Effect of countercyclical investment on employment

An interesting paper by Buchheim and Watzinger (2023) published in AEJ: Economic Policy [15(1)] shows that investments in public buildings in Germany can quickly and cost-effectively increase employment in the short run. They can be a viable tool for counteracting an economic slowdown. 

They explore if the renovation of public buildings create jobs quickly and cost-effectively? Their paper estimates the causal impact of a sizable German public investment program, which provided 0.16% of GDP for upgrading public buildings, on employment at the county level. The program focused on improving the energy efficiency of school buildings, making it possible to use the number of schools as an instrument for investments. It also enforced tight deadlines, reducing potential implementation lags. The program was cost-effective, creating, on average, one job for one year for an investment of €24,000. The employment gains are detectable after nine months and are accompanied by an unemployment reduction amounting to half of the job creation. Employment grew predominately in the directly affected industries.

They addressed the endogeneity problem (governments may target regions that are hardest hit by the recession) by exploiting the legal structure of the stimulus bill. The bill prescribed that 65 percent of funds had to be spent on investments in the educational infrastructure, in particular on improving the energy efficiency of existing buildings. This implies that the local scope for investments was closely linked to the historically predetermined number of schools. Since the number of schools is a predetermined stock variable and thus unrelated to the magnitude of the recession in a county, it constitutes an ideal instrument for local investments. To put the cost of one job per year in perspective, the average labor costs in the construction industry was at least €45,000. The employment gains translate into a fiscal multiplier of about 1.5. 

High cost of geoeconomic fragmentation

Geoeconomic fragmentation, a policy-driven reversal of global economic integration, may be caused due to trade restrictions, barriers to the spread of technology (technology diffusion), restrictions on cross-border migration, reduced capital flows, and a sharp decline in international cooperation. These will affect various segments of the population and country differently. For instance, lower income consumers in advanced economies will lose access to cheaper imports, and economies heavily reliant on trade will suffer and per capita income catch up becomes challenging and adjustment costs rise.

According to a new IMF staff discussion note, the cost to global output from trade fragmentation could range from 0.2 percent (in a limited fragmentation / low-cost adjustment scenario) to up to 7 percent of GDP (in a severe fragmentation / high-cost adjustment scenario); with the addition of technological decoupling, the loss in output could reach 8 to 12 percent in some countries.

The IMF recommends a pragmatic approach to increasing geoeconomic fragmentation. These include strengthening international trade system including diversification of supply; helping vulnerable countries deal with debt as fragmentation makes it harder to resolve sovereign debt crises if key official creditors are divided along geopolitical lines; stepping up climate action including setting a floor on international carbon price and innovative use of public balance sheets—such as credit guarantees, equity and first-loss investments— to help mobilize funds for private financing. 

About 15 percent of low-income countries are already in debt distress and an additional 45 percent are at high risk of debt distress. Among emerging markets, about 25 percent are at high risk and facing default-like borrowing spreads.

Development beyond country averages

McKinsey Global Institute has an interesting article that highlights the importance of microregions as opposed to country averages to account for changes in growth and development. 

The concentration of global economic activity looks very different under a microregional lens. For instance, India and Portugal at the country level might have large difference (5x) in per capita GDP, but if we look at Goa (India) and Porto (Portugal) there is not much difference (GDP per capita of $33,000 in 2019).  We will see similar pattern in other countries and their cities in terms of life expectancy. 

MGI's analysis shows that half of the additional GDP generated from 2000 to 2019 came out of 3,600 microregions from a total of 40,000 as ranked by the increase in GDP per square kilometer. These 3,600 microregions were scattered across 130 countries but cover just 0.9% of the world’s land mass. 27% of the global population lived in them in 2019, totaling two billion people.

In India, they found 270 microregions home to 114 million people in 2019 where GDP per capita grew more than $7,100. The country average excluded them. Microregions with GDP per capita gains of at least $7,100 (or the top 30% globally) were considered. 

They also regressed five-year moving average annual growth rates at the microregional level on annual growth at the country level to estimate the explanatory power of country-level growth. The result showed that a country’s GDP per capita growth rate can explain only 20% of the variation in the microregional growth rates in that country.

How to build support for climate change policies?

 Abstract from a new NBER working paper:

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Using new surveys on more than 40,000 respondents in twenty countries that account for 72% of global CO2 emissions, we study the understanding of and attitudes toward climate change and climate policies. We show that, across countries, support for climate policies hinges on three key perceptions centered around the effectiveness of the policies in reducing emissions (effectiveness concerns), their distributional impacts on lower-income households (inequality concerns), and their impact on the respondents' household (self-interest). We show experimentally that information specifically addressing these key concerns can substantially increase the support for climate policies in many countries. Explaining how policies work and who can benefit from them is critical to foster policy support, whereas simply informing people about the impacts of climate change is not effective. Furthermore, we identify several socioeconomic and lifestyle factors – most notably education, political leanings, and availability of public transportation – that are significantly correlated with both policy views and overall reasoning and beliefs about climate policies. However, it is difficult to predict beliefs or policy views based on these characteristics only.

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IMF's latest view on capital flows: CFM and MPMs can be applied pre-emptively without surge in capital inflows

The IMF has updated its view on capital flows. Specifically, it now recommends that countries should have the option to pre-emptively curb debt flows to safeguard macroeconomic and financial stability. Excerpts from a blog post:

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Economies with large external debts can be vulnerable to financial crises and deep recessions when capital flows out. External liabilities are riskiest when they generate currency mismatches—when external debt is in foreign currency and is not offset by foreign currency assets or hedges. [...]Since the beginning of the pandemic many countries have spent to support the recovery, which has led to a build-up of their external debt. In some cases, the increase in debt in foreign currency was not offset by foreign currency assets or hedges. This creates new vulnerabilities in the event of a sudden loss of appetite for emerging market debt that could lead to severe financial distress in some markets.

