Liquidity trap and optimal fiscal policy

Following New Keynesian Economics models, Krugman sketches out a model where he shows the optimal fiscal policy (increasing government expenditure up to the point where full employment is maintained) when the economy is in a liquidity trap.

…when the economy is in a liquidity trap government spending should expand up to the point at which full employment is restored. That’s not a guess or a statement of personal preferences, it’s a result.

The basic intuition behind this result is that when the economy is in a liquidity trap, the social marginal cost of government spending is low, because there isn’t enough private demand to fully employ the economy’s resources. This means that we would normally expect more government spending to raise welfare, right up to the point that full employment (a concept that needs a bit of explanation here) is restored. At that point the marginal cost of government spending jumps up, because it’s diverting resources from private spending.

What I’ve illustrated here is the marginal cost and benefit of government purchases of public goods in and near a liquidity trap. The marginal benefit is presumably a downward-sloping
curve. If G is low, so that monetary policy cannot achieve full employment, the marginal cost of an additional unit of G is low, because the additional government purchases don’t crowd out
private spending. Once G is high enough to bring full employment, however, any further rise in government purchases will be offset by a rise in the interest rate, so that extra G does come at the expense of C, implying a jump in the marginal cost.

As the figure suggests, there should be a fairly wide range of situations in which the optimal level of G is precisely the level at which the marginal cost jumps – that is, the optimal fiscal
expansion is one that brings the economy right to full employment.

…The bottom line here is that while we usually think of Keynesianism as the preserve of ad hoc models, in this case doing it “right” – using a macromodel with maximizing agents and a proper concern for intertemporal constraints – actually suggests a very strong case for big government spending in the face of a liquidity trap. When the economy is depressed and monetary policy can’t set it right, the true opportunity cost of government spending is low. So let’s get those projects going.

The year 2008 in review- the WB version

Here is WB’s review of the year 2008

YCL and load-shedding fall heavy on the industrial sector

The Maoists militant youth force, YCL, and 13 hours of load-shedding in Nepal is taking toll on the industrial sector. Lack of energy and YCL’s campaign to close down industries by putting unjust demands that are beyond the rich of the fledging industrial sector are forcing industries to close down.

Global economics crisis, moribund garment and textile industry, energy crisis, threats to property rights, lack of appropriability (private), high inflation rate…the list of problems in the Nepali economy is never-ending…The last thing Nepal needs now is YCL’s politically motivated rage and labor unrest.

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UPDATE: THT reports that the industrial sector is in fact feeling the heat of YCL’s excesses pretty intensely!

With increase in load-shedding hours in the country, up to 50 per cent of the productivity has been cut. “Serious alternative measures should be taken immediately to prevent the collapse of industries,” he recommends to the government.

Resource curse and reversal of (corrupt) contracts

The latest democracy to be a victim of a coup d’état is Guinea, a country rich in natural resources, mainly bauxite, gold, diamonds, iron and nickel. Nearly one-half of the world’s bauxite reserves is located in Guinea.

After overthrowing the elected administration, following the death of a repressive president, the army officials announced that they are going to review mining contracts and stamp out corruption. Actually, stamping out corruption and holding new free and fair election have been favorite lines to justify coups.

Without naming firms, Capt Moussa Dadis Camara told a public meeting in Conakry that any contracts found to be "defective" would be revised.

He outlined his view of the mining sector, which has attracted billions of dollars in investment from international firms.

"We have blocked the mining sector," he said. "There will be a renegotiation of contracts."

Without naming names, Capt Camara vowed to eradicate corruption, saying: "It was the government officials who surrounded the [late] head of state who looted the country."

"Anyone found guilty of corruption will be punished," he added. "Anyone who has misappropriated state assets for his benefit, if caught, will be judged and punished before the people

The junta thinks that there is massive corruption and unfair contracting in the mining sector, its main revenue base. So, it wants a review of unfair deals. Good! But free and fair review as is stated by juntas rarely happen. In Russia, Venezuela, and Bolivia, the governments reviewed contracts in favor of their cronies, often forcing foreign companies to leave the country. Leaders start with good intentions but things take a different turn later on due to inefficient administration and weak regulatory bodies.

Most of the resource-rich countries are marred with corruption because contracting is often done without following normal procedures or by bypassing regulations. Also, nepotism and favoritism is a common feature in countries rich in natural resources. Moreover, coup threats are also high. This means natural resource abundance leads to slower growth. See this paper.

Here is a paper about political foundations, resource curse, and the importance of solid institutions:

(1) politicians tend to over-extract natural resources relative to the efficient extraction path because they discount the future too much, and (2) resource booms improve the efficiency of the extraction path. However, (3) resource booms, by raising the value of being in power and by providing politicians with more resources which they can use to influence the outcome of elections, increase resource misallocation in the rest of the economy. (4) The overall impact of resource booms on the economy depends critically on institutions since these determine the extent to which political incentives map into policy outcomes. Countries with institutions that promote accountability and state competence will tend to benefit from resource booms since these institutions ameliorate the perverse political incentives that such booms create. Countries without such institutions however may suffer from a resource curse.

