Thursday, 27 December 2012

Cliffhanger: The fiscal cliff bargaining game

The negotiations over the fiscal cliff in the US are entering its final stages. The current situation is a stand-still, where both sides know the concessions they need to make, but neither is willing to make the first move and loose leverage. The Republicans are unwilling to make concessions on tax increases to high-income earners, while the Democrats are refusing to reign in the welfare system and finally reform it. The situation is close to a classical hawk-dove game (or even better a game of deterrence  in which neither of the two actors are willing to back off.

We've heard arguments from both sides claiming that if no agreement is reached the other side is willing to “push” the US over the fiscal cliff. In particular if either of the sides is unwilling to back off from cutting spending or raising taxes, then both will have to agree to a status quo level of automatic deep spending cuts and big tax hikes. Only then will we experience the full effects of a completely wrong austerity policy. Bottom line is that neither party is willing to let the other party hold the country “hostage”. In this desire they are both very likely to reach a unique Nash equilibrium in which the US is pushed off the fiscal clif (i.e. the status quo policy is achieved). Let's draw a game table: 

Dems/
Reps
Strike deal
No deal
Strike deal
-2,-2
-10,0
No deal
0,-10
-5, -5 *

The unique Nash equilibrium of the game is (no deal, no deal) with a payoff of (-5,-5) to both parties. The reasoning is the following; it is obvious that both parties would receive a higher payoff from cooperation (strike deal) than from defection (no deal), but neither of the parties wants to back down from its proposals, leading to a worse off equilibrium where no deal is reached. If one party backs down and is willing to accept the deal under any circumstance to avoid the fiscal cliff, then the other party may decide to defect on making the deal and force its own terms. This outcome makes the other party worse off since they lose reputation in the face of their own voters. To each party losing credibility of their own voters seems to be a much worse option than resorting to a no deal “fiscal cliff” equilibrium. With neither party willing to back down, the rational result must be a defection strategy from both parties, where the fiscal cliff is applied. 

However, as Axelrod (1984) and many others have proven in many real-life scenarios the cooperative equilibrium is achieved despite the fact that sometimes it’s more rational to choose a defection strategy. This could end up being the case here, but it wasn’t the case in August 2011, during the first big quarrel over the budget deficit. The current conundrum is actually an effect of the inability to make a deal back then, where a status quo policy was set to be initiated in the end of this year, if no solution is reached. 

Let’s draw the dynamic bargaining game (click to enlarge):


Democrats (the President) move first and propose policy q1 = f(τ1,y1), a combination of tax increases and spending cuts.

Tax increases in the case τ1, are lower than in the status quo, fiscal cliff scenario. These would include only tax increases on the rich, in particular on those with over $250,000 yearly income, raising about $1.6 trillion in the course of the next 8 years. This would still be lower than the status quo case, τ0, which would raise taxes on almost all Americans (letting the Bush tax cuts expire for all). The ypolicy implies spending cuts that are lower than the status quo, and represent around $400bn in various cuts and entitlement reforms. If the Republicans accept than this is the equilibrium policy and the deal is reached, with Republicans accepting fully and making no amendments. If they reject then we enter period t = 2.  

In period 2, Republicans make their own proposal and set tax increases to be lower than τ1, and much lower than the status quo τ0. On the spending side they propose a platform of higher spending cuts y2 > y1, but still not higher than the status quo policy. If the Democrats accept and make no amendments, the equilibrium policy is reached at q2. If the Democrats reject, the game enters period t = 3. Each policy offered in the next round of negotiations is more preferred to than the previously offered policy qo q1 q2 q3. The proposed policies can also be modelled as a deviation from each party’s optimal policy, but the intuitive result of the game is the same. 

Period 3 is the last period since there is a time constraint given in the negotiations (31st of December 2012). If until this period of negotiations no deal is reached then the status quo (“fiscal cliff”) is applied. 

In the last period the Democrats again move first and propose lower tax increases than in τ1, but still higher increases than the previous Republican proposal of τ2. They propose higher spending cuts than in q1, but still lower than the Republican proposal of q2y1 < y3 < y2. The Republicans now make the final move of the game. Their choice to give in and accept will depend on how close the Democrats were to their most preferred option. If they were rather far from it, the Republicans choose to reject the proposal and lead to the fiscal cliff. A similar scenario occurred last week after the Republican leaders rejected Boehner’s proposals. Instead of being the final period this resulted in yet another round of bargaining. We can enter yet another period in which the Republicans have a chance to make their final proposal, but it wouldn’t hurt the intuitive result of the game. 