In a review of its Institutional View on capital flows released today, the IMF said that countries should have more flexibility to introduce measures that fall within the intersection of two categories of tools: capital flow management measures (CFMs) and macroprudential measures (MPMs). [...]these measures, known as CFM/MPMs, can help countries to reduce capital inflows and thus mitigate risks to financial stability—not only when capital inflows surge, but at other times too. 

The main update is the addition of CFM/MPMs that can be applied pre-emptively, even when there is no surge in capital inflows, to the policy toolkit. [...]Pre-emptive CFM/MPMs to restrict inflows can mitigate risks from external debt. Yet they should not be used in a manner that leads to excessive distortions. Nor should they substitute for necessary macroeconomic and structural policies or be used to keep currencies excessively weak.

CFMs to restrict inflows might be appropriate for a limited period, the Institutional View said, when a surge in capital inflows constrains the policy space to address currency overvaluation and economic overheating. It said CFMs to restrict outflows might be useful when disruptive outflows risk causing a crisis. In turn, CFM/MPMs on inflows were considered useful only during surges of capital inflows, assuming that financial stability risks from inflows would arise mainly in that context.

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Preemptive CFM/MPMs on debt inflows (primarily in FX) may be useful in the presence of private sector debt stock vulnerabilities (primarily FX mismatches), which MPMs cannot sufficiently address. Those stock vulnerabilities may have accumulated during prior inflow surges or gradually over time without an inflow surge. Preemptive inflow CFM/MPMs should be targeted, transparent and, while potentially longer-lasting, temporary, being recalibrated or removed as the vulnerabilities that led to their adoption subside, or if an effective MPM (that is not designed to limit capital flows) becomes available.

In the context of capital inflow surges, inflow CFM/MPMs may be useful to address financial stability risks arising from the surge, and CFMs on inflows may be useful in the circumstances outlined in the Venn Diagram in Figure 2 (upper panel).

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Impact of fiscal rules on subnational government spending

Interesting research by Carreri and Martinez on the impact of fiscal rules at the subnational level in Colombia. Briefly, it reduced overspending without affecting public goods or living standards, and aligned with voters' preferences. Here is another related study by Bianchi et al (2021) in Italy where they find that fiscal decentralization reduced local spending but expanded municipal services, and it also increased female labor supply.

Abstract from a recent article on VoxDev:

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[...] In recent research (Carreri and Martínez 2021), we study a sub-national fiscal rule introduced in Colombia in 2000. This rule was the national government’s response to a growing fiscal imbalance associated with the country’s decentralisation process from the early 1990s. The rule set a cap to the operating expenses of municipal governments, expressed as a share of their current revenue. For the municipalities in our sample (90% of the total), which are smaller, less developed, and have a homogeneous institutional structure, this cap was set at 80%. Compliance with the rule is determined every year by the country’s fiscal watchdog agency and non-compliers face disciplinary sanctions from the Inspector General’s office. They also lose access to financial assistance from the national government.

Current revenue includes local tax revenue, fees and fines, and some formula-determined intergovernmental transfers. This is the denominator of the fiscal outcome targeted by the rule, which we refer to as the ‘overspending indicator’. Operating expenses (i.e. the numerator) include remuneration of administrative staff, general expenses such as procurement, rent, maintenance, travel, and training, as well as pensions of former employees and payments dictated by court sentences. Importantly, all expenses associated with local public goods (education, health, water, sanitation, culture, etc.) are classified as investment and fall outside the scope of the regulation.

Even though the fiscal rule affected all municipalities de jure, only those with operating expenses exceeding the cap at the time of the reform were exposed to it de facto. Our research design exploits this variation in exposure and examines whether municipalities affected de facto by the fiscal rule experienced disproportionate changes in our outcomes of interest after the reform. These outcomes include fiscal variables, various measures of public goods and living standards, as well as electoral support for the local incumbent party and incidence of protests.

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The result:

• Fiscal rule reduced overspending in public administration
• Fiscal rule did not affect public goods or living standards
• Voters rewarded incumbent parties for fiscal restraint

Fiscal decentralization and local public services delivery

Abstract from a NBER working paper by Bianchi et al (2021): Fiscal decentralization reduced local spending but expanded municipal services, and it also increased female labor supply in Italy. 

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This paper studies how fiscal decentralization affects local services. It explores a 1993 reform that increased the fiscal autonomy of Italian municipalities by replacing government transfers with revenues from a local property tax. Our identification leverages cross-municipal variation in the degree of decentralization that stems from differences in the average age of buildings caused by bombings during WWII. Decentralization reduced local spending but expanded municipal services, such as nursery schools. These effects are larger in areas with greater political competition. The paper also investigates how the reform affected labor markets. Decentralization increased female labor supply—probably through expanded availability of nursery schools—thereby reducing the gender gap in employment.

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Briefly, in 1993, Italian municipalities saw fiscal decentralization increase when the central government replaced government grants with revenue from a newly established local property tax. Local revenue (from local taxes and service fees) increased by more than 50% relative to 1992 in just a year's time and replaced central government transfers as the major source of municipal revenues. This boosted accountability as local politicians had to be more accountable to residents for any mismanagement of funds. 

