Esther Duflo on aid, development and RCTs

Was the 2008 financial crisis unprecedented?

Not at all! It would be a mistake to consider this crisis unprecedented and assume that "this time is different", according to a new report (particularly, see pp.11; this blog post is a summary of that section). For a discussion about growth in developing countries after the 2008 financial crisis, see this.

There were similar crises before: the US in the early 1990s during the Savings and Loans (S&L) debacle, costing 3% of GDP; Japan and Sweden in 1992; Mexico in 1994; Hong Kong, Indonesia, Malaysia, the Philippines, South Korea, and Thailand in 1997-98 (cost of bank restructuring: 50%, 25% and one-third of GDP in Indonesia, Japan and Thailand and South Korea respectively) ; Brazil and the Russian Federation in 1999; Turkey in 2000; and Argentina and Uruguay in 2002.

The 2008 crisis follows a pattern seen many times before. The pattern is captured by Hyman Minsky model.

1. In a successful capital economy, the financial structure abets enterprise but when finance fosters speculation the performance of a capitalist economy falters. Keynes defined enterprise as the "activity of forecasting the prospective yield of assets over their whole life" and speculation as the "activity of forecasting the psychology of the market."
2. Some exogenous event improves the prospects for profits, justifying speculative bets. Usually financial liberalization is followed by speculation as happened after the financial liberalization in Japan in the 1980s and in Sweden preceding 1992 crisis. The 2008 financial crisis was preceded by a significant increase in asset prices, fueled by leverage, low interest rates, and the perception that financial innovation had tamed financial risk.
3. Expectations take off, losing touch with reality. Euphoria, optimism, irrational exuberance, manias, bubbles, blindness to risk, animal spirits are some of the way to describe the psychological forces at work.
4. Credit system permits highly leveraged investments in the pursuit of socially valuable goods. But it also enables the pursuit of short-term capital gains in real estate, commodities or financial assets. Borrowers tend to progress from hedge finance (where the yield on an asset is sufficient to pay the interest and principal of the loan that financed) to speculative finance (where it is sufficient to pay only interest) to Ponzi finance (where the borrower is wholly dependent on capital gains).
5. A negative event triggers a reversal in the cycle. The greater the leverage, the more violent the downward journey. Prices fall and leveraged borrowers are unable to honor their debt.

Book review: Freefall: America, free markets, and the sinking of the world economy

[A review published in Trade Insight, Vol 6. No.1, 2010]

Joseph Stiglitz, a 2001 Nobel laureate in economics and a professor at Columbia University, had severely criticized the International Monetary Fund and the United States (US) Department of Treasury for their handling of the East Asian crisis in 1997, which cost him his job as Chief Economist at the World Bank. The global financial crisis of 2008, which he had predicted, has vindicated him of his incessant rant on and vilification of the “market fundamentalists” and their flawed models.

In his new book Freefall: America, Free Markets, and the Sinking of the World Economy, Stiglitz explains the causes of the Great Recession that started with the collapse of Lehman Brothers on 15 September 2008, exposes main players in the financial industry, berates the state of economics, and outlines what lies ahead for the global economy. Though the book is mostly about the US economy, it also contains interesting discussions about global economic challenges and their potential solutions.

He thinks that the unraveling of the causes of the global financial crisis is like "peeling back the onion", i.e., figuring out what lies behind each blunder. The markets failed because of the presence of large externalities, which in turn is caused by misalignment of incentives in the banking sector and information asymmetry in the asset market. Digging deeper would reveal that this was caused by blind faith in a flawed economic ideology about markets. He argues that “economics has moved—more than economists would like to think—from being a scientific discipline into becoming free market capitalism's biggest cheerleaders". Dancing to the tune of the market cheerleaders, the people responsible to oversee the financial industry either failed to see the crisis coming, or did nothing to stop it when warned, or did too little too late when the downward spiral began.

