Bhagwati on the financial mess

Jagdish Bhagwati calls for a truly independent commission of experts to scrutinize each financial innovation’s potential downside. He terms the back-and-forth appointment of bigwigs from the Wall Sts to Treasury department and then again to the Wall Sts a “Wall Street-Treasury Complex”. Nice naming there!

When the dust has settled, we must ask the question: why did this crisis occur? There are specifics that are not applicable everywhere. The crisis was, for example, kicked off by highly leveraged lending for uncreditworthy mortgages by the quasi-governmental Freddie Mac and Fannie Mae. But the problems became huge because “policy innovations” had been racing ahead of comprehension. The securitisation of mortgages was an innovation that led unwittingly to what Wall Street calls “betting the company”. Credit-default swaps allowed AIG to bring in huge returns but at high risk if things went wrong, which they did.

The Long Term Capital Management crisis had a similar problem. At its heart were derivatives that no one quite understood. …The downside had not been anticipated.

The failure to think about the downside results from what I call the “Wall Street-Treasury Complex”. Robert Rubin went from Goldman Sachs to the Treasury and back to Citigroup. Hank Paulson went from Goldman Sachs to the Treasury and will doubtless return also to Wall Street. This network shares the optimistic scenarios that Wall Street spins. Mr Rubin was in charge of the Treasury during the Asian financial crisis, whereas Mr Paulson was among the five major investment banking chief executives who persuaded the Securities and Exchange Commission not to extend prudential reserve requirements to their companies.

The question is: how can you assess the downsides without first letting the innovation play into real economy? If something is an innovation, then it is a new thing, which essentially means that even the innovator is not fully aware of its full potential or risks or downsides. The innovator can argue that the innovation will work by showing high degree of success (i.e. the probability of success might be pretty high). But this itself is not fully guaranteed because no one can test innovation against unexpected circumstances or yet-to-be-known risks. The best way to assessing downsides of an innovation would be to periodically review its impact on the economy—this means that you cannot test an innovation beforehand because you don’t know the set of circumstances under which it will not work (the innovator might have an idea of the set of circumstances where it can work, but he or she cannot list the full elements of the set). But having a regulatory authority that can assess risks beforehand is a good idea. We are yet to have one of these things in the world! Anyway, thats it for now. Its getting too late. Time to go to bed!

Nice sentences about a good economist

Sourced from The Economist:

In neither contribution did Mr Krugman claim great originality for his ideas or great realism. His achievement was to formalise insights that many people had previously had informally. Ideas that had fluttered in and out of people’s grasp for decades, he pinned down like a butterfly on display. Sometimes a good economist, like a good columnist, succeeds not by making a point before everyone else, but by making it better than anyone else.

Resource curse in Congo

Policy Innovations has a nice article about resource curse, weak government, and violence in the Democratic Republic of Congo (DRC):

The DRC's turmoil can be traced to the country's toxic combination of tempting mineral wealth, feeble government, vast size, and weak cohesion. This mixture turns the DRC's rich natural resource heritage into a poison that affects every aspect of its body politic.

Instead of acting as the country's economic engine, the plentiful deposits—including uranium, diamonds, and copper—have repeatedly fueled violent conflict and corruption. Local militia and foreign armies smuggle vast amounts out of the country—an estimated $400 million in diamonds and gold alone have been lost this way annually in recent years—while doing everything within their power to prevent a weak state from establishing its authority.

Barely connected to each other by meager transportation, communication, and institutional links, local groups have little reason to profess loyalty to an ineffective and distant state—and every incentive to seek enrichment at that state's expense. As a result, the country's history has been plagued by a zero-sum competition among mutually antagonistic cities, regions, and ethnic groups.

