Friday, October 31, 2008

Does poverty cause civil war?

Not necessarily, according to this column by Simeon Djankov and Marta Reynal-Querol. It is generally argued that poverty is one of the causes of civil war. One corollary to this argument is that to avert civil war, poverty should be reduced first. The authors argue that this line of argument banks on the findings of two major studies by Fearon and Laitin and Collier and Hoeffler.
This “stylised fact,” that poverty breeds conflict and war, is supported by two empirical papers. Fearon and Laitin (2003) find that lower income per capita increases the likelihood of civil war. They argue that income per capita is a proxy for the state’s overall financial, administrative, police, and military capabilities. If the government is weak, rebels can expect success. Collier and Hoeffler (2004) find that income per capita, which could be related to the viability of rebellion, has considerable explanatory power in civil war regressions. Neither study deals with the possibly endogeneity of war to economic stagnation.

They argue that this line of argument could be accounted for by historical phenomena that jointly determine income evolution and conflict in the post-WWII era. Poverty and civil war could be driven by the same determinants (like colonial history), some of which are missed by in the typical econometric specifications.

A plausible explanation for the results found in the literature, on the strong relationship between poverty and civil war, is that there are some determinants that favour both economic development and peaceful negotiations, which are absent in the traditional specification. If this is the case, then OECD countries are peaceful not because they are rich, but because historically they suffered some circumstances that favoured negotiated settlements and economic development at the same time.

In particular, in a recent paper (Djankov and Reynal-Querol 2008), we show that the statistical association between poverty, as proxied by income per capita, and civil wars disappears once we include country fixed effects. The standard regression in the literature usually omits country fixed effects. In this context, these dummies capture any time-invariant country characteristics that affect the probability of civil war. This is important in the study of the relationship between per capita income and civil war, as some determinants that affect the condition for conflict may at the same time affect the condition for economic development. These results are robust to dividing the sample by 5-years 10-year, or 20-year periods or using annual data. Using a historical sample from 1825 to 2000, divided in periods of 25 and 50 years, produces the same result.

The authors not only look at the relationship between poverty and civil war in recent decades but also go back to history (from 1825 to 2000) and account for historical variables, which they include in their civil war regression. They find that poverty does not have an effect on civil wars. They include variables like European settler mortality rates and the population density. So, the relation between poverty and civil wars is at best indirect.

This finding has a very different policy implication: economic policies to reduce poverty does not necessarily lower the probability of having civil war.


Update: Fisman and Miguel respond by arguing that in Africa an income drop of 5% increases the risk of civil conflict in the following year to nearly 30%.

If we believe that a direct link connects poverty and violence, then when failing rains create economic hardship, war should follow. In this case, we can actually figure out whether poverty caused violence by isolating rainfall’s effects. Drought and the resulting economic hardship turn out to matter a lot for understanding conflict in Africa. In work with co-authors Shanker Satyanath and Ernest Sergenti of NYU, we find that a 1% decline in national GDP increases the likelihood of civil conflict by about 2 percentage points. So an income drop of 5%—a large but altogether common deterioration in economic conditions, especially when the rains fail—increases the risk of civil conflict in the following year to nearly 30%, up from an already-high average probability of conflict in Africa of around 20% in normal rainfall years. So we find that short-term shocks to income – exactly the type that Djankov and Reynal-Querol purport to study – do trigger violent conflict on the world’s war-prone continent.

Wednesday, October 29, 2008

Law of demand in action

It is a familiar story that economic agents respond to changes in price of a commodity by changing quantity demanded. This is the basic law of demand formally learnt in Econ 101—that is, price and quantity demanded are inversely related.

Here is the same principle applied in the real world:

The number of climbing expeditions to Himalayan mountains, including Mount Everest, has risen since Nepal reduced off season climbing fees three months ago, officials said on Wednesday.

Nepal announced a 50 percent cut in the climbing fees in August for the three-month autumn season starting in September as incentive to off-season climbers and boost tourism, hit by years of Maoist civil war and political unrest.

As a result the number of expeditions to different Himalayan peaks in Nepal during the Autumn season had increased to 145 this year, up from 84 in 2007, Tourism Ministry official Gyanendra Shrestha said.

Officials say tourist arrivals in 2007 also jumped 27.1 percent to 360,000 as visitors began to return to the scenic nation after the Maoists declared a ceasefire in 2006.

By the way, eight of the world’s 14 highest peaks above 8,000 meters, including Mount Everest, are located in Nepal, which is the poorest country in Asia with a GDP per capita income of $1,500 (PPP 2006 estimate).

Sachs and Green on the financial crisis

Jeff Sachs argues for expansionary, co-ordinated action from the US, EU, China, Japan, and the Middle East to prop up credit market and domestic demand in these countries and in the developing countries as well.

Any co-ordinated expansion should include the following actions. First, the US Federal Reserve, the European Central Bank and the Bank of Japan should extend swap lines to all main emerging markets, including Brazil, Hungary, Poland and Turkey, to prevent a drain of reserves. Second, the International Monetary Fund should extend low-conditionality loans to all countries that request it, starting with Pakistan. Third, the US and European central banks and bank regulators should work with their big banks to discourage them from abruptly withdrawing credit lines from overseas operations. Spain has a role to play with its banks in Latin America.

Fourth, China, Japan and South Korea should undertake a co-ordinated macroeconomic expansion. In China, this would mean raising spending on public housing and infrastructure. In Japan, this would mean a boost in infra- structure but also in loans to developing nations in Asia and Africa to finance projects built by Japanese and local companies. Development financing can be a powerful macro­econ­omic stabiliser. China, Japan and South Korea should work with other regional central banks to bolster expansionary policies backed by government-to-government loans.

Fifth, the Middle East, flush with cash, should fund investment projects in emerging markets and low-income countries. Moreover, it should keep up domestic spending despite a fall in oil prices. Indeed, the faster a global macro­economic expansion is in place the sooner oil prices will recover.

Sixth, the US and Europe should expand export credits for low and ­middle-income developing countries, not only to meet their unfulfilled aid promises but also as a counter-cyclical stimulus. It would be a tragedy for big infrastructure companies to suffer when the developing world is crying out for infrastructure investment.

Finally, there is scope for expansionary fiscal policy in the US and Europe, despite large budget deficits. The US expansion should focus on infrastructure and transfers to cash-strapped state governments, not tax cuts. This package will not stop a recession in the US and parts of Europe, but could stop a recession in Asia and the developing countries. At the least it would put a floor on the global contraction that is rapidly gaining strength.

Again, support for Keynesianism, which is the need of the hour (even Bernanke is falling into the lap of Keynes with all those talk about second round of stimulus package)…actually, it Keynesianism is always relevant in some scale! Also, a US sponsored global summit on Nov 15 will decide whether to overhaul key global institutions like the IMF and WB. It will most be in the regulatory side.

Meanwhile, Duncan Green fleshes out more on the financial crisis, Keynesianism and the climate change.

From the wreckage of the Depression emerged radical new approaches to running the world’s economies: Roosevelt’s New Deal, Keynesian beliefs in using government spending to manage slumps, and, in developing countries, a wholesale switch away from reliance on exporting raw materials such as coffee or copper to the pursuit of industrialisation.

A similar scale of tectonic shifts may be building below the surface of the current crisis. Some could resemble earlier transformations, others will have to break new ground – the world and its economy are now very different.

As in the previous crash, we are likely to see a retreat from the excesses and bubbles of laissez-faire capitalism as markets are re-regulated.