Bottom line is, whatever the Democrats move forward as their final proposal before the deadline, the Republicans will have the final choice whether or not to accept it. 

We can introduce time discounting in the game and say that the closer we move to the deadline, the more likely it is for a party to reach a deal, since their voters don’t think of further defection as a sound strategy, but rather as stubbornness. However, if this isn’t the case then the deal will not be reached as long as both parties are too far apart from their optimal combination of tax increases and spending cuts f(τ*, y*). Whether or not the deal will be reached depends on the preferences of each party’s support on how long to keep a strong position and not back off. Recall the first table. The parties are reluctant to back off and cave in to the other party’s position, since they will see this as a potentially worse off outcome than the fiscal cliff (in terms of lost voter support, particularly for the upcoming local elections). The fiscal cliff is a better option since each party can always accuse the other one for not cooperating. 

Commitment device 

One can claim that the status quo, offering a series of automatically induced horror stories, is enough of a commitment device to ensure a cooperative equilibrium, where both parties reach a satisfactory outcome. But the commitment device obviously isn’t strong enough. If we think of this game as a classical cold war nuclear game of deterrence, where both parties have a credible threat they are willing to use, but both of them knows that triggering an action will lead to the least preferable outcome – a nuclear war, the commitment device is much stronger. Because of a strong commitment device, both parties abstain from initiating an action. 

This game, however, is a bit different, since the least preferable outcome is inevitable after January 1st (in the nuclear game, the nuclear war can be prevented by doing nothing, while in this game the fiscal cliff must be prevented by commencing an action). Knowing this both actors should find a strong incentive to cooperate. Imagine if January 1st is the day when the nuclear war starts. Then both actors have really strong incentives to prevent it. In the fiscal cliff scenario, this apparently isn’t the case. In other words, both actors apparently don’t see the fiscal cliff as such a huge threat, even though it is highly enforceable (and credible). 

This is the main issue preventing a cooperative outcome. Apparently the threat isn’t credible enough, or better yet, the threat isn’t assumed to be that devastating. Bottom line is that some members of both parties are rather willing to allow the threat to be achieved than they are willing to make any concessions.

Maybe I can get a good paper out of this? 

Monday, 24 December 2012

Happy 2013!? (the yearly predictions)

This time last year I finished off with a post summarizing briefly the predictions on the upcoming year. I was surprised to see that I was right on several predictions. Here's what I've written back then, for the US, UK and Eurozone economies: 
Unemployment is still at high levels and is likely only to rise. Output on the other hand, as well as investments, are likely to fall. Stagnation is upon us.
Ok, so the US has experienced stronger growth (3.1% in Q3) and falling unemployment (7.7 % in November) (even though the employment-population ratio is still stagnant), but the shadow of the fiscal cliff looms over the entire 2013. For Britain and the Eurozone the prediction was spot on - the recession re-emerged in the form of a "double-dip". 2013 doesn't look that good either, even though the US could turn out to be much better if the fiscal cliff is avoided. 

Further more, this part of the previous text summarizes not just the past year, but the entire recession so far:
The picture is gloomy and the politicians are realizing this more quickly than before as their election dates are closer. The current situation of postponing the necessary solutions [reforms] is only pilling up the pressure on them and is increasing the dissatisfaction and antagonism among voters. Sooner or later, we will all have to face the necessary consequences and accept painful solutions. [More bailouts and stimuli] will result only in more debt accumulation and won’t create a favourable environment for private sector growth. It may temporary restore investor confidence but the banks will still be reluctant to lend and the regulatory requirements will still raise costs for private sector enterprises.
An overview of the following year

This time, I'll provide a more detailed look in the future. It's not particularly rewarding to offer predictions (especially in politics) since there is always a risk to make a fool of oneself, but I'll give it a go anyway. 



In Europe, its strongest economy Germany awaits elections and is likely to experience slow growth throughout the year. The chancellor Angela Merkel will be re-elected for another mandate in September, perhaps with new coalition partners, but still strongly in power. It's growth rates will correspond to the Eurozone average of around 0.5%. 

Italy expects elections as well. Mario Monti most likely won't be continuing as Prime Minister, but the possible winner Mr Bresani is likely to continue with Monti's reforms. There's even an option of Monti becoming the President himself thus overlooking the work of the new cabinet. Whatever happens I expect Italy to continue of a stable path out of the crisis and maybe even reach miniscule growth by the end of the year.