An advocate of a Keynesian fiscal stimulus to overcome the adverse impact of the economic crisis, Stiglitz is dissatisfied with the structure, size and progress of US President Barack Obama’s stimulus package. An ideal stimulus is fast; effective in increasing employment and output; addresses long-term problems such as low savings, trade deficit, social security and infrastructure; investment-oriented; fair (relief for the middle-class, not the richest 5 percent); deals with short-run exigencies (insurance and mortgage payment); and targets job loss ( to retain skills and workers). Australia was the first country to design a stimulus package in line with these principles, and, no wonder, the first advanced country to emerge out of recession.

Stiglitz advocates a second round of stimulus in 2011 and a redistribution of income with progressive taxation in the US. He advises the US government not to "give into deficit fetishism" because as long as returns on investment in technology, education, and infrastructure are greater than the size of the deficit, it should not be a problem to roll out another stimulus. He also pitches for a coordinated global stimulus as global multiplier is greater than national multipliers.

The world has to address, argues Stiglitz, six economic challenges: (i) mismatch between global demand and supply; (ii) climate change because environment prices are distorted, leading to unsustainable use of resources; (iii) global imbalances due to excess consumption in advanced countries and excess savings in developing countries; (iv) manufacturing conundrum because there is increase in productivity but decrease in employment; (v) inequality because it is affecting overall aggregate demand as there is more money with the rich and less with the poor; (vi) and growing financial instability leading to unmanageable risks.

These challenges call for a new economic model, which should include a bigger role for government. It is the government's responsibility to ensure that errant markets do not lead to catastrophic social and economic situations. It should play a critical role in maintaining full employment and a stable economy; promoting innovation; providing social protection and insurance; and preventing exploitation by “correcting” market distortion of income distribution.

Stiglitz censures economists who pushed their model of rationality beyond its appropriate domain and blasts inflation-targeting ideology, predicting that it will die after this crisis. Even if this ideology persists, the crisis has revealed the limitation of markets and resurrected Keynesian economics. Indeed, “the fall of Lehman Brothers may be to market fundamentalism what the fall of Berlin Wall was to communism”.

The Sinking of World Economy_Trade Insight 2010

Post-crisis trade recovering (but not fast enough)!

Merchandise trade volume grew in the Q4 2009 in the G7 countries, albeit at a slower pace than in Q3 2009. Though trade volumes and values have recovered since the plunge in Q3 2008 and Q1 2009, their level is still below the pre-crisis levels of mid-2008 (by almost 20 percent lower to pre-crisis level). Import and export volumes from G7 countries rose 3.1% and 3.9% respectively. The more rise in imports by G7 countries, the better is the chance of developing countries benefiting from the trade recovery, assuming that majority of imports by G7 countries come from the developing countries!

 
 Here is real GDP figures (see the plunge!)

Industrial policy is back: Rodrik

Rodrik argues industrial policy was never dead! Successful economies always used it.

British Prime Minister Gordon Brown promotes it as a vehicle for creating high-skill jobs. French President Nicolas Sarkozy talks about using it to keep industrial jobs in France. The World Bank’s chief economist, Justin Lin, openly supports it to speed up structural change in developing nations. McKinsey is advising governments on how to do it right.

Industrial policy is back.

In fact, industrial policy never went out of fashion. Economists enamored of the neo-liberal

Washington Consensus may have written it off, but successful economies have always relied on government policies that promote growth by accelerating structural transformation.

The shift toward embracing industrial policy is therefore a welcome acknowledgement of what sensible analysts of economic growth have always known: developing new industries often requires a nudge from government. The nudge can take the form of subsidies, loans, infrastructure, and other kinds of support. But scratch the surface of any new successful industry anywhere, and more likely than not you will find government assistance lurking beneath.

