Keynes and the current financial crisis

I don't like to get too deep into the US economy because this is not directly related to the stuff going on in the developing countries-- my primary field of interest. However, the stuff that goes in the US economy does have some impact on the developing country's economy. [Well, that said it is hard to believe that at a time when the world stock markets are going downhill, or at least are very vulnerable and fickle, the Nepali stock market (NEPSE) is going uphill-- a hard to believe happening at this point of time. I think the time lag in the Nepali economy is much more larger than in the West's economy (I presume, somewhere at least 8-10 months in the financial sector). I always am amazed by the deviance of Nepali economy from the standard predictions of fiscal and monetary theories!]

Anyway, back to the US economy. I somehow stumbled into the CEPR Policy Insight No. 23 (Keynes and the Crisis by Alex Leijonhufvud). It is an interesting and fascinating discussion (well, at least to those (like me) who are slightly inclined towards Keynesianism) about the Keynes and the current financial crisis in the US. What can we learn from Keynes(ianism) and the moral philosophy associated with it?

The most important lesson from his life and work may be that the macroeconomist should start from the important problems of the day and should face the following questions: (1) How are we to understand what is happening right now? (2) What can be done about it? What is the best policy to follow? (3) Do recent events force us to modify what is today widely accepted economic theory? If so, what is wrong and how might we go about arriving at a more satisfying theory?

Why did the Keynesian policies did not work in Japan (heavy spending on public transportation and other sectors leading to nearly insurmountable debts) when the policymakers tried to tackle two bursts- stock market and real estate? Ans: moral hazard and liquidity trap

The effective demand failure that plagued Japan rather was that business firms could not and later would not do the intertemporal trade of expected revenues from future output for the factor services in the present needed to produce that output; that is, they could not or would not borrow to finance investment. In the early post-crash years, the state of the banks was such that they would not lend. Even when the Japanese banks eventually got into healthier shape, many business firms still had balance sheets in such condition that they were loath to borrow...The other lesson to draw from the Japanese experience is that once the credit system had crashed, a central bank policy of low interest rates could not counteract this intertemporal effective demand failure.

He argues that the current financial crisis is a result of policy failure, particularly obsession with inflation-targeting and too low interest rates. The Fed maintained low interest rates without paying attention to the fact that price stabilization was being done by "competition from abroad and the exchange rate policies of the countries of origin of those imports."

He has a dire prediction about the near term future of the US markets: it is definitely going into stagflation and the "issue is how much inflation and how much unemployment and stagnation are we going to have."

Also, here is a challenge to Miltion Friedman, who said that the real interest rate was determined by real factors and could not be manipulated by the Central Bank. Leijonhufvud argues that the "real interest rate does not exist in reality but is a constructed variable." Why? Because the low interest rates during the Greenspan era produced "virtually no CPI inflation, but drastic asset price inflation and very serious deterioration of credit standards." He also takes on the validity of rational expectation based models and provides arguments showing empirical inconsistency to the Ricardian equivalence, modern financial theory, and the representative agent model.

He extols Keynes:

"More than seventy years ago, Keynes already knew that a high degree of downward price flexibility in a recession could entirely wreck the financial system and make the situation infinitely worse."

Three lessons should be learned from Keynes:

• To take our social responsibilities seriously and focus on the macroproblems of our own day (the ongoing credit crisis and its gradually unfolding consequences).
• To try to understand what can be done with #1 (standard Keynesian policies are not the answer and nor are the standard central banking doctrine)
• To ask whether events proved that existing theory needed to be revised (dynamic stochastic general equilibrium theory is an intellectually bankrupt enterprise)

More importantly, we need to realize that macroeconomic is much more dynamic to just fit into the stochastic general equilibrium models and the current events should not be tied with standard economic theories, which have already fallen prey to empirical evidences, by hook or by crook. Though current economic events should be viewed in terms of standard economic theories, they should not be unnecessarily tied with the theories because the market is too dynamic to follow standard theories!

What we need to learn from Keynes, instead, are these three lessons about how to view our responsibilities and how to approach our subject.

The paper reminds me of my Intermediate Macroeconomic and Money and Banking classes!