It's hard to tell how the Hollande reforms will affect France. With many of the rich fleeing the country following the examples of Gerard Depardieu and Bernard Arnault, it will be interesting to see how effective the 75% top marginal tax rate will be. In addition there might be increased tensions between France and Germany over the remedies to resolve the euro crisis. 

In the UK, the issue of whether or not to stay in the EU is likely to take up the majority of the political debate. The rest will be the economy. More monetary stimuli is expected from the BOE, particularly now with the new governor Mark Carney, who's more open to new, innovative ideas. Even though this might briefly help the UK economy pull itself our of the recession (the expectation is around 0.5% growth), the monetary stimuli solutions will not be enough.   

The rest of Europe (particularly the Eurozone) will be locked down in low growth, still waiting on the proper reforms to kick in (with exceptions like Poland, the Baltics and Sweden). Spain and Greece are still presenting the biggest threat to the survival of the euro, despite the continuous efforts of the FT's man of the year, Mario Draghi to "do whatever it takes to save the euro". This will be enough from the monetary perspective for now, but the reforms must start. In Greece this will be particularly sensitive due the political risk still surrounding that country. The rise of the anti-austerity socialist Syriza party and the radical right wing Golden Dawn will present the biggest obstacle to reforms for PM Samaras. The political risk of early elections will be the biggest drag for Greece, but its euro exit and consequential contagion should be avoided.

Whatever happens, the EU will end up larger in 2013 (EU 28), with one country joining in July: Croatia! 

Nation(s) with the highest growth in 2013: One of the Baltics (Estonia, Latvia or Lithuania). 

Nation with the lowest (negative) growth in 2013: Greece or Portugal. 

USA

As mentioned earlier, the fiscal cliff negotiation (hopefully to be resolved this week) will cast the longest shadow not only over the US economy, but on the world economy as well. The eyes of the world will look upon the US politicians not to repeat the August 2011 scenario which triggered a boiling point in Europe in November 2011. It will be interesting to see how the US will cope with the effects of the wrong type of austerity (higher taxes, and some, if any, spending cuts being the wrong approach). 

The rest of the economy will do fine, providing the effects of the cliff don't kill off the recovery. The housing market is recovering and more savings are finding their way back into the real sector. If proper entitlement, regulation and tax reforms follow, then the economy will grow out strongly than before, despite the austerity pledge. If this part of the deal fails, and the whole deficit bargaining resorts only to higher taxes, postponing everything else, then don't expect much from the US next year. 

The Fed will still support the recovery with "QE infinity" and is likely to keep RGDP growing steadily at around 2%. With a stronger effect of the deficit reduction, it will be expected from the Fed to contribute even more. 

Japan 

The new PM Abe offers new ideas on how to break the Japanese 20-year low-growth deadlock. From the sound of it (a combination of monetary and fiscal stimuli, but avoiding the pension and other structural reforms), it won't happen. Another year of close to 1% growth with a high budget deficit and rising debt is expected. 

BRICs

Brazil's economy is likely to grow more strongly this year (4-5%) providing that President Dilma Rousseff's reform agenda is realized and her fight against corruption and cronyism is successful. Due to the preparation for the World Cup in 2014 and the Olympics two years later, in 2013 Brazil will turn itself into a construction site.

Russia, again (and still) under Putin's leadership is facing more uncertainty in the next decade over the sustainability of its current economic growth model. More protests are likely, but none so strong to endanger his authority. Putin is likely to reverse some of the pro-market reforms done under Medvedev, and turn Russia back on the dependency on energy prices. This won't send Russia into a recession next year, as it will still grow at around 4%, but it is seriously endangering its long-term position.

India is slowing down due to its structural instabilities (like corruption, poverty and lack of skilled labour), even though its industry is still buoyant. It will still grow above 6%, but the trend is now clearly decreasing. Too bad they haven't used the accumulated wealth to reform the country and raise living standards substantially. Next year won't be any different in that perspective.

China will experience a slowdown from its double-digit growth, although with a still impressive 8.5%. Consumption is expected to rise and it will most likely present the strongest component of GDP growth. The new party leadership will continue the previously mapped out policies. It's also interesting to note that more and more Western companies are moving production from China back home (insourcing), primarily due to the increase in Chinese wages and rising transportation costs. This won't hurt China next year, but it will have an effect in the years to come. 

The new reformist President of Mexico promises much and hopes Mexico will soon enough join the BRICs. This won't happen next year, but keep a close eye on Mexico in the following decade.