…Even before the current crisis, the world was facing new challenges. Since the Second World War, massive economic growth based on fossil fuels has brought material benefits to millions. Now we are entering an age of scarcity – of water, fertile soil and, above all, carbon.

Whether through the onset of “peak oil” or the response to climate change, the rationing of carbon will transform the nature and language of politics. Avoiding catastrophic climate change while still allowing poor countries to grow their way out of poverty will require the United States and Canada to reduce their per capita emissions from 20 tonnes to roughly two (some argue it should be nearer one tonne). The average starting point for Germany and France is ten tonnes per head. China stands at three tonnes.

…But that is not enough. Development requires effective states. The extraordinary transformation of countries such as South Korea, Vietnam and Botswana has invariably involved governments able to ensure their people are healthy and educated and that there are decent roads and power supplies, and which are willing to steer their economy through the dangerous, but ultimately rewarding rapids of globalisation.

The fight against poverty, inequality and the threat of environmental collapse will define the 21st century, as the fight against slavery and for universal suffrage defined earlier eras. It is hard to imagine a more worthwhile cause. Fail, and future generations will not forgive us. Succeed, and they will wonder how the world could have tolerated such needless injustice and suffering for so long.

Monday, October 27, 2008

Larry Summers argues for activist policy

Larry Summers argues that policy activism, especially in the fiscal side, spurs growth (well, at least it did after the WW II). He agrees that investment in interstate highway system, air travel and electronics led to such growth rate.

The most plausible explanation is that an array of transforming investments and technologies – the interstate highway system, widespread air travel and the expansion of electronics – were spurs to growth during the postwar period.

And, he also argues for selective policy intervention—identification of investments that stimulate demand in the short run and positively affect productivity in the long run. Does not this sound familiar, like industrial policy, to which Summers is so opposed to. See this as well.(This is exactly what Senator Obama has been arguing for in his campaign speeches).

So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.

All of these considerations suggest that the pendulum will swing – and should swing – towards an enhanced role for government in saving the market system from its excesses and inadequacies. Policymakers need to be attentive to potential government flaws as well. For example, they need to recognise that, even as events compel larger deficits in the short run, they reinforce the need for longer-term measures to keep government finances on a sound footing. They must also be wary of measures that have a short-term superficial appeal, yet have adverse long-term consequences.

Nepal at a loss of $256 million due to financial crisis

$256.16 million is the amount of loss the Nepali manufacturing sector will have to incur because of the global financial crisis (and ensuing economic slowdown). This estimate comes from the Confederation of Nepalese Industries (CNI). Though not a huge sum in terms of the scale of bail out package in the West, this means a lot to an economy with GDP amounting to US$ 42 billion. Also, this number accounts for just the manufacturing sector. The main sectors to be hit hard will be tourism sector, and possible hydropower—the two most prioritized sectors that could lead to stimulation of economic growth in the short and medium term. Moreover, melting purchasing power of customers in the West mean less demand for exportable products from Nepal. This loss will be much more higher and severe than the number CNI came up with. In Nepal, the effect will be seen in full scale in late 2009/early 2010 if the financial meltdown in the West reaches its nadir by this end of this year.

The industries that are hit hard now are iron, plastic, edible oil, metals an other manufacturing industries. It is also expected to affect tourism sector, FDI, housing and financial transactions and remittance inflow. This will pose a challenge in meeting the expected revenue for the current fiscal years, as was outlined by the Finance Minister in his budget speech.

The recent decision by the central bank to increase reserve ratio from 10 to 20% has worried investors because of potential tightening of credit market. Due to series of collapse of banks in recent months in the US and EU, the Nepali government increased reserve ratio by 10 percentage point to avert bank failures in Nepal. However, it seems that it comes with high opportunity cost of high cost of borrowing/finance for the private sector, the engine of growth for the economy.

Sunday, October 26, 2008

A mockery of copyrights

Big Mac...actually, its Yac Donalds!

7-Eleven up in the mountains...

These pictures are interesting. They were taken in Mustang, a trekking site in Nepal very popular among domestic and foreign tourists. I sourced the pics from Manoj Gajurel's facebook album.He is a popular comedian in Nepal.

And, a real pic of Kagbeni, Mustang:

Friday, October 24, 2008

The (insurmountable) level of crisis in the emerging countries

Dani Rodrik gives a feel about what the scale of the present financial crisis would be in the emerging countries. He thinks that the emerging countries would face much more severe crisis than the developed counterparts.

Emerging markets for the most part have weak and fragile fiscal systems, and the magnitude of the potential run is huge relative even to the large mountains of reserves that many of them have built up.  Socialization of private liabilities may enhance confidence in the rich countries; it will likely magnify the run in emerging markets.  So we are talking about economic collapses that could be significantly bigger than what the rich countries will experience.  And this time developing countries can legitimately say: it wasn't our fault!

It would be interesting to know what new ideas transpired/were floated when Rodrik, Rogoff, Stiglitz, Birdsall, and Sachs met with the UN Secretary-General Ban Ki-Moon recently. Rodrik sees a possible role for the IMF as a true global lender (massive) of last resort (without too many preconditions).

On a similar note, here is an interesting perspective: From capital flow bonanza to financial crash:

To examine the potential links with financial crises of various stripes, we constructed a family of country-specific probabilities. For each of the 64 countries, this implies four unconditional crisis probabilities, that of: default (or restructuring) on external sovereign debt, a currency crash, and a banking crisis. We also constructed the probability of each type of crisis within a window of three years before and after the bonanza year or years, this we refer to as the conditional probability of a crisis. If capital flow bonanzas make countries more crises prone, the conditional probability should be greater than the unconditional probability of a crisis.

For the full sample, the probability of any of the three varieties of crises conditional on a capital flow bonanza is significantly higher than the unconditional probability. Put differently, the incidence of a financial crisis is higher around a capital inflow bonanza. However, separating the high income countries from the rest qualifies the general result. As for the high income group, there are no systematic differences between the conditional and unconditional probabilities in the aggregate, although there are numerous country cases where the crisis probabilities increase markedly around a capital flow bonanza episode.

For sovereign defaults, less than half the countries (42%) record an increase in default probabilities around capital flow bonanzas. (Here, it is important to recall that about one-third of the countries in the sample are high income.) In two-thirds of the countries the likelihood of a currency crash is significantly higher around capital flow bonanzas in about 61% of the countries the probability of a banking crises is higher around capital flow bonanzas.

Most emerging market economies have thus far been relatively immune to the slowdown in the US. Many are basking in the economic warmth provided by high commodity prices and low borrowing costs. If the pattern of the past few decades holds true, however, those countries may be facing a darkening future.

Wasteful investment

This picture shows what happens when supply is created irrespective of demand. Wasteful investment!

These houses were built two years ago under the Maoists resettlement program. Two training centers and 80 houses (one for two family) were built. Some form of wearing and tearing (depreciation) is already seen in these houses without a single family residing on it. This is a complete waste of resources by the government.

Without first assessing whether the displaced families want to resettle in this particular location (Rupendehi) the government went ahead with the project. Officials now concede that the choice of location was wrong in the first place. This is a typical waste of resource resulting from lack of careful diagnostic of incentives and constraints to resettlement.

Money wasted: NRs 1 crore 65 lakhs (do the maths in dollars, US$1=NRs 74). More here.