The author argues that traditional Western prescription-elections, economic reform, and administrative restructuring- of fixing conflict-prone countries is not going to work. He recommends three institutional innovations:

1. Multinational natural resource companies could play a greater role in protecting major mineral sites and providing services to citizens.Although many people might recoil at this idea, major international corporations have the strongest management capacity in the country and—under the right contractual arrangement—could have the greatest incentive to ensure that the state's mineral wealth be used to improve the lives of the DRC's people.
2. Instead of attempting to build the DRC along the lines of the Western model of top-down governance, the international community should be advocating a far more horizontal model. The main governing structures would be shaped around cities and their surrounding rural areas, with programs built from the ground up. A looser, more horizontal governing structure, in which power and responsibility flowed from large municipalities upward and outward would make individual units far more effective, especially if outside assistance focused on improving their management, transparency, and accountability.
3. International donors could improve government performance if they focused more on designing systems that would keep local officials responsible to their constituents. Elections alone will not dramatically improve how government operates—especially elections for leaders in distant cities who have little influence on local programs (the international community spent more than $500 million on national elections

The dismal output from trade liberalization in Africa

What happens when trade liberalization is not followed by reforms in structural and institutional constraints? Well, the level and composition of exports will not change and will lead to decrease in market share as foreign goods and services flood domestic market, which lacks strong industrial background. According a report from UNCTAD, trade liberalization in Africa in the past 25 years has led to decrease in market share for world exports from 6%  in 1980 to 3% in 2007. Moreover, there is barely any headway in the level and composition of exports.

The report highlights that despite trade liberalization, the African countries have not diversified their exports towards more dynamic primary commodities and manufacturing goods, which are less prone to the vagaries of international markets. The report attributes Africa’s weak supply response as the most important impediment to the continent’s export performance. It recommends that future export policies should focus more on way to increase production for export.

In a way the report declares that the structural adjustment programs, spearheaded by the IMF and the WB, in Africa was a complete failure. By 1985, 60% of African countries were under the SPAs and by 1995, almost all the African nations were under the such programs. The result after two and a half decades: dismal performance in the very sector the reform programs were supposed to help Africa grow! The Washington Consensus was an utter failure in Africa.

Export diversification is very low in Africa. African countries remain principally primary commodity exporters and the dependence of African countries on a small number of export products has increased in the period following liberalization. Many countries in the region are at present less able to withstand price shifts for a few key  commodities than they were prior to liberalization.

The tide of trade liberalization (cut high taxation and “getting prices right”)was expected to increased production of tradables, generate positive externalities for the economy by improving efficiency of production, generate substitutions effect so that price of imported inputs were lower and thus promote exports by increasing production, increase investment both from domestic as well as foreign investors, etc. However, huge subsidies in the US and EU on agricultural sector basically wiped off the African agricultural base because cheap products not only displaced African agriculture production in the market but also created disincentives among farmers to engage in agriculture, leading to high dependence rate on foreign food aid and imports.

Production and marketing costs increased during liberalization, with the removal of subsidies and currency devaluations, while the dissolution of marketing boards added price risks to the uncertainties of rain-fed agriculture. The consequence is that much of Africa continues to be dependent on traditional bulk agricultural commodities for a major share of its export earnings. Paradoxically, African countries have been losing market share to other developing countries even in exports of these commodities.

The report recommends increase in public investment in R&D, including roads and irrigation facilities, health and education. Also, facilitating access to inputs, encouragement of new investment, and better access to market information would help improve overall efficiency in agricultural trade. The point that remains unanswered is: how much of a damage does subsidies inflict on agriculture development in Africa.

For the manufacturing sector the report recommends to:

• increasing firm competitiveness at the economy level and at the firm level
• encouraging establishment of large manufacturing firms
• facilitating access to credit to invest and foster firm growth
• creating a framework of interaction between financial institutions and private sector

The report states that trade liberalization should not be seen as an end in itself; it should be a subset of a comprehensive developments strategy. Focus should be shifted back to the development strategies that are consistent with the development challenges and priorities of African countries.

Funny stuff on a funny show!

A glance at poverty in Nepal

So, today is the Blog Action Day. This year’s topic is poverty. Here is my blog post about poverty in Nepal.