In the Middle East and the Arab world, prospects don't look good. I expect more turmoil in Egypt with a range of possible political deadlocks. This young democracy is still operating in an old formal and informal institutional system and it will take a few decades to change that. The same goes for all young democracies in the Arab world. It will take some time before they reach stability and prosperity. Hopefully, there won't be another descent into dictatorship for any of these countries. We all know this has happened before (see Acemoglu, Robinson (2006): Origins of Dictatorships and Democracy on the inability to consolidate democracies). In Syria, I expect a Libya-like scenario, with Assad ousted from power by the end of the year. 

All together it will be a turbulent year. I hope no more natural disasters or similar exogenous shocks will happen and slow down the fragile recovery. And it will be slow, particularly in Europe. But perhaps the US will finally "get it together" and be the pull factor the rest of the world (especially Europe) needs. It looks like the final week of this year and the outcome of the fiscal cliff bargaining will determine whether or not 2013 will be a bounce-back or a further descend into the abyss. 

Finally, I wish you all a Merry Christmas and a Happy New 2013!

Wednesday, 19 December 2012

Understanding the "growth problem"

Buttonwood, a columnist in the Economist, had a recent column on the "Growth problem" in the West. He seems to hold strongly to the austerity vs. growth paradigm and claims that the issue of declining economic growth has been a problem in the West for quite some time: 
Source: Buttonwood, The Economist 
"But it is worth remembering that Europe's growth problems did not start in 2010. As the table shows, real growth rate in the six European countries featured above has been slower in each successive decade (on average); the drop between the 1960s and the noughties was a staggering 54 percentage points. The US, which is shown for contrast, saw fairly steady growth from the 1970s to the 1990s before dropping off this century.

...
It may well be that European economies would perform better collectively if austerity programmes were relaxed. But it is a stretch to believe that Europe can return to the growth rates seen in the 1960s or even the 1970s. And those rates might be needed to make the debt problem go painlessly away."
Yes, it is a "stretch" to believe that Europe can return to the 60s and 70s growth rates, but there is a good reason why this is the case - convergence theory! Moving to a higher, more technologically advanced level of development, as these countries have done relentlessly in the past half a century, implies a slowdown in economic growth. One cannot repeat post-WWII growth rates for 50 years. They only last for a decade or so, while the subsequent path of nations is to converge to an upper steady-state level of wealth. This was the case in Europe, and the obvious consequence was a significant increase of living standards and personal incomes. Convergence theory can teach us one thing: that if you have lower GDP p/c you're much more likely to grow faster. 

Economic growth by itself isn't the goal. The goal is to use rapid economic growth to reach a sustainable level of development, as the aforementioned countries did. Rapidly growing BRIC nations should take note here and use the accumulated economic wealth to increase the living standard of their populations and achieve a higher level of development. As the WEF's Global Competitiveness Index explains, this means moving from a factor-driven or an efficient-driven economy to an innovation-driven economy. The danger is to get stuck in a transitional period (between an efficient-driven and an innovation-driven type of development), as this implies that something was wrong with the growth model applied in the economy. 

He's right about one thing though: 
"A company can borrow to invest and a society can too. But there is not much evidence that the debt has been used to finance productive investment; it seems to have gone on speculation and consumption. We have "borrowed from the future" and are suffering accordingly."
This was an unfortunate case in some of Europe's countries, but not for the whole group. The different growth models applied in pre-crisis times are creating a new divergence in Europe - on one side those who borrowed to finance productive investments ("the core" - even though this is arbitrarily defined), and those who borrowed to finance private and public consumption ("the periphery"). If you can expect any higher growth in the future it's most likely to come from the "periphery" and their catching up with the "core". However, don't expect to see 50% across decade growth rates in Europe in any country, not because their growth model is wrong, but because their development level is high. 

Monday, 17 December 2012

Explaining the US "fiscal cliff"

From the Economist comes a good video on what is the fiscal cliff all about:




The Wall Street Journal offered their own interactive feature called "Make your own deficit-reduction plan".

So I did. Feel free to check it out here. Please be aware that I was being politically careful when I was making this "plan". On the tax side I extended the Bush tax cuts for middle income families, and focused mostly on easing out tax deductions (here is where I agree with the Economist in pointing out to eliminate tax breaks rather than increasing the tax rates - recall an earlier text on taxes). I've also found this part interesting: "Tax greenhouse-gas emissions by setting up a program to force polluters to buy a permit for each ton of carbon dioxide emitted into the atmosphere". Sounds like a good Coase solution to an externalities problem, particularly if these permits could be bought and sold on the market. This, I feel, is one of the best possible solutions to combat pollution. And it'll reduce the deficit; win-win! 
All together, the tax revenue increases could generate around $600bn over then next 8 years (mostly through removing tax loopholes and the expiration of tax cuts on high income families - the two unavoidable solutions in the fiscal cliff negotiations). 

