Tuesday, 30 July 2013

Video of the week: the Dismal science

A video on how economics got to be called the "dismal science":


It's a very interesting history lesson from the Marginal Revolution University (the online University I wrote about last September, led by Tyler Cowen and Alex Tabarrok). The video goes all the way back to the 19th century philosopher and historian Thomas Carlyle who coined the derogatory phrase. And the reason was his disagreement with economists (like John Stuart Mill) on the question of slavery and Black Emancipation. Carlyle's political philosophy was Hero worship (superiority of dictators like Oliver Cromwell or Napoleon) expressing the benefits of hierarchy where everyone should "know their place". He strongly opposed abolishing slavery for which he though was necessary to prevent order and force people to work who otherwise wouldn't do so. His ideas are said to have influenced both the rise of socialism and fascism in the 20th century (thus reinforcing Hayek's points of how these two ideologies are essentially the same as they compete for the same type of mind, in particular “those who have no strong convictions of their own but are prepared to accept a ready-made system of values only if it drummed into their ears sufficiently loudly and frequently", Hayek, 1944, pp. 143). Naturally the classical liberal economists of the 19th century opposed such backwards ideas. After all classical economists have witnessed and understood the benefits of the industrial revolution, something that was obviously not evident to philosophers like Carlyle. 

Basically, the dismal science got its name because economists opposed slavery and supported liberty and equality. Hurrah for the economists! 

HT: Cafe Hayek

Saturday, 27 July 2013

Graph of the week: Climbing the income ladder

New York Times has the story:

Source: NY Times (Click to enlarge)
The map depicts US counties based on the probability a child raised in the bottom income quintile (bottom fifth) rises to the top income quintile (top fifth). The redder the district, the lower the level of upward mobility. The Southeast seems to score the worst in those terms, in particular in states like Georgia, North and South Carolina, Alabama and Mississippi it appears to be really hard to climb the income ladder. 

The story NYT was focusing on is Atlanta, one of America's most affluent metropolitan areas (pop. 5.4m), yet a city with a great level of income inequality, and apparently a terrible level of upward mobility (only 4% chance to reach the top quintile). According to a study done by researchers from Harvard and Berkeley, "The Equality of Opportunity Project", economic geography of Atlanta is what could be one of the culprits for its low social mobility:   
"The low-income neighborhoods here [Atlanta] often stretch for miles, with rows of houses and low-slung apartments, interrupted by the occasional strip mall, and lacking much in the way of good-paying jobs. This geography appears to play a major role in making Atlanta one of the metropolitan areas where it is most difficult for lower-income households to rise into the middle class and beyond...
...in Atlanta, the most common lament seems to be precisely that concentrated poverty, extensive traffic and a weak public-transit system make it difficult to get to the job opportunities."
The map shows us the great variation across the country to which extent people can pull out of poverty. What is also interesting is that upward mobility rates differ in areas where income is similar, like in Atlanta or Seattle for example. So economic geography in terms of access to local jobs and markets, as well as the available infrastructure seems to be an important part of explaining this variation. I wouldn't say these are the key issues, but are significant to a certain extent. However the authors also show how this geography matters much less for well-off children than for middle or low class ones. 

Their study is based on millions of earning records in addition to information on education, family structure and the layout of the metropolitan area. The authors, interestingly, hypothesized that tax breaks would be the most important factor in influencing inter-generational mobility, however they found strikingly different results: 
"The researchers concluded that larger tax credits for the poor and higher taxes on the affluent seemed to improve income mobility only slightly. The economists also found only modest or no correlation between mobility and the number of local colleges and their tuition rates or between mobility and the amount of extreme wealth in a region. 
But the researchers identified four broad factors that appeared to affect income mobility, including the size and dispersion of the local middle class. All else being equal, upward mobility tended to be higher in metropolitan areas where poor families were more dispersed among mixed-income neighborhoods.
Income mobility was also higher in areas with more two-parent households, better elementary schools and high schools, and more civic engagement, including membership in religious and community groups."
Of course, as the authors warn us, this is all correlation, not causation, meaning one shouldn't make any strong inferences based on just these results. But they are interesting nonetheless, and this surely is the best research project so far measuring upward mobility in the US. And it seems to lack any ideological bias, for now. But most importantly, it brings in the issue of economic geography into the equation, an often overlooked topic in economics in explaining both income inequality and labour market inefficiencies (access to markets, and access to skills). 