Thursday, October 23, 2008

Stiglitz for transparency, oversight and fair competition

Here is a piece from Joseph Stiglitz, who argues that letting financial markets run wild was a risky business and now there is a need for more transparency, oversight and fair competition. Always interesting to read his pieces! He claims that the financial markets are not fulfilling their function- to mobilize savings, allocate capital and manage risk, transferring it from those less able to bear it to those more able.

In America, and some other countries, financial markets have not performed these functions well. They encouraged spendthrift patterns, which led to near-zero savings. They massively misallocated capital. And they created risk, did not manage it well and left huge risks with ordinary Americans, who are now bearing huge costs because of these failures. These problems have occurred repeatedly and are pervasive. The failures in financial markets have effects that spread out to the entire economy.

There are three related reasons for these failures: poorly designed incentive structures, inadequate competition and inadequate transparency.

Strong competition is an essential aspect of well-functioning markets. But information imperfections often limit the extent of competition. America's financial markets have gone beyond these natural limitations of competition to engage in anti-competitive practices…The failure to have strong competition enforcement has meant that there are a number of institutions that are so large that they are too big too fail. That provided an incentive to engage in excessively risky practices.

Finally, markets often fail to produce efficient outcomes (let alone fair or socially just outcomes) when information is imperfect or asymmetric. But information imperfections and asymmetries are at the centre of financial markets - that is what they are about. Our financial markets have even worked hard to exacerbate these problems, as they created non-transparent products that were so complex that not even those who created them fully understood them. This non-transparency is a key part of the credit crisis we have experienced over recent weeks.

Here is what Stiglitz thinks is needed for the wild markets (we need more of some Keynesian stuff):

We need more transparency to ensure that incentive structures do not encourage excessively risky short-sighted behaviour and to reduce the scope of conflicts of interest - our financial markets are rife with them. At the very least, they need to be disclosed. We need countercyclical capital adequacy/provisioning requirements and speed limits. We need to proscribe predatory lending - many of our problems are a result of lending that was both exploitive and risky. We need a financial products safety commission to make sure that the products purchased by, say, a bank or pension fund are safe and appropriate, designed to manage the risks they face; and a financial systems stability commission, to assess the overall stability of the system.

Part of the problem has been our regulatory structures. If government appoints as regulators those who do not believe in regulation, one is not likely to get strong enforcement. We have to design robust regulatory systems, where gaps in enforcement are transparent. Relatively simple regulatory systems may be easier to implement and more robust, and more resistant to regulatory capture.

Structural shift in employment, migration and inclusive growth in Nepal

Nepal, which has a per capita GDP of US $470 (2007/08), has witnessed impressive progress in poverty reduction in the last decade. According to NLSS II, the headcount poverty rate declined from 42% to 31% between 1995/96 and 2003/04, urban poverty declined from 22% to 10%, and rural poverty declined from 43% to 35%. However, income inequality is increasing: 6.4% per year for the richest 20%, as compared to 3.7% for the next quintile, and 2.5% for the lowest 20%.

The main four reasons for decrease in poverty level are remittances, farm wages, urbanization, and decline in fertility. But this decrease in poverty level is not uniform among all the population groups. Two factors that account for this are shift in structural employment and discrepancy in migration, according to a paper on inclusive growth in Nepal. This is a pretty different explanation as compared to the earlier standard explanations from the WB and government reports. This probably is true for regional reduction in poverty. Also, the author argues that he finds a strong relation between social exclusion, as defined by the caste system, and economic poverty.

The main pathways out of poverty from 1995 to 2003 have been landless farm workers who became subsistence farmers, construction or manufacturing workers, and subsistence farmers who added to their income by working in the same trades of construction and manufacturing industries, or as migrants to India.

The high poverty rates among the Tamang and Rai people of the eastern hills are reflected in the high average poverty rate of the eastern hills as reported in NLSS (2005). The eastern hills of Nepal is the only part of the country where the poverty rate increased from 1995 to 2003. This supports the conclusion that labor migration is a main explanation for the decline in poverty…. migration is at the lowest in the eastern hills, and if they migrate they tend to migrate within Nepal. In the western hills, on the other hand, a large majority migrate to India. The high level of labor migration to India from the western hills may explain the reduction in poverty in this region.

Can more households follow the same pathways out of poverty? The paper states that this (quite predictably) depends on the economic policy of the government. The author suggests that the government can learn from the experiences of successful Indian states like Kerela and Punjab. Meanwhile, for inclusive growth in sustainable agricultural sector and manufacturing sector hold the key to path out of poverty—for instance, employing Dalits and marginalized groups in manufacturing and construction business in semi-urban areas and freeing permanent laborers from landlords in villages and enacting moderate land distribution schemes, the author argues.

A combination of a social security net with competitive markets and secure property rights, may foster domestic and foreign investments in productive physical and human capital. The role of the government will be to broaden the tax base, and spend the tax incomes, as well as foreign aid, on public goods in support of the combined goal of social security and economic growth. This implies investments in roads, transmission lines for electricity, irrigation, as well as primary education and subsidized health services. Nepal may also consider to copy the rural employment guarantee of India. With a sound social and economic policy Nepal may in general be able to copy the developments of the most successful states of India, with a combination of the policies of Kerala and Punjab, where Kerala focused early on the social sectors, while Punjab focused on agriculture. 

Note that the present government is run by the Maoists who have gained popular support on the back of land reforms and end to feudalism. But the question is how are they going to do land reforms with tempering market and individual incentives? Concerns of private appropriability is running high. I remain skeptical about land redistribution program because of the unclear policies of the Maoists in this regard. A Maoist land minister had to resign last month after he refused to refute and retune a land grab stint Maoists party cadres did on his leadership! My concerns about the land reforms under the red flag here.

Policy interventions for inclusive growth:

Education and training programs leads to improved human capital. Subsidized health services insure people against major risks, which, in turn, allow them to make profitable investments rather than investments that make them able to handle different types of risk. Investments in physical capital, like transmission lines, roads and irrigation is necessary for economic growth, and a broad-based tax system is necessary to finance these and other costs. Finally, some targeted programs may be beneficiary, such as land redistribution to landless Dalits in remote villages of terai, and experiments with a rural employment guarantee in the same areas.

More on poverty in Nepal here.

Tuesday, October 21, 2008

Former Botswana President Mogae wins the Mo Ibrahim prize

Former Botswana President Festus Mogae was awarded the Mo Ibrahim Prize for Achievement in African leadership, which is also the world’s largest individual award with a price tag of $5 million (the Nobel prize is $1.4 million). This prize is awarded annually to a former African executive Head of State or Government who has demonstrated excellence in African leadership. All this to promote good governance, one of the main factors lacking in Africa!

Key facts about Mogae’s leadership:

- Mogae served two terms in office, nearly 10 years, before handing over to Seretse Khama Ian Khama in a peaceful transition in April 2008. Before that he was vice president for six years.

- He studied economics in Britain, before becoming a civil servant in Botswana. He has held roles at the International Monetary Fund and Bank of Botswana.

- Botswana's GDP per capita is the highest in sub-Saharan Africa, and the country is ranked the continent's least corrupt by Transparency International.

Mo Ibrahim is a Sudanese-born telecommunication tycoon who is the founder of Celtel International, one of Africa’s most successful private companies. He believes that good governance requires an environment conducive to peace, security, and development, based on the rule of law and respect for human rights.