On the spending cuts, I focused mostly on reducing pay rises for federal employees and  some of the reductions already included in the fiscal cliff. Not the most popular of solutions but it would decrease the deficit by $169bn. Perhaps one can be more generous here, since according to Krugman, a stable or declining debt to GDP would be possible even with a $400bn deficit (meaning that we don't need to aim to balance the budget). 

But I went further, and made savings of $350bn in cuts to benefits and entitlements, without repealing Obamacare (a politically sensitive issue), at least not all of it - see here why. I focused mostly on raising the eligibility age for Social Spending and Medicare and how to change the way these are calculated so that they grow more slowly. Once again, this is a delicate issue and it has much wider implications than a deficit-reduction plan, or the fiscal cliff. It's a question of the US welfare state model all together, or the infamous 47 percent

In sum, I managed to balance the budget by 2020 - hey, I'm even better than Bowles and Simpson!

Friday, 14 December 2012

"The World's most important chart", courtesy of Goldman Sachs

In an interview for Business Insider, the chief economist of Goldman Sachs, Jan Hatzius, predicts an acceleration of US economic growth in the second quarter of 2013. Business Insider points out that Mr Hatzius had the foresight to predict the housing boom in 2007 (so at least a year after Shiller, Roubini, Schiff and many others), and has a unique framework for analyzing the economy. After all, he is the top economist of Goldman Sachs which is by itself worth (some sort of) admiration. 

He stressed out the following chart depicting the relationship between private sector savings and government budget deficits (click to enlarge): 

Source: Goldman Sachs (2012) "The US Economy in 2013-2016: Moving
Over the Hump" via Business Insider
Here's the logic behind it: 
"The chart demonstrates a critical economic concept: Government deficits (the grey line) are essentially the mirror image of private sector savings (the dark black line). When the private sector tries to save money aggressively (as happened during the crisis) the government deficit will inevitably explode (as happened). Periods associated with small government deficits (such as the late '90s) are associated with extreme private sector leveraging. 
The key to understanding the economy, and forecasting growth, is to think about which sectors are increasing and decreasing their savings."
Basically, Hatzius predicts savings of the private sector to decrease and hence add up to around 1.5 percentage points to real GDP growth in the next year. Residential investments and housing are supposed to be the forefronts of this impulse. 

This actually might prove to be true, since the indicator of new building permits seems to be recovering (as opposed to its previous value in February or July): 

Source: FRED
As I've pointed out earlier in the aforementioned months this indicator of economic activity is a good leading indicator (included in the LEI) that can offer precise insight on the point of recovery of the construction and housing market. 

Even residential and non-residential investments are showing slightly better results than in the previous three years: 



All this could point out to a gradual and 'careful' recovery of the housing market and the construction industry and could justify the confidence of Goldman Sachs's economists on the start of a strong recovery, at least in those two sectors which are supposed to be the drivers of GDP growth next year. 

However all of this is subject to not having the US "fall off the fiscal cliff" and not having the politicians in Washington trigger another global downturn (as it almost happened after August 2011). 

Going back to the balance sheets, Mr Hatzius has this to say: 
"Basically, in order to have above-trend growth – a cyclically strong economy – you need to have some sector that wants to reduce its financial surplus or run a larger deficit in order to provide that sort of cyclical boost, most of the time." 
So basically, reducing a financial surplus (households pushing savings) or running large deficits (governments or households financing consumption) will result in a temporary (or a decade-long) boom on the market. This can coincide well with Bernanke's famous global savings glut story where financial surpluses from Asian households and governments were translated into investments and consumption in the West. The analogous story can be told in Europe, and the 'interaction' between the savings in the "core" and the deficits in the "periphery". 

Read the whole interview, it's very interesting. 

Tuesday, 11 December 2012

Graph of the week: Where's the money?

The Wall Street Journal brings the following story:
"$8.4 trillion: The amount of debt owed by U.S. corporations at the end of September. 
When policymakers at the Federal Reserve meet next week, one of their main agenda items will be assessing the effectiveness of their latest bond-buying program, known as “quantitative easing” or QE. A key goal of the program is to stimulate the economy by driving down interest rates, making it cheaper for companies and individuals to borrow. More borrowing, the Fed hopes, will lead to more spending, more investing and, crucially, more hiring."
Source: WSJ Real Time Economics blog
One should ask himself, with all this debt pilling up, where is the money ending up? The logical explanation is to pay off former debt thereby paying off the creditors (have in mind that the graph shows nonfinancial corporate debt). Is this how the deleveraging process is supposed to work? Piling up more debt to pay off the former debt? According to this the only true deleveraging took place immediately during the crisis. Everything afterwards, in total, was an increase of corporate debt.