On the other hand of the equation however...
"Yet the parts of this country with the highest mobility rates — like Pittsburgh, Seattle and Salt Lake City — have rates roughly as high as those in Denmark and Norway, two countries at the top of the international mobility rankings." 
A divided nation indeed. 

Wednesday, 24 July 2013

Britain's recovery?

How is Britain's recovery hanging on? Recent indicators from the ONS reported a 0.3% growth in the first quarter of 2013. However, one can never be too careful with Britain. After all, haven't we seen the UK going in and out of recession two or three times in the past 3 years? And it was always less than a percentage point upwards or downwards.


The labour market however has remained resilient, with unemployment still around 7.8%. During the recession employment is reported to have fallen only by around 2% from peak to trough, while total hours worked have fallen by around 4%. It is rather interesting how the labour market was struck much less than initially expected. Even though a lot of public sector jobs were lost in the midst of the coalition government cuts, this hasn't translated into the labour market that severely. There can be several potential reasons for this, some of which I covered before, but the fact remains that the labour market recovery was much more robust  than the recovery of the economy as a whole. It is in fact already around 500,000 above the 2008 peak. 
Source: ONS
However, many are still rather careful. First of all the ONS has revised the total fall of UK GDP since the start of the crisis, which is estimated to be 7.2%, thus representing one of the biggest slumps since the Great Depression. This means the British economy will have to experience several years of above-trend growth in order to catch up on it's pre-crisis trend. The underlying factors of the British economy make this all but likely. Exports are stagnant, investments are down 25% since the peak, and the real wages experienced a 2% decline. This is why Britain is currently lagging behind other developed countries (see graph below).

Another problem is declining total factor productivity, which is a good way to explain why even though more people are getting employed and are working longer hours, GDP growth is still stagnant. Some attribute this to Britain's flexible labour market, where private sector firms faced with worsening prospects didn't cut jobs, but cut wages instead. The major job losses actually only came from the public sector. And according to the latest data it appears that many of these workers have managed to reallocate themselves into the private sector. Nevertheless, declining wages combined with low productivity and low investments is bad news. 

Business investment is particularly worrisome. There is a problem from both the supply side and the demand side. On the supply side there has been a serious lack of funding offered to SMEs (20% down since 2008), with the latest annual decline around 6% suggesting that the gap is still widening. The banks are further trimming their balance-sheets and building up equity due to new regulations being put in place. This makes it even harder for SMEs to get the necessary credit. On the demand side business owners and managers are reluctant to go into risky ventures (just like the banks actually). One of the things that certainly isn't helping in re-encouraging the business owners to invest are Britain's constraining planning laws. 

Source: The Economist
















As always signs of potential recovery are welcomed by the government. Osborne was brave to declare the economy "coming out of intensive care". Even the IMF has for the first time revised UK's growth predictions upwards to 0.9% for this year (up from 0.7% predicted earlier). This is still far from what Britain needs to get back on it's pre-crisis trend and thus cancel out the 7.2% total drop. Particularly with respect to the aforementioned underlying factors. It will be extremely difficult to turn the economy around if most of these trends remain unchanged, and if the policymakers continue with hit and miss policies. A 0.3% growth isn't really growth at all. It's a continued stagnation. It's another Japan.  

P.S. John Van Reenen from LSE has a good text in the Economist raising similar issues behind the interpretation of Britain's recovery. I can't say I agree with some of his recommendations on what should be done, but he raises a few good points. 