• They find that decentralization induced local politicians to cut waste and increase efficiency. After the reform measure, local administrators decreased the size of government (both expenditure and revenue), but also rebalanced spending in favor of revenue-generating and customer-facing services, thus reducing administrative processes and associated costs. 
• They also find that municipalities that raised more revenues through the local property tax dedicated a larger share of their budget to nursery schools (+18%) and had more public nursery schools (+20%). The number of pupils in nursery schools increased by an additional 24% after the reform in the same cities.
• They document that municipalities that raised more revenues through the local property tax experienced a larger increase in female participation in the labor market. Women's LFPR increased by up to 20%, leading to reduction in preexisting gender gap in employment.  

Agriculture productivity shocks and nonagricultural employment in India

Abstract from Jonathan Colmer's published paper in American Economic Journal: Applied Economics, 13(4):101-24

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To what degree can labor reallocation mitigate the economic consequences of weather-driven agricultural productivity shocks? I estimate that temperature-driven reductions in the demand for agricultural labor in India are associated with increases in nonagricultural employment. This suggests that the ability of nonagricultural sectors to absorb workers may play a key role in attenuating the economic consequences of agricultural productivity shocks. Exploiting firm-level variation in the propensity to absorb workers, I estimate relative expansions in manufacturing output in more flexible labor markets. Estimates suggest that, in the absence of labor reallocation, local economic losses could be up to 69 percent higher. 

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Brief highlights from IPCC's Sixth Assessment Report

AR6 Climate Change 2021: The Physical Science Basis, the IPCC’s Sixth Assessment Report submitted by Working Group I is out now. The report includes the most updated physical understanding of the climate system and climate change, and includes regional climate simulations as well. It provides evidence on how and why climate has changed and the effects attributable to human actions. 

Excerpts from the report:

The evidence regarding human influence on warming of atmosphere, ocean and land is unequivocal. Widespread and rapid changes in the atmosphere, ocean, cryosphere and biosphere have occurred.  Observed increases in well-mixed greenhouse gas (GHG) concentrations since around 1750 are unequivocally caused by human activities. Each of the last four decades has been successively warmer than any decade that preceded it since 1850. Global surface temperature in the first two decades of the 21st century (2001-2020) was 0.99 [0.84-1.10] °C higher than 1850-1900. Global surface temperature was 1.09 [0.95 to 1.20] °C higher in 2011–2020 than 1850–1900. 

The likely range of total human-caused global surface temperature increase from 1850–1900 to 2010–2019 is 0.8°C to 1.3°C, with a best estimate of 1.07°C.

Globally averaged precipitation over land has likely increased since 1950, with a faster rate of increase since the 1980s (medium confidence). It is likely that human influence contributed to the pattern of observed precipitation changes since the mid-20th century, and extremely likely that human influence contributed to the pattern of observed changes in near-surface ocean salinity.

Human influence is very likely the main driver of the global retreat of glaciers since the 1990s and the decrease in Arctic sea ice area between 1979–1988 and 2010–2019 (about 40% in September and about 10% in March).

It is virtually certain that the global upper ocean (0–700 m) has warmed since the 1970s and extremely likely that human influence is the main driver. It is virtually certain that human-caused CO2 emissions are the main driver of current global acidification of the surface open ocean.

Global mean sea level increased by 0.20 [0.15 to 0.25] m between 1901 and 2018. It increased by .7 [3.2 to 4.2] mm yr–1 between 2006 and 2018 (high confidence). Human influence was very likely the main driver of these increases since at least 1971.

Global surface temperature has increased faster since 1970 than in any other 50-year period over at least the last 2000 years (high confidence). Temperatures during the most recent decade (2011–2020) exceed those of the most recent multi-century warm period, around 6500 years ago13 [0.2°C to 1°C relative to 1850–1900] (medium confidence).

Human-induced climate change is already affecting many weather and climate extremes in every region across the globe. Evidence of observed changes in extremes such as heatwaves, heavy precipitation, droughts, and tropical cyclones, and, in particular, their attribution to human influence, has strengthened since AR5. It is virtually certain that hot extremes (including heatwaves) have become more frequent and more intense across most land regions since the 1950s, while cold extremes (including cold waves) have become less frequent and less severe, with high confidence that human-induced climate change is the main driver of these changes.

The frequency and intensity of heavy precipitation events have increased since the 1950s over most land area for which observational data are sufficient for trend analysis (high confidence), and human-induced climate change is likely the main driver. Human-induced climate change has contributed to increases in agricultural and ecological droughts15 in some regions due to increased land evapotranspiration (medium confidence).

Decreases in global land monsoon precipitation from the 1950s to the 1980s are partly attributed to human-caused Northern Hemisphere aerosol emissions, but increases since then have resulted from rising GHG concentrations and decadal to multi-decadal internal variability (medium confidence). Over South Asia, East Asia and West Africa increases in monsoon precipitation due to warming from GHG emissions were counteracted by decreases in monsoon precipitation due to cooling from human-caused aerosol emissions over the 20th century (high confidence).

Heating of the climate system has caused global mean sea level rise through ice loss on land and thermal expansion from ocean warming. Thermal expansion explained 50% of sea level rise during 1971–2018, while ice loss from glaciers contributed 22%, ice sheets 20% and changes in land water storage 8%. The rate of ice sheet loss increased by a factor of four between 1992–1999 and 2010–2019. Together, ice sheet and glacier mass loss were the dominant contributors to global mean sea level rise during 2006-2018.

