Monday, 30 December 2013

Prognosis: Negative - or How close were my predictions for 2013?

Last year, a few days before the year ended I embarked in a bold quest of making predictions on economic and political outcomes in the year to come, facing the risk of making a fool of myself by completely misfiring. Luckily, I was actually rather close in most of the predictions made.

Before I start evaluating my performance, I would just like to make a quick digression on the precision of forecasting. Why do we make predictions? Because we're facing an uncertain future. Our decisions today depend on the expectations of what the future will bring and how our decisions will be affected by it. 

So how can we be sure that a forecast will actually turn out to be correct? We cannot. We can evaluate someone's past performance in predicting things like real economic variables or political outcomes and based on this alone determine how good he or she is in making a correct prediction. But in general we can never be certain. I read somewhere of an experiment done back in the 80-ies involving around 300 experts (economists, analysts, political scientists, notable journalists) and comparing their forecasting performance. What they've found out is that the average expert did only slightly better than a random guess. However, a new forecasting project, involving an even bigger pool of experts found better results where the top experts significantly outperformed the mean predictions. 

With this in mind I will evaluate my forecasting performance.  Overall, I did ok. Economic growth was slow in Europe as predicted (surprise, surprise), slightly better in the US, and declining in China and India. However I was a bit more pessimistic for some countries and too optimistic for others (I'll go through each individually). 

I couldn't possibly foresee the vast anti-government protests that hit most of the developing world during the summer. I covered the protests in a blog post, supporting their plea for a better democracy and more political and economic inclusiveness. 
Yes, it's a Seinfeld reference
Germany - spot on; slow growth coupled with Merkel's persuasive electoral victory, with possibly a new coalition. I didn't state that it would necessarily be another grand coalition with SPD, but after some twelve weeks of negotiations they finally did reach an agreement. Merkel's third primeministership was never doubted for a second. 

France - I was waaay too careful on this one. France is descending faster than anticipated, with unemployment rising (close to 11%) and growth being so slow that the country is persistently on the verge of a double-dip recession (if it already isn't in one - by today's standards, who can honestly tell?). This is all due to Hollande's ridiculously high taxes, no significant reforms, and a series of policy mistakes and U-turns. His approval ratings keep hitting new lows - currently down to only 15%!  

Italy - Even though I correctly anticipated Bersani winning the elections, he himself did not become the Prime Minister after failing to strike a deal with the unanticipated wild card, Italian comedian Beppe Grillo and his anti-establishment Five Star Movement. Instead, because of a strange political gridlock (rather common for Italy actually), Italy's President Napolitano in April gave the mandate for forming the government to Enrico Letta, creating Italy's first grand coalition, where he received support from his own center-left party, Berlusconi's center-right party and Monti's centrist party. The political battles didn't stop there as in September Berlusconi pulled his party members out of government. In the mean time Berlusconi was evicted from Parliament on tax evasion charges. I was much more pessimistic in my predictions for Italy immediately after the electoral results (I revised my forecasts), however they've somehow managed to restore stability with the Letta government.

I was right that the new government will continue with Monti's reforms, with Letta being impressive on that front. On that behalf I expected Italy to achieve some positive economic growth by the end of this year. This unfortunately didn't happen. The economy stopped contracting, but it is still in dire straits. At least the borrowing costs have decreased and the debt picture looks slightly better.

UK - I was right about the UK pulling itself out of a (triple-dip?) recession, as Q3 growth is now standing at 0.8%. My prediction was a yearly growth rate of 0.5%. It may well end up above this target. However, a lot still needs to be done in Britain, despite the welcoming signs of somewhat positive growth. The nomination of Mark Carney to the BoE also proved to be encouraging for Britain.

The rest of Europe did poorly as usual, unfortunately. Spain, Portugal and Greece were all still contracting, joined by Cyprus, Slovenia, Czech Republic, Finland and even the Netherlands. The Eurozone in total is still in a double-dip, as predicted.

I was also correct in estimating that the biggest growth in Europe will belong to one of the Baltics (it was Latvia with 4.5%), while the largest negative growth will be either Greece or Portugal (it's still inconclusive, but these two are leading the pot).  Also, Croatia entered the EU in July. 

Source: Trading Economics.

USA - I was carefully optimistic regarding the fiscal cliff being resolved in January, but couldn't foresee the government shutdown in October. I was wrong in the predicted 2% growth rate, when it was actually stronger than that (around 3%). Still a lot of problems await to be resolved in the US, so I'm sticking to the same warnings for next year (this will be covered in my next post).

Japan - Abe's policies are proving to be much more effective than I've predicted. Growth for this year is close to 2%, whilst I predicted another slow year of 1% growth with rising pubic debt. I intend to cover Abenomics in a separate post pointing out to Japan's unresolved structural problems, but in the short run, Abe has surprised me, I must admit. 

BRICs - I was correct on China's and India's slowdowns, only slightly missing their forecasts (8.5% vs. the actual 7.8% for China, and 6% vs the actual 3% for India) and was also slightly over for Russia (4% vs the actual 3.4%). Where I failed completely was Brazil, predicting strong 4 to 5% growth, while the economy is stagnating at 0.9%. You can't win 'em all!

In the Arab world, I actually did expect more political turmoil in Egypt (not the coup however, but instabilities yes). In Syria I expected the Libya scenario where Assad would be ousted by the end of the year. Needless to say, I underestimated him as well as the political protection he currently holds. 

Overall, with some good hits and some hard misses, I believe I did quite well, so I'll do the same thing for next year.

In the mean time have a Happy New 2014!

Thursday, 26 December 2013

Graph(s) of the week: The year in review

The Economist ends the year with a series of eye-catching charts characterizing the state of last year's recovery. 

We are all still aware of the recovery being a slow and painful one (in some places more than in others), but what's even more interesting is that some of the negative effects of a poor response to the aftermath of the crisis are already being visible. 

For example, in the private sector stock indices are booming, but corporate debt issuance is higher than ever, as the companies are taking advantage of the historically low interest rates and using this mainly to refinance their debts (see graphs below). Interestingly enough, the stock market indices are far above their pre-crisis peaks. Many like to point out that this is a signal of another potential bubble rising on the stock market, but I would beg to differ. 

Source: The Economist
The Dow is higher than its 2007 pre-crisis peak, but so is the US GDP (see below). Does this mean the US has by now completely recovered from the financial crisis? Not really. It is simply following a new trajectory, a new trendline, or to be completely precise, it is on a new (lower) potential output path. The stock market is noting but a reflection of this. That's why I wouldn't call it a bubble. 

Source: FRED
The same thing, however, can't be said for the potential monetary policy bubble. Low interest rates combined with massive QE are still mainly reflecting on the banks' balance sheets and are not entering the private sector as fast as the policymakers are hoping for. However, the question is what will happen when all this money does enter the real economy? If we continue down the path of a "lost decade" then the answer is probably nothing. At least in the short run. 
US monetary base. Source: FRED

On the other hand the losers seem to be the SMEs where loans (as % of GDP) are still falling:

Too bad the policymakers aren't making it any easier for them to rebound.