A wonderful Xmas gift: 13 hours of load-shedding in Nepal!!

12-14 hours of load-shedding. That’s a Xmas gift from the government to the Nepali people!

Faced with acute shortage of power in the country, the government declared “power crisis” in the country. This means use of electricity on hoarding boards is banned. Too bad for the advertisement industry! The government has encouraged use of compact fluorescent lamp (CFL). It has also given subsidies on import of such lamps, initiated generation of 200 MW electricity from thermal plants, and is trying to import electricity from India. There is a shortage of 3.8 million units of electricity in the country. Moreover, the government has waived red tapes for investors willing to immediately invest in power plants below 50 MW.

Why so late? Why did not the leaders heed to this impending crisis earlier? Corruption? Lack of visionary leaders? More here. Compare the state of energy production in Bhutan and Nepal and you’ll realize how messed up is the political system in Nepal to forge a consensus in a unified energy plan for the country. Note that, Nepal has a comparative advantage in the production of hydro electricity. Why not exploit it rather than scrambling to resuscitate the beleaguered export-oriented firms?

Assessments needed:

[1] the fallout of power crisis on the advertisement industry

[2] the effect of [1] on advertisement revenue for newspapers and online news portals

[3] the effect on price of diesel due to increase in demand for use in thermal plants

[4] the effect of this crisis on the industrial output

[5] the effect of this crisis on FDI

[6] the effect of this crisis on private sector demand for new hydropower plants

[7] the effect of this crisis on the price of alternatives like candle, lamp, biogas generation

The mechanics of growth

Abhijit Banerjee explains the mechanics of growth:

The problem is that for a business to rise beyond its many competitors—the thousands of fruit vendors in Chennai---it has to have something special about it: The product (P) must be different or the quality (Q) must be especially high, or the firm must have special reputation for reliability (R) or the scale of operations (S) must be large enough to generate significant cost savings. And each of these requires a combination of special skills and substantial amounts of money, both beyond the reach of all but a few poor or even not so poor business owners.

It is these PQRS businesses that generate the good jobs that other aspire to, and the earnings that come out of them lead to other businesses and so on. This, to a first approximation, is my vision of the process of how growth happens. It is what China has managed to do very successfully and Africa will have to find a way of doing.

Consider this particular feature of self-employed, self-sustaining, (and stagnant at lowest equilibrium)  business model in the developing countries (“follow-the-herd” business model):

It turns out that the businesses of the poor are also poor businesses: The typical business has zero paid employees and no machines in almost every country where we have data and where we have the information to be able to calculate this, what the household earns from the business is less than what they would earn on the lowest end of the labor market. They are in effect buying a job and not particularly good job at that.

Isn’t this just a reflection of the fact that they do not have enough capital to run a proper business? Yes and no. These businesses are certainly undercapitalized, but the businesses of those who are significantly richer (those who live on $6 to $10 a day, for example) really do not look all that different from these. Moreover the amounts of money invested in these businesses are so tiny that a family living on three or four dollars a day per capita, could easily double or treble their capital stock in a year by simply halving what they spend on tea or cigarettes.

Dean Karlan and Sendhil Mullainathan, in a recent paper, put this point rather starkly. They study fruit vendors in Chennai, India, who make about two to three dollars a day by buying fruit in the morning on credit and paying it back at night. It turns out that the interest rate they pay is 5% per day and at that rate, saving the ten cents they spend on tea for just one day would allow them to pay back their entire loan in six months (the power of compound interest) and add a dollar a day to their earnings. Yet most of them seem to be permanently stuck in their business model.

More praise for Keynes

Martin Wolf writes, “We are all Keynesians now.” [This exact sentence was used by Krugman and Stiglitz in the beginning of their past columns. In fact, this has been a popular starting sentence among writers who want to discuss the connection between Keynesianism, present financial crisis, and increasing government spending in the economy!]

Three relevant Keynesian stuff, according to Wolf:

The first, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”.

The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company, it makes sense to cut costs. If the world tries to do so, it will merely shrink demand. An individual may not spend all his income. But the world must do so.

The third and most important lesson is that one should not treat the economy as a morality tale. In the 1930s, two opposing ideological visions were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order; the latter in the idea that the identical motivation could lead only to exploitation, instability and crisis.

I like the second one: that economy cannot be analyzed in the same way as an individual business. This also means sum of individual units does not equal to a whole, i.e. the sum of outputs generated from self-interested individual’s actions does not equal to the output generated from one big player’s action. Micros do not add up to macro!!

And, very nice (and comforting) words about Keynes:

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge. He wished to preserve as much liberty as possible, while recognising that the minimum state was unacceptable to a democratic society with an urbanised economy. He wished to preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds.

…Yet Keynes would have insisted that such approaches are foolish. Markets are neither infallible nor dispensable. They are indeed the underpinnings of a productive economy and individual freedom. But they can also go seriously awry and so must be managed with care.

Again, not that Keynes did not say markets don’t work. He said markets do not always work, so government should fill the gap. He treated markets and governments not as substitutes but as some form of complementary forces.

Here is an old article from Time magazine, which put Keynes’ picture on its cover page and named him Person of the Year in 1965. More here.