SAARC Development Fund

South Asian Association for Regional Corporation's (SAARC) 15th annual meeting has just concluded in Sri Lankan capital Colombo. With the eight members countries (India, Nepal, Pakistan, Bhutan, Sri Lanka, Maldives, Bangladesh, and Afghanistan), it is the largest regional bloc in the world in terms of population. It has new "observer" members likes the US, the EU, China, South Korea, Japan, Mauritius, and Iran (now Myanmar and Australia as well). Usually, the meeting is overshadowed by bitter diplomatic ties between India and Pakistan. The meeting is usually a gathering of heads of state, without any substantial outcome. Nevertheless, it provides a very useful forum for the countries to discuss the most common issues plaguing the region with the highest number of people below $1 a day.

This time the meeting decided to establish a SAARC Development Fund (SDF), with an initial capital of $300 million. Bhutan has offered tax breaks and other diplomatic level incentives to host headquarter of SDF. Though the initial capital, which is just a commitment and has yet to be realized in real terms, is very small, the leaders have rightly identified maternal and child health, women empowerment, and teacher's training as a priority. Teacher absentee is one of the most pressing problems in the education sector in South Asia. More here.

It needs to be seen how effective and fruitful the Colombo declaration would be in terms of increasing regional trade, reducing poverty, facilitating energy cooperation and trade, and cooperation in the fight against the threat of terrorism. The people are yet to feel the effect of SAFTA, the free trade agreement among the seven (plus Afghanistan added last year) countries.

Though I am skeptical of great strides in economic cooperation due to SAARC agreements, I am hopeful that it would be one of the most important regional blocs in the world in the coming years. Why? Because of India's growing economic and political power in the international arena, because of the availability of the only forum where the bitter ties between India and Pakistan can be resolved, because of the importance of fighting terrorism in Afghanistan and Pakistan, because of the highest number of people under $1 a day, because of the political development in Nepal, where terrorism was put to rest through political reconciliation-a reminder to the world that victory over insurgency is best achieved through political means, not through military might, and because of increasing interest of the most powerful countries to associate with SAARC as observers (imagine what the US, Australia, Iran, and Myanmar have to with a regional bloc in South Asia!).

Sliding towards Socialism

I have always been skeptical about the Maoists' ability to steer the economy towards a path of success because of their anti-market behavior(I have been always critical of their planned land reform program). Now, they have agreed to form a government and have a 50 point common minimum agenda. And, there are a lot of commissions:

...In the program, the Maoists pledged to form a peace and reconstruction commission, a truth and reconciliation commission, a state restructuring commission, a commission on disappearances and a land reforms commission. It has vowed to make necessary arrangements for monitoring past peace accords through the peace and reconstruction commission.

Besides, the program proposed an administration reforms commission, a youth commission and a powerful Muslim commission.

...The Maoists proposed a model of economic activity through the partnership of government, cooperatives and the private sector. It pledged to formulate immediate short-term, mid-term and long-term plans for development and give priority to agriculture, hydropower, tourism, human resources and infrastructure.

The Maoists have proposed to categorize hydel projects for purposes of investment. "Small and medium-size projects will be run through internal investment and big and export-oriented projects through foreign investment," the proposed program stated.

...The Maoists propose to attract foreign investment in industrialization and development for the benefit of the country. The party pledged dual citizenship for Non-Resident Nepalis to attract their investment in national development.

The Maoist program proposed revolutionary land reforms to end feudal ownership of  land and establish access of peasants to the land.

The program also proposed that primary health care, employment and education up to high-school will be made part of the fundamental rights of the people. The party proposed to reduce the age criteria for senior citizens to 70 from existing 75 for purposes of the old age allowance. It pledged an increment in the allowance amount for widows and old people.

 

Food crisis in Nepal

Sky News has a good series of articles, some of them focusing on a typical Nepali household, about the impact of rising food prices (HT: Deepak's Diary).

24 Hours of A Nepalese Diet (the reporter experiences firsthand how it feels to live in a typical Nepali household)

Life Below The Breadline in Nepal

Lush Land Where Millions Need Aid

This one makes me homesick:

...There's no running water either, so Anju has to wash the vegetables in rather murky water from a container. Quite a bit has gone into the cooking too. I notice that the dal, which Anju complains has become so expensive lately, was thoroughly diluted.