The (limited) impact of foreign investment in the Americas

It is expected that the level of foreign investment has a direct positive relationship with stimulation of investment and hence the economy in a given investment-deficient country. Actually, in reality this depends on whether FDI acts as a complement (crowd in) or substitute (crowd out) to the level of domestic investment in an economy. (more below)

A study (Foreign Investment and Sustainable Development: Lessons from the Americas) by the Working Group on Development and the Environment in the Americas finds that foreign investment has fallen short of stimulating “broad-based” economic growth and sustainable development in Latin America. The working group studies the impact of foreign investment on economic growth, environment policy, and the political economy of Argentina, Brazil, Bolivia, Chile, Costa Rica, Ecuador, Mexico, Uruguay, and Venezuela.

They studied various regional and bilateral agreements like NAFTA, US-Chile FTA, CAFTA, US-Peru FTA, etc and looked at the impact of investment liberalization (a part of the Washington Consensus) on the Americas. What did they find? This wave of liberalization that started in the 1990s did not produce significant results as was expected. Economic growth in per capita terms in the region was slower than in the final decades of the import substitution period, according to the report.

Major findings of the report:

  • 80% of all the FDI was concentrated in Brazil, Argentina, Chile, and Venezuela.
  • Foreign firms in Mexico were export platforms to the US and those in the South America tended to sell in their own domestic market.
  • Foreign firms tended to have higher level of productivity and higher wages.
  • FDI fell short of generating spillovers and backward linkages that could help stimulation of domestic economy through emergence of local small and medium sized businesses. In fact, FDI tended to displace and kill local businesses. R&D expenditures in the host economies were not upped.
  • Environmental performance of foreign firms was mixed, sometime better and sometimes worse performance than domestic counterparts.

Note that the report does not label that the FDI’s impact on economic growth and environmental sustainability was a complete flop- it had a limited success in Latin American countries. There are cases where FDI has been a crucial factor behind rising economic growth like in China, South Korea, Bhutan, Taiwan, Malaysia, Singapore, and Mauritius, among others. The report slides in a space where there is always a trade off between growth objectives and impact on environment arising from increasing investment (both domestic and FDI). Cost is always high when considering the impact of an investment plan in an environmentally conscious manner.

Important lessons from the Latin American experience:

  • FDI is not an end but a means to sustainable development. Simply attracting FDI is not enough to generate economic growth in an environmentally sustainable manner.
  • FDI policy needs to be paired with significant and targeted domestic policies that upgrade the capabilities of national firms and provide a benchmark of environmental protection.
  • There needs to be policy space to accommodate domestic concerns in international agreements.

One of the lessons from the report is that FDI does not necessarily crowd in domestic investment. Actually, the impact of FDI on domestic investment is mixed. In Latin America, FDI has in crowed out domestic investment, as shown by this report, but in Asia (East Asia especially) and Africa, FDI has led to crowding in of domestic investment. FDI tend to be a substitute for domestic investment when there are lot of domestic firms. Meanwhile, FDI tend to be complementary when there are few domestic firms (whole sorts ancillary firms will emerge because of R&D and knowledge spillovers from MNCs). The existence of backward and forward linkages from the establishment of foreign investors is a key consideration for determining the total impact of FDI on capital formation.

Background working papers leading to the report are available here.

Sunday, October 19, 2008

Roads, growth, and development

After reading my latest op-ed, some readers emailed me interesting (and positive) remarks. The piece was about Krugman and application of his New Economic Geography theory in the context of Nepal. Towards the end of the op-ed, I tried to draw in some policy implications and said that for development and poverty reduction, the government should try to induce spread of industries from "core" to "periphery". And, one important step in this direction would be to build, build, and build roads (I mean transportation services). It means high public expenditure and an activist policy. I also suggested the way in which the private sector can be engaged in this effort. Okay!

Today, Shailee Pradhan published an op-ed arguing that "the creation of roads does not always lead to development and prosperity". To be frank, this was the subtitle. The main title was: Road to development. It is up to the readers to judge how contradictory the main title and the subtitle of the op-ed is!

High transportation costs have led to industries clustering in select few locations, creating an uneven development process. The difference between the urbanised "core" and the lesser developed "periphery" is troubling. While the question of how to ensure the formation of such cores in the villages is an important one, it is first necessary to ask where to encourage such cores and what sectors to specialise in.

...However, it is critical to plan where to build roads by identifying and prioritising key areas based on the population and their needs. How important was it to build the road to Jomsom? With a population of less than 10,000, Mustang district (Jomsom is the district-headquarters) is sparsely populated. Mustang is not a high food-producing area either, except for apples of which only about 20,000 tons are produced annually.

Furthermore, the ecosystem around the Annapurna Circuit is very fragile as these are young mountains made of sedimentary rocks. The road construction process involving heavy blasting as well as the additional traffic flowing in now have put serious pressure on the ecosystem and the biodiversity here.

...It is necessary to diversify "cores" for a more even development, but building roads and creating industries is not the only way to diversify such cores. Where the costs of building roads, monetary and environmental, are extremely high, alternative modes of transportation such as cable cars and airplanes should be considered.

Let me take on some of the issues. I agree that there is some form of trade-off between building roads and environment. Also, there is no doubt that health of ecosystem and negative externalities should be kept in mind before building roads. Period.

Regarding this op-ed, I have two points to say: (i) the concept of "core" and "periphery" is primarily related to the nature of location or clustering of industries in one location, (ii) industries tend to cluster around locations where there is relatively easy availability of backward and forward linkages, where there is potential consumer, and where there is low transportation costs. With this, this process is self-sustaining (some form of endogenity will come into play).

To induce spread of industries in other places except in few industrial hubs only, I argued for government intervention to create necessary conditions (one of them to build roads) to decrease transportation costs. This was in context of explaining the theory I was discussing about. It is not possible to have "cores" in an area like Jomsom, where per capita purchasing power is very low and the population itself is not considered to be worthy of generating enough effective demand to fend off associated costs of establishing new industries. By arguing for activist policies to induce spread of industries, I meant to focus on building roads in places where the two conditions discussed above are satisfied.

Yes, there are places like Syangja, Palpa, Butwal, Baglung, etc. where the two conditions are fairly fulfilled. Obviously, this also means that Mustang is out of consideration. Moreover, I not only argued for building roads. Where it is not feasible, it is fruitful to build other means of transportation like cable car, airports, and railways. In places like Jomsom, these means of transportation can only link the outlier districts with the urban places. Except for railways (which is not feasible due to budget constraints and topographical issues), the other two modes of transportation will not decrease transportation costs. It will, in fact, increase the cost of production. Furthermore, road construction project should not be carried out if the marginal cost of making it is higher than the private cost.

Roads are one of the most effective means to link production site to markets  and vice versa. This is actually one of the necessary conditions for long term economic growth. This is essential both for economic growth and long term development. And yes, it can be done in a sustainable fashion.

Saturday, October 18, 2008

Ubiquitous Keynes

Keynesianism is in high demand! Come crisis the markets cannot deal with, bank on Keynes, whose life’s mission was “to save capitalism from itself”. Could not agree more!! Even Hayek described him as “the one really great man I ever knew, and for whom I had unbounded admiration”. Here is a nice piece from the FT.

As the world reels from a 1929-style stock market plunge and a 1931-style banking crisis, his words are a fair assessment of the dangers we face once again. Keynes, whose life’s mission was to save capitalism from itself, is more relevant than at any time since his death in 1946.

His renewed influence can be seen everywhere: in Barack Obama’s planned stimulus package, for example. When George W. Bush said his administration’s plan to take equity in banks was “not intended to take over the free market, but to preserve it”, he could have been quoting Keynes directly.