A graph I've shown earlier in October depicts the deleveraging of the US government, household, financial and corporate nonfinancial sectors, and it seems that only the final category (corporate nonfinancials) is not deleveraging at all. The WSJ graph above confirms this troublesome trend. 

This means that Reinhart and Rogoff were right in pointing out that the deleveraging process currently under way has been very sluggish, which is what they recognize as the main obstacle to a faster recovery.

Going back to the initial point made by the WSJ blog, what does this tell us about the effectiveness of Fed's bond buying program? It tells us that large scale bond buying (QE) doesn't seem to show (the expected) positive effects. More borrowing isn't being translated into more investments or more hiring (at least not to the expected extent). Neither are real wages increasing, while business activity experienced a decrease for the first time since 2009 (2.2% in the thrid quarter).

The only place where money could end up is in reserves. Cash reserves to be more specific. A total of $1.74 trillion. So just like banks and their overnight deposits (among other types of reserves), private sector corporations are also pilling up cash (cash hoarding). The reason is simple - uncertainty. The type of uncertainty that cannot and will not be solved by short-run policy measures aiming to affect medium run expectations on easy policy. Throwing more cash at cash-hoarding companies and banks won't incentivise them to spend it. The incentives must come from another angle

Monday, 10 December 2012

CPS: "Technology - a friend or foe"

A new text of mine gets published at the Centre for Policy Studies blog, entitled "Technology - a friend or foe". For all my CPS writings see here.

The text is about the joint effect of the third industrial revolution and the recent crisis on the restructuring of the labour market in the West. It's premise is that companies failed to adjust to the pre-crisis technological changes due to a range of (mostly political) constraints and other market rigidities. After the onset of the crisis abrupt restructuring of the labour market took place. The crisis was a trigger point for the companies to apply the necessary adjustments. This theory is similar to the logical conclusions of the PSST theory devised by Arnold Kling, and referred to in a previous text on the fiscal stimulus. 

Here's an excerpt, but you can read the whole text here:
"...The so-called third industrial revolution, or the IT revolution, manifested during the last 20 years. However during the pre-crisis decade it supposedly had a negative impact on the jobs market through the digitalisation of jobs and their outsourcing to Asia. 
We may interpret the outsourcing of jobs to Asia as one potential indirect effect, but it is more likely that this shift of jobs was due to globalisation, new supply chains, and the law of comparative advantage. Some countries specialise in manufacturing and labour-intense technologies, while others, where this is too expensive to support, switch to services. This is a natural transition in which the emerging economies are becoming leading manufacturers, while leading nations such as the US and the UK are switching to financial services, IT industry, higher education and science. 
In the pre-crisis decade due to the outsourcing effect and the digitalisation of jobs, many workers in manufacturing industries in the West became redundant, but there were no consequential job losses due to ongoing market rigidities, political protection of certain industries and the non-responsiveness of companies. Western companies simply failed to adjust their demand for labour. The crisis resulted in increasing costs and declining revenues forcing companies to rationalise their existing labour stock through many lay-offs. It became too costly to keep all the excess workers employed. The inadequate adjustment of companies to the technological changes in pre-crisis times is one of the reasons behind a slow labour market recovery today. The lost jobs won’t be coming back, and those who lost them are forced to re-specialise or face long-term unemployment. A transition and restructuring of the labour market demand usually lasts up to a couple of decades, but in the midst of the recent crisis it developed rather quickly."
I would add here that even though a new trend of insourcing is currently under way, where certain US companies are bringing 'jobs back home' as a reaction to increasing transportation costs and wages in China, this effect still isn't fully visible or measurable. This also means that outsourcing wasn't caused by the technology shock, but by the law of competitive advantage (among other things). The technology shock had a different impact on the labour market. 
"The visible impact of technology 
Holding back the adjustment to the current technological change will make it even harder to adapt to the rapidly forthcoming technological shock. The internet is already revolutionizing education (see Marginal Revolution University) and making it more affordable, and 3D printing has the potential to completely revolutionize manufacturing to the point where we won’t need factories any more. This is a clear signal to all those currently employed in manufacturing to enhance their skills and re-specialize (a recent New York Times article described the necessary re-specialization of factory workers into a “hybrid of an old-school machinist and a computer programmer”). Also this is a clear signal to developing nations that their manufacturing advantage won’t last as long as they hope, and that they too should examine the possibilities to use the currently gained income to invest into education and skills. 
Other changes will improve our lifestyles. The use of biotechnology and nanotechnology could change the entire health industry. There is a big technological impact on agriculture and aqua plants which will increase the food supply, thereby (potentially) reducing the protection to old-style farmers. Energy is ready for its biggest shift yet, with shale gas and a plethora of other alternatives significantly decreasing energy costs.
Even in economic policy decision-making the use of technology can be of much help. The Economist demonstrated using a Google search engine to count words like “job” or “benefits” which are closely correlated to the unemployment rate (see graph), can develop indexes which offer a more realistic and up-to-date picture on the real economy than we can get from measures like the unemployment rate or GDP, making it easier for policymakers to react more quickly." 
More good examples here are the adjustment of US newspapers in terms of online subscriptions, or the historical restructuring of industries and jobs in London and the UK in the 1980s and 1990s. 