On the other hand fiscal policy has had partial success - depending on how we define the goals of fiscal policy. The austerity package has at least succeed in curbing the budget deficits: 

But the wrong way of conducting austerity (via mostly tax hikes without reforming the spending side) means that unemployment is still a huge issue for the developing economies: 

Maybe Richard Koo is right, maybe this is a typical "balance sheet recession". It certainly has all the symptoms. That would mean that by continuing with the current type of policy responses we really are in for a lost decade of the Japanese type. Or maybe even a few. Just look at the UK

Sunday, 22 December 2013

Economic history: mercantilism and international trade

All too often during poor economic times many debunked economic fallacies of the past get reinvented. The reason is simple: a search for ideas and solutions alternative to the "mainstream" (however we define it) allows those who succumb to these fallacies to repeat the ancient errors classical economics was hoping to get rid of. The short-termism of politics plays a crucial role in the process of persistent perpetuation of such fallacies. This is why in times like these it is essential to go back in economic history and debunk some of the ideas that tend to surface repeatedly. In the following couple of posts, I attempt to do just that. 

Misunderstanding trade 

One of the most misunderstood areas of economics is international trade. More precisely, the idea that if we were to boost net exports - by subsidizing exports and constraining imports - we can achieve higher GDP growth. If one looks at the simple arithmetic of a standard Keynesian macro model: Y=C+I+G+NX, then it's pretty obvious - boosting net exports will indeed result in higher Y (output). However, the question is how does one properly boost exports? 

Higher exports come as a consequence of higher domestic production. The direction of causality is pretty clear in this case. We first need higher demand and stronger productive activities (usually encouraged by a set of supply-side reforms), and we need to operate in a competitive market economy which will generate economic winners who will be able to compete with their products globally. The crucial point is for the market, not the government, to generate winners. So boosting exports is a process that starts with a stronger productive base and rests upon domestic competition. When a politician says "we need to double our exports" what he should be thinking is that we need more competition and a more favourable business environment to boost domestic production. However, what he actually means is: "we'll flush money down to the exporters, heavily subsidizing them until they fulfill this goal". But they never do. 

To understand why, let's first take a trip back in time. 


This fallacy isn't new. It is actually one of the most denounced schools of economic thought, and yet one of the most recurring ones (in one way or another). I'm referring to, of course, mercantilism:
At the heart of mercantilism is the view that maximising net exports is the best route to national prosperity. Boiled to its essence mercantilism is “bullionism”: the idea that the only true measure of a country’s wealth and success was the amount of gold that it had. If one country had more gold than another, it was necessarily better off. This idea had important consequences for economic policy. The best way of ensuring a country’s prosperity was to make few imports and many exports, thereby generating a net inflow of foreign exchange and maximising the country’s gold stocks.
It was the dominant economic doctrine for more than three centuries (16th - 18th), mostly associated with the colonization era. It was often dubbed economic nationalism where the efforts to boost exports were backed by a powerful state protecting domestic monopolies (such as the British East India Company). 

It was a way nation-states were competing with each other. The nation which had more gold (=wealth) could raise a stronger army, and thus be more powerful. The role of colonies was crucial in this power struggle, as they were the source of precious metals and raw materials, and on the other hand the recipients of exported goods.

Mercantilism was characterized by a triangular trade system, where European countries were exporting manufacturing goods and textiles to Africa and America, America was sending raw materials to Europe, while Africa was "sending" slaves to America (see map below). It is in fact upon this system that many see the origins of the Great Divergence. However, as denounced in the previous post, the Great Divergence started after the Industrial Revolution and its causes were completely different and much more complex to be resorted to pure colonialism. After all, during the period of mercantilist dominance, the living standards of the population were still miserable, not much better than during the hunter-gatherer times

Why did mercantilism fail? 

A big part of the mercantilist doctrine was protectionism. More precisely protectionism of business interests against any forms of competition. Governments applied many forms of different protectionist policies, from guild rules and taxes, tariffs and quotas, prohibitions of imports to big state-run monopolies. It provided capital to exporting industries and even prohibited exports of tools (technology) and skilled labour that would allow foreigners to produce the same goods the home country is producing. In shipping for example the rules were even more absurd, where according to the famous British Navigation Act of 1651 all imports to England had to be carried on an English ship, while colonial exports to Europe had to first land to an English port before going further.

The collapse of the doctrine itself can be attributed to Adam Smith's classic "The Wealth of Nations" in 1776. Smith's argument was that the wealth of a nation consisted not in the amount of gold or silver stashed in its treasuries, but in the productivity of its workforce. He clearly showed that trade can be mutually beneficial, an argument also made later by Ricardo and his law of comparative advantage which states that countries specialize in the production of those goods which they can produce relatively more efficiently than any other country. Smith's second crucial point was that specialization in production creates economies of scale which affects both efficiency and growth. Specialization was the key reasoning behind the Industrial Revolution itself. Smith also argued against the harmful relationship between government and big industry. With policies such as these the only beneficiaries were the ruling elites and the big merchants. As a direct consequence inequality was extreme, which is why the living standards of the general population were terrible. Gradually, as the Industrial Revolution was looming based on the principles of laissez-faire economics, the mercantilist doctrine was slowly becoming obsolete. It took a lot of time before the benefits of the Revolution reached the general population, but this was the only shot societies had to achieve prosperity. Mercantilism was never the answer. 

Protectionism vs free trade

The protectionist argument opposing free trade, both today and during mercanitlist times, rests on the assumption of protecting domestic jobs. This is completely wrong. In the long run, in today's globalized world no one can protect the declining industries from going under. Giving them protection and thus disabling them from adapting to the new market conditions only makes it even worse for them in the end. This is why government-protected companies never succeed in being globally competitive. They become overly dependent on government protection knowing there is a safety net below them, meaning that they never achieve their full market potential. Which is a shame. 