Saturday, 20 July 2013

The perplexity that is Japan

This week in the blogosphere Japan captured the center of attention. Noah Smith started the debate pointing out that Japan isn't a textbook example of anything, claiming that neither monetary nor fiscal stimuli will work there.
"It seems to me that the standard New Keynesian sticky-price story just cannot explain Japan. The “short run” for Japan is over and done. We are not looking at a “short-run” fluctuation caused by sticky prices. This has implications for policy. It means that we can’t expect the “first arrow” of Abenomics – quantitative easing – to boost the real economy through the kind of channel described by a New Keynesian or AD-AS model. ...  
...But I don’t think Japan is living in an RBC world either. Because in an RBC world, keeping interest rates at zero for decades, and printing a bunch of money (as the Bank of Japan did in the mid-2000s), should cause inflation (without helping growth). Instead, we see persistent deflation. ... [and even declining wages]
I’m not sure I know any model that describes Japan; ... my guess is that it’s a world in which “Aggregate Demand” and “Aggregate Supply” are not as distinct entities as they are in Econ 102. In an AD-AS framework, either the AD curve or one of the AS curves shifts on its own. But in Japan, it may be that what looks like supply shocks (falling productivity) and what look like demand shocks (deflation) may actually be due to the same cause [Indeed, and this cause is structural, not temporary]
...whatever world Japan is living in may have multiple equilibria. It may be that Japan is trapped in a “bad equilibrium”, and it will require a “big push” to kick it back to the “good equilibrium”. ... 
In any case, we shouldn’t be thinking about Japan solely in terms of our standard textbook models. The real world appears to be much weirder than those toy environments."
I suggest reading the whole post. It contains some good basic explanations of certain macroeconomic models which a reader interested in economics could find useful. Besides his argument makes a lot of sense. Japan has had both signs of an AD shock - the 1990s bubble burst followed by persistent deflation (liquidity trap?) and an AS shock - falling productivity for the last 20 years. This is probably why conventional measures haven't been too effective:


The immediate response came from the two biggest advocates of fiscal and monetary stimuli, respectfully, Paul Krugman and Scott Sumner

Krugman insists Japan's story is a liquidity trap:
"But Japan has been in a liquidity trap during the whole period Smith looks at. Monetary expansion is ineffective unless it can raise expectations of future inflation. Deflation is definitely not going to help. In fact, by raising the real burden of debt, it makes things worse...
A corollary is that while sticky wages are a real phenomenon — the evidence just keeps getting stronger — their importance has to be appreciated correctly. You need them to understand what we’re seeing, which is the failure of deflation to appear in the US now (and the slow pace of deflation in Japan). They are not, repeat NOT the reason either Japan or we have failed to recover."
This is a somewhat similar argument to the one made by Richard Koo and his balance-sheet recession story. I find neither convincing enough to truly explain the perplexity of Japan. And I've explained this several times before. 

Sumner, on the other hand, argues the problem was monetary tightening from the BOJ:
"Japan’s NGDP is lower than 20 years ago, that’s the biggest fall in AD I’ve ever seen. The only question is why has Japan suffered such a big adverse demand shock, spread out over 20 years. And the answer is simple; the BOJ has had an unusually tight monetary policy. The BOJ has produced 20 years worth of adverse AD shocks. In both 2000 and 2006 they raised interest rates despite the fact that Japan was experiencing deflation. In 2006 they cut the monetary base by 20%. I’ve often disagreed with Bernanke, but he’d never do anything THAT crazy. Indeed Bernanke wrote some powerful pieces criticizing the insanity of BOJ policies as far back as the late 1990s."
Here's why I find that argument hard to believe:

Sumner correctly points out that BOJ has cut rates in 2000 and 2006, however I can't see how the massive QE done before, after and in between these cuts was helpful for the economy. In addition the year 2006 was portrayed as the start of a recovery for the Japanese economy (at least that's what Koo claims). 

Possibly the best comment in the debate was provided by Arnold Kling, who like Smith rejects the standard macro argument. In addition, Kling is the only one who admits he knows nothing of Japan. 
"I think we need to get away from static thinking, including AS-AD and RBC. In static thinking, there is a full-employment equilibrium out there, if everyone would just adjust to it (match the right person with the right job, or cut wages by enough, or whatever). In the dynamic world of PSST, new opportunities to reconfigure production constantly arise. Some of these create ZMP situations, in which (some) workers’ value to the firm drops essentially to zero. These workers are released into the economy as free resources. Entrepreneurs can try to pick up these free resources and do something profitable with them. But it may take some time for entrepreneurs to figure out exactly what this “something profitable” might consist of.

