People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. The effect is stronger for emotionally charged issues and for deeply entrenched beliefs. For example, in reading about gun control, people usually prefer sources that affirm their existing attitudes. They also tend to interpret ambiguous evidence as supporting their existing position."

In other words when one person thinks his or her opinions are based on years of rational and objective analysis, but in reality they are the result of years of exposure to information that only confirmed his or her prior beliefs, while any information that was challenging the predetermined opinion was being ignored and/or rejected. 

Why am I referring to this psychological phenomenon? Because I'm starting to enjoy reading behavioral economics more and more, but mostly because of this recent text from David Henderson where he quotes Milton Friedman
"In 1964--to the disgust and dismay of most of my academic friends--I served as an economic adviser to Barry Goldwater during his quest for the Presidency. That year also, I was a Visiting Professor at Columbia University. The two together gave me a rare entree into the New York intellectual community. I talked to and argued with groups from academia, from the media, from the financial community, from the foundation world, from you name it. I was appalled at what I found. There was an unbelievable degree of intellectual homogeneity, of acceptance of a standard set of views complete with cliche answers to every objection, of smug self-satisfaction at belonging to an in-group. The closest similar experience I have ever had was at Cambridge, England, and even that was a distant second.

The homogeneity and provincialism of the New York intellectual community made them pushovers in discussions about Goldwater's views. They had cliche answers but only to their self-created straw-men. To exaggerate only slightly, they had never talked to anyone who really believed, and had thought deeply about, views drastically different from their own. As a result, when they heard real arguments instead of caricatures, they had no answers, only amazement that such views could be expressed by someone who had the external characteristics of being a member of the intellectual community, and that such views could be defended with apparent cogency. Never have I been more impressed with the advice I once received: "You cannot be sure that you are right unless you understand the arguments against your views better than your opponents do."
Scott Sumner quoted the same thing, with an emphasis on Paul Krugman's 'New York' confirmation bias: 
"Some have asked if there aren’t conservative sites I read regularly. Well, no. I will read anything I’ve been informed about that’s either interesting or revealing; but I don’t know of any economics or politics sites on that side that regularly provide analysis or information I need to take seriously. I know we’re supposed to pretend that both sides always have a point; but the truth is that most of the time they don’t."
It's very important to keep an open mind in thinking about economics (or any other social issue), removed of any ideological constraint, which is why I'm surprised that celebrated economists like Paul Krugman mostly keep it closed and with a strong political/ideological bias.

I consider myself a libertarian, primarily because I enjoy logical thinking, and libertarian arguments excel in that perspective. However, I don't blindly follow every libertarian idea, and always have my own uniquely formulated opinion on a variety of issues (except when it comes to personal liberties where I closely align with the libertarian mindset). In economics especially I tend to think a bit outside the paradigms of current economic theories, not because I want to create something new, but because I want to look at an issue from a variety of angles and always from a bigger picture before I reach a conclusion. This is why I favour new institutional economics and political economy.

Anyway, I hope that my political economist vocation and a tendency to look at the big picture are sufficient and necessary conditions for never falling into a confirmation bias trap. 

Thursday, 18 October 2012

Graph(s) of the week: economists and elections

The Economist recently had a story on the survey conducted among America's economists on  how they feel about the current recovery, and how they assess each of the two Presidential candidates. It should be said that the whole survey was a bit biased towards President Obama, since 45% of the respondents rated themselves as Democrats, while 7% were Republicans. According to this it's even more surprising that the Romney campaign attracted over 600 US economists (6 Nobel prize winners) to sign up for the Hubbard-Taylor-Mankiw plan. I'm guessing not all of them responded in the survey. It attracted only 312 NBER research associates and 51 NABE forecast panel members (which is actually a fair sample). 

It's not that economists have any influence on who turns out to be the electoral winner, but it's interesting to examine how they feel on things they are supposed to be experts on, like the recovery. Even though they rarely agree with each other. 

The most interesting is the divide among the academics on the reason why the recovery is so slow:

It's good that they mostly agree that the recovery tends to be weak after a financial crisis (see graph 3 as well), but it's not so good that a lot of them don't realize the structural slowdown and an unsustainable pre-crisis growth model, which failed to respond to the technological shock of the past 15 years. 