Suggested reading lists

For those more interested in mercantilism itself, the Economist has produced an interesting and helpful reading list summarizing some of the classics along with some simple yet thorough explanations:
  • Foucault, M., Senellart, M., & Ewald, F. (Eds.). (2009). Security, Territory, Population: Lectures at the College de France 1977--1978. Macmillan. [The chapter on scarcity demonstrates Foucault’s conventional (and, this blog would argue, incorrect) understanding of mercantilism in comparison to classical economics]
  • Keynes, J.M. (1936) ‘Notes on mercantilism’ in The General Theory of Employment, Interest and Money. Available here. [Readable introduction to the link between mercantilism and Keynesianism] 
  • Magnusson, L. (2002). Mercantilism: the shaping of an economic language. Routledge.[The introduction is a very good primer for someone new to this subject] 
  • Phillipson, N. (2010). Adam Smith: An Enlightened Life. Penguin. [Excellent examination of Smith’s life and times]
  • Smith, A. (1776) ‘Of Restraints upon the Importation from foreign Countries of such Goods as can be produced at Home’ An Inquiry Into the Nature and Causes of the Wealth of Nations, [Book IV, part ii, chapter II]. Available here. [Smith’s discussion of the Navigation Acts].
To this list I would add:
  • Braudel, F. (1983) Civilization and Capitalism, 15th-18th century: The Wheels of Commerce (vol.2) Harper & Row.
  • Ekelund, R. B., and Hébert, R.F. (1997) A History of of Economic Theory and Method. Waveland Press. Chapter 3
  • Schumpeter, J. (1954) History of Economic Analysis. Oxford University Press. Chapter 7. 
  • Econlib: Mercantilism

Saturday, 14 December 2013

Economic history: Factors behind the Great Divergence

All too often during poor economic times many debunked economic fallacies of the past get reinvented. The reason is simple: a search for ideas and solutions alternative to the "mainstream" (however we define it) allows those who succumb to these fallacies to repeat the ancient errors classical economics was hoping to get rid of. The short-termism of politics plays a crucial role in the process of persistent perpetuation of such fallacies. This is why in times like these it is essential to go back in economic history and debunk some of the ideas that tend to surface repeatedly. In the following couple of posts, I attempt to do just that. 

My previous post on the benefits of the Industrial Revolution briefly touched upon the issue of the so-called Great Divergence. The Great Divergence isn't a fallacy, it is a fact, but understanding the reasons as to why it emerged is often subject to false interpretation.

As I've pointed out previously, after the Industrial Revolution and the rapid development of the West (both economic and political), many countries outside Europe resisted this change and as a consequence were left lagging behind shackled by the Malthusian trap.

Source: The Economist

These countries (the Ottoman Empire, Russian Empire, Austro-Hungarian Empire, China etc.) weren't any less developed than England or the Netherlands, in fact if anything they were equal in wealth and power before the 1800s (for example it was China where gunpowder and the compass, two crucial ingredients during the colonization era, were invented). But understanding why the Revolution started in Britain, not anywhere else in world, is key to understanding the Great Divergence itself.

Culture, geography, colonization and exploitation?  

The causes of the Great Divergence are one of the most hotly debated topics in the field of economic development. The layman may recognize these debates through the ultimate question: "why are some nations rich and other are poor?" Many of these debates start with culture. Weber's famous Protestant ethic argument is the centerpiece of the idea of cultural supremacy of Europe over the rest of the world. It stresses the European values of hard work, frugality and diligence that made the Europeans more prone to success and prosperity than the rest of the world.

A direct opposition to this argument is the so-called dependency theory, the notion that resources flow from the poor countries ("periphery") to the rich countries ("core") enriching the core at the expense of the periphery*. The pillaging and plundering of colonized areas in the 15th, 16th and 17th century have brought in enormous wealth to the European colonizers (not only in terms of raw material and gold, but also labour), who were enriching themselves at the expense of the rest of the world. Many dependency theorists like to point out that Britain's accumulated wealth during the colonization period led to their rampant success during the 19th century. But why hasn't the same thing happened to Spain? Or the Austro-Hungarian Empire, or the Ottoman Empire, all of which built their empires on theft and larceny of conquered areas, only to see their empires fall by the end of the 19th and beginning of the 20th century? 

The mercantilism phase (my next topic) did result in higher accumulation of wealth and resources for the Europeans, but it doesn't explain why the Revolution originated in Britain and not, say, Spain which at the time was even richer than England having controlled more fruitful lands of South America and having imported more gold than England and France. After all, the mercantilist system failed since it was based on entirely false assumptions of international trade. The dependency story looks at the patterns of development only from one angle, preventing it to see the deeper factors responsible for failure of the poor nations and the success of the richer ones. 

A very different take on the whole story, albeit in line with the colonization argument, is Diamond's emphasis on environmental factors and geography. He argued that Europeans, when they colonized the new world, brought with them the diseases they became immune to, but to which the indigenous populations of the new world weren't, causing the Europeans to conquer them more easily. Diamond's environmental endowment argument also explains why growth started in Europe:
"Europe was uniquely endowed with domesticable plants and animals. Its population was also more immune to diseases. These factors led to higher productivity and, crucially, higher population density. The upshot? The development of institutions such as cities, bureaucracies and literate classes, which contributed to economic growth." (The Economist, August 2013)
Why England?

But again, why England? England is hardly endowed with resources such as France, Spain, Russia, Turkey or the Austro-Hungarian Empire. Netherlands even less. And yet, it is precisely England where the Revolution started, and from which the Divergence emerged. The theory I subscribe to is the one presented last time, given by Acemoglu and Robinson (A&R):
"They explain in particularly detail why the Industrial Revolution started in England, not anywhere else in the world. It developed on the trails of the Glorious Revolution, where the demand for more property rights and a greater political voice set the stage for sustained growth and prosperity. The rising wealth of the merchants and manufacturers overcame the opposition from the elites and the sovereign, thus initiating the beginning of a new historical era. It was the broad coalition of the (albeit richer) people that succeeded in initiating progress. Acemoglu and Robinson call this irreversible political change that ensured constant institutional adaptation and the final switch towards greater political and economic inclusinvess."
Countries that failed to follow the same path of political inclusivness failed to achieve this dynamic progress. A&R cite the specific examples whose their ruling elites prevented development, fearing that they may lose power. All the aforementioned countries such as the Ottoman Empire, Austro-Hungary, Russia or Spain had rulers who strongly opposed and prevented any signs of innovation and progress. The same was actually true for Britain as well, where queen Elizabeth I also prevented progress by shutting down innovations such as the knitting machine. Both she and her successor feared the potential destabilization such an innovation would cause for jobs in the textile industry. But they and their further successors couldn't hold progress for long, and it was shortly after the Glorious Revolution and Cromwell's brief dictatorship (after which they executed the sovereign Charles I), that William III of Orange took over (after Charles II and James II) and gave more power to the Parliament. After that point there was no coming back. England was changed politically, and economic progress was under way. 

The point is that it first took political change to curb the power of the sovereign to foster innovation and technological progress. A society trapped by a dictator or a sovereign cannot be innovative and will always be condemned to stagnation.

Failure to adapt 

The Great Divergence was an event many see responsible for the huge inter-country inequality we have today. But this simply isn't true. Yes, after the Industrial Revolution many Western countries rose to prominence rather quickly, leaving most other countries behind. But they didn't grow on the expense of the poorer nations, the gap increased because the poorer nations failed to adapt. 

Looking at this from today's perspective, many nations fail today because they fail(ed) to adapt to the new economic environment being triggered by the Third Industrial Revolution. I've divided a great amount of attention to this topic on the blog; how technological changes or more precisely the failure to adapt to these changes led to a relative impoverishment of nations. All the once richer countries, particularly in the West, who got trapped in political dependency, got stuck in a welfare dependent society, and are now facing serious problems in reigniting their growth. In order to do so they need a complete revision of their growth model and they need to learn upon the lessons from history and adapt to the technological change. 