I know nothing about Japan. But if I were looking for the source of its problems, I would examine the cultural, legal, and institutional factors that surround the formation of new businesses. If what you had during Japan’s post-war resurgence was an economy based on top-down industrial policy and cronyism, and what you need to fix the problem today is bottom-up entrepreneurial energy and creativity, then, as Noah suspects, the solution is not going to come from wiggling interest rates and deficits."
This is the part of the argument I subscribe to. Japan is a great example of how things don't seem to work as people would think in terms of standard macro models. It's primarily because the world is much more complex than that. Economic models are precisely that - models! They are an approximation of reality. Really good ones like the the New Keynesian or the RBC can perhaps explain a lot of the usual variation created in the economy. But when the marginal error does happens it's probably due to something much deeper than AS-AD. It is a mixture of factors, where the third industrial revolution technological shock is surely one of the most important ones. One thing is certain, Japan doesn't need standard policies, it needs something new. Abenomics is not necessarily something new - it's just one big package of standard policies. 

Monday, 15 July 2013

The Chinese bubble economy: How long will it withstand the pressure?

China's GDP growth slowed down to 7,5% in the second quarter of this year, mostly thanks to faltering exports and retail sales. Albeit, this is still impressive growth, despite the fact that the government will probably miss its annual growth target for this year. There is something to be worried about - it's the way in which China keeps on hitting its growth targets. Here's the WSJ:
"China’s economy is far too dependent on investment–which has in recent years made up around half of all growth. Household consumption, meanwhile, was just 38% of GDP in 2011–some 20 to 25 percentage points below the consumption rates among China’s neighbors ...  
China’s massive investment rate all but guarantees vast amounts of malinvestment. In other words, plenty of these resources haven’t really been invested but rather have been consumed in altogether unsatisfying ways that have made people marginally better off in the near term (keeping people in work and oligarchs rich) while doing nothing to expand the economy’s productive potential and thus nothing to boost standards of living long term. Whole new cities are likely to rot away, abandoned and useless like stranded Mary Celestes. 
Worse still, it takes ever larger infusions of money and credit to keep up the pace of growth."
And this brings us to the current state of the Chinese bubble economy and it's recent bank bailout. With so much credit being pushed into the system to sustain the government growth targets, it's only a matter of time before the whole thing bursts. And as China sneezes...

Source: WSJ. Click to enlarge.
...the rest of Asia (and the world economy) shivers.

To remove this dependency of the Chinese growth model on (mal)investments and switch it to consumption requires a real restructuring of the Chinese economy. Something which its leaders have pledged to do, announcing liberalization of product markets, helping private entrepreneurs to compete with state-owned ones (causing a fair share of resistance form state owned CEOs and ideological party members), and even delivering statements like the one from Prime Minister Li Keqiang saying that "the state should remove its hands from many parts of the economy, even if doing so felt like cutting its own wrists." However, it doesn't seem the situation has reached a boiling point quite yet. Not even after the "hiccup" of the Chinese banking system last month.

When the money stops pouring

Last month's panic started on the Chinese interbank lending market (where banks borrow from each other to gain temporary liquidity) when the People's Bank of China (the central bank) refused to inject liquidity into the market when things got too tight. Usually it always does so in order to sustain the boom it has created (i.e. meet its credit targets, which the Bank finds more important than financial stability). The reason for no reaction this time was to show clear commitment that it aims to tighten its policy on credit growth, and curb the shadow banking system. As a result interest rates hiked (see graph below), the stock market went down, and some banks found themselves in serious trouble.

However, all of this was an inevitable consequence of the Chinese artificially overheated growth model. Here's from the FT
"China powered through the global financial crisis in large part thanks to an explosion of credit, first through the formal banking system and then through a series of “shadow banks” and off-balance-sheet vehicles. The result has been a remarkable increase of leverage in China. The overall credit to gross domestic product ratio has shot up from about 120 per cent to nearly 200 per cent over the past five years."

This is what its CB is trying to fix; the oversized shadow banking system. The very same one they helped create and fueled over the past decade. Many lenders seized the opportunity to borrow at low rates on the central bank-controlled interbank market, so that they could use this money to make risky, high-return investments. Many small banks also took the risk of borrowing short and lending long, which is ok if they can roll over their borrowing on the stable interbank market. Hence the panic when the CB pulled out. Yet another example is balance-sheet mischief. The Economist reported that "Many banks sell wealth-management products (WMPs) to investors that mature just before the end of the quarter. The repayments are paid into the bank’s deposits in time for regulatory inspections, only to disappear into a new product immediately afterwards. Meanwhile, the bank needs to borrow the funds it repays to the products’ buyers." Greed for profit? Absolutely. In China? How can this be? 