The heart of the book [The General Theory of Employment, Interest and Money, 1936] is the idea that economic downturns are not necessarily self-correcting. Classical economics held that business cycles were unavoidable and that peaks and troughs would pass. Keynes contended that in certain circumstances economies could get stuck. If individuals and businesses try to save more, they will cut the incomes of other individuals and businesses, which will in turn cut their spending. The result can be a downward spiral that will not turn up again without outside intervention.

That is where government comes in: to pump money back into the economy by some means, such as spending on public works, to persuade individuals and businesses to save less and spend more themselves.

Markets are either imperfect or heavily distorted or agents lack incentives or there are rampant failures (or all) in the developing countries. So, the need of Keynesian approach is ever increasing. Remember that the fantasy to institute markets in a place where there was no foundation for it to take place, usually Africa, in the 80s and 90s did not lead to progress in growth and development (also, the number of conflicts at a given point of time did not decrease). What is needed is not austerity but a sensible application of Keynesian approach so that while aggregate demand and economy are stimulated, the market incentives are not tempered as well. The market and government can be complements and save each other from going down. There is no more for one and less for the other. It depends on contexts and circumstances individual countries are in. There are some sectors where letting markets loose bring wonders but there are also some sectors where markets cannot simply work or even if they work, they work for a select few. Government can help create an unsuitable place for market into a suitable place by sharing risks, building perquisites for the markets to function properly, instituting good governance, providing productivity enhancing subsidies, etc.—there are a whole slew of demand management techniques to follow (sensibly).

That being said, there should be no room for failed Marxist ideology. China has already experienced it. So has Vietnam. Now, Nepal (where Maoists party run the government…yes, they were elected by the people) should follow suit rather than getting bogged down on sloppy socialist slogans. Keynesianism is neither socialism nor Marxism. It is a complementary buddy of the market!

A nice description of Keynes:

image He was an imposing figure, six feet, six inches tall and full of jokes, gossip and sharp observations. Alongside economics, he had an array of other interests as mathematician, administrator, academic, investor, journalist, art collector, politician, impresario and diplomat. He was even an exemplary husband, devoted to his wife, Lydia Lopokova, a ballerina. In his language he could be carelessly provocative. But, as he said: “Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.”

When bad policies were making economic problems worse, he felt a moral obligation to change them. He worked with distinction at the Treasury during the first world war and at the war’s end argued presciently against the imposition of excessively harsh conditions on Germany. When his advice was ignored, he left and published his views in his first great polemic, The Economic Consequences of the Peace .

Here is a full text link to Keynes’ masterpiece: The General Theory of Employment, Interest, and Monetary Theory. Downloadable version of The Economic Consequences of The Peace. More about Keynes and the current financial crisis here.

Keynes, Keynes, Keynes…

Krugman argues that there is not much the Federal Reserve can do right now because despite repeated interest rate cuts, unemployment is rising and credit market is still tight. So, way out of rising unemployment is to go by the Keynesian rules, i.e. in the face of ineffective monetary policies, use fiscal policies to stimulate aggregate demand by public investment in infrastructure, unemployment benefits, and emergency aid. With this comes deficit, which Krugman says can be forgotten for now.

In other words, there’s not much Ben Bernanke can do for the economy. He can and should cut interest rates even more — but nobody expects this to do more than provide a slight economic boost.

On the other hand, there’s a lot the federal government can do for the economy. It can provide extended benefits to the unemployed, which will both help distressed families cope and put money in the hands of people likely to spend it. It can provide emergency aid to state and local governments, so that they aren’t forced into steep spending cuts that both degrade public services and destroy jobs. It can buy up mortgages (but not at face value, as John McCain has proposed) and restructure the terms to help families stay in their homes.

And this is also a good time to engage in some serious infrastructure spending, which the country badly needs in any case. The usual argument against public works as economic stimulus is that they take too long: by the time you get around to repairing that bridge and upgrading that rail line, the slump is over and the stimulus isn’t needed. Well, that argument has no force now, since the chances that this slump will be over anytime soon are virtually nil. So let’s get those projects rolling.

Here is similar call for Keynes by Jayati Ghosh. Here is Keynes and the Crisis by Axel Leijonhufvud.

Friday, October 17, 2008

Bhagwati on the financial mess

Jagdish Bhagwati calls for a truly independent commission of experts to scrutinize each financial innovation’s potential downside. He terms the back-and-forth appointment of bigwigs from the Wall Sts to Treasury department and then again to the Wall Sts a “Wall Street-Treasury Complex”. Nice naming there!

When the dust has settled, we must ask the question: why did this crisis occur? There are specifics that are not applicable everywhere. The crisis was, for example, kicked off by highly leveraged lending for uncreditworthy mortgages by the quasi-governmental Freddie Mac and Fannie Mae. But the problems became huge because “policy innovations” had been racing ahead of comprehension. The securitisation of mortgages was an innovation that led unwittingly to what Wall Street calls “betting the company”. Credit-default swaps allowed AIG to bring in huge returns but at high risk if things went wrong, which they did.

The Long Term Capital Management crisis had a similar problem. At its heart were derivatives that no one quite understood. …The downside had not been anticipated.

The failure to think about the downside results from what I call the “Wall Street-Treasury Complex”. Robert Rubin went from Goldman Sachs to the Treasury and back to Citigroup. Hank Paulson went from Goldman Sachs to the Treasury and will doubtless return also to Wall Street. This network shares the optimistic scenarios that Wall Street spins. Mr Rubin was in charge of the Treasury during the Asian financial crisis, whereas Mr Paulson was among the five major investment banking chief executives who persuaded the Securities and Exchange Commission not to extend prudential reserve requirements to their companies.

The question is: how can you assess the downsides without first letting the innovation play into real economy? If something is an innovation, then it is a new thing, which essentially means that even the innovator is not fully aware of its full potential or risks or downsides. The innovator can argue that the innovation will work by showing high degree of success (i.e. the probability of success might be pretty high). But this itself is not fully guaranteed because no one can test innovation against unexpected circumstances or yet-to-be-known risks. The best way to assessing downsides of an innovation would be to periodically review its impact on the economy—this means that you cannot test an innovation beforehand because you don’t know the set of circumstances under which it will not work (the innovator might have an idea of the set of circumstances where it can work, but he or she cannot list the full elements of the set). But having a regulatory authority that can assess risks beforehand is a good idea. We are yet to have one of these things in the world! Anyway, thats it for now. Its getting too late. Time to go to bed!

Nice sentences about a good economist

Sourced from The Economist:

In neither contribution did Mr Krugman claim great originality for his ideas or great realism. His achievement was to formalise insights that many people had previously had informally. Ideas that had fluttered in and out of people’s grasp for decades, he pinned down like a butterfly on display. Sometimes a good economist, like a good columnist, succeeds not by making a point before everyone else, but by making it better than anyone else.

Resource curse in Congo

Policy Innovations has a nice article about resource curse, weak government, and violence in the Democratic Republic of Congo (DRC):

The DRC's turmoil can be traced to the country's toxic combination of tempting mineral wealth, feeble government, vast size, and weak cohesion. This mixture turns the DRC's rich natural resource heritage into a poison that affects every aspect of its body politic.

Instead of acting as the country's economic engine, the plentiful deposits—including uranium, diamonds, and copper—have repeatedly fueled violent conflict and corruption. Local militia and foreign armies smuggle vast amounts out of the country—an estimated $400 million in diamonds and gold alone have been lost this way annually in recent years—while doing everything within their power to prevent a weak state from establishing its authority.