Ten bad ideas for economic growth

It comes from a recent report about post-crisis growth and developing countries by the Growth Commission. The set of bad ideas for growth are:

1. Assuming the crisis is a “mean-reverting” event and the we will return to a pre-crisis pattern of growth, capital costs, trade and capital flows.
2. Interpret the need for better regulation and government oversight of the financial sector as a reason for micromanagement of the financial sector.
3. Abandon the outward-looking, market-driven growth strategy because of financial failures in the advanced countries.
4. Allow medium-term worries about the public debt to inhibit a short-term fiscal response to the crisis.
5. Adopt counter-cyclical fiscal policies without concern for the returns on public spending, and without a plan to restore the public finances to a sustainable path over time, once the crisis is past.
6. Ignore the need for more equitable distribution of gains and losses in periods of prosperity as well as in crisis.
7. Continue with energy subsidies on the assumption that commodity prices will not rebound after the crisis.
8. Treat the financial industry like any other, ignoring its external effects on the rest of the economy.
9. Focus monetary policy on “flow” variables like inflation, job creation and growth, ignoring potential sources of instability from the balance sheet (asset prices, leverage, derivates exposure).
10. Buy assets whose risk characteristics are hard to understand. The high returns are likely to reflect higher risk even though the latter may be hidden from view. They will be overpriced and salable, if at all, in a crisis only at distressed prices. Things that seem too good to be true, probably are.

Growth in developing countries after the crisis

The Growth Commission has published a report (Post-Crisis Growth in Developing Countries) assessing the financial crisis and its fallout on economic growth in the developing countries. I was planning to read it last month but couldn’t do so. This report assesses if the previous recommendations in The Growth Report still holds true after the 2008 financial crisis.

The conclusion is that the recommendations are still relevant but some restraint on capital controls and financial liberalization might be fruitful. The report emphasizes the crisis does not show the failure of market-based system but that of the financial sector. The outward-looking strategy is still relevant but it may not be as rewarding as it was before the crisis because of slower growth in trade, costlier capital, and a more inhibited American consumer.

Below are notes from the report. The figures are from WEO 2010:

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Economies that had sustained growth of 7 percent or more for 25 years or longer had some common features:

• Fully exploited the world economy; imported ideas, knowhow and technology; produced goods that met global demand, specialized and expanded rapidly without saturating the market.
• Maintained macroeconomic stability; inflation under control and sustainable fiscal paths.
• High rates of investment (25% of GDP), including public investment, financed by equally impressive rates of domestic savings.
• Followed the market signals while allocating resources; used industrial policy to bent the law of comparative advantage, by favoring some industries over others; the favored industries had to pass a market test by successfully exporting their products to foreign customers who did not have to buy them; relatively mobile labor; stagnant industries were allowed to fail; protected laid-off workers from economic misfortune 
• Strong, committed, credible and capable governments; their macroeconomic strategies and microeconomic regulations provided the setting in which market dynamics could work; provided a range of public goods such as schooling and infant nutrition that markets under-provide.

What did the crisis teach us? The crisis delegitimized an influential school of thought, which held that many financial markets could be left to their own devices, because self-interest of participant would limit the risks they took. At a huge cost, it taught an unforgettable lesson about how financial systems really work. But, the crisis is a failure of the financial system, not the market per se.

Before the crisis (September 2008), developing countries faced very high commodity prices for eighteen months, peaking in the spring and summer of 2008. When the crisis erupted, there were declines in investment, employment and trade. The crisis spread to the developing countries through financial channel (credit tightened everywhere) and real economy channel (trade collapsed more than economic activity). China was less vulnerable to mobile investment funds because of its capital controls. China's response to this crisis was a repeat of its response to the Asian financial crisis in 1997-98, but on a much larger scale.

The government has to prevent a complete failure of the financial system and replace essential functions like credit provision until the normal channels reappear. It should also prop up economic activity and asset prices by filling the gap left by sidelined consumers and investors. Moreover, it has to act as a "circuit-breaker", interrupting the transmission of shocks from one part of the economy to the other. Fiscal stimulus reduces declines in the real economy, boosting employment, income and credit quality.