Markets at work (if you try to destabilize equilibrium by charging more, demand will decrease!):

...I work in the shop with my wife Anju. We sell food and basic household items. But business is slow now. People can't afford to buy much with the increased prices. We have a profit margin of around 3%. If we charged more money, we wouldn't sell anything. I don't want to lose my customers.

And, signs of more people being pushed below the poverty line by rising food prices:

...Its costs about 300 rupees ($5) to put a basic meal together for the family. And that's the same amount we earned working in shop all day. The worrying thing is that prices are increasing daily. I don't know how we'll manage if this trend continues. Maybe we won't be able to stay in the city. At least in the village we could grow our own food. But prices are high there too now.

Again, similar stuff:

A gardener living in the capital Kathmandu, Rajendra Bahadur Bista, 30, earns 5,000 Nepalese rupees a month (about £36). He spends 3,000 rupees from that to feed himself, his wife and two daughters, aged eight years and six months respectively.

"We eat less rice now, less bread and fewer vegetables," he tells me. "We had to cut back on other things, too, such as clothes."

 

Leaking customs and weak trade

That's the title of my Op-Ed published in today's The Kathmandu Post. The article basically centers on the argument that in order to realize potential gains from trade, just joining free trade blocs is not enough; the developing countries like Nepal should focus on fine-tuning trade facilitation to promote exports and reduce domestic inefficiencies. This requires taking care of institutions that help facilitate trade, which of course cannot be done overnight.

Almost after five years of sluggish growth, Nepal's economy has grown at over 5 percent this year. According to UN ESCAP's recent estimate, the real GDP growth rate is expected to be 4 percent in 2008, up from a low of 0.1 percent in 2002. Various factors like windfall growth in agricultural sector, tourism, and remittance helped push up the otherwise lagging economy.

Now, it is time to ponder on how to sustain this, or even achieve higher GDP growth rate, in the coming year(s). This growth rate won't be sustained if we continue to bank on tourism and agriculture - both are vulnerable to external factors like weather. No country has sustained such a growth rate even for a short time without fine-tuning and promoting trade, both export-oriented policies and policies aimed at reducing domestic inefficiencies. Nepal is already a member of regional and global trading blocs. However, the potential gains from trade have not yet been realized, at least when we look at the impact on the GDP growth rate.

Curiosity abound when we learn that despite being a member of many trading blocs, Nepal has not seen even a minimal impact on the GDP growth rate. Closer look at this puzzle divulges an uncomfortable fact that despite being one of the most open economies in South Asia, Nepal still has one of the most cumbersome and investor unfriendly trade facilitation procedures in the world - one of the constraints to realization of the potential gains from trade.

Procedural hassles and delays in clearing goods at the customs are not new things; businessmen and economists have been calling for reforms for a long time. Years of neglect from the state to reform governance and trade facilitation has severely impacted Nepal's trade standing in the world. Nepal's trade facilitation process is so slow and inefficient that, in every parameter for trade facilitation that the World Economic Forum (WEF) came up with in its recent publication The Global Trade Enabling Report 2008, it was ranked at the bottom position, along with countries like Chad and Burundi.

Read the full Op-Ed here.

Links of Interest

Jamie Diamond: Cutting aid would have dire consequences

85 Percent of Africa's Land Has No Titles

Stiglitz and Sen, Food and Morals: Reflections on intellectual cowardice (very fascinating discussion on why economists are so detached from reality, especially in the context of rising food prices)

Cell phones used to expedite work in government offices!

This is one novel use of cell phones. Forgoing ages old tradition of ringing bells in offices to communicate between different departments and to call caretakers, some officials in the Nepalese government jobs have been using cell phones. How? Well, by giving missed calls!

One missed call and the peon attends to the seniors to offer his service like serving tea, photocopying documents, printing and so on. The system of pushing call bell beneath senior officers' desks has been replaced by mobile phones.

Krishna Poudel, who works as a peon at the District Election Office, says, "Who needs buzzer system when there is mobile phone. With the help of mobile phone I can now hear my seniors call, no matter where I am."

Chief Returning Officer Mahesh Raj Timalsina is also happy with this practice. "We press the call bell and sometimes they do not hear it so it is better to give them a missed call instead," he says.

I don't know how efficient this system would be, but this is one novel use of cell phones! More here.