The text ends with a paragraph on the resistance to change
"Changes in technology naturally result in strong resistance since it’s hard to convince workers that their jobs are inefficient, obsolete and unnecessary; at least for the price they are prepared to offer. This is why the creative destruction is necessary to enable a faster shift from inefficient to efficient jobs (i.e. enable a faster trial and error process) and which won’t be constrained by political interference. Politics is always in a way an impediment to technological progress, since new technologies deliver changes in social patterns. For short-termist, office-oriented politicians, these types of changes are a natural enemy and they will do anything to prevent them and prove to the people that they do care about preserving old jobs.  
The restructuring on the labour market was necessary since it allowed the market to discover new production techniques. And despite the fact that a technological shift will always result in changing the structure of jobs in the economy and lead to the abolition of old jobs, the focus should be on new types of jobs being created as a result, and whether or not this is done without any external interference."

Friday, 7 December 2012

Igniting the recovery? Fiscal policy and aggregate demand

From David Beckworth comes the following graph on the effect of fiscal policy (fiscal contraction) in the crisis and its effect on aggregate demand:

Source: David Beckworth's blog: Macro and Other Market Musings
HT: Tyler Cowen
Here's what he concludes:
"This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010. Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures."
It seems to me that even before the crisis there hasn't been a clear correlation between the two variables. Based on this graph (and on the other one he shows in his text) it's far from concluding anything on the effects of counter-cyclical fiscal policy or its low multiplier. And this was the center-point behind Beckworth's argument that fiscal policy is ineffective in igniting the recovery. As the regular readers of the blog will know, I agree with the point that fiscal policy is ineffective, but this graph is far from proving that point. 

Observing only the given series of federal government expenditures relative to NGDP (blue line), their decline since 2010 can be attributed to the restoration to its pre-crisis levels. We can see a strong peak in 2009 following the Obama stimulus (rising from another high point after the Bush bailout), so everything afterwards is simply restoring the pace and size of government spending to its previous levels. This is why a fiscal consolidation is necessary. Fiscal stimulus responses to the crisis shock in 2007-2009 in both the US and particularly in Europe are the reason behind the unsustainability of public finances in many of these countries (particularly Ireland and Spain which didn't have problems with debts and deficits before the crisis). In order to resolve these unsustainable issues arising primarily because of a faulty welfare state model (which still isn't being reformed), structural reforms are necessary.

Generally, the graph above is an argument that fiscal policy was ineffective from 2010 onward so the US should engage in a monetary stimulus, presumably target its NGDP growth rate at 5% (a full percentage point above its current growth rate, by building up inflation, thereby increasing the value of currently produced goods and services simply by increasing their price). Once again I fail to see how this strategy will do any good for the US recovery. 

Noah Smith makes a good point on that perspective in his critique to Beckworth's arguments:
"Also, note that if fiscal policy is effective (i.e. if the multiplier is high), then aggregate demand will depend not just on current deficits but on expectations of the response of deficits to future external AD shocks. This is a central tenet of the "market monetarism" that Beckworth espouses, but there's no reason that forward-looking expectations can't be applied to fiscal policy as well as monetary policy."
And this is exactly why I don't align with market monetarism arguments. There is no reason that forward-looking expectations of a favourable fiscal policy won't result in a similar effect as expectations over accommodative monetary policy. If you believe that one policy response is effective because of forward-looking expectations than there is no reason not to believe that the other policy won't work. I, for one, don't believe that forward-looking expectations of any of the two policy alternatives will be effective in increasing current confidence. The overview of business and consumer confidence (particularly following monetary stimuli) as well as the policy uncertainty in the economy suggests otherwise.