Post-crisis global economy

• The US consumer will become the US saver in an effort to repair the damage to household balance sheets. The world will also face a set of additional challenges: energy, climate and demographic imbalances, among others.
• Regulators and central banks cannot afford a narrow focus on consumer prices and employment, leaving asset prices and balance sheets to their own devices. They cannot hope to control inflation, manage growth, check overstretched balance sheets and ward off related sources of instability by manipulating short-term interest rates alone.
• The government has a legitimate reason to intervene to ensure that taxpayers' interests are safeguarded. Vulnerabilities in the financial sector represent contingent liabilities for the government and rest of the economy.
• Financial re-regulation should and will emphasize capital, reserve and margin requirements, seeking to limit the build up of systemic risk by constraining leverage.
• The cost of capital will increase, debt will be more expensive and less ubiquitous, and risk spreads will not return to the compressed levels that prevailed before the crisis.
• Joblessness in the advanced economies may not peak until late into 2010. Labor markets are still deteriorating.
• Some of the fundamental determinants of growth are relatively crisis-proof: demography or human ingenuity.
• The average rates of protectionism in the world economy, weighted by GDP, will increase as big emerging economies, which tend to have higher trade barriers on average than the industrial economies, grow in prominence.
• No magic bullet for getting out of the crisis: The economy should gradually right itself, as financial markets stabilize and the real economy follows, pulling the sea anchor of extended deleveraging along with it. Policies likely to err on the side of running short run inflation risk, rather than the reserve.

Growth strategies

Successful economies have generally found a formula that includes a dynamic and innovative private sector supported by government investment in public goods, effective regulation, and redistribution to protect the most vulnerable. That balance varies across countries.

The crisis represents a major failure of the financial systems in the advanced countries. In particular, the lightly and incompletely regulated model that was influential in many Western economies is fundamentally flawed and in need of change. There is no evidence of a more broad based failure of the market and capitalist economies. The debate should focus on the financial sectors' stability and performance, rather than on a more sweeping condemnation of the whole market-based system.

The government should do more to protect people during times of extreme economic turbulence. Safety nets are indispensable to maintain public confidence and support for the market-led outcomes. Some countries (such as Brazil, Mexico and India) have shown that it is possible to devise more permanent programs that can serve the economy both in good times and bad, expanding during crises to meet sudden spikes in need. "Leaky" safety nets buys political support. Broader coverage may be the political price we have to pay for a well-supported safety net. Countries should prepare an inventory of well-designed projects that can be taken "off the shelf" when the need arises.

Quantitative easing, capital injections into the financial sector, bail-outs in a number of other industries, and fiscal stimulus programs have all added to the government's scope and influence. Budget deficits, if left unaddressed, will eventually raise long-term interest rates, making debts even harder to sustain.

The state's expansion needs to be reversed as the crisis subsides. Fiscal stimulus packages need to be replaced by medium-term programs to restore fiscal balance, based on realistic (and perhaps diminished) estimates of future growth. The expanded central bank balance sheets need to shrink through the sale of assets over time to the private sector.

Road ahead for developing countries

Consumption cuts and increase in savings by the American consumer could mean a $700 billion or more shortfall in global aggregate demand, relative to the world economy's productive potential. This shortfall should be filled by an increase in domestic demand in surplus countries.

To grow rapidly, countries must reallocate resources from traditional, low-productivity activities, such as agriculture, to new industries, which allow for rapid gains in productivity that often spill over to the wider economy. As countries make economic progress, their production of tradable goods tends to rise rapidly, leading to trade surpluses. There is no necessary connection between increasing the share of tradable goods in GDP and running a trade surplus. Rodrik has shown that trade surpluses do not have any independent, positive effect on growth, once you control for the share of industry in GDP. The share of "industry" captures the importance of non-traditional, high-productivity activities in a country's economy. Countries grow by promoting these activities, not by promoting trade surpluses per se.

Domestic demand is not a perfect substitute for global demand,where countries can specialize in a narrow range of products to serve specific customers. To cater to domestic demand, countries need to produce a broad range of products, so as not to saturate any particular local market niche. The limits to specialization are tighter and depend on the evolving composition of domestic demand.

Developing countries should curb financial products they may be ill equipped to handle. Several countries, including Brazil, India and China make heavy use of reserve regulatory restrictions to dampen their banks' enthusiasm. China imposes different requirements depending on the kind of assets banks hold, thereby influencing the direction of credit as well as its quantity.

Developing countries should ensure that some banks remain domestically owned, even if they are not owned by the state. The government's focus is quite understandably on the domestic economy. But foreign entities will have divided loyalties at best.