Marginal Propensity to Consume and Invest

The marginal propensity to consume (MPC) of poor people is high. Similarly, the marginal propensity to invest of a small scale enterprise with good prospects of future return is relatively high. Fiscal stimulus geared towards propping up these two measures would be more effective than tax cuts to the rich, argues Stiglitz. Moreover, investment in infrastructure, education and technology also helps stimulate the economy. In short, follow Keynesianism!

Tax breaks for business may prove to be a sink-hole as bad as the troubled assets relief programme.

Some of the spending in the stimulus serves multiple ends. Increased unemployment benefits have the largest multiplier effects – cash-strapped families spend every cent given – and meet vital social needs. It is imperative to provide health insurance to the unemployed: without that, a single serious incident can push a family into bankruptcy. Helping the unemployed meet house payments reduces foreclosures, addressing one of the underlying causes of the crisis. There are thus triple benefits.

We are in uncharted territory in this crisis. But household tax cuts, except for possibly the poorest, should have no place in the stimulus. Nor should business tax breaks, except when closely linked with additional investment. The one tax cut that should be included is a temporary incremental investment tax credit; it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending. Increased investments in infrastructure, education and technology, relief to states, and help to the unemployed need pride of place.

Why government intervention works?

Here is Jeff Madrick:

However, it is possible to look at the question of regulation empirically rather than theoretically. One useful area is cross-country analysis, whereby economists look at how countries with bigger governments and higher taxes fare. In recent years, Peter H. Lindert, a leading economic historian from the University of California, Davis, has comprehensively analyzed the literature. One argument against government is that public spending is unproductive and crowds out private spending. But, time and again, he found that studies claiming that high taxes reduce economic growth simply did not hold up.

Lindert’s exhaustive statistical analyses were based on eighteen countries over ninety years. No matter how he juggled the data, he found no relationship between the growth of GDP per capita and productivity and the level of taxes or the extent of social spending. There is a dramatic “conflict between intuition and evidence,” he writes. “It is well-known that higher taxes and social transfers reduce productivity. Well-known—but unsupported by statistics and history.” And he goes on: “Neither simple raw correlations nor a careful weighing of the apparent sources of growth shows any clearly negative net effect of all that redistribution.”

These days we all know how easily statistical analyses can be rigged. But if the case against big government were open and shut, then there would not even be a debate among economists. As Lindert notes, if a dollar of social spending reduces GDP by, say, sixty cents, then why are so many European nations doing well? They spend 25 to 35 percent of their national income on the poor, the elderly, the sick, and the unemployed, which therefore means, according to anti-government economists, they must have reduced their GDP by 15 to 20 percent. In other words, if they simply eliminated this spending, they would all be as rich or much richer than the United States, even as their people work many fewer hours.

Very interesting article. Read the full article to get some Kurgman and Stiglitz flavor!! Madrick is the author of a new book The Case for Big Government

On a similar note, here is what 2009 looks like for international development:

Markets and the State are already being rebalanced to fit these new times. It is time to say exactly who governs what, why, when and how. This will not be easy, but those who have been clamouring for more state involvement in development will also have to deliver better state involvement. This will be a big debate in 2009 with questions around (a) the appropriate balance of regulation, stimulus, and the provision of missing goods and markets, (b) how the balance is identified and (c) how the activity will be paid for. These debates must yield concrete actions very quickly.

...2009 will see: new ways of thinking about how the state and market can work together to encourage sustainable behaviour; new ideas influenced by the idea of wellbeing and what constitutes ‘consumption’; new ways of coordinating donor financing to generate new technologies; fresh perspectives on justice and accountability; novel ways of listening and reconciling ideas from around the world; and a more serious effort to understand everyday attitudes to international development.

Trade in South Asia: So open yet so closed

South Asia has opened its door to the rest of the world but it remains closed to its neighbors. Poor market integration, weak connectivity, and a history of friction and conflict have resulted in two South Asias. The first South Asia is dynamic, growing rapidly, highly urbanized, and is benefiting from global integration. The second South Asia is rural, land locked, full of poverty, and lagging.

That is from a WB policy research working paper Making Regional Cooperation Work for South Asia’s Poor.