Monday, 15 October 2012

Nobel prize in economics to Alvin Roth and Lloyd Shapley

The 2012 Nobel prize in economics has been awarded today to Alvin Roth from Harvard and Lloyd Shapley from UCLA for their contributions in "the theory of stable allocations and the practice of market design". What this means is the following:

"This year’s Prize to Lloyd Shapley and Alvin Roth extends from abstract theory developed in the 1960s, over empirical work in the 1980s, to ongoing efforts to find practical solutions to real-world problems. Examples include the assignment of new doctors to hospitals, students to schools, and human organs for transplant to recipients. Lloyd Shapley made the early theoretical contributions, which were unexpectedly adopted two decades later when Alvin Roth investigated the market for U.S. doctors. His findings generated further analytical developments, as well as practical design of market institutions."

So it was a successful empirical application from Al Roth, based on a game theory approach from Shapley (something called the Gale-Shapley algorithm). This explains how in certain situations when the price mechanism fails to allocate resources efficiently, some individuals can still cooperatively reach an efficient equilibrium allocation. The application for this in the real world is allocation of kidneys to patients for example, or students to high schools, or matching in marriage between couples. See here for a really good explanation of the ideas, or read it from Alex Tabarrok at Marginal Revolution: 
"The field of matching may be said to start with the Gale-Shapley deferred choice algorithm. Here is how it works, applied to men and women and marriage... Each man proposes to his first ranked choice. Each woman rejects any unacceptable proposals but defers accepting her remaining suitors. Each rejected man proposes to his second ranked choice. Each woman now rejects again any unacceptable proposals, which may include previous suitors who have now become unacceptable. The process repeats until no further proposals are made; each woman then accepts her most preferred suitors and the matches are made. 
What Roth has done is extend the Gale-Shapley algorithm to more complicated matches and to actually design such algorithms to solve real problems. In the 1970s, for example, the medical residency algorithm began to run into trouble because of a new development, the dual career couple. How to match couples, both doctors, to hospitals in the same city? By the 1990s assortative matching in the marriage market was beginning to derail matching in the doctor-hospital market! Roth was called in to solve the problem and moved from being a theorist to a market designer. Roth and Peranson designed the matching algorithm that is now used by Orthodontists, Psychologists, Pharmacists, Radiologists, Pediatric surgeons and many other medical specialties in the United States.
Most famously, Roth has worked on improving kidney allocation...
...Your spouse is dying of kidney disease. You want to give her one of your kidneys but tests show that it is incompatible with her immune system. Utter anguish and frustration. Is there anything that you can do? Today the answer is yes. Transplant centers are now helping to arrange kidney swaps. You give to the spouse of another donor who gives to your spouse. Pareto would be proud. Even a few three-way swaps have been conducted. 
But why stop at three? What about an n-way swap? Let’s add in the possibility of an exchange that raises your spouse on the queue for a cadaveric kidney. And let us also recognize that even if your kidney is compatible with your spouse’s there may be a better match. Is there an allocation system that makes all donors and spouses better off (or at least no worse off) and that maximizes the number of beneficial swaps? In an important paper Alvin Roth and co-authors describe just such a mechanism and show that it could save many lives.
Who says that theoretical economics isn't applicable to the real world? Game theory is universally applicable. 

Alvin Roth co-runs a blog, Market Design, which I noticed has suddenly gained momentum and audience (judging by the comments on his previous posts). 

As for the predictions, Tyler Cowen missed it this time, but WSJ was spot on by saying that Roth was the favorite to win it.

Congratulations to Alvin Roth and Lloyd Shapley!

Sunday, 14 October 2012

One year of blog

This day a year ago in London, in a computer room at LSE, I opened the "Don't worry, I'm an economist!" blog. What started off as an idea to educate readers on some basic economic concepts and mechanisms (the opening topics were QE, banking reform, financial transaction tax, credit easing, regulation and the euro break-up) ended up as a place where I contemplate on any idea I come across, often analyzed from a political economy, libertarian, and institutional perspective (depending on the topic). I am happy to say that the blog has evolved into a platform for my ideas on what caused the crisis (see a summary of my paper on the political economy of the crisis, or an analysis into the causes of the Eurozone contagion, both of which I have decided to make into a special page), and how to start the recovery. 