Global surface temperature will continue to increase until at least the mid-century under all emissions scenarios considered. Global warming of 1.5°C and 2°C will be exceeded during the 21st century unless deep reductions in CO2 and other greenhouse gas emissions occur in the coming decades. Global warming of 1.5°C relative to 1850-1900 would be exceeded during the 21st century under the intermediate, high and very high scenarios considered in this report (SSP2-4.5, SSP3-7.0 and SSP5-8.5, respectively).

Many changes in the climate system become larger in direct relation to increasing global warming. They include increases in the frequency and intensity of hot extremes, marine heatwaves, and heavy precipitation, agricultural and ecological droughts in some regions, and proportion of intense tropical cyclones, as well as reductions in Arctic sea ice, snow cover and permafrost. Every additional 0.5°C of global warming causes clearly discernible increases in the intensity and frequency of hot extremes, including heatwaves (very likely), and heavy precipitation (high confidence), as well as agricultural and ecological droughts in some regions (high confidence).

Monsoon precipitation is projected to increase in the mid- to long term at global scale, particularly over South and Southeast Asia, East Asia and West Africa apart from the far west Sahel (high confidence). A warmer climate will intensify very wet and very dry weather and climate events and seasons, with implications for flooding or drought (high confidence). It is very likely that rainfall variability related to the El Niño–Southern Oscillation is projected to be amplified by the second half of the 21st century.

From a physical science perspective, limiting human-induced global warming to a specific level requires limiting cumulative CO2 emissions, reaching at least net zero CO2 emissions, along with strong reductions in other greenhouse gas emissions. Strong, rapid and sustained reductions in CH4 emissions would also limit the warming effect resulting from declining aerosol pollution and would improve air quality.

The likelihood of an outcome is expressed in the following way: virtually certain 99–100% probability, very likely 90–100%, likely 66–100%, about as likely as not 33–66%, unlikely 0–33%, very unlikely 0–10%, exceptionally unlikely 0–1%. Additional terms such as extremely likely 95–100%, more likely than not >50–100%, and extremely unlikely 0–5% are also used. A level of confidence is expressed using five qualifiers: very low, low, medium, high and very high.

South Asia

• Heatwaves and humid heat stress will be more intense and frequent during the 21st century (medium confidence)
• Both annual and summer monsoon precipitation will increase during the 21st
• century, with enhanced interannual variability (medium confidence).
• Over most of the Hindu Kush Himalayan region, snow cover has reduced since the early 21st century, and glaciers have retreated and lost mass since the 1970s.
• The Karakoram glaciers have remained either in a balanced state or slightly gained mass. During the 21st century, snowcovered areas and snow volumes will decrease in most of the Hindu Kush Himalayan, and snowline elevations will rise and glacier volumes will decline (high confidence).
• A general wetting across the whole Tibetan Plateau and the Himalaya is projected, with increases in heavy precipitation in the 21st century.
• Extreme precipitation is projected to increase in major mountainous regions (medium to high confidence, depending on location), with potential cascading consequences of floods, landslides and lake outbursts in all scenarios (medium confidence).
• With few exceptions, mountain glaciers have retreated since the second half of the 19th century (very high confidence). This retreat has occurred at increased rates since the 1990s, with human influence very likely being the main driver. This behaviour is unprecedented in at least the last 2,000 years (medium confidence). Furthermore, glaciers will continue to lose mass at least for several decades even if global temperature is stabilized (very high confidence).
• Mountain glaciers will continue to shrink and permafrost to thaw in all regions where they are present (high confidence). Mountain glaciers are projected to lose more mass in higher greenhouse gas emissions scenario over the 21st century (medium confidence).
• It is virtually certain that snow cover will decline over most land regions during the 21st century, in terms of water equivalent, extent and annual duration.

Conditional or unconditional convergence

In their latest NBER working paper on economic convergence, Kremer, Willis and You (2021) argue that there was a trend towards unconditional convergence (GDP per capita today depends on its GDP per capita in the past) since 1990 and absolute convergence since 2000 owing to broad faster catch-up growth and slower growth of the frontier economies. They also show that many of the correlates of growth such as human capital, policies, institutions, and culture also showed convergence with higher income country groups.  As both correlates and growth have changed, their relationships (coefficients of growth regressions) have also changed. The shrinkage of growth regression coefficients has led to the narrowing of the gap between unconditional and conditional convergence. Absolute convergence has converged towards conditional convergence.

Major highlights from the working paper:

There was a steady trend towards unconditional convergence since the late 1980s and absolute convergence since 2000. Between 1985 and 1995, income per capita diverged by an average 0.5% annually, but between 2005 and 2015, it converged at a rate of 0.7%. The richest quartile of countries had the fastest growth in the 1980s, but the slowest growth since then as it became flat in the 1990s and then declined since 2000. However, the three other quartiles all experienced accelerating growth through 1990s and early 2000s. 

They argue that the conditional convergence could be due to (i) faster spread of technologies due to globalization as well as greater capital and labor mobility (accelerates convergence), and (ii) convergence in growth correlates themselves such as human capital, policies, institutions and culture (these could narrow the gap between unconditional and conditional convergence). 

The authors also explore whether growth correlates have changed over time by looking at four groups. First, enhanced Solow fundamentals, namely investment rate, population growth and human capital, which are fundamental determinants of steady state income. Second, short-run correlates, namely policies (political and financial institutions, fiscal policy) that can change in relatively short period of time. Third, long-run correlates, namely historical determinants of institutions and geography that change slowly, if at all. Fourth, culture (they consider 10 cultural variables such as views on inequality, political participation, the importance of family, traditions, work ethics, etc). They find that these correlates have not been highly persistent as many have undergone large changes and themselves converged substantially across countries, especially towards those of rich countries.