* A brief digression: The Eurozone sovereign debt crisis, according to some, follows on the trails of dependency theory, where the countries of the Euro periphery (Italy, Spain, Portugal, Greece, Ireland) blame the core countries (Germany, France, Netherlands, etc.) for benefiting at their expense. However, remember that capital was flowing from the core to the periphery, not vice versa. The large CA deficits experienced in the periphery after the introduction of the euro were misused by the periphery as the money ended up in consumption not investment. This is why their debt (both public and private) is a huge burden - you have troubles paying it off when you just used it for consumption. 

Tuesday, 10 December 2013

The great rise in living standards

If one were to ask a question "What was the greatest achievement of mankind?" what would the logical answer be? The invention of electricity (light bulb)? The internal combustion engine? Penicillin? The internet? Airplanes and cars? The development of the scientific method? Improved methods in agriculture? Or would we say something ancient such as the wheel or learning to control fire? Or the printing press?

All of these are certainly groundbreaking achievements, but if I had to chose I would go for the one thing that links most of these together = the Industrial Revolution.

All the enormous wealth we enjoy today, all the things mentioned above (apart from the wheel, the press and fire) could not have been possible without the onset and the long shadow of the Industrial Revolution. During the relatively short period from 1800s until today, we created a wider variety of goods than ever before, and consequently have achieved tremendous increases in wealth, prosperity, and health; or altogether, tremendous increases in living standards. 
Source: Gregory Clark (2007) A Farewell to Alms: A Brief Economic History
of the World
. Princeton University Press
As can be seen in the figure above, taken from Clark's exciting book A Farewell to Alms (read the intro chapter here), the development of the world economy and by that the human society is characterized by two distinct phases: the pre-Industrial Revolution times, from the dawn of man to the 1800s, also denoted as the Malthusian Trap, and the post-Industrial Revolution period, lasting from the 1800s to the modern age. 

Not until one understands the misery and poverty of the Malthusian Trap, can one truly appreciate the importance and magnitude of the Industrial Revolution. As Clark notices the living standards in the 17th and 18th century, even in the richest countries such as England or the Netherlands, weren't any better for the average person than in the Stone Age. In fact, he argues, at least the hunter-gatherer societies during the Stone Age were egalitarian, which can't be said for the 1700s, where the living standard of the poor majority was arguably lower than 2000 years ago. Not to mention that in the 18th century average life expectancy was around 35 years, the same as it was for the cavemen. 

And then in the midst of the 18th century came a series of events that triggered an unprecedented rise in living standards and wealth. The simple inventions of the First Industrial Revolution (1760-1850) such as the introduction of water- and steam-led machines only set the stage for more advanced inventions and technological progress that happened during the Second Industrial Revolution (1850-1910), from which we got the internal combustion engine and electricity. Innovation unraveled quite rapidly during that time, and has been unstoppable ever since. Just imagine, only 60 years after discovering how to fly (Wilbur brothers in 1903), we send the man to the moon (NASA, 1969). If you put this into perspective of the time lost during the 2000 years of Malthusian stagnation, this seems like only a brief moment in time. And yet so much progress has been achieved.

The Great Divergence 

However, simultaneously with the rapid increase of wealth in the Western world, countries whose rulers succeeded in avoiding the Industrial Revolution fearing change and loss of power were condemned to centuries of stagnation and a persistent Malthusian Trap, thus giving scope to the so called Great Divergence. The alternating paths of the world economies originating from the 1800s created the huge inter-country inequality, and have left the world divided ever since. Until around the last few decades, which saw a huge uplift of China and India (where China succeeded in pulling 600 million people out of poverty from the 1980s till today), and some Latin American economies. Many (too many) parts of the world remain impoverished, trapped in the same poor living standards that societies had 2000 years ago, still living the Malthusian scenario. 

Possibly the greatest contribution towards understanding this great division was done by Acemoglu and Robinson in their often mentioned book on this blog - Why Nations Fail. They explain in particularly detail why the Industrial Revolution started in England, not anywhere else in the world. It developed on the trails of the Glorious Revolution, where the demand for more property rights and a greater political voice set the stage for sustained growth and prosperity. The rising wealth of the merchants and manufacturers overcame the opposition from the elites and the sovereign, thus initiating the beginning of a new historical era. It was the broad coalition of the (albeit richer) people that succeeded in initiating progress. Acemoglu and Robinson call this irreversible political change that ensured constant institutional adaptation and the final switch towards greater political and economic inclusinvess. 

This pattern is not only obvious, but even characteristic of the post-Industrial Revolution period. The very beginning of the Revolution was infused with initially greater inequality and diminishing living standards for the poor. However, the political change for which the stage was set earlier implied that the fight for more political inclusiveness was not going to fade. This is why it was possible for the worker movements in the beginning of the 20th century to fight for more rights and be successful in carrying it out. Against a sovereign or a dictator, this would be impossible, which is something we witness even today. If it hadn't been for this rapid economic progress initiated 200 years ago, the relative abundance we take for granted today would have been impossible to achieve. As for the countries that are still trapped in poverty, the blame falls fully on the extractive elites preventing them from experiencing their own Industrial Revolution. Just like the one China experienced after Mao.  

Friday, 6 December 2013

A short guide for attracting foreign investments

Flying back home from my honeymoon, I had to catch a connecting flight in Istanbul where at the airport I noticed a very interesting billboard. Here's what it said: 

"Want to cut costs? Invest in Macedonia!

0% tax on retained earnings / competitive labour costs / access to 650 million customer base / foreign entities buy property freely / skilled workforce"

These are just some of the many benefits the "Invest in Macedonia" campaign is promoting. They offer a 10% personal and corporate income tax rate, an 18% VAT (lower than anywhere else in Europe with the exception of Luxembourg's 15%), and a series of low property, sales, and inheritance taxes declaring themselves the new business heaven in Europe. The 650 million customer outreach is based on trade agreements Macedonia has with the EU, CEFTA and EFTA plus two bilateral free trade agreements with Ukraine and Turkey. It has set up a One-Stop-Shop that enables registering a company for only 4 hours (realistically 1-2 days), thus tackling all sorts of administrative barriers for starting a business. 

The Doing Business Report has singled them out as the 4th biggest reformer in 2008, particularly in terms of starting a business, dealing with licences, and paying taxes. Five years later, they are still more than impressive in the individual categories of the Report: they are ranked 7th in the world for starting a business and an incredible 3rd in getting credit. They are showing persistent progress in dealing with construction permits, getting electricity, registering property, protecting investors and resolving insolvency. Overall they are ranked 25th in the 2014 Report (up from 36th in the 2013 Report) - ranked higher than Japan, Netherlands, Austria, Portugal, Chile, Israel, France, Belgium, Poland, etc.

Why does Macedonia need to offer a package such as this one to attract foreign investment? Simple; to gain competitiveness. 