Source: Financial Times. Click to enlarge.
It's all about incentives. Party leadership and the CB have given clear signals to the market to act risky and pile up leverage in order to sustain the enormous credit boom necessary to fuel the economy. This is important in order to keep hitting government-set growth targets, which are a pure political factor chosen by party leadership to show the West that having high rates of growth for so long is possible and, more importantly, that it is sustainable. In order words to show the West that state capitalism is the way to go. Unfortunately, this fairy tale will soon be over. Even if we accept the premise that the banking system is robust to failure due to its closed nature and unlimited protection from the government, the unprecedented credit boom and shadow banking system growth cannot last forever. This has been proven time and time again. 

The new party leadership has certainly realized this and are striving for restructuring and reform. Progress so far has been slow. This is somewhat understandable since party leadership cannot jeopardize its long term political goals, nor can it allow for the economy to go down too fast and risk a recession on their hands. I'm sure that in terms of confidence loss China wouldn't be hit as hard as the US or Europe (party propaganda can do wonders), but it terms of a systemic failure it could get even worse. Something like Japan in the 90-ies after it reached the end of its rapid boom. After the crisis, China will most likely apply similar policies Japan did to offset it (I covered some of them here), meaning that China too is facing several decades of stagnation. Unfortunately, for China this will all happen too soon; i.e. before it's people started experiencing true consumerism and higher living standards. 

Finally, after all of this, who can honestly say China isn't capitalist? The fact that it has a capitalist system run by central-planning, short-term target-oriented socialists, only makes it more fragile and extremely dangerous in terms of potential consequences. Consequences that will, because of China's size, affect the global economy. Let's just hope this all happens when the West comes out of its recession. Time is running out. 

Thursday, 11 July 2013

100 years of the US Federal Reserve

In retrospect not the best of decisions, however thanks to it we have learned a lot about monetary policy over the past 100 years (this is purely academic curiosity talking). Then again, many economists still disagree over what monetary policy can and can not do (and more importantly under which circumstances it can or can not react), which is probably why monetary policy is one of the most misunderstood areas of economics for laymen. Yet another reason why preserving central bank independence (both goal and instrumental) is crucial for financial stability. 

Anyway, the NBER has organized a conference for the occasion, featuring some impressive names in the field of monetary policy, including former governor Paul Volcker, Stanley Fischer, Larry Summers, Martin Feldstein, Jean-Claude Trichet, Frederic Mishkin, Carmen Reinhart, David and Christina Romer, and of course current Fed Chairman Ben Bernanke. Here are some interesting parts from his speech (a fairly well historical overview of 5 important, "Great" episodes of the Fed's history: the founding, the Great Depression, the stagflation of the 70-ies, Paul Volcker's Great Moderation, and finally the recent current Great Recession):
"The Great Depression was the Federal Reserve's most difficult test. Tragically, the Fed failed to meet its mandate to maintain financial stability. In particular, although the Fed provided substantial liquidity to the financial system following the 1929 stock market crash, its response to the subsequent banking panics was limited at best; the widespread bank failures and the collapse in money and credit that ensued were major sources of the economic downturn ... Economists have also identified a number of instances from the late 1920s to the early 1930s when Federal Reserve officials, in the face of the sharp economic contraction and financial upheaval, either tightened monetary policy or chose inaction. ... It may be that the Federal Reserve suffered less from lack of leadership in the 1930s than from the lack of an intellectual framework for understanding what was happening and what needed to be done."