Establishing relationship between two trends -- towards convergence in income and the convergence of many of the correlates of growth itself-- is a bit challenging because causality can run both ways (for instance, converging income causes policies, institutions and culture to converge or it could be the other way round). By using omitted variable bias formula, they decompose the gap between absolute convergence (convergence across countries without conditioning on determinants of steady state income) and conditional convergence by looking at the product of the slopes of two relationships: correlate-income slopes and growth-correlate slopes. 

They find that while cross-sectional relationships between income and the correlates have changed in levels, their slopes have mostly remained stable. However, growth-correlates regression coefficients have shrunk substantially and show little autocorrelation for correlates (institutional homogenization) except for Solow model fundamentals (investment rate, population growth, and human capital), which have remained stable. This flattening of growth-correlates relationship suggest that absolute convergence converged towards conditional convergence. 

They argue that their results are consistent with neoclassical growth models, particularly after 1990. While conditional convergence held throughout the period (1985-2015), absolute convergence did not initially but as human capital, policies and, institutions improved in poorer countries, their explanatory power with respect to growth and convergence have declined. So, "the world has converged to absolute convergence because absolute convergence has converged to conditional convergence". Policies and institutions used to matter, but that they have converged, they matter less (and their effects are non-linear). Evidence support convergence in policies and institutions, but divergence in income over 1960-1990 (inconsistent with neoclassical growth model). However, convergence changed since 1990 and the outcome is consistent with neoclassical growth models (but not AK models such as endogenous growth models or poverty trap models that predict divergence). 

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Meanwhile, Acemoglu and Molina (2021), in a follow up comment, argue that the results of  Kremer, Willis and You (2021) working paper are driven by the lack of country fixed effects controlling for unobserved determinants of GDP per capita across countries. This "create a bias in convergence coefficients towards zero and this bias can be time-varying, even when the underlying country-level parameters are stable." They find no evidence of major changes in patterns of convergence and no flattening of the relationship between institutional variables and economic growth. 

Pande and Enevoldsen (2021) argue that convergence towards development-favored policies that drove the trend outlined by Kremer, Willis and You (2021) also mean that this has happened with rising within-country inequality, resulting in more of the world's poor clustering in (lower) middle-income countries. 

Entry and exit of informal firms

In a latest NBER working paper, McCaig and Pavcnik (2021) present several stylized facts about entry and exit of informal firms using a nationally representative panel data from Vietnam. 

Most informal firms are often operated only by the owner. Lower wealth and aggregate productivity tend to correlate with smaller average firm size. With economic development, average firm size also increases as self-employed entrepreneurs seek wage opportunities (so informal business is a necessity in part affected by lack of other employment opportunities). It indicates that self-employment decreases and size of firms increases with economic development. Other causes of smaller firms include imperfections in capital markets, barriers to hiring labor, cost of registration and formalization, and lack of business training. 

Major highlights/excerpts from the working paper:

First, informal businesses exhibit rates of entry and exit around 14-18% annually. Entry and exit rates are similar and highly correlated at a point in time, within industries, and within regions. They both decline over time and across space with economic development. 

Second, although market selection influences which firms survive, entry and exit has little net effect on aggregate (revenue) productivity or hiring of workers outside the household. This owes to overlapping labor productivity of entering and exiting firms and low subsequent productivity growth and hiring among the surviving entrants.  Almost half of the entrants exit within two years and the surviving entrants do not significantly improve their performance over time or begin to hire paid workers. This could be due to market-selection, but also due to owner-specific characteristics and shocks, alternative employment options, and household-specific shocks. Business exit and entry is associated with large decreases and increases, respectively, in individual and household income.

Third, the large overlap in revenue of entering and exiting informal businesses and the high correlation between entry and exit rates are related to the education and economic activities (self-employment, wage work or just outside of the workforce) of business owners prior to starting, or after closing down, an informal business. Informal business owners are less educated on average than wage workers in the formal sector, but more educated than agricultural workers. Entering and exiting owners have very similar levels of education. 

Fourth, the transitions in and out of operating an informal business reflect the underlying structure of economic activities of the working age population, with education gaps also playing a role. About one-third of informal non-farm business entrants and exiters transition to and from self-employment in agriculture.  However, the likelihood of this transition declines with economic development, highlighting the role of net entry from agriculture into informal non-farm businesses in structural change.

A Proposal to End the COVID-19 Pandemic

Abstract from a latest IMF Staff Discussion Note by Ruchir Agarwal and Gita Gopinath:

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Urgent steps are needed to arrest the rising human toll and economic strain from the COVID-19 pandemic that are exacerbating already-diverging recoveries. Pandemic policy is also economic policy as there is no durable end to the economic crisis without an end to the health crisis. Building on existing initiatives, this paper proposes pragmatic actions at the national and multilateral level to expeditiously defeat the pandemic. The proposal targets: (1) vaccinating at least 40 percent of the population in all countries by the end of 2021 and at least 60 percent by the first half of 2022, (2) tracking and insuring against downside risks, and (3) ensuring widespread testing and tracing, maintaining adequate stocks of therapeutics, and enforcing public health measures in places where vaccine coverage is low. The benefits of such measures at about $9 trillion far outweigh the costs which are estimated to be around $50 billion—of which $35 billion should be paid by grants from donors and the residual by national governments potentially with the support of concessional financing from bilateral and multilateral agencies. The grant funding gap identified by the Access to COVID-19 Tools (ACT) Accelerator amounts to about $22 billion, which the G20 recognizes as important to address. This leaves an estimated $13 billion in additional grant contributions needed to finance our proposal. Importantly, the strategy requires global cooperation to secure upfront financing, upfront vaccine donations, and at-risk investment to insure against downside risks for the world.

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Effect of fiscal expansion and adjustment on sustainable development

Aizenman et al (2021) outline four stylized patterns from large fiscal impulses (expansions and adjustments) in Chile, Poland, South Africa, and Thailand:

• Fiscal expansions led to higher growth rates and reduced negative trade-offs, e.g., pollution and poor-health mortalities associated with economic growth. 
• Fiscal adjustments led to a more inclusive economy, lowered poverty headcounts, improved sanitation, and cleaner technology access. 
• Fiscal expansions followed an increase in direct taxes (especially corporate taxes) and a decline in social contributions, and preceded a decline in other direct taxes and an increase in wage bills. 
• Fiscal adjustments followed a decline in other direct taxes and social contributions, an increase in wage bills, and preceded a decline in government consumption expenditure and transfers.

Key takeaways include:

• Countries have distinct fiscal challenges, underlined by their economic and institutional structure. VAT accounted for 30%-60% of total revenues in the countries. Domestic public resources of commodity-exporting countries are vulnerable to commodity TOT shocks. The fiscal conditions of manufacturing-exporting countries are dependent on the GVCs, the global business cycle, and supporting services.
• The associations between fiscal expenses, taxes, and sustainable development outcomes (prosperity, resilience, and inclusivity) differ across countries.
• DRM should consider the time paths of the taxes and expenditure components to understand their empirical linkages with the sustainable development outcomes in the respective countries.
• It is practically useful to have a template for tracing the linkages between fiscal stance and the sustainable development outcomes.
• More data may shed more light on correlations between the fiscal conditions and DRM for sustainable development in the coming years.

Some basic definitions used in the working paper (all % of GDP):

• Primary deficit = Primary expense (wage+non-wage+subsidies+transfer)-total tax revenue (personal income tax+corporate tax+payroll and workforce tax and property tax+indirect tax+social security contributions
• Fiscal episode is defined as significant change in primary deficit (% of GDP) from the previous year.

Cyclically adjusted variables:

• Fiscal impulse = Cyclically adjusted primary deficit in year t – primary deficit in year t-1.
• Cyclically adjusted primary deficit = Cyclically adjusted primary expenses – Cyclically adjusted total tax revenue
• Cyclically adjusted total tax revenue = Summation of cyclically adjusted components of total tax revenue.
• Cyclically adjusted primary expense = Cyclically adjusted transfer + wage + non-wage + subsidies.

Cyclically adjusted variables are computed by first regressing each fiscal variable on time trend and unemployment, followed by estimation of each fiscal variable in year t if unemployment rate were to remain the same in the previous year t-1.

Fiscal adjustment and fiscal stimulus:

• Strong fiscal adjustment is referred to as fiscal impulse (% of GDP) less than -1.5.
• Strong fiscal stimuli is referred to as fiscal impulse (% of GDP) larger than 1.5

COVID-19 related economic scarring

The IMF’s WEO April 2021 includes a chapter on the possible persistent effects of the pandemic on economic activities (scarring). It notes that the emerging markets and low-income countries are expected to face greater scarring due to their limited policy space to launch relief measures for struggling households and firms. It argues that the crisis could result in substantial and persistent damage to supply potential and extend scarring due to diminishing labor force participation, bankruptcies, and disruption of production networks. The longer the recession, the more likely the effects will be permanent, especially in countries with the prevalence of small firms and shallow capital markets. Persistent supply disruptions could result from the loss of economic ties in production and distribution networks as job destruction and firm bankruptcies increase— these tend to lower productivity growth and slowdown capital accumulation. These could dampen investment and employment, and cripple productivity growth for an extended period of time. 

The IMF states that although financial instabilities have been largely avoided this time and the spillovers of the pandemic’s initial impact on high contact-intensive service sectors are limited, the scale of the impact could still represent a large shock to the economy. It estimates that the global output in 2024 could be 3% lower than the anticipated pre-pandemic output. However, the degree of scarring varies by country. Policymakers could limit scarring by providing support to the most-affected sectors and workers while the pandemic is ongoing. To address long-term GDP losses, countries need to focus on remedial policies for the setback to human capital accumulation, boost investment, and support reallocation of workers and firms (retraining, reskilling, and insolvency procedures).

The COVID-19 pandemic resulted in a combination of supply and demand shocks. Pandemic-induced lockdowns reduced effective productive capacity as some firms were forced to close or operate at below capacity than usual times, and some had to reorganize production on account of physical distancing between workers, which in turn lowered productivity. The initial supply shocks spilled over to other sectors through production networks. Meanwhile, demand decreased due to reduced mobility and as precautionary savings increased amidst heightened uncertainty. The initial supply shock also led to a decline in demand as workers earned either less or were laid off outright, which decreased private savings.  

After recessions or health shocks in the past, technology adoption, employment, and capital accumulation suffered, leading to extended period of economic slowdown. For instance, unemployment continued to remain high and lowered labor force as discouraged workers exited the labor market. Extended period of unemployment affects skills deterioration, delays labor market entry for young workers, negatively affects educational achievement in the long-term (especially, parental job losses adversely affect children’s schooling and future labor market outcomes)— all affecting human capital accumulation. Similarly, recessions also dampen investment, slowing down physical capital accumulation, which affects productivity though slower technology adoption. Also, business bankruptcies permanently affect productivity due to the loss of firm-specific know-how. Decline in research and development, and increase in resource misallocation also affect productivity permanently. 