Nepal, which has a per capita GDP of US $470 (2007/08), has seen witnessed impressive progress in poverty reduction in the last decade. According to NLSS II, the headcount poverty rate declined from 42% to 31% between 1995/96 and 2003/04, urban poverty declined from 22% to 10%, and rural poverty declined from 43% to 35%. One of the major challenges for policymakers now is to make sure that villages are not left behind in the process of growth and development. Proportionally, the benefits of improvement in GDP growth rate has gone to the urban folks while the village folks, who are the ones reeling under poverty and hunger, are left behind. Adverse production season and global rise in commodity prices has put more than 25 districts under the radar of acute food shortage, according to the WFP.

The bad news: inequality increased—Gini coefficient shoot up from 34.2 to 41.1

Reasons for decrease in poverty, according to the WB, are:

Remittances: A significant increase in remittances propped up consumption. The proportion of households receiving remittances increased to 32% in FY03/04 from from 24 percent in FY95/96. In 2004, about 1 million Nepalese worked abroad, primarily in India, the Gulf and East Asian countries. Also, the average real remittance amount has risen by more than 80% .

Farm wages: After improving productivity and tightening the labor market, agricultural wages increased by about 25% in real terms over ten years. Increased demand, coupled with improved connectivity and better access to markets, stimulated entrepreneurial activities and allowed for non-agricultural wages and incomes to increase.

Urbanization: Increased urbanization moved workers from low productivity jobs in rural areas to higher productivity jobs in urban areas.

Fertility: The decline in fertility (starting in the 1980s) reduced the household size and the dependency ratio.

According to the Nepal Living Standard Survey II (NLSS II), self-reported welfare has improved across all types of consumption over the last eight years. If we assign households reporting "less than
adequate" consumption as self-reported “poor”, such subjective poverty has decreased substantively from 1995/96 to 2003/04. In this period, inadequacy in food consumption has declined by 21 percentage points, housing by 23, clothing by 22, health care by 31, and schooling by 24 percentage points. Inadequacy in total income, however, shows a slight decline from an already very high rate in
NLSS I.

Description	Survey Year	Survey Year
% of HH reporting “less than adequate”	1995/96	2003/04
Food consumption	50.9	31.2
Housing	64.1	40.6
Clothing	57.6	35.6
Healthcare	58.7	28.3
Schooling	45.4	21.4
Total income	72.6	67.0

 

Increase in remittances is one of the main factors that led to such a progress in poverty reduction. Inward remittance flows amounted to 18% of GDP in 2006 (US$ 1453 million in 2006). Emigrants constituted 2.8% of the population in 2005. Usually, youths from poor households go abroad to do labor work and send money back directly to their families. Unlike foreign aid or investment plans (where money gets filtered among different strata of the bureaucracy, leaving a gap between what is initially allocated and what is delivered on ground during implementation), remittances are sent directly to households, which, in turn, is used to fulfill consumption needs. It might be surprising to note that reduction in poverty level in Nepal has little to do with meager economic growth rate and the rate of expansion of the manufacturing sector (see the figure below).

Agricultural productivity and the level of inflow of remittances are the two most important variables of the poverty function in Nepal. As money gets into household’s hand readily from these two variables, they use extra income in consumption. It is hardly surprising that there has been a booming demand for consumer products, especially those made in and imported from China. People buy cheap Chinese products ranging from TVs to fancy cloths and bikes (yes, they do…leading to horrible traffic congestion!). Earlier, we used to joke:  Material standard of living has leapfrogged real standard of living because of the influx of Chinese goods in the market. Well, who cares as long as people have money to spend on them!