... With respect to goals, the high unemployment of the Depression ... elevated the maintenance of full employment as a goal of macroeconomic policyThe policy framework to support this new approach reflected the development of macroeconomic theories--including the work of Knut Wicksell, Irving Fisher, Ralph Hawtrey, Dennis Robertson, and John Maynard Keynes--that laid the foundations for understanding how monetary policy could affect real activity and employment and help reduce cyclical fluctuations. At the same time, the Federal Reserve became less focused on its original mandate of preserving financial stability, perhaps in part because it felt superseded by the creation during the 1930s of the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, along with other reforms intended to make the financial system more stable."
Stagflation of the 70-ies, caused by the ignorance of conventional economic thought at the time, however fixed by accepting new paradigms from Friedman, implemented by Volcker: 
"...beginning in the mid-1960s, inflation began a long climb upward, partly because policymakers proved to be too optimistic about the economy's ability to sustain rapid growth without inflation "... policymakers chose to emphasize so-called cost-push and structural factors as sources of inflation and saw wage- and price-setting as having become insensitive to economic slack. This perspective, which contrasted sharply with Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon," led to Fed support for measures such as wage and price controls rather than monetary solutions to address inflation. A further obstacle was the view among many economists that the gains from low inflation did not justify the costs of achieving it.

The consequence of the monetary framework of the 1970s was two bouts of double-digit inflation. Moreover, by the end of the decade, lack of commitment to controlling inflation had clearly resulted in inflation expectations becoming "unanchored," with high estimates of trend inflation embedded in longer-term interest rates.  
As you know, under the leadership of Chairman Paul Volcker, the Federal Reserve in 1979 fundamentally changed its approach to the issue of ensuring price stability. This change involved an important rethinking on the part of policymakers. By the end of the 1970s, Federal Reserve officials increasingly accepted the view that inflation is a monetary phenomenon, at least in the medium and longer term; they became more alert to the risks of excessive optimism about the economy's potential output; and they placed renewed emphasis on the distinction between real--that is, inflation-adjusted--and nominal interest rates. The change in policy framework was initially tied to a change in operating procedures that put greater focus on growth in bank reserves, but the critical change--the willingness to respond more vigorously to inflation--endured even after the Federal Reserve resumed its traditional use of the federal funds rate as the policy instrument. The new regime also reflected an improved understanding of the importance of providing a firm anchor, secured by the credibility of the central bank, for the private sector's inflation expectations. Finally, it entailed a changed view about the dual mandate, in which policymakers regarded achievement of price stability as helping to provide the conditions necessary for sustained maximum employment."
Read the full speech, it's a very good monetary history lesson. I also recommend some of the papers presented at the conference

Oh, and celebrate! Who knows what we are to expect in the next 100 years of the Fed. I'm hoping we can learn even more. It's all trial and error in economics anyway. 

Saturday, 6 July 2013

The quest for inclusivness (and a better democracy)

Over the past few weeks some parts of the World have been subdued into protest mode. In Turkey it all started as a protest against a dubious building site project in one of the largest parks in Istanbul, and has escalated into a country-wide protest against a controversial, authoritarian Prime Minister Erdogan, whose corrupt and unconstitutional activities too often get unnoticed in the West. On the other part of the globe, in Brazil, protests started against bus fare increases in Sao Paolo, but quickly evolved into mass protests against the government's policies vis-a-vis the organization of the FIFA 2014 World Cup, where the protesters demanded to know why the government is building stadiums, and not investing into proper health care, education or public services (* - see note below). In the semi-consolidated Egypt a military coup has ousted the authoritarian, however democratically elected president Morsi, triggering violence and fights on the streets of Cairo between pro- and against-Morsi supporters. Acemoglu and Robinson draw a striking comparison between Egypt today and Turkey 50 years ago. It is another painful proof of the iron law of oligarchy. 

These aren't the only cases however; in Indonesia protests started against high fuel prices, in Bulgaria against a corrupt government, organized crime and powerful oligarchs (triggered by nomination of a media mogul as the head of the national security agency), in Europe against austerity every now and then, in the rest of the Arab world some conflicts still haven't ended (Syria), and in India a few months earlier a similar uprising took place. China, Russia and Saudi Arabia also experienced some minor or major troubles, but in a dictatorship (or semi-dictatorship) ending protests is much easier than in a democracy. The long run costs of pilling up anger are far greater however. 

What do these seemingly different protests in several distant countries across the globe have in common?

The Economist draws an interesting comparison with the revolutionary years 1848, 1968, and 1989, where a number of countries were driven by desire to change a corrupt and unjust system, and more importantly succeeded in doing so. 