What I hoped to have achieved is to send a message on what is needed to start a recovery - a set of pro-market structural reforms supported by a strong institutional environment. This is not a 'one size fits all' approach since every country has a different formal institutional environment characterized by different historical and cultural development of its informal institutions. The shock of the crisis that led to its long-lasting consequences wasn't an aggregate demand shock, but a structural shock characterized by years of declining productivity and an inability to adapt to a huge technological change in the past 10-15 years. So it is only natural to suggest that the old system needs to be changed structurally to adapt to its new surroundings and new assumptions. Just like an old economics model, it needs to recalculate in new variables. 

Since this is an anniversary post, I'll look back on some of my proudest (and most read) works: 

I am particularly thankful on the feedback I received from some of the readers on how helpful the blog has been to them. And I am thankful for all the interesting comments I receive that often light up a discussion on a particular topic. 

Finally, thanks to all my readers for making this worthwhile.

Tuesday, 9 October 2012

Imports are good

Madsen Pirie of the ASI has an excellent 10-point lesson on "very good things" for the economy. I especially recommend his insights on profitsbankruptcies and capitalism (more to follow). However, what I wanna touch upon today are imports:
"A common fallacy supposes that nations become rich by exporting more than they import. Many governments make the effort to augment exports and diminish imports. This usually involves subsidizing exports by means of grants and lower taxes, and discouraging imports by means of tariffs. 
It used to be thought that a country's wealth was augmented by a positive 'balance of trade,' under which the surplus of exports over imports would bring in more gold and silver than went out, leaving the nation richer. Adam Smith exposed this fallacy [also called the mercantilism fallacy], pointing out that the wealth of nations consisted in the productive labour of its peoples rather than in bars of precious metals stored in its treasury. 
In fact it is imports that make a nation richer. [my emphasis] By importing goods that are cheaper than those they can produce themselves, nations have cash to spare as well as the goods. This makes them wealthier than if they were self-dependent. Adam Smith said that Scotland could grow grapes and produce wine "by means of hot-walls and glass houses" on the slopes of Ben Nevis, but it would cost them 30 times the price of equivalent French wine. By buying the French wine, they saved twenty-nine thirtieths of the cost and could spend it on other things. 
Of course these imports have to be paid for, and exports make that possible. We export to gain the wherewithal to enrich ourselves through imports. It need not be manufactured goods we export. It can be services such as insurance, skills such as design, or the returns on our own overseas investments."
Madsen couldn't have made the point more simply.  Imports make a country richer.

I read a great book a while ago by Brian Caplan called "Myth of the Rational Voter: Why Democracies Choose Bad Policies" where he compares survey data of how the public and professional economists seem to think about a variety of issues. It is striking how in most cases they tend to differ. Particularly in the field of international trade, migration or corporate profits. Where almost every economist would strictly oppose things like tariffs or export subsidizing, the majority of the people would reach a completely different conclusion. Voters seriously underestimate the benefits of markets. This, in effect, drives political decisions in favour of the median voter opinion, which is too often lacking information and good judgement. 

Caplan's conclusion is that voters almost never posses enough information, operate under strong prejudices and tend to be highly irrational when picking political leaders. But that's another story.

Why am I linking this to Madsen's post? Simply because the fallacy of imports being "bad" is the most widespread fallacy in modern society. It is a topic where common sense will say one thing, but political ideology and voter prejudice will claim another. Among the other most misunderstood topics (and very often for the silliest reasons) are also immigration and trade. Prejudice is very hard to fight, but that's exactly why we need efforts like Madsen's or Caplan's to point out the fallacies, and keep an open mind. 

Sunday, 7 October 2012

German labour market: reform matters

It is often believed that the German labour market has much more nominal rigidities than the US market for example, which is supposed to be more flexible and hence more volatile. However a research by three German economists seems to show otherwise: “business cycle volatility of the labour market is twice as large in Germany than in the US.” They also find that Germany tends to have lower worker flows (longer worker-firm relationships), and point that these are mutually dependent. (see graph)

Source: Gartner, Merkl, Rothe (2012) "The German labour market: Low worker
flows and large volatilities"
VoxEU, August 2012
They do a comparison of the two countries’ labour markets from 1980 to 2004. Read the paper for technical details. 
"Our recent research (Gartner et al. 2012) provides a model that shows that low worker flows and large labour market volatilities are two sides of the same coin. The reason is that low worker flows generate long-term worker-firm relationships. When the economy is hit by a persistent aggregate (productivity) shock, this has a larger effect on firms’ present values under long-term relationships. Why? Imagine an economy with one period worker-firm relationships (e.g. all workers quit after one period). In this economy, only the contemporaneous aggregate productivity changes are relevant for the firm’s contemporaneous behaviour. By contrast, if workers quit very infrequently (i.e. workers stay within the same firm for several periods), expected future productivity is also relevant, i.e. the present value of a firm is affected more substantially by a persistent shock. Thus, under long-term relationships firms hiring and firing reacts more sensitively to macroeconomic shocks." 
How does this explain the relatively mild reaction of the German labour market compared to the US labour market during the Great Recession? The answer is in the labour market reform made in 2003 that initiated a period of wage moderation.