SAARC is probably the least integrated regional blocs in the world. Moreover, SAFTA, the proposed free trade bloc, has not made any headway despite years of talks. It is a market of more than 1.3 billion people and an emerging one with increasing purchasing power. All talks on SAFTA or any regional development initiatives are clouded by off-and-on dispute between India and Pakistan.

Acemoglu on the financial crisis

Daron Acemoglu argues:

…Free markets are not unregulated markets. Well-designed institutions and regulation are necessary for the proper functioning of markets. Institutions have received more attention over the past 15 years, but focus was on understanding why poor nations were poor – not on understanding which institutions are necessary as the basis of markets and for continued prosperity in advanced economies.

…The first point is that fixing the short-run problem with policies that harm long-run growth is a bad option from a policy and welfare perspective. Innovation and reallocation are the keys to long-run growth, but potentially powerful groups tend to resist such changes. In developing nations, it is easy for impoverished populations suffering from adverse shocks and economic crises to turn against the market system and support populist, anti-growth policies. These threats are as important for advanced economies, particularly in the midst of the current economic crisis.

…A comprehensive stimulus plan, even with all of its imperfections, is probably the best way of fighting these dangers. Nevertheless, the details of the stimulus plan should be designed so as to cause minimal disruption to the process of reallocation and innovation. Sacrificing growth out of our fear of the present would be as severe a mistake as inaction. The risk that the belief in the capitalist system may collapse should not be dismissed.

Finally, wrong notions that led economists to ignore the impeding problems:

• Astute policy and new technologies had ended the era of aggregate volatility.
• The capitalist economy lives in an institutional-less vacuum where markets miraculously monitor opportunistic behaviour.
• We could trust the long-lived large firms to monitor themselves because they had sufficient “reputational capital”.

Maoists (ridiculous) definition of capitalism

So the left-wing Finance Minister Bhattarai of Nepal has his own distorted definition of capitalism:

Industrial capitalism or productive national capitalism caters to the market within the country and utilises the labour and resources of the country. We are in favour of that sort of capitalism. Bureaucratic capitalism involves very unproductive capital and is parasitic. It takes advantage of state power and tries to make an easy, quick profit. But it doesn't produce goods and it doesn't provide employment. Comprador capitalism involves trading in goods and producing a profit in between. It doesn't produce goods or create jobs within the country. Historically in Nepal, we've had comprador and bureaucratic capitalism. We may also call it crony capitalism. Instead of that we want to have national or industrial capitalism which has roots within the country, will produce goods required by the people, and provide employment in the country.

The capitalism the Maoists favor is inward-looking and is distant from the usual model of capitalism through which developed countries became developed. Essentially, he thinks that FDI is a form of bureaucratic capitalism, which are “very unproductive capital and parasitic” because all they care about is profits. But, he also wants investors (especially foreign ones) to be confident and invest in the country. Isn’t this a contradiction??

Investors, regardless of their origin, invest when they see prospect for profitable investment. It is not the government’s business to regulate profits. It can regulate the way of doing business but not profits. This creates an environment where there is lack of appropriability on returns on investment, leading to shortfall of required investment. This is precisely what is happening right now in the Nepali economy. Industrial sector is going downhill. Domestic investors are losing large retail customers abroad. See this article and this blog post.

Fyi, this is capitalism in econ literature:

Capitalism is an economic system in which wealth, and the means of producing wealth, are privately owned and controlled rather than publicly or state-owned and controlled.In capitalism, the land, labor, capital and all other resources, are owned, operated and traded by private individuals or corporations for the purpose of profit,and where investments, distribution, income, production, pricing and supply of goods, commodities and services are primarily determined by private decision in a market economy largely free of government intervention. A distinguishing feature of capitalism is that each person owns his or her own labor and therefore is allowed to sell the use of it to employers. In capitalism, private rights and property relations are protected by the rule of law of a limited regulatory framework. In the modern capitalist state, legislative action is confined to defining and enforcing the basic rules of the market, though the state may provide some public goods and infrastructure.