What is interesting this time is the quick spread of protests cross-country and world-wide, primarily thanks to technology and social networks. Relying on the so-called "latte" protesters holding up their smartphones to record the whole thing is much better than having things reported by domestic government-controlled media (in most cases). Because of this interlink with social networks, the protests are characterized by an amazing level of spontaneity. Almost insignificant events seem to trigger mass movements, and one simply cannot predict what will be the next big thing. Or even where will it happen. That's why these protests are different that the Occupy movement. They might be driven by similar arguments, but in essence they are much more widespread and more likely to yield results. 

They aren't driven by interest groups loosing their precious political support, they are driven by regular, middle-class people who are fed up being pushed around by their countries' arrogant elites (Egypt, Turkey), their corrupt system (Brazil, Bulgaria, Indonesia), faulty economic policies leading to more and more misery (Europe), or in most cases some combination of these. Indulgence and inefficiency of poorly skilled political leaders and their often even worse alternatives has reached a boiling point. Particularly in those countries which have experienced rapid growth in the past decade, and from which the majority of the people were partially excluded. Notice also how in every one of these countries the index of social capital (measuring interpersonal trust) is substantially low. Turkey, Brazil and Indonesia are among the 10 worst ranked countries. I guess the rule of elites has only made things worse in terms of polarization within the domestic populations. 

Modernization hypothesis tested

The events happening in these relatively new democracies show us that the assumptions of the modernization theory don't seem to hold. As the paper by Acemoglu, Johnson, Robinson and Yared shows, countries that grow fast don't have a tendency to automatically become democratic or consolidate their democratic institutions faster. Even countries like South Korea or Taiwan had inter-political conflicts before their institutions had consolidated. The problem is when countries grow under authoritarian regimes, or political systems in which wealth is unevenly distributed, inequality starts becoming a big issue. The question of transition of power thus becomes the crucial issue in the quest for more inclusivness and the drive for change. 

Ultimately, these protests are much more than the usual protest against government. They present a resistance against an entire system, in which political, corporate and media elites in addition to a series of well-organized interest groups have captured most of the newly gained prosperity. The protests represent a quest towards more political and economic inclusiveness. People want to be included in the economic benefits their societies are achieving. Despite the progress most of these countries have achieved in the past decade, this new accumulation of wealth hasn't resulted in higher living standards for the domestic population. The economic rewards of growth have been captured by political elites and their vigilant cronies, with very little being left for the booming middle classes. By pulling many people out of poverty (or at least out of the low-income trap), the effect of globalization has empowered the middle classes who now demand higher inclusion in the democratic decision-making process. First and foremost through greater accountability and less corruption.

An economic theory of transitions

An economic theory of this story has been brilliantly portrayed by Acemoglu and Robinson in their first book, "Economic Origins of Dictatorships and Democracies". Their theory (which I teach to 4th year undergraduates in my Political Economy class) claims that the path towards consolidating a democracy will depend first and foremost on the allocation of political power and resources within a society. A democracy is always preferred by citizens, and always opposed by the elites who have captured most of the productive resources and hence posses de jure power (decision-making power). It was like this in both England and France, and in countries like South Africa or Argentina. However, citizens tend to posses de facto power (actual, real power), consisting of a credible threat of revolution. In a game theoretical equilibrium, when the costs of repression are sufficiently high and the promises of future redistribution and concessions by the authorities not credible, the elites will be forced to create a democracy (as the British PM Earl Grey in 1831 has made it clear: "...the principal of my reform is to prevent the necessity of revolution..."), and it will be consolidated to ensure further social stability. Thus elites chose democratization (or in today's terms more power to the people and more accountability) to avoid expropriation. Inequality also plays an important role in their theory, where intermediate levels of inequality make the path towards a democracy more likely. It all basically depends on how much each player has to lose. This will determine both the incentive for revolution, and the incentive for a counter coup by the elites. This is why some countries will find it hard to consolidate a democracy once it has been achieved (they mention Argentina in the book, however the most recent perfect examples are Turkey and Egypt).  

Finally, many commentators have stated how these protests are aimed against democracy or even against capitalism itself (particularly in Europe). I disagree. These protests aim for more democracy not less. The people desire a better democracy, characterized by greater accountability of politicians, less corruption, and altogether a strong plea against crony capitalism. They seek changes, reforms that will bring more justice, more human rights and higher living standards. They represent a quest for political and economic inclusiveness. 