In another paper Gartner and Merkl (2011) compare two German recoveries, in 1974 and in 2008. The graph below summarizes the comparison.

Source: Gartner, Merkl (2011) The roots of the German miracle. VoxEU, March 2011 
"The 1974 recession hit Germany at a time of rising unit labour costs (i.e. real wages divided by productivity), while the Great Recession arrived at a time of wage moderation. We argue that the wage moderation in Germany is at the root of the German Miracle, potentially interacting with other measures such as the public short-time work scheme."
The fall in output was larger during the 2008 recession, but fall in employment was much worse in 1974. The reason for this, the authors claim, is in unit labour costs. They were rising in the begining of the 70-ies, but were falling steadily 5 years before the Great Recession. The labour market reforms initiated in 2003 made room for this wage moderation in Germany. The authors describe wage moderation as a positive permanent supply shock: 
"...what we see in the data is Germany’s move to a higher permanent employment level which was interrupted by the Great Recession. Since firms saw a fall in their wage costs before the crisis, they could accept a temporary rise in wage costs during the crisis (anticipating that the crisis would be temporary) and afford to keep their workers."
As for the public short-time work scheme, the authors reject that it was the key to the recovery since it was also used to a similar extent in 1974 (3.6% of total employed were part-time workers in 1974, compared to 3.8% in 2008). 

I particularly like the author's concluding points, some of which I have pointed out as well in my previous text on the German Agenda 2010:
"Without the wage moderation before the Great Recession, the German miracle would have been impossible. This is a point that is often ignored in the German public debate. The German Hartz reforms, which made the unemployment benefit system less generous, were certainly one of the reasons for the wage moderation. The reform was initiated in 2002 by a governing coalition, led by chancellor Schröder and the ruling Social Democrats. For some reason the Social Democrats are currently ashamed of this reform. If only they were to look at the facts from the Great Recession, they would surely be proud."
Going back to the first set of graphs comparing the German labour market to the US labour market, can we conclude that Germany was undergoing reforms that didn't allow the aggregate demand shock to manifest itself on the labour market? The reason for this is purely accidental. Germany initiated the reforms in 2003 whose direct effects took place several years afterwards and acted as a buffer against the Recession. In that scenario, Sweden was no different. The reforms they initiated in 1992 made the system more robust to future shocks, one of which occurred in 2008. 

Bottom line is that supply-side reforms were responsible for a quick recovery and a minuscule recession effect on the labour market. 

Thursday, 4 October 2012

Graph of the week: debt is bad

Relating to my previous post on the dangers of low interest rates, here's the debt time series for Japan: 

Source: The Economist, 19th September 2012

Looking at the development of Japanese debt since the 90-ies, we can say that it was one interesting ride. Observe the decade long deleveraging done by the private sector and households. On the other hand government debt rose substantially (as % of GDP). What caused the Japanese economy to undergo such a transition and turn itself into the world's largest debt holder? Two decades of low interest rates (among other things). They made it favourable for the government to use debt financing more and more. The result is the graph above depicting an even worse situation for Japan now than it was 20 years ago. I will repeat my point from the previous post: there is a real threat that today's Western economies follow this path and try to deficit-spend themselves to a recovery. This is proven not to work, particularly in the long run (after all we're not even in the short run anymore). As for the short run, today's crisis is much more than an aggregate demand shock. 

On the other hand, observe the deleveraging done currently in the US:

Source: The Economist, 19th September 2012

This is again another proof that no direct stimuli to the people (like a tax rebate) or the businesses will help them raise their confidence and future expectations so that they can start investing and spending. Check out this previous post to see why. 