Barely connected to each other by meager transportation, communication, and institutional links, local groups have little reason to profess loyalty to an ineffective and distant state—and every incentive to seek enrichment at that state's expense. As a result, the country's history has been plagued by a zero-sum competition among mutually antagonistic cities, regions, and ethnic groups.

The author argues that traditional Western prescription-elections, economic reform, and administrative restructuring- of fixing conflict-prone countries is not going to work. He recommends three institutional innovations:

  1. Multinational natural resource companies could play a greater role in protecting major mineral sites and providing services to citizens.Although many people might recoil at this idea, major international corporations have the strongest management capacity in the country and—under the right contractual arrangement—could have the greatest incentive to ensure that the state's mineral wealth be used to improve the lives of the DRC's people.
  2. Instead of attempting to build the DRC along the lines of the Western model of top-down governance, the international community should be advocating a far more horizontal model. The main governing structures would be shaped around cities and their surrounding rural areas, with programs built from the ground up. A looser, more horizontal governing structure, in which power and responsibility flowed from large municipalities upward and outward would make individual units far more effective, especially if outside assistance focused on improving their management, transparency, and accountability.
  3. International donors could improve government performance if they focused more on designing systems that would keep local officials responsible to their constituents. Elections alone will not dramatically improve how government operates—especially elections for leaders in distant cities who have little influence on local programs (the international community spent more than $500 million on national elections

The dismal output from trade liberalization in Africa

What happens when trade liberalization is not followed by reforms in structural and institutional constraints? Well, the level and composition of exports will not change and will lead to decrease in market share as foreign goods and services flood domestic market, which lacks strong industrial background. According a report from UNCTAD, trade liberalization in Africa in the past 25 years has led to decrease in market share for world exports from 6%  in 1980 to 3% in 2007. Moreover, there is barely any headway in the level and composition of exports.

The report highlights that despite trade liberalization, the African countries have not diversified their exports towards more dynamic primary commodities and manufacturing goods, which are less prone to the vagaries of international markets. The report attributes Africa’s weak supply response as the most important impediment to the continent’s export performance. It recommends that future export policies should focus more on way to increase production for export.

In a way the report declares that the structural adjustment programs, spearheaded by the IMF and the WB, in Africa was a complete failure. By 1985, 60% of African countries were under the SPAs and by 1995, almost all the African nations were under the such programs. The result after two and a half decades: dismal performance in the very sector the reform programs were supposed to help Africa grow! The Washington Consensus was an utter failure in Africa.

Export diversification is very low in Africa. African countries remain principally primary commodity exporters and the dependence of African countries on a small number of export products has increased in the period following liberalization. Many countries in the region are at present less able to withstand price shifts for a few key  commodities than they were prior to liberalization.

The tide of trade liberalization (cut high taxation and “getting prices right”)was expected to increased production of tradables, generate positive externalities for the economy by improving efficiency of production, generate substitutions effect so that price of imported inputs were lower and thus promote exports by increasing production, increase investment both from domestic as well as foreign investors, etc. However, huge subsidies in the US and EU on agricultural sector basically wiped off the African agricultural base because cheap products not only displaced African agriculture production in the market but also created disincentives among farmers to engage in agriculture, leading to high dependence rate on foreign food aid and imports.

Production and marketing costs increased during liberalization, with the removal of subsidies and currency devaluations, while the dissolution of marketing boards added price risks to the uncertainties of rain-fed agriculture. The consequence is that much of Africa continues to be dependent on traditional bulk agricultural commodities for a major share of its export earnings. Paradoxically, African countries have been losing market share to other developing countries even in exports of these commodities.

The report recommends increase in public investment in R&D, including roads and irrigation facilities, health and education. Also, facilitating access to inputs, encouragement of new investment, and better access to market information would help improve overall efficiency in agricultural trade. The point that remains unanswered is: how much of a damage does subsidies inflict on agriculture development in Africa.

For the manufacturing sector the report recommends to:

  • increasing firm competitiveness at the economy level and at the firm level
  • encouraging establishment of large manufacturing firms
  • facilitating access to credit to invest and foster firm growth
  • creating a framework of interaction between financial institutions and private sector

The report states that trade liberalization should not be seen as an end in itself; it should be a subset of a comprehensive developments strategy. Focus should be shifted back to the development strategies that are consistent with the development challenges and priorities of African countries.

Thursday, October 16, 2008

Funny stuff on a funny show!

A glance at poverty in Nepal

So, today is the Blog Action Day. This year’s topic is poverty. Here is my blog post about poverty in Nepal.

Nepal, which has a per capita GDP of US $470 (2007/08), has seen witnessed impressive progress in poverty reduction in the last decade. According to NLSS II, the headcount poverty rate declined from 42% to 31% between 1995/96 and 2003/04, urban poverty declined from 22% to 10%, and rural poverty declined from 43% to 35%. One of the major challenges for policymakers now is to make sure that villages are not left behind in the process of growth and development. Proportionally, the benefits of improvement in GDP growth rate has gone to the urban folks while the village folks, who are the ones reeling under poverty and hunger, are left behind. Adverse production season and global rise in commodity prices has put more than 25 districts under the radar of acute food shortage, according to the WFP.

The bad news: inequality increased—Gini coefficient shoot up from 34.2 to 41.1

Reasons for decrease in poverty, according to the WB, are:

Remittances: A significant increase in remittances propped up consumption. The proportion of households receiving remittances increased to 32% in FY03/04 from from 24 percent in FY95/96. In 2004, about 1 million Nepalese worked abroad, primarily in India, the Gulf and East Asian countries. Also, the average real remittance amount has risen by more than 80% .

Farm wages: After improving productivity and tightening the labor market, agricultural wages increased by about 25% in real terms over ten years. Increased demand, coupled with improved connectivity and better access to markets, stimulated entrepreneurial activities and allowed for non-agricultural wages and incomes to increase.

Urbanization: Increased urbanization moved workers from low productivity jobs in rural areas to higher productivity jobs in urban areas.

Fertility: The decline in fertility (starting in the 1980s) reduced the household size and the dependency ratio.

According to the Nepal Living Standard Survey II (NLSS II), self-reported welfare has improved across all types of consumption over the last eight years. If we assign households reporting "less than
adequate" consumption as self-reported “poor”, such subjective poverty has decreased substantively from 1995/96 to 2003/04. In this period, inadequacy in food consumption has declined by 21 percentage points, housing by 23, clothing by 22, health care by 31, and schooling by 24 percentage points. Inadequacy in total income, however, shows a slight decline from an already very high rate in

Description Survey Year Survey Year

% of HH reporting “less than adequate”




Food consumption 50.9 31.2
Housing 64.1 40.6
Clothing 57.6 35.6
Healthcare 58.7 28.3
Schooling 45.4 21.4
Total income 72.6 67.0


Increase in remittances is one of the main factors that led to such a progress in poverty reduction. Inward remittance flows amounted to 18% of GDP in 2006 (US$ 1453 million in 2006). Emigrants constituted 2.8% of the population in 2005. Usually, youths from poor households go abroad to do labor work and send money back directly to their families. Unlike foreign aid or investment plans (where money gets filtered among different strata of the bureaucracy, leaving a gap between what is initially allocated and what is delivered on ground during implementation), remittances are sent directly to households, which, in turn, is used to fulfill consumption needs. It might be surprising to note that reduction in poverty level in Nepal has little to do with meager economic growth rate and the rate of expansion of the manufacturing sector (see the figure below).