Btw, currently the finance minister is reading Confessions of an Economic Hit Man, by John Perkins. I hope he understands how crucial it is for the country to not borrow excessively to fund politically motivated projects and resuscitate sick, moribund industries! The government is expecting foreign assistance of Rs 65 billion 793.8 million for this fiscal year. This is composed of grants and loans, which comes with multiple strings (often unpleasant ones) as bonus attachment. I hope Bhattarai comprehends the core thesis of the book!! It is a good book.

No value of paper money in Zimbabwe

So the Reserve Bank of Zimbabwe has introduced ZW$50 billion note. The hyper inflation has collapsed the economy and it is reported that this new note is enough to purchase just two loaves of bread. This week the exchange rate was US$ 1= ZW$25 billion.

Hyperinflation in Zimbabwe at present is estimated to be at 231 million percent. Unless the whole economy (and hopefully Mugabe and his juntas) collapse, it will be hard to revive the economy using the same currency, whose cost of printing is slightly lower than the true worth of note. A classis case of economic and political mismanagement, indeed! On top of this, the country is facing Cholera outbreak, whose cause Mugabe blames on the West.

Meanwhile, a note from Zimbabwe:

It is just after midnight in Harare. I have just returned from a midnight tour of the ATMs in Harare with a cousin. There are queues of people still waiting to get their weekly cash withdrawal limit of $100,000,000,000 (US$2.50). I saw the queues this morning when I went for my first meeting at 7.45am. I did not know then that I would be seeing them throughout the day. Most of the ATMs had run out of money. Rather than go home, people saved their precious place in the lines by lying down where they stood and taking a nap. Covering themselves with sacks, newspapers and whatever warming clothing they had. Those ATMs that were still paying out cash had queues of policemen and soldiers…

Photo source here

…There was a power outage from 6 p.m. and it had taken us two hours to find a house I last visited 20 years ago as a boy. But I did ask how she was coping in Harare; and to her nephew she poured her heart out. No clean water for weeks on end, no food in the shops and constant power cuts. She drives an hour and half across the township in search of clean drinking water, which she brings back in plastic containers. When the city council water does run through the taps in the house, the water is discolored with sewer water. The shops in the neighborhood are empty of basic necessities including mealie meal.

…With civil service wages eroded by hyperinflation, people necessarily spend more time in the parallel economy trying to make ends meet. Interestingly, there are no runs on banks. The value of the withdrawals is so meaningless that the banks will be able to meet depositor demands with ease.

More here.

Links of Interest (01/09/2009)

1. Reservation policy, which gives voters the ability to observe the effectiveness of women leaders, does work in improving women’s access in politics and reducing discrimination, argue Duflo, Pande, Topalova, Chattopadhyay, and Beaman. Paper here. (I wrote an opinion piece (The Economics of Reservation) supporting reservation policy in government scholarships and public sector jobs in Nepal. Nepal has one of the highest women representations in parliament in the world- a product of this positive discriminatory policy.)
2. Keynes advocated regulating the economy through investment, not consumption, combined with a low and permanent rate of interest, writes Peter Clarke.
3. The importance of great managers
4. It is wrong to assume that emerging markets won’t recover until America rebounds.
5. The meager benefits of the Doha Round, trade and development
6. Why did ADB-assisted water resource management fail in Sri Lanka?

The authors argue that this failure is largely attributable to a lack of understanding of the Sri Lankan context characterised by:

• a multi-party system with governments often held together in fragile coalitions
• strong cultural values attached to water
• a vocal civil society fearful of water privatisation, and
• a politicised media willing to exploit controversies

The guiding principle of the projects was that Sri Lanka’s water resources management should be holistic and efficient. This new policy introduced a number of unfamiliar approaches to the sector, some of which were highly controversial, including the idea of entitlements (ownership rights to water) and water tariffs to introduce demand management.

Coming after controversial attempts to institutionalise land reforms in Sri Lanka, and high profile cases of water privatisation elsewhere in the world, these moves were seen by some civil society groups as steps towards commodification and privatisation of water resources.
The focus on efficiency and increasing tariff were seen a threat to paddy cultivation and small farmers, causing public anger, while endogenously-designed strategies for water conservation were ignored as possible alternatives to entitlements and demand-management. (Source: Eldis)