2008 Nobel Prize in Economics and Nepali Economy

New Op-Ed in today’s The Kathmandu Post: Roads to progress: Nobel thoughts about the Nepali economy

I like to apply economics theories I learn in my classroom and from textbooks to the real world. I sometimes struggle to understand some awesome theories if I am not able to relate them with real world issues! O.K. I have been reading Krugman’s work since I first used his Microeconomics book in Econ 101 class during first semester of freshmen year. Since International Economics course has not been offered for some time now, I am following Krugman’s work freely (without order) and whenever I get time (there is always increasing returns while reading his work!). And, since his model on trade theory is relatively realistic than others (I mean the classics), I was wondering the application of his theory on the Nepali economy. I was also interested on policy implication of the theories.

I was thinking about writing an Op-Ed on the application aspect of his theory but kept on postponing the idea! Now, what an appropriate time to write about it. Paul Krugman was awarded the 2008 Nobel Prize in Economics on Monday for his work on the “analysis of trade patterns and location of economic activity.” And, I snatched this occasion (while enjoying no classes/free time during Fall pause!) to write an Op-Ed. Ya, finally! Note that I am just looking at his work that are relevant to the Nepali economy (based on my presumptions about the economy). Other factors like availability of credit, local and regional political situation, raw materials and intermediate inputs availability in a given locality, etc also influence the conclusion/analysis I have outlined in this Op-Ed. Nevertheless, I think the argument derived from the theory does justice to policy interpretation and prescription.

Check out the full piece titled Roads to progress: Nobel thoughts about the Nepali economy

Krugman's work on transportation costs and the role of geography in development has a direct present day relevance to the state of the Nepali economy. If we look at the location of firms in the country, it is not hard to realize that most of them are located in the tarai and in cities near the Nepal-India border. Why do most of them opt to establish factories in the tarai and in major metropolitan areas like Kathmandu and Pokhara? Why don't they establish factories in hilly districts like Syangja, Bajura, Rukum, Kabhre, Bhojpur and Gorkha, among others? It is because of high transportation costs and dim prospects for increasing returns to scale!

Profit-seeking economic agents and private firms always opt to invest and operate in areas where the cost of transportation is low and there is a chance to exploit economies of scale. Hence, we are seeing increasingly divergent episodes in terms of regional growth and development. Metropolises like Biratnagar, Birgunj, Pokhara and Kathmandu are the urbanised “core”, and places like Syangja, Rolpa, Rukum and Bhojpur are the less developed “periphery”.

The “cores” have better forward and backward linkages and a fairly higher concentration of purchasing power. Also, intermediate inputs are available with less hassle and at lower cost. Moreover, these areas are also transport hubs as major highways joining outlying districts with the capital and other major cities pass through them, leading to a lower per-unit cost of transportation. It becomes a self-reinforcing process, and the few cores always leap forward in terms of development while leaving the peripheries languishing in traditional activity with low wages. This might explain why the big cities mentioned above have more industries and firms than other areas in the country.

And some policy stuff:

What can the government do to encourage relocation of industries? The answer is build, build and build roads and other means of transportation! Only 43 percent of the population has access to roads, and six districts are still unreachable by surface transport. Most of the districts are connected by unpaved roads, and those that have paved roads are pockmarked by potholes -- a recipe for higher transportation costs. Given this situation, it is no wonder that investors are establishing new firms in the same cores that have already been swamped by firms and people. Constructing roads and other appropriate means of transportation to lower shipping costs will probably lead to the spread of industries to other parts of the country.

One way the government can expedite the process of achieving lower transportation costs, increasing returns to scale and spreading industries from the core to the periphery is by offering subsidies in the form of tax credits and sharing of risks. The government can involve the private sector in road construction by offering direct subsidies on machinery and equipment and by sharing financial and social risks. This will probably encourage the private sector to not only invest in infrastructure construction in different parts of the country, but also to establish factories in villages that will be connected with roads and other means of transportation. This might also lead to a relatively equitable spread of industries.

Meanwhile, for export-oriented industries, the government can fast-forward the process of establishing Special Economic Zones where transportation costs are significantly lower by providing tax incentives and readily available forward and backward linkages.

A pdf version of the page: