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.

Does skilled migrants remit less?

Who remits more: skilled or unskilled migrants? According to a new Asian Development Bank (ADB) working paper, unskilled migrants remit more than skilled migrants. Okay! But what policy conclusion can we derive from this finding? Well, the authors of the paper argue that for a source country, it would be better to focus on policies to promote unskilled labor migration. This finding somehow support the argument that brain drain is bad. But it may not be necessarily so in this globalized world- see this article from The Economist. Also, migration does not always have to be from poor to rich countries; it can happen the other way round or from poor to poor countries.

Skilled migrants tend to have higher incomes and can afford to send more remittances to their families back home. On the other hand, they tend to come from better off families whose demand for remittances is lower relative to poorer ones. Furthermore, skilled migrants are able to bring their families along with them as they tend to enjoy more secure legal status. All of these factors reduce the incentives to send remittances. Thus, the net impact of an increase in migrants’ level of education on remittances is ambiguous a priori. Empirical studies have so far been unable to resolve the debate on this issue. This paper’s main contribution is to show that remittances actually decrease with an increase in migrants’ overall level of education.

They find that remittances decrease for migrants with tertiary education.This is hard to believe given the fact that India, China, and France (three of the top five recipients of remittances in 2007) get a substantial chunk of remittances from skilled workers. Meanwhile, countries like the Philippines, Bangladesh, Mexico, and Nepal receive a major chunk of remittances from unskilled workers. Here is a list of top ten remittance receivers in 2007.

The determinants of remittance are migration levels and rates, migrants’ education level, and source countries’ income, financial sector development, and expected growth rate, among others. I think rate of return of labor and rate of return of education of workers in their home country are two of the main variables of migration function. A World Bank study on remittances and brain drain found that in the case of Mexico, migrants are less uneducated than nonmigrants. Generally, if the rate of return for labor and education is higher in source country, then educated workers opt to stay back. On a policy level, it is not necessary to focus on retaining educated migrants because they make decision based on the rate of return in the domestic market. Meanwhile, it might be fruitful if policies are designed to facilitate migration of unskilled workers to countries where there is high return to labor, provided that the domestic market is either saturated or incapable of absorbing unskilled, unemployed workers.

Doing Business in Nepal

Here (or here) is a Doing Business Report 2009 focused on Nepal.

Check this one out for my earlier blog post, which contains discussion about the ease of doing business in Nepal and South Asia.

Global financial crisis and Sub-Saharan Africa

The IMF has released a report highlighting the effect of the current financial meltdown on the Sub-Saharan Africa region. The regional growth rate is expected to slow down to 6% in 2008 and 2009, down from 6.5% in 2007, because of the impact of rising commodity and fuel prices in oil-importing countries and the worsening impact emanating from financial meltdown in the West. Meanwhile, inflation is expected to shoot to 12% and 10% in 2008 and 2009 respectively (how much has hyperinflation in Zimbabwe skewed this number?). Concerns on remittance and private capital flow to Africa remain high amidst the worsening financial crisis.

…So far, the main effects of the global financial turmoil appear to be indirect, in the form of slower global growth and volatile commodity prices. Recent heightened turbulence raises the risks, including of a decline in resource flows to Africa in the form of private capital, remittances, and even aid.

The challenge for policymakers is to adjust to the food and fuel price shock, preserve economic stability in the face of global financial turbulence, and shield the poor. With food and fuel prices substantially off recent peaks, it should be easier to fully pass through higher prices to the economy to encourage adjustment. With food accounting for a major part of household expenditure, the resulting loss in the purchasing power of the poor is a serious concern. Measures to cushion the impact of higher food and fuel prices on the poor therefore need to be well targeted—and also supported by donors. For oil exporters a particular challenge is to preserve a medium-term perspective; caution use of oil revenue windfalls permits smoothing of fiscal spending in the face of price declines as well.

Here are some important observations about Sub-Saharan African growth:

• Sub-Saharan Africa has enjoyed a remarkable growth takeoff since the mid-1990s.
• Sustained growers in sub-Saharan Africa have gotten the critical basics right and avoided major policy failures.
• Recent African success stories also demonstrate that governments need to play a proactive role but that there is no simple recipe for achieving high growth.
• Higher aid has been part of the story for fast growers that have not benefited from large resource rents, providing room for higher social spending and public investment and promoting or at least being consistent with fast growth.
• High growth cannot be taken for granted.

The IMF, which is more obsessed with the free market ideology than its sister organization, WB, quite surprisingly argues that the government can do a lot to stimulate economic growth. Remember that, unlike in the past the IMF recently supported the $700 rescue package while it opposed a bail out package during the 1997 Asian Financial Crisis (especially in South Korea and Indonesia, which it described as not having as “systemically important” financial institutions as the US has right now!). Here, it also supports country specific growth policies, unlike in the past!

Countries need to choose policies that allow them to benefit from what is happening externally, preserve macroeconomic stability, promote effective public and private investment, and ensure that all share in the benefits of growth, which must include improvements in health, education, and the other areas addressed by the MDGs as well as income. Moving toward growth trajectories that emphasize value added and nontraditional exports—paths that characterize most sustained fast growers in other regions—is not easy, but it can be done.

More on financial crisis and IMF: Can the IMF save the world?

Special section on the financial crisis from the BBC News here.

Aftermath of the financial mess: Redistribution of talent

Esther Duflo feels that the growth of financial sector until now has led to unproductive distribution of intelligence (talent). She argues that with stricter oversight and monitoring of CEO salary and bonus and disappearance of their exorbitant earning may encourage talents to seek job opportunities in other industries, thus leading to a more realistic allocation of talent.

If paying the bankers (a lot) less or taxing them (a lot) would certainly be more desirable from a moral point of view (not to mention considerations of equity), would it be harmful in terms of economic efficiency, as many economists suggest? Is there a risk of discouraging the most talented to work hard and innovate in finance? Probably. But it would almost certainly be a good thing. A study on Harvard graduates showed that those who work in finance earn almost 3 times more than others. The temptation for young talent to work in this sector is enormous – 15% of 1990 Harvard graduates are working in finance, compared with only 5% of the class of 1975. More generally, the massive deregulation of the financial sector, which began in the 1980s, and the opportunity to make extraordinary profits have been accompanied by an increase in the number and qualifications of employees in this sector. Again, according to Philippon and Resheff, one has to go back to 1929 to see such a gap between the average education of an employee in the financial sector and one in the rest of the economy. The complex financial products, but also the evolution of standards in the social sectors over the past 30 years, have made the financial sector particularly attractive to any graduate, intelligent as he or she may be.

What the crisis has made bluntly apparent is that all this intelligence is not employed in a particularly productive way. Admittedly, a financial sector is necessary to act as the intermediary between entrepreneurs and investors. But the sector seems to have taken a quasi-autonomous existence without close connection with the financing requirements of the real economy. Thomas Philippon calculates that the financial sector, which accounts for 8% of GDP in 2006, is probably at least 2% above the size required by this intermediation. Worse, the sub-prime crisis is almost certainly in part linked to the fact the needs of the financial markets (the insatiable demand from banks for the (in)famous “mortgage-backed securities”) led to excessive borrowing and a housing bubble. Watching the events of the last few days unfold does make us one want to send some of the finance CEOs back home. More pragmatically, the disappearance of their exorbitant earnings may encourage younger generations to join other industries, where their creative energies would be socially more useful. The financial crisis could plunge us into a severe and prolonged recession. The only silver lining is that it could cause a more realistic allocation of talents. One must hope that the bail-out packages in Wall Street and in Europe do not convince the best and brightest that the financial sector is still their best option.