As a small economy it's only chance to achieve economic progress is to be a very open economy with a highly competitive tax system. As a transitional economy it suffers from a relatively weak institutional environment, which is exactly where one needs to start reforming if you want to achieve growth. And Macedonia did just that. It improved its institutional efficiency and designed a set of policies and laws that attract capital. It attracted foreign companies with low tax rates (both corporate and income) and a cheep yet skilled workforce, and when they've caught their attention they made it very easy for an investor to purchase property and open a business. 

Countries with a relatively stronger and safer institutional environment can afford to set higher tax rates, have higher labour costs and put relatively more restrictions on buying property. The institutional and macroeconomic stability of these countries ensures that they don't need to compete with low tax rates, and that despite their administrative inefficiencies many entrepreneurs will still picture them as business heavens. 

As I've stated in my earlier post "Doing business" despite all the problems the UK business owners face and constantly complain about, the UK is still far more attractive for starting up companies than any other European country. This is all due to the relative strength of UK's domestic institutions and the fact that London is a financial center of the world. UK's institutional stability is the biggest pulling factor for investors. The same thing is true for USA or Japan which have the world's highest corporate tax rates (40% and 38%), but which still, despite this fact, attract investments and see a lot of new businesses open up every year. Scandinavian countries, well known for their high taxation and government spending, offer a prosperous wealth generating environment for investors. Their governments are among the most efficient ones in providing public goods and promoting a stable environment free of corruption and expropriation. In Scandinavia, size doesn't matter, it's all about efficiency. 

However countries with inefficient and large governments, with constraining bureaucratic procedures, corruption and rent-seeking interest groups must first tackle these issues in order to achieve international competitiveness. Basically, there are two equilibria - one for the rich (OECD) economies, who have already achieved institutional stability and inclusinvess and thus operate at a higher level of economic progress, and the second, lower equilibrium for the developing economies who need to grow quickly to catch up (converge) to the rich economies (higher equilibrium). In order to do so they need to adopt a set of policies similar to the one done by Macedonia which will free their business activity and gradually reform their institutional environment. 

Macedonia is just one positive example. There are nations even more impressive than Macedonia in terms of attracting capital - Georgia is ranked #1 in the world for registering property, #2 for dealing with construction permits, #3 in getting credit and #8 in starting a business. It's ranked 8th in the overall table (it's worst results are in getting electricity and resolving insolvency), which is higher than the United Kingdom and all the Scandinavian countries except for Denmark. And even bigger success is Malaysia (6th overall), while Mauritius is also impressive closing the top 20 group of countries

Countries that fail to take this approach will remain stuck in a lower equilibrium for a long time. 

Sunday, 24 November 2013

Blogging on pause

You might have noticed that blogging activity has been slow for the past two weeks. This was due to me getting married this weekend to my, by now wife Barbara. With the honeymoon ahead of us, blogging will be on pause for the upcoming two weeks. 

Monday, 11 November 2013

Video of the week: playing with stats

From TED talks comes this excellent presentation delivered by Hans Rosling, a professor of global health at Karolinska Institute (the institution that decides upon the Nobel prize in medicine). The focus of his talk is on disproving the myths about the developing world, which is, according to Rosling, actually quickly closing the gap with the rich countries and is moving forward the same direction (following the same pattern) of the Western world. They are now where the West was some 40-50 years ago. Basically he claims, and I agree, that we shouldn't generalize aid policies towards one area, since within this area there are huge within and across-country inequalities. The same policy on curing diseases cannot be applied towards the top income groups in South Africa and the low income groups in Nigeria (as he mentions in the video; or in this great slideshow: Africa is not a country!). There's many more good points being made, so I recommend the video: 

He has a few more videos on TED (this was the earliest one, from 2006), but the web page he mentions, Gapminder, is truly amusing and features a bunch of interesting statistics and graphics. 

For example, here is a lecture on the changes brought by the industrial revolution - the global development since 1800. Video is here. From an average income per person of less than $3000 and a life expectancy of around 40 years, and with all countries clustered pretty densely on the bottom left end (life expectancy on the upper axis, income p/c on the lower axis), over the course of 200 years you can witness a rapid change in development patterns of some world areas, while others - even though they were falling behind on this development scale - still saw an increase of income and health standards. The slide show is here - notice how the big leap in living standards for the poor countries starts somewhere around the 1950s, but their income growth didn't follow until the last decade or so. 

Of course, observing and playing with stats is not everything. Econometricians will often say 'correlation does not imply causality', and they're right. However interesting correlations found in a variety of useful data can give pretty good hints on what to start your research on. Sometimes you hopefully get something out of it. 

Thursday, 7 November 2013

Creative destruction reversed

Bryan Caplan found a disturbing graph from Edmund Phelps's new book "Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge and Change":

Source: Brian Caplan, taken from Phelps: Mass Flourishing 
Caplan infers:
"At first glance, this confirms a quarter-century of steadily declining creative destruction - falling job creation and job destruction. On closer look, though, there was little trend until the small recession of the early 2000s. Since then, however, creative destruction has relentlessly fallen.

Striking fact: The rate of job destruction during the Great Recession used to be perfectly normal! We experienced it as a calamity because job creation not only kept falling, but dipped below expectations."
He's right, the trend is obvious only in the pre-crisis decade. One could easily link this pre-crisis decline in job creation to the outsourcing trend or even to the role of technological progress. I've covered this topic extensively; it implies that the necessary restructuring in the labour markets was prevented as many companies didn't see fit to lay off workers as an reaction/response to the ongoing technological shock, however, once the crisis had started the layoffs were inevitable. Their inaction prevented the process of restructuring and re-specialization into new skills. 

This implies that the rate of job destruction prior to the 2007-09 crisis should have been higher, so that the rate of job creation would have been higher as well, since they basically follow a very similar pattern. A plausible, even testable assumption. I might look into it. 

Btw, notice one more interesting fact - an economy always experiences job losses, even in very good economic times (90s, 2000s), however, as long as the rate of job creation is higher than the rate of job destruction the economy is doing well. The whole point of creative destruction is that companies should be allowed to go under, since when they do their owners develop new ideas until they find a successful one - it's a classical trial and error process (as it always is in life). The rate of companies going bankrupt and new companies emerging is quite similar to the above picture of job growth. It is only from a persistent trial and error process that new ideas and efficient patterns of production emerge. One should never attempt to interfere with this process in any way.

Monday, 4 November 2013

Gated globalization?