Monday, 1 October 2012

Dangers of low interest rates: case study Japan

A lot of pro-fiscal stimulus arguments in the US and the UK come from the classical zero lower bound (ZLB) assumption, in which monetary policy is said to be ineffective when interest rates hit zero (the lower boundary). This means that the central bank is basically ineffective in its further monetary operations to kick-start the economy, since it cannot lower rates to negative levels (this is not to be confused with real negative interest rates paid on, for example, German bonds). 

So in this situation of the zero lower bound trap (or as Keynes called it the Liquidity trap), the only favourable option is to kick-start recovery via fiscal stimulus. In particular, the fiscal stimulus would include more spending on infrastructure projects and direct packages of support to certain business projects (like the green economy). 

(Disregard at the moment monetary stimulus arguments I’ve covered in three previous texts – here, here and here; ideas such as NGDP targeting for example certainly have merit, and they certainly overrule the ZLB assumption, but I don’t see them as the best response to the current crisis, simply due to a different opinion I hold in which type of shock caused such a persistent crisis.)

From another perspective, low interest rates signal that the government can borrow more under such good conditions. This is an example of a counter-cyclical economic policy, one that tries to stimulate the economy out of a recession (depression), and within its scope it is ok to increase the deficit and raise public debt in order to get the economy going. The reason this isn’t unsustainable are precisely the low interest rates at which governments can borrow. 

Without repeating my previous points on why I think infrastructure projects, more government spending and/or higher deficits won’t do us any good at the moment, I will just briefly touch upon the dangers of keeping interest rates too low for too long, and what their real costs for the economy might be. 

Here’s from a speech by James Bullard, President of the St. Louis Federal Reserve Bank, back in February 2012:
"...the lengthy near-zero rate policy punishes savers in the economy...
These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive."
Ken Rogoff wrote a good article a while back titled “How Long for Low Rates?”, where he also emphasizes the dangers of low interest rates, saying that the low interest rate dynamic is not stable and that it could unwind quickly: 
"Investors are increasingly wary of a global financial meltdown, most likely emanating from Europe, but with the US fiscal cliff, political instability in the Middle East, and a slowdown in China all coming into play. Meltdown fears, even if remote, directly raise the premium that savers are willing to pay for bonds that they perceive as the most reliable, much as the premium for gold rises. These same fears are also restraining business investment, which has remained muted, despite extremely low interest rates for many companies."
What happened in Japan?

One good case study that can point us to the dangers of keeping low interest rates for too long is Japan:

Looking at the graphs we can see that slow responsiveness of monetary policy in the beginning of the 90-ies had negative repercussions for the economy. Also, the 1990 increase in rates was obviously a very bad idea. Having learned their lesson, the Japan central bank has kept rates at zero or near zero ever since, persistently for the last 16 years (FYI, it's currently zero, and has been since October 2010, down from 0.1).

For the record, Ben Bernanke criticized Japan's monetary policy on accounts that it was too slow, its communication policy was unclear, and that it was afraid to raise inflationary expectations (this caused Japanese inflation to levitate around zero for the past 20 years, with several deflation periods - see here). 

Was Japan hit by a one-off aggregate demand shock which would have been allegedly easily solved with monetary or fiscal stimuli? Not likely. It is true that Japan's economy was hit by an aggregate demand shock in the early 90s, but the shock triggered structural problems in the economy, all hidden due to the previous boom in the 80s. Japan didn't fail to react with fiscal or monetary stimulus, it failed to reform. 

The arguments that monetary or fiscal stimulus came too late are not very sound in this case. After all, they did occur. The fact that they were late meant that there was no immediate, short-run bounce-back of the economy. There was a reverse of the negative trend in 1996 and 1997, but this period, and all others, was characterized by sluggish growth, much like what the West is experiencing today. So their monetary and fiscal efforts could only produce short-run effects when the economy was expecting supply-side reforms. The case study of Japan isn't proof that they failed to apply a stimulus, it is proof that stimuli didn't work in Japan.

Observing it from today's perspective this is exactly what more fiscal stimuli would result in. Monetary policy would continue in keeping interest rates low and continue with unconventional measures, while ambiguous fiscal policy and higher taxes would keep the economy locked in the lower equilibrium. Today's economies in recession should take serious note of this.

Besides, have in mind that one other economy also entered a crisis in the early 90s which was rightfully portrayed as an aggregate supply shock and productivity slowdown. Regular readers of the blog recognize that this country is Sweden, and its structural reform response was more than successful.