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.