The pandemic has already caused some form of supply-side scarring from lower productive capacity and demand-side persistent preference shits. The report three particular features of the crisis on scarring:

1. Although lower than after the global financial crisis in 2008, the prospects for scarring from COVID-19 are substantial. This time there is relative financial stability following the COVID-19 shock thanks to large-scale fiscal and monetary measures. Previously, financial crisis resulted in deep recessions, which then led to persistent output losses. However, this time financial stress could easily build up as loan defaults increases after debt service moratoriums and several regulatory forbearances are phased out. These affect productivity, and efficiency of labor and capital inputs. 

Lower-skilled workers have seen a disproportionately large decline in employment and business exits of small businesses are increasing. 

2. Some sectors have not recovered after productivity shocks in the past and that the spillovers from COVID-19 shocks are still sizable (despite high-contact sectors are less central to production networks). Scars become persistent due to lower productivity growth and slower capital accumulation. 

Note that scarring in the labor market may be larger than in previous recessions because of permanent shrinkage of some high-contact sectors. For instance, some student in low-income countries may not be fully able to switch to virtual learning and this could have devastating implications on human capital accumulation. Similarly, physical capital shrinkage could also amplify scarring because of sector-specific idle capital in the case of high-contact sectors, and large corporate debt buildup that lowers investment by more leveraged firms. 

The pandemic related disruptions to upstream (from customers to focal sector of interest) and downstream (from suppliers to focal sector of interest) production networks could have knock-on effects on productivity of connected firms. Productivity could also suffer if small businesses close down in high-contact sectors but large companies strengthen their market power. The increased digitization and innovation in production and delivery processes could offset some of the adverse productivity shocks though. 

The report finds that adverse productivity shock (supply shock) in own sector results in 5% lower total gross value added for up to five years after the shock. Government spending shock is not statistically significant on total GVA. For spillover shocks, downstream effects are dominant, highlighting the importance of supply shocks arising from COVID-19. The ‘own effect’ is larger for high-contact sectors such as wholesale and retail trade, hotels and restaurants, entertainment and personal services, transportation, education, healthcare, and construction.  

3. Global losses are smaller than during the global financial crisis largely due to unprecedented policy support and contained financial stability risks. That said, medium-term output losses from the shock are still sizable, but they exhibit significant variation across economies and regions. The IMF estimates that the COVID-19 shock will lower world output by 3% in 2024 compared to the pre-pandemic projections (over the same period, output losses were 10% in the case of global financial crisis). However, emerging and developing economies will likely have deeper scars than advanced economies, thanks partly due to the larger pandemic-related fiscal responses in the latter and faster access to vaccines. Particularly, economies more dependent on travel and tourism, and those with larger service sectors, are expected to experience more persistent losses.  

Medium-term scarring is contingent on: (i) the path of the pandemic and associated containment measures, (ii) impact of the pandemic shock on high-contact sectors, (iii) adaptation capability of firms and workers to a lower-contact working environment and lower-contact transaction, and (iv) the effectiveness of policy response to limit economic damage.  

Depending on the level of fiscal space, the IMF recommends countries to 

• Reverse setbacks to human capital accumulation and encourage employment by ensuring adequate resources for healthcare, early childhood development programs, education, worker retraining and investment in digital literacy, expansion of social safety nets, and support for displace workers.
• Support productivity by allowing exit of nonviable firms, active labor market policies (help workers transition between jobs by retraining, public employment services, public work schemes, wage subsidies, and support for self-employment/micro-entrepreneurs), and facilitate resource reallocation (to improve labor mobility and reduce product market rigidities). Other measures include promotion of competition, innovation and technology adoption. 
• Boost investment in infrastructure, particularly green infrastructure to help crowd-in private investment. Repairing corporate balance sheet to reduce debt overhand will also promote investment. Improved bankruptcy and debt restructuring mechanisms help to reallocate productive capital. 

Divergent recovery and policy options

In the latest edition of World Economic Outlook (WEO, April 2021), the IMF states that without the extraordinary fiscal and monetary policies, the pandemic would have resulted in an economic contraction three times larger than the current estimates. 

GDP growth

The IMF is projecting the global economy to grow at 6% in 2021, up from an estimated contraction of 3.3% in 2020, and moderate to 4.4% in 2022. These revised projections are higher than earlier estimates owing to the favorable effect of easing of lockdowns, adapting to new ways of working, substantial fiscal support in advanced economies, and an anticipated vaccine-led recovery in the second half of 2021. The IMF projects global growth to moderate to 3.3% over the medium term as the damage to supply chains scars output capacity and aging in advanced economies slows down labor force growth.

Inflation

Inflation in advanced economies is projected to rise to 1.4% in 2021, up from 0.4% in 2020, and 1.9% in 2023. In EMDEs, inflation is projected to remain stable at around 3% from 2021-2023, up from 2.8% in 2020.

The IMF expects price volatility to be short lived and that inflation will return to its long-term average as remaining slack subsides gradually and commodity-driven base effects fade away. Commodity prices, particularly oil, are expected to firm up in the months ahead. But, overall subdued inflation outlook reflects labor market conditions as well, especially subdued wage growth and weak worker bargaining power that are compounded by high unemployment, underemployment, and lower labor force participation rates. 