* I turn here to an assumption from my Political Agency paper, where I claim that people do in fact notice useless, white elephant projects (particularly on a local level) particularly when such projects supersede the basic needs for welfare and other public services of the government. A decrease of voter utility is the trigger for expressing concern. Within this assumption I define the term "state of the economy". The affected voters send a signal of a poor state of the economy to the indifferent (swing) voters, who then vote against the indulgent government.

Monday, 1 July 2013

Croatia joins the EU!

Today Croatia became the 28th member of the European Union. After a long (12 year) EU accession process, after undergoing rigorous scrutiny (EC became careful after Bulgaria and Romania), a couple of corruption scandals, border issues with Slovenia and some attempts to strengthen domestic institutions, the European Commission has declared Croatia fit to join the EU.


The media across the globe has followed the story; the comments range from optimistic, realistic to pessimistic (see ReutersNew York TimesBBCFinancial Timesthe EconomistWSJGuardianDeutsche Welle, etc.). 

This 4,3 million populated country with GDP a bit over $60bn is hardly going to affect economic affairs in Europe. However, as we've seen by the examples in Cyprus or Slovenia, one can never be too careful. Having said that, it should be noted that Croatia didn't experience the financial troubles of Greece, Cyprus or Slovenia. In Croatia the banking system remained strong and well capitalized throughout the crisis. It was in fact the domestic (foreign-owned) banks that have bailed out the government in 2009 (by opening more liquidity when sources of financing were scarce). Croatia's problems are more structural not financial, and are linked to poor public management, corruption and expensive political concessions to various interest groups. Some attempt to reform domestic legal institutions was made thanks to outside pressure from the EU, but it remains to be seen how these institutions will interact in the new European environment. 

I have been asked on several occasions to comment on how the EU accession will impact Croatia, most recently by Neil Buckley of the Financial Times (in addition here is a text from an Irish journalist who quotes me as Dr Vuković - that's very nice of him). This is more or less what I've told the reporters: 

For a small open economy like Croatia the initial effect of EU accession will be significant, of course depending on the industry. For all those industries which haven't been able to adapt to the new market entry (via forming export clusters for example) will experience great difficulties and most likely go under. A decade long dependence on political concessions will hardly be helpful once the external competition enters the domestic market more strongly. On the other hand there is a possibility that the new increased competition from the EU will encourage new innovative solutions among Croatian entrepreneurs and thus contribute to more wealth creation. However, this is only possible if the domestic institutional system would encourage innovation and entrepreneurial incentives, and not discourage them by a huge number or regulatory and fiscal constraints or an inefficient bureaucracy (as was the case so far). It will be interesting to see how the EU bureaucratic apparatus will function in Croatia; will it add to the domestic woes or will it make things more efficient (a bit unlikely isn't it)? 

Secondly, the EU accession could paradoxically help Croatia's labour market situation by emulating the Polish effect. Since entering the EU almost 500,000 Polish citizens have emigrated to the UK, generally taking lower-paid jobs. The effect for the Polish economy was lower unemployment and lower pressure on its public finances, but also a significant increase of remittances being sent back home. (Croatia already experienced a similar scenario in the 70-ies when a lot of domestic labour emigrated to West Germany - these remittances have helped many families survive at the time). Such a scenario would imply a negative effect on the already poor domestic demographic picture, but it will be hard to avoid it since our governments haven't done much so far to maintain the educated and productive work force in Croatia. 
 
The only difference between 2004 and today is the poor labour market situation across Europe. This may after all keep the people at bay.

With regards to domestic aspirations, the people in general tend to feel that the EU will be helpful in terms of greater transparency and further fight against corruption. It was the pressure of EU negotiations that have forced governments to battle against huge domestic corruption scandals (most of them revolving around the ex PM Sanader and his party). Without outside pressure, the people feel this would have never been revealed.

Another thing almost everyone is looking forward to is using the money from EU structural funds. People like to stress out that we need to emulate the cases of Ireland, Poland or Estonia and how they have managed efficiently and effectively to use the EU funds into helping their domestic economies. So far, some funds have been allocated efficiently, but the general perception is that more needs to be done.