In one of last month issues of the Economist, they opened up quite an interesting topic on how the consequences of the financial crisis have affected globalization. As we all know an immediate reaction to the sudden credit stop in 2008 was a strong decline of international trade (see graph below). As jobs in the real economy were being lost, and as many companies went under, a paradoxical solution of many quack economists and the panicking public was a plea for protectionism of domestic jobs and industries. Even though this wasn't the main debate point at the time, there were indeed strong advocates of this necessity to protect domestic industries via higher tariffs and quotas, among other things. To save domestic industries from foreign competition in these tough times - a campaign well accepted by many interest groups seeking protection. 
Data taken from WTO
However, despite protectionism being anticipated as a likely outcome (as it happened during the Great Depression), it seems that the world has gone in a slightly different direction. What we have now as a consequence is some form of "gated globalization" - not a reverse of globalization, but a more carefully managed interventionist style. Perhaps the difference in responses to the recent Recession and the lessons learned from the 1930s prevented the forces of protectionism to reinvent themselves (and the fact that today we have the WTO which prevents hard-line protectionism), but many interventionist patterns remained. Calling for more intervention and more regulation is an expected consequence when people lose their trust and confidence in the system, despite the fact that it was the artificial demand caused by misplaced regulation and a series of other factors that led to systemic instabilities (particularly in Europe). The people have a hard time realizing the true causes and think an omnipotent government can fix the system. So far it has failed in this attempt, but it's still not giving up, particularly in the developing countries.

Probably the biggest outrage of the general population in the Western world is aimed at the bankers (widely perceived as the main culprits of the crisis). And even though the bankers did play a big role, they cannot be the only ones to blame (as mentioned earlier). Regardless of the facts, people need to find an enemy and the bankers seem like the perfect one. The consequence are stricter regulations on banking standards, and consequently a drop in capital flows (they've fallen to a third of their level in 2007), and a well anticipated drop in bank lending - which is of course constraining the recovery of the real sector. Newly imposed capital controls and bank ring-fencing are constraining investments, as confidence is still low due to high policy uncertainty. 

Source: The Economist
In addition to capital controls, much worse measures are being implemented worldwide, despite the WTO's efforts to curb them: 
"New impediments—subsidies to domestic firms, for instance, local content requirements, bogus health-and-safety requirements—have gained popularity. According to Global Trade Alert, a monitoring service, at least 400 new protectionist measures have been put in place each year since 2009, and the trend is on the increase. 
Big emerging markets like Brazil, Russia, India and China have displayed a more interventionist approach to globalisation that relies on industrial policy and government-directed lending to give domestic sellers a leg-up. Industrial policy enjoys more respectability than tariffs and quotas, but it raises costs for consumers and puts more efficient foreign firms at a disadvantage. The Peterson Institute reckons local-content requirements cost the world $93 billion in lost trade in 2010."
The typical protectionist response of those who don't understand the basic laws of international trade. Just remember the comparison of Brazil and Mexico over the free trade vs protectionism debate, and who is likely to emerge as the victor. The performance of all the gate-builders is disappointing, to say the least. Their policies are misfiring. Their growth, their productivity, as well as their currencies are declining, so now some of them are rethinking their strategies. 

International economics is really hard to understand for most of the people, as they view it from a really narrow perspective: let's protect our domestic industries and encourage them to export, and this is the best way to achieve prosperity. Like the classical mercantilist view, the idea is doomed to fail, since the protected domestic industries will always underachieve precisely because of the protection. They will never operate under the proper market conditions and will never achieve their strength through competition. In economics it's all about incentives. If you don't give the domestic industry an incentive to compete and if you over-rely them on government support and subsidies, then they will never fully flourish on the international market and are bound to fail soon enough. This is true for rich countries as well - just look at the US automotive industry. The proper response to revitalizing the domestic industries is - and always will be - more competition, not less! 

Finally, I call upon the opening paragraph of the earlier quoted article: 
"Imagine discovering a one-shot boost for the world’s economy. It would revitalise firms, increasing sales and productivity. It would ease access to credit and it would increase the range and quality of goods in the shops while keeping their prices low. What economic energy drink can possibly deliver all these benefits? 
Globalisation can."
Let's hope the West realizes this soon enough and once again leads the world economy to open up and put this crisis behind us. 

Thursday, 31 October 2013

Doing business

The newest Doing Business Report 2014 once again sheds light on where in the world opening and owning a business is a welcomed venture, and where you would be better of not being in the private sector at all. 

The report is an annual World Bank publication comparing countries in 10 different areas of business regulations such as starting a business, resolving insolvency, getting licences and permits, and even credit availability. It ranks countries based on the ease of starting and handling a business, thereby painting a picture to investors as to which country is more open for investments, i.e. more business friendly. For lower-income countries specific policies aimed at lowering the regulatory burden on businesses will ensure they rise high on the rankings, while for high-income countries, the relative strength of their institutional environment will still keep them on top, despite some of their policies being less business friendly than expected. 

For example, in my Adam Smith Institute report published last year, there is a series of policies aimed at releasing some of the burdens that still worry a lot of UK business owners, particularly the small and medium sized ones. They were (and still are) concerned about high National Insurance Contributions (NIC), unfair dismissal laws, an increase of business rates, new regulation coming from the EU, and of course credit availability. However, despite these problems (and some others), the UK still offers a favourable business environment where a lot of entrepreneurs would be happy to start and register a company. And they do. London tends to be a very attractive start-up destination for many European entrepreneurs, particularly those from Eastern Europe. And this is all because of the relative strength of UK's institutions, and the fact that London's financial superpower position makes it attractive to search for funding. So despite many UK SME business-owners worried about the scope and size of many regulatory constraints, the UK still manages to attract many new business ventures who will, despite facing the same problems, still rather chose the stability and strength of the UK economy to fulfill their ideas, than having to deal with the relatively inefficient domestic institutions (wherever they come from).

Top of the pops 

So who's topping this year's list (data collected from June 2012 to May 2013)? Singapore and Hong Kong are still holding firmly to the first two positions. Followed by New Zealand, United States, Denmark, Malaysia, Korea (South obviously), Georgia, Norway, United Kingdom, Australia, and the rest of Scandinavians (Finland, Iceland, Sweden). The two unusual inclusions, Malaysia and Georgia, are recognized for the pace and efficiency of their regulatory reforms. Judging by this alone, in the long run these countries are likely to excel very rapidly and thus quickly bridge the gap with the developed economies. Good luck to them, as I can only say they are on the right track. Some other positive examples loom, such as Mauritius (#20), Macedonia (#25), Rwanda (#32) (recall this positive example from Rwanda), Armenia (#37), Montenegro (#44) etc. None of these countries are "paradises", but they are all making the step in the right direction. For example Rwanda (along with Ukraine) implemented the largest amount of reforms in the observed period that reduced costs and complexity for businesses (a total of 8). Along with Rwanda and Ukraine, the positive movers in terms of implemented reforms were Russia, Philippines, Kosovo, Djibouti, Ivory Cost, Burundi, Macedonia and Guatemala. 

In total, 114 economies implemented 238 regulatory reforms aimed to ease the regulatory burden in their domestic economies. A positive trend indeed. This produced the second highest number of reforms since 2009. I guess for many countries it was now or never, even though the pace of reforms in a lot of these countries is still too slow. However, the good news is that low-income countries are narrowing the gap with the high-income ones. Their logic is rather simple; since their institutional environment is still rather weak, and since their stability is questionable, the only way to attract foreign investments is to deregulate the business environment. As more investment is being brought in, it is likely to pull the country out of its poverty trap and create scope for refining the existing institutional environment and hence achieving higher levels of prosperity. Of course the initial push is necessary, and it consist of an initial set of institutional reforms that all these countries are in fact doing. This is the best way to ignite the positive reinforcement mechanism.