Agricultural productivity and the level of inflow of remittances are the two most important variables of the poverty function in Nepal. As money gets into household’s hand readily from these two variables, they use extra income in consumption. It is hardly surprising that there has been a booming demand for consumer products, especially those made in and imported from China. People buy cheap Chinese products ranging from TVs to fancy cloths and bikes (yes, they do…leading to horrible traffic congestion!). Earlier, we used to joke:  Material standard of living has leapfrogged real standard of living because of the influx of Chinese goods in the market. Well, who cares as long as people have money to spend on them!

Wednesday, October 15, 2008

2008 Nobel Prize in Economics and Nepali Economy

New Op-Ed in today’s The Kathmandu Post: Roads to progress: Nobel thoughts about the Nepali economy

I like to apply economics theories I learn in my classroom and from textbooks to the real world. I sometimes struggle to understand some awesome theories if I am not able to relate them with real world issues! O.K. I have been reading Krugman’s work since I first used his Microeconomics book in Econ 101 class during first semester of freshmen year. Since International Economics course has not been offered for some time now, I am following Krugman’s work freely (without order) and whenever I get time (there is always increasing returns while reading his work!). And, since his model on trade theory is relatively realistic than others (I mean the classics), I was wondering the application of his theory on the Nepali economy. I was also interested on policy implication of the theories.

I was thinking about writing an Op-Ed on the application aspect of his theory but kept on postponing the idea! Now, what an appropriate time to write about it. Paul Krugman was awarded the 2008 Nobel Prize in Economics on Monday for his work on the “analysis of trade patterns and location of economic activity.” And, I snatched this occasion (while enjoying no classes/free time during Fall pause!) to write an Op-Ed. Ya, finally! Note that I am just looking at his work that are relevant to the Nepali economy (based on my presumptions about the economy). Other factors like availability of credit, local and regional political situation, raw materials and intermediate inputs availability in a given locality, etc also influence the conclusion/analysis I have outlined in this Op-Ed. Nevertheless, I think the argument derived from the theory does justice to policy interpretation and prescription.

Check out the full piece titled Roads to progress: Nobel thoughts about the Nepali economy

Krugman's work on transportation costs and the role of geography in development has a direct present day relevance to the state of the Nepali economy. If we look at the location of firms in the country, it is not hard to realize that most of them are located in the tarai and in cities near the Nepal-India border. Why do most of them opt to establish factories in the tarai and in major metropolitan areas like Kathmandu and Pokhara? Why don't they establish factories in hilly districts like Syangja, Bajura, Rukum, Kabhre, Bhojpur and Gorkha, among others? It is because of high transportation costs and dim prospects for increasing returns to scale!

Profit-seeking economic agents and private firms always opt to invest and operate in areas where the cost of transportation is low and there is a chance to exploit economies of scale. Hence, we are seeing increasingly divergent episodes in terms of regional growth and development. Metropolises like Biratnagar, Birgunj, Pokhara and Kathmandu are the urbanised “core”, and places like Syangja, Rolpa, Rukum and Bhojpur are the less developed “periphery”.

The “cores” have better forward and backward linkages and a fairly higher concentration of purchasing power. Also, intermediate inputs are available with less hassle and at lower cost. Moreover, these areas are also transport hubs as major highways joining outlying districts with the capital and other major cities pass through them, leading to a lower per-unit cost of transportation. It becomes a self-reinforcing process, and the few cores always leap forward in terms of development while leaving the peripheries languishing in traditional activity with low wages. This might explain why the big cities mentioned above have more industries and firms than other areas in the country.

And some policy stuff:

What can the government do to encourage relocation of industries? The answer is build, build and build roads and other means of transportation! Only 43 percent of the population has access to roads, and six districts are still unreachable by surface transport. Most of the districts are connected by unpaved roads, and those that have paved roads are pockmarked by potholes -- a recipe for higher transportation costs. Given this situation, it is no wonder that investors are establishing new firms in the same cores that have already been swamped by firms and people. Constructing roads and other appropriate means of transportation to lower shipping costs will probably lead to the spread of industries to other parts of the country.

One way the government can expedite the process of achieving lower transportation costs, increasing returns to scale and spreading industries from the core to the periphery is by offering subsidies in the form of tax credits and sharing of risks. The government can involve the private sector in road construction by offering direct subsidies on machinery and equipment and by sharing financial and social risks. This will probably encourage the private sector to not only invest in infrastructure construction in different parts of the country, but also to establish factories in villages that will be connected with roads and other means of transportation. This might also lead to a relatively equitable spread of industries.

Meanwhile, for export-oriented industries, the government can fast-forward the process of establishing Special Economic Zones where transportation costs are significantly lower by providing tax incentives and readily available forward and backward linkages.

A pdf version of the page:

Keynesian Renaissance??

Steve Lohr writes intervention is bold, but has a basis in history.

The high-stakes program is intended to halt the worst financial crisis since the 1930s. If successful, it could long be studied by historians as a textbook case of the emergency role that government can play to rescue a teetering economy.

“The goal is to get the engine of capitalism going as productively as possible,” said Nancy Koehn, a historian at the Harvard Business School. “Ideology is a luxury good in times of crisis.”

David Brooks sees big government ahead.

we’re in for a Keynesian renaissance. The Fed has little room to stimulate the economy, so Democrats will use government outlays to boost consumption. Nouriel Roubini of New York University argues that the economy will need a $300 billion fiscal stimulus.

What we’re going to see, in short, is the Gingrich revolution in reverse and on steroids. There will be a big increase in spending and deficits. In normal times, moderates could have restrained the zeal on the left. In an economic crisis, not a chance. The over-reach is coming. The backlash is next.

Anthony Faiola paints a gloomy picture for the American Capitalism: The End of American Capitalism?

The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism.

Since the 1930s, U.S. banks were the flagships of American economic might, and emulation by other nations of the fiercely free-market financial system in the United States was expected and encouraged. But the market turmoil that is draining the nation's wealth and has upended Wall Street now threatens to put the banks at the heart of the U.S. financial system at least partly in the hands of the government.

"People around the world once admired us for our economy, and we told them if you wanted to be like us, here's what you have to do -- hand over power to the market," said Joseph Stiglitz, the Nobel Prize-winning economist at Columbia University. "The point now is that no one has respect for that kind of model anymore given this crisis. And of course it raises questions about our credibility. Everyone feels they are suffering now because of us."

To some degree, those calls are even being echoed by the International Monetary Fund, an institution charged with the promotion of free markets overseas and that preached that less government was good government during the economic crises in Asia and Latin America in the 1990s. Now, it is talking about the need for regulation and oversight. "Obviously the crisis comes from an important regulatory and supervisory failure in advanced countries . . . and a failure in market discipline mechanisms," Dominique Strauss-Kahn, the IMF's managing director, said yesterday before the fund's annual meeting in Washington.

Dionne disagrees with Faiola and argues that its the rebirth of American capitalism.

Acknowledging an important role for government in social and economic life is -- and always has been -- the American way. American capitalism has thrived in a mixed economy that accomodated a large role for the state. The exceptional period has been the last three decades, when truly radical doctrines took hold. It is actually radical to imagine that the economy will go forward smoothly if the government rips up the rules, deregulates willy-nilly, gets out of the way and stops investing in public goods (education among them) that the market tends to under-finance.