The IMF notes that unless output gaps become positive and very large for an extended period of time, and monetary policy does not react to rising inflation expectations, inflation is unlikely to increase much. It also does not expect monetary policy to be used primarily to keep government borrowing costs low at the expense of price stability as most economies have independent central banks. 

External sector

On external sector, the IMF projected global trade to accelerate to 8.4% due to the rebound in merchandise goods. But, cross-border services trade (travel and tourism) is expected to remain subdued. 

Divergent effects

The output losses have been divergent. The most affected are the economies that rely on tourism and commodity exports and those with limited fiscal space to respond to the crisis. Many countries entered the crisis without much fiscal space and the ability to mount an effective healthcare policy response. The WEO states that economic situation now (and eventual recovery) is influenced by factors such as the proportion of ‘teleworkable’ jobs, share of employment in small and medium enterprises, capital market deepening, size of informal sector, and quality of and access to digital infrastructure. 

The economic recovery since the second half of 2020 has been led by strong demand for products suitable for working from home and pent-up demand for durable goods such as automobiles. Industrial output is now at pre-pandemic level, but contact-intensive services activities have remained depressed. Likewise, although merchandise trade is back to the pre-pandemic levels, cross-border trade in services remains subdued.  

Unemployment and underemployment remain at elevated level. Labor force participation rate has dropped despite wage and jobs retention programs in many countries. The report notes that youth, women, less educated workers, and informally employed are hardest hit by the pandemic. Poverty (additional 95 million people) and income inequality are likely to increase. The unequal setback to schooling could further exacerbate inequality. 

Asset markets have been surging, thanks to policy stimulus and expectations of a vaccine-driven normalization. However, the IMF notes that the divergence between valuations and broader economic prospects raise financial stability risks. 

GDP loss

The IMF projects the average annual loss in per capita GDP over 2020–24, relative to pre-pandemic forecasts, to be 5.7% in low-income countries and 4.7% in emerging markets. In advanced economies the losses are expected to be 2.3%. Unlike the global financial crisis in 2008, the substantial policy support in response to the pandemic has averted a financial crisis, and medium-term losses are expected to be lower than in 2008 (about 3% lower). However, the emerging markets and low-income countries are expected to face greater scarring owing to their limited policy space. 

Fiscal authorities provided relief to households and firms in the form of transfers, wage subsidies, liquidity support, expansion of safety net such as unemployment insurance and nutrition assistance. Financial regulators facilitated credit provision by easing classification guidelines for nonperforming loans, relaxing provisioning requirements for banks, reducing risk weights on bankruptcy proceedings, and flexibility regarding bank capital requirements. 

The IMF estimates that policy actions such as automatic stabilizers, discretionary measures, and financial sector measures contributed about six percentage points to global growth in 2020. 

Economic outlook

There is considerable uncertainty over the economic outlook though. The WEO notes that it is contingent on the path of the health crisis including vaccine effectiveness against new variants, the effectiveness of policy actions to limit persistent economic damage (scarring), the evolution of financial conditions and commodity prices, and the adjustment capacity of the economy. 

Vaccine procurement and distribution are uneven with broad vaccine availability in advanced economies and some emerging market economies. Since vaccine deployment will be staggered across regions, spread of new variants forcing occasional and localized lockdowns is possible. However, the IMF notes that these may not constrain economic activities like in the initial lockdowns because they will be more targeted and that people and firms have adapted to remote work. 

The size of fiscal package will also drive the nature of recovery. The fiscal package unveiled by the US government will boost growth in the US in 2021 and provide sizable positive spillovers to its trading partners, the WEO states. The IMF expects debt service costs to remain manageable across advanced economies because their debt profile is largely dominated by long-term and sometimes negative-yielding bonds. However, it notes that EMDEs will have limited fiscal support now, but as revenue mobilization improves with pickup in economic activities and crisis-related expenditures unwind, they will have lower fiscal deficits than now. But high debt service costs are expected in EMDEs. 

The crisis could still result in substantial and persistent damage to supply potential and extend scarring due to diminishing labor force participation, bankruptcies, and disruption of production networks. It argues that the longer the recession, the more likely that the effects will be permanent, especially in EMDEs where the prevalence of relatively small firms and shallow capital markets could dampen investment and employment for an extended period of time. These may cripple productivity growth too. 

The IMF expects monetary policy to remain accommodative and tighten only gradually as recovery takes hold. It also expects oil prices to increase as OPEC+ producers curb supply. The strong rebound in PRC will put upward pressure on metal prices. Food prices are also expected to increase in 2021. 

Policy response

Against this backdrop, the IMF recommends policymakers to prioritize policies prudently including strengthening social protection with wider eligibility for unemployment to cover the self-employed and informally employed; adequate resource for healthcare, early childhood development programs, education, and vocation training; and investment in green infrastructure to accelerate the transition to lower carbon dependence. Policy support should be flexible such as shifting lifelines, reallocations, and linked to improvements in activity, but they should safeguard social spending and avoid inefficient spending outlays. Anchoring short-term support in credible medium-term frameworks is key. Economies facing high debt burden should consider creating fiscal space through increased revenue mobilization and reduced wasteful subsidies.

It recommends policy responses to be tailored to the stage of the pandemic, strength of the recovery, and structural characteristics of the economy. As the pandemic continues, policies should focus on prioritizing the healthcare spending, providing well-targeted fiscal support, and maintaining accommodative monetary policy. As recovery progresses, policymakers should limit long-term economic scarring by broadening productive capacity and increasing incentives for an efficient allocation of productive resources.