Closing the gap

However, the current comparison between rich and poor countries still infers a wide gap (see graph below). The rich OECD countries perform better at every category tested (on average), with the largest gap being in resolving insolvency and trading across borders. In order for the developing economies to truly catch up they need to at least equate the average OECD business freedom levels.
Source: The Economist. Doing Business Report 2014
This means there is still a lot of work to be done, as reformer countries tend to be more successful in some areas but terrible in others. The Economists cites the example of Azerbaijan which ranks in the top 15 easiest to register property, and simultaneously the worst 15 for getting construction permits. Areas like those are still the source of high corruption and vested interests, and this is actually where the reforms should start. 

In conclusion, the report works wonders in at least partially explaining the institutional difference between countries. I would say it suggest of a negative reinforcement mechanism between poor institutions and poor performance, as the worse off the domestic institutional environment, the harder it is to reform it. On the other hand it suggest of a strong positive reinforcement mechanism where countries which were quicker and more successful to reform, managed to create better growth opportunities for the private sector. Policymakers worldwide should take note of this. 

Monday, 28 October 2013

Taleb's antifragility and pseudostability

Nassim Nicholas Taleb, most famous for his bestselling brilliant book "The Black Swan", published a new book last year - "Antifragile: Things That Gain from Disorder", where he presents a rather interesting argument. I haven't read the new book yet (I intend to), but I came across two interviews he did for Financial Times presenting his argument. 

His main point is on political volatility. If I were to ask you a question: "Which country is going to be better of in the future - the one characterized by more political volatility or the one with more political stability?", what would you answer? The first though that comes to mind is that stability is inherently good. But according to Taleb this need not always be the case. 

If one approaches this question through the democracy vs autocracy debate, where democracies will always carry more political volatility than autocracies, then the argument makes much more sense. A democratic system, with all its flaws, always comes superior to an autocracy particularly because of its volatility and accountability. Due to its economic and political inclusivness it ensures persistent innovation and technological progress and it is a system of everlasting change. On the other hand, an autocracy is an overstabilized system where the rule of one dynasty or party for decades makes the system too fragile. A closed system with limited, state-driven innovation can never hold on for too long (the Soviet Union is a perfect example, but so are many other modern dictatorships, particularly those destabilized by the Arab Spring). 

Taleb's intuitive point is that autocracies (overstabilized systems) in times of systemic collapse have no idea what to do or how to react. Its people cannot anticipate the consequences as they've never experienced such a situation. This in turn leads to a perpetuating crises of consolidation. The most recent example he cites is Syria, but predicts the same thing happening to Saudi Arabia, which tends to keep smoothing out their real problems instead of dealing with them, and is thus only achieving "pseudostability". 

A digression: Chinese pseudostability

Speaking of pseudostability and artificial smoothing, China tends to fit the framework quite similarly to Saudi Arabia. However, I don't think the reaction in China will be a complete regime collapse after the inevitable bubble burst. Why? The mere size of the economy and the composition of savings. If the Chinese start spending money and consuming, they are likely to be pulled out of an AD crisis much faster than the West. The difference is that unlike the Americans and the Europeans, the Chinese save a lot (savings rate of 50% compared to the global average of 20%). They are a traditionalist, savings society, unlike a consumerist society of the West. When an AD shock hits the US, one cannot expect consumption to pull it out on its own, as most of US consumption is based on credit. In China, high savings already imply that consumption is low (investments are the biggest contributor to Chinese GDP growth), so during a strong AD shock all the government needs to do is convince people to start spending. With a one party rule, I assume this wouldn't be too hard. However, there is still reason to be worried, as Japan had almost all the similar characteristics to China at the time of its biggest rise, only to see it all fade away during a 20-year-long stagnation.

Systemic fragility solved by more decentralization 

Going back to Taleb after this brief digression, in the first video he touches upon the legacy of the crisis. He claims that the system is much more fragile today than it was before. Why? A healthy system allows for fluctuations and improves upon the errors made. When the policymakers in the US and Europe decided to bail out the "too big to fail" banks, they failed to punish those who made mistakes. The socialization of investment banking mistakes sent the wrong signals to the market, making the whole system more prone to failure in times to come. The moral hazard implication is huge, as there is nothing to prevent the bankers from making the same mistakes in a few years time. Particularly as many of the big banks became even larger. Their failure will always threaten the stability of the system which is why their collapse will continue to be avoided by pumping in the taxpayer's money. 

The consequence is huge public debt. Taleb rightfully recognizes that the large post-crisis debt came as a result of massive bank bailouts. And according to him high debt makes the system more fragile and unstable than ever.  

His solution to make the system more robust to fat tail (black swan) events is more decentralization. Mistakes should, according to Taleb, be made locally, rather than nationally. Their cross-country distribution makes sure that they stay constrained within the local community and thus never threaten the overall systemic stability. 

Debt should be managed the same way - locally rather than nationally. He cites Switzerland as an example of such a system, claiming that the people tend to be more responsible with local debt and local public finances than national ones. However this operates under the assumption that political variation is higher in local politics than on the national level. I disagree, as many local areas are characterized by a long-lasting one-party rule. Such communities are perfect examples of the aforementioned pseudostability. There is something appealing in Taleb's decentralization argument, but I wouldn't hold on to it as the key to solving the debt problem. 

I guess I have to read the book now.

Thursday, 24 October 2013

"Yes, Economics is a science, but many economists are not scientists!"

This title is actually taken from Paul Krugman. For once I agree with him.

Krugman's blog came as a response to a great text by this year's John Bates Clark medal recipient Raj Chetty from Harvard. Chetty wrote a column for the New York Times this weekend where he defended the field of economics on the basis of its scientific rigor. His text came as a reaction to many non-economists questioning the recent Nobel prize being awarded to two opposing theorists explaining the same phenomenon (Fama and Shiller), but also (I believe) to a series of texts about economics and philosophy started in the NYT back in August, initiated by two philosophers Alex Rosenberg and Tyler Curtain writing a text called "What is Economics Good For?". Their main resentment towards economics is the imprecision in its predictive abilities. Or in other words, economics, with all its new modern analytical tools, not only couldn't predict the crisis, but is also failing to solve it. This caused a series of immediate reactions from many notable names including Krugman, Vernon Smith, Eric Maskin, and a number of others that carried on the debate. The debate actually never stopped since the origination of the financial crisis, when many wondered why economists couldn't have predicted neither the severity nor the length of the crisis. Its ambivalence over what the actual causes were, and consequentially what the best solutions could be are only causing further discomfort to the field.  