Wednesday, 5 December 2012

Minimum wages: the ultimate effect

Note: This article was written for and published on the Adam Smith Institute blog, entitled "Minimum Wages: examining the research". For all my other ASI writings see here.

The Economist's Free Exchange column analyzed some of the existing research on this controversial topic. They point out to a number of results that claim how moderate minimum wages do more harm than good for the economy, and can, in fact, have a net positive impact on total employment. 

The argument from the left of the political and economic spectrum usually claims that employers tend to sometimes act as monopsonists and can set wages below a competitive rate. In addition minimum wages are supposed to solve the problem of wage inequality and increase the disposable income of lower paid workers. The Economist calls upon the results on two "noted labour economists", David Card and Alan Krueger, who accounted an increase of employment in New Jersey's fast-food restaurants to its newly legislated minimum wage. They used a DD (differences-in-differences) approach comparing total employment in February 1992 and in November 1992, so in two different points in time between which the (supposedly) only difference is the introduction of the minimum wage (in April 1992). 

However, it is easy to dispute this type of research by referring to the omitted variable bias where the net employment effect was most likely affected by a factor that has nothing to do with the minimum wage law. Perhaps it was the general economic climate in the state during the observed period, or within-state differences that can explain the effect of employment increases at the given time in New Jersey. It's very hard and demanding to conclude of a causal relationship between a minimum wage law and employment, at least without taking into consideration a series of control measures. In addition there is a whole bunch of papers that can overrule the argument empirically and give it a completely different direction. This happens too often in the economics profession. 

Something that empiricists often omit is the general effect a minimum wage could produce. Here’s a good point from a book by Jason Brennan: "Libertarianism, what everyone needs to know"
"If Wal-Mart started to pay high wages, Wal-Mart jobs would become attractive to skilled workers. People who currently work as medical assistants or car mechanics would want Wal-Mart jobs. Since they are more productive and have more skills - since their labor is worth more - they will outcompete the kind of people who currently work at Wal-Mart. So, raising wages above market levels is unlikely to help unskilled workers. Instead, it causes job gentrification. (Imagine if Wal-Mart offered to pay its workers $100/hr. Then many of my colleagues would consider becoming Wal-Mart cashiers). "

This I fear is the problem. Even if an increase of the minimum wage could have a positive net effect on employment, as some research seems to show, the problem is re-specialization of people with higher skills for currently low-paying and low-skilled jobs. 

It's interesting that the research by Card and Krueger (1993) actually did look at fast food restaurants. Increasing the minimum wage made this easily accessible job more attractive than the alternative of investing into gaining more skills or finding another, more demanding job. 

The result is a reshuffling of the labour market towards certain types of jobs, rendering some higher paying jobs a lack of skilful employees, while the net effect for lower-skilled workers is negative. It would be interesting to observe the total effect on all industries during the observed periods, not just on one, favourable industry, to prove the employment effect of minimum wages.

Source; The Economist
In Britian, there are similar results to be found: 
"Britain’s experience offers another set of insights. The country’s national minimum wage was introduced at 46% of the median wage, slightly higher than America’s. A lower floor applied to young people. Both are adjusted annually on the advice of the Low Pay Commission. Before the law took effect, worries about potential damage to employment were widespread. Yet today the consensus is that Britain’s minimum wage has done little or no harm." 
It is very difficult to conclude this based on the available evidence. Since the introduction of the minimum wage in 1999 Britain's economy experienced a boom decade which saw an upsurge of productivity and declining unemployment, but also an increase in labour costs and real wages. It is very hard to conclude that the minimum wage was a cause of all this. One can easily conclude that the labour market conditions improved despite the introduction of the minimum wage, not because of it. 

As for the effect on increasing the relative wage for the bottom 5% thus lowering wage inequality, it would have been arguably much better for both the employers and the employees to increase the personal allowance which would have lowered the tax burden for the employers and leave the employees with more disposable income. 

It would require a careful empirical analysis to prove this, but I suggest that an increase of personal allowance would have had a similar if not better effect on lowering inequality in Britain, than what the minimum wage floor did. For simplicity, compare the current net minimum wage in Britain with a personal allowance of £12,875 p/y which the Adam Smith Institute has proposed on several occasions, and calculate whether or not low paid workers would benefit from it. This doesn't necessarily imply that every employer would pay his employees the upper limit of the personal allowance, but it would open up the market for lower-skilled workers much wider than it was with the minimum wage, contributing to the liberalization of the labour market, and better occupational heterogeneity.