In our history, strong and active government has always helped make capitalism work. It goes back to Alexander Hamilton and Henry Clay’s “American System,” much admired by Abraham Lincoln. Clay thought it essential for the government to invest in “internal improvements,” including roads and canals, and he favored protective tariffs that would allow American industries to grow. Yes, for all the free trade talk today, American industrial might grew behind high and thick protectionist walls. You can argue about the merits of those policies, as Americans did at the time, but they are part of our history and they played an important role in our development as a manufacturing power.

What’s going away today, in other words, is not “American Capitalism” but a doctrine of pure laissez-faire capitalism that was deeply flawed and not in keeping with the traditionally American approach to markets. We are coming back to how we historically did business. And I am persuaded that we will be far better off with a less doctrinaire approach.

Kevin Gallagher predicts that the intellectual tide is turning against free trade:

Last Friday the New York Times quoted the World Bank as saying "There's no question the Washington consensus is dead," indeed it "died at the time of the $700bn bail-out." If the bail-out is death, then awarding Paul Krugman the Nobel prize for economics is the nail in the coffin.

In another classic book, Development, Geography, and Economic Theory, Krugman argued that the government should also play a role in connecting beneficiaries of strategic trade policy to the overall economy. Evoking the work of economists such as Albert O Hirschman and Paul Rosenstein Rodan, Krugman argued that developing countries often needed a "big push" of coordinated government investments to help strategic industries get off the ground and to link the growth of such industry to the economy as a whole.

We find that in general the world's trading system makes it much more difficult for nations to craft strategic trade and industrial policies for growth and development. Indeed, enshrined in virtually all trade agreements is the "national treatment" idea that says a nation may not treat its domestic industries any differently than foreign ones. That may make sense when rich nations compete against each other, but in a world where 57.6% of the population lives on less than $2.50 per day, one size can't fit all. This restriction is accentuated in provisions for foreign investment, intellectual property, and subsidies.

And, I like this pic:

And, finally Williamson takes on Rodrik to the real meaning of the Washington Consensus. Rodrik responds.

Tuesday, October 14, 2008

Paul Krugman speaks about the Nobel Prize and the financial crisis

License to invest in just 10 days in Nepal

The Nepali Finance Minister Baburam Bhattarai says:

Dr. Bhattarai also promised to facilitate the entry of new investment into Nepal by immediately activating the Investment Board, which has the prime minister as chairman and the finance minister as vice chairman.

“We will endorse large-scale projects and issue licenses within 10 days through the board,” he said, adding that the government was very keen on welcoming large-scale infrastructure projects in Nepal.

What a good news! But, the Maoists have a big mouth-- they hardly implement what they say!!

Monday, October 13, 2008

Krugman wins the Nobel Prize in Economics

The very popular economist Paul Kurgman has been awarded The Sveriges Riksbank Prize Prize in Economics Sciences in Memory of Alfred Nobel 2008 “for his analysis of trade patterns and location of economic activity.” Here is a paper complied by the Prize Committee.

Krugman's approach is based on the premise that many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. Meanwhile, consumers demand a varied supply of goods. As a result, small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another.

Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars. This kind of trade enables specialization and large-scale production, which result in lower prices and a greater diversity of commodities.

Economies of scale combined with reduced transport costs also help to explain why an increasingly larger share of the world population lives in cities and why similar economic activities are concentrated in the same locations. Lower transport costs can trigger a self-reinforcing process whereby a growing metropolitan population gives rise to increased large-scale production, higher real wages and a more diversified supply of goods. This, in turn, stimulates further migration to cities. Krugman's theories have shown that the outcome of these processes can well be that regions become divided into a high-technology urbanized core and a less developed "periphery".

From the NYT:

He has developed models that explain observed patterns of trade between countries, as well as what goods are produced where and why. Traditional trade theory assumes that countries are different and will exchange different kinds of goods; Mr. Krugman’s theories have explained why worldwide trade is dominated by a few countries that are similar to each other, and why some countries might import the same kinds of goods that it exports.

“There was something very beautiful about the old existing trade theory and its ability to capture the world in a surprisingly simple conceptual framework,” Mr. Krugman said. “And then I realized that some of the new insights coming through in industrial organization could be applied to international trade.”

Here is a talk with Krugman taken back in 2006. Read about the economies of scale and trading preferences in this paper Is Free Trade Passe. Here is a paper on The Role of Geography in Development. More links here and here.

Favorite economists commenting on the financial mess

One of my favorite economists, Joe Stiglitz points his finger to the economics profession (along with political and financial institutions)for the current financial mess. Watch the full video here.

Another favorite economist, Michael Spence argues for better understanding and regulation of risk. He argues that the current financial crisis will ultimately lead to the demise of unregulated vehicles such as hedge funds.

“People will put a high premium on financial stability,” he says. “I think you can confidently predict that regulation won’t be fragmented so nobody can see the whole system.

Also, there won’t be big unregulated sectors – hedge funds, credit default swaps, you name it. They’ll be regulated and they’ll have capital requirements.”

“The problem here is that people simply did not understand how much risk there was in the system,” he says. “We simply didn’t have a measure of risk.”

Among Spence’s suggestions is the setting up of an international institution that not only diagnoses when certain economies or financial systems are looking vulnerable but also has the legitimacy to do something about it.

“An IMF with teeth – including domestically,” he suggests. “There’s no entity in the US where someone thinks the main job they have when they get up in the morning is to figure out and report to the various authorities and the financial sector that there’s a growing problem of risk. Nobody does that.”

The other favorite economist, Dani Rodrik argues 

In view of what was about to happen, it might have been better for Paulson to hold his nose and do with Lehman what he had already done with Bear Stearns and would have had to do in a few days with AIG: save them with taxpayer money. Wall Street might have survived, and U.S. taxpayers might have been spared even larger bills.

Perhaps it is futile to look for the single cause without which the financial system would not have blown up in our faces. A comforting thought ― if you still want to believe in financial sanity _ is that this was a case of a ``perfect storm," a rare failure that required a large number of stars to be in alignment simultaneously.

So what will the post-mortem on Wall Street show? That it was a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure? We will likely never know.
The regulations and precautions that lawmakers will enact to prevent its recurrence will therefore necessarily remain blunt and of uncertain effectiveness.

Not to forget, Paul Romer on the value of ideas and the New Growth Theories. Here is his take on the financial crisis.

Who is a realist?

Paul Romer is one and he responds:

Realists were ones who said that given the unusual conditions that prevailed, it was too risky to let them go into bankruptcy. By these criteria, most of the people who signed the letter opposing the Paulson plan were probably fundamentalists. Remember, the realists were the ones who said that given the complexity of interconnection, a competitive market in telephony would never work. Fundamentalists were the ones who said that they didn't know precisely how, but they were sure that market competition would work just fine even there. So it is not true that everyone wants to be called a realist. Or that realists are always right or more sensible. My point was that fundamentalists should listen to realists and they should put more weight on what they say when predictions based on the fundamentalist models are turning out to be wrong.

…Personally, I switched sides when I saw how much damage the Lehman bankruptcy did and how quickly the damage was accumulating. If my prediction was so wrong, it seemed to me that the time had come to place less trust in the models and to listen more carefully to people closer to the front lines who were raising alarms. I switched to support for giving Bernanke and Paulson all the firepower they asked for because I thought the increased risk of a financial panic that we would run if we didn't far outweighed any risks from spending the resources in the wrong way or from giving Paulson too much discretion.