But luckily, many of those who did step in and defend the field handed in some pretty persuasive arguments. Maskin made a good point in saying that prediction isn't everything, comparing economic predictions to those of seismology or meteorology, where neither of the two can be a 100% accurate in predicting when an earthquake is going to occur or whether or not we're in for a sunny day or a rainy day. Economics is more about explanation. Just like any social science, it will never make perfect predictions, but it will provide us with a detailed understanding of many phenomena. How does this differ from every other science? Can medicine be absolutely sure in the effectiveness of one treatment method over another? No. At least not with a 100% certainty. But no one ever questions the scientific methods behind medicine. And rightfully so. 

Chetty draws an interesting parallel with medicine:
"It is true that the answers to many “big picture” macroeconomic questions — like the causes of recessions or the determinants of growth — remain elusive. But in this respect, the challenges faced by economists are no different from those encountered in medicine and public health. Health researchers have worked for more than a century to understand the “big picture” questions of how diet and lifestyle affect health and aging, yet they still do not have a full scientific understanding of these connections. Some studies tell us to consume more coffee, wine and chocolate; others recommend the opposite. But few people would argue that medicine should not be approached as a science or that doctors should not make decisions based on the best available evidence."
The proper usage of models

Economic models used for making predictions also raise many eyebrows from the regular folks. But economic models are just that - models. An approximation or better yet, a simplification of reality, not meant to be perfectly applicable, since all aspects of a complex environment cannot be included in a model (they are determined exogenously, i.e. outside the model - a crisis is a good example of such an unanticipated, exogenous shock).

Models operate under a delicate trade-off between complexity and applicability. If you make them too complex by trying to include too much stuff in there (culture, socio-economic preferences, informal institutions, etc.), you end up getting very little predictability. If on the other hand you make them too simple, you again get low applicability. The key is to reach some satisfactory level of complexity so that you can maximize the predictability and applicability of a model (almost like a Laffer curve). But in neither scenario does it imply a perfect mechanism for making predictions. Their purpose is to design a hypothesis which needs to be tested empirically and/or defended theoretically - so in both cases it requires a scientific method to support it. 

A social science  

Empirical methods in economics are not as robust as those done in say, physics. Take this example; before being sure that the researchers at CERN have actually discovered the Higgs boson, they wanted to be sure up to a 6 sigma standard deviation, i.e. at a margin of error of 0.0001%, while for economists, anything between a 1% to 5% margin is good enough (this is the so called statistical significance used in econometrics). So even though economics is less precise, this has a lot to do with the fact that economic social experiments are much harder to do in the real world. As Chetty says, one cannot perpetuate financial crises over and over just to learn how to solve them. Unlike natural sciences, here we're actually messing with peoples' lives. But one can actually do economic policy related experiments thereby testing the efficiency of a certain policy, as Chetty notices. All one needs to do is make an experiment with one treatment group and one control group in order to examine the effects of a particular policy on the treatment group, and how their behaviour or actions differ from those of the control group. This is how we capture the causal effect (the average treatment effect on the treated). 

Apart from policy experiments, one can also use economics to establish monetary or fiscal policy rules, like the Taylor rule (which was abandoned in the pre-crisis decade, mostly because of a need to respond to the 2001 IT bubble when the Fed created scope for the housing bubble). Or in fiscal policy one can test and establish things like the limited budget deficit - to curb the politicians' incentives to misappropriate budgets. One can also establish debt ceilings to control public debt...oh wait, that one doesn't work that well actually, does it?

Economics is too closely interlinked with politics, so demanding answers only from economics without thinking of the political implications is a faulty approach. For example, many economically sound ideas on which >90% of economists agree upon - like free tradeimmigration, the efficiency of subsidies, a number of empirically proven models and theoretical concepts (stylized facts ranging from public choice theory and institutional economics, to basic micro and macro models), or the basic price mechanism and the simple dynamics behind the laws of supply and demand - will never be implemented by politicians who care only of satisfying and protecting partial interests in order to remain in power. So when you think about the soundness of a certain fiscal policy, tax rate, or budget spending, have in mind that behind that decision, it's not an economist, but a politician.

Detaching science from policy 

Many critics of economics as a science are persistently confusing economics and economic policy. The field of economics does contain scientific method, but economic policy is mostly craft. And in order to "sell" an economic policy to the public, one needs to have good "sales skills". This is where politicians step in. But how often do you see politicians actually calling upon relevant economic research? Only when it supports their ideological viewpoint. 

Which brings us down to Krugman's argument. His reaction on Chetty's text was spot on. He agrees that economics is indeed characterized by scientific method, however he also emphasizes that many economists don't do much science at all:
"The point is that while Chetty is right that economics can be and sometimes is a scientific field in the sense that theories are testable and there are researchers doing the testing, all too many economists treat their field as a form of theology instead."
He cites Chetty's examples of empirical research being done on the health insurance policy in Oregon, where a genuine randomized experiment was conducted with a well defined treatment and control group. Krugman is outraged that many conservative economists don't like to take this evidence supporting Obamacare for a fact. And he has every right to be outraged. But what about other empirical facts that many liberal economists tend to disregard? Such as the inefficiency of state stimulus programs, or the fact that the deficit and debt busts were caused by bailouts not the crisis - something Krugman is actually holding a pretty tautological view of? 

This is a good example of conflicting opinions among economists, where the issue at hand is either highly controversial or on which economists are still unsure about. But with upcoming decades of vigorous research, relevant policy solutions to these issues will surely be given. The question is how likely are they to be implemented by those in power?  

The problem with quacks

Conflicting theories in science will always exist, and are in fact welcomed as out of opposing views usually arise the best ideas (avoiding the confirmation bias). But economics tends to be attacked more than any other science on the soundness of one approach over another. The reason is simple: during bad economic times (as we have now) many forgotten fallacies of the past suddenly get rediscovered. Why is this? A partial culprit is believe it or not - the media. In search of explaining a certain phenomenon the press likes to match opposing economic ideas; one being the so-called "mainstream", and the other "the alternative". Even though sometimes the alternative proposals can indeed be quite sound (it all depends on how we define mainstream), in most cases they are not. Too often a lot of space is given to obscure economists (quacks) offering their own quick fixes without any scientific method whatsoever standing to confirm their findings, and without ever considering even the basic effect their misplaced ideas might cause on systemic stability. But since debates on economic topics are much more popular and widespread than debates on topics in physics or chemistry, these quacks tend to get a lot of media space to push forward their ridiculous and washed up ideas.

You can surely find the same thing in every science (how many times have you seen people claiming to be scientists talking mostly nonsense? And it wasn't because they weren't "mainstream", it's just that their conclusions are often completely senseless). However, in economics these quacks tend to be much more widespread, particularly when non-economists start thinking they have a magic idea of how to fix the system. Most of these people are luckily never taken seriously, but some tend to attract quite large crowds of followers. It is because of this that a lot of people seem to think economics is mostly hokum, and it is precisely because of this why economists must react and explain to the public the crucial difference between economic policymaking and economic science. Economic science must always stand to support economic policymaking. When it doesn't, markets start to crash.