Stimulus ‘crowding in’ investment

A guest post by Greg Shinsky, a fellow resident at ISH and one of the smartest, engaging and intelligent persons I have met at ISH.

The Center for American Progress, a DC-based think-tank, hosted a conference today discussing the significance of sustained US public structural deficits in the medium to long-run. The panelists emphasized that although the stimulatory measures adopted by the Obama administration were necessary, the threat of sustained deficits would lead to damaging long-run consequences.  However, bringing the budget back into balance is no simple task.  The seriousness of this issue raises fundamental questions about the future sustainability of both spending patterns (namely in the areas of health, defense and social security) and raising revenues (through various tax measures).  Moreover, not only are both these elements of the deficit reduction equation fraught with sensitivity and complexity, the politics of Congress is unlikely to facilitate an appropriate compromise. 

The speakers agreed that current political procrastination, eventually leading to an abrupt policy amendment (for instance cuts in Medicare or Medicaid), will most likely affect those members of society least able to afford sudden changes – namely the poor.  For this reason, it is imperative that strong leadership addresses the problem sooner rather than later – this is especially so given that the magnitude of persistent structural deficits will only get larger with time.

Notably, Nobel Laureate Paul Krugman, dismissed arguments that we ought to be concerned about the massive fiscal stimulus ‘crowding out’ private investment.  In the alternative, Krugman argued that the severity of the crisis actually means that the current fiscal stimulus describes a situation of government ‘crowding in’ of private investment (i.e. public investment is supporting what otherwise would be a mass stagnation of private investment).  Skeptical of a political solution in the foreseeable future, Krugman also reasoned that there are potential budgetary savings to be realized in defense spending and the Waxman-Markey Climate Change Bill.

Krugman argues:

fiscal expansion does not crowd out private investment — on the contrary, there’s crowding in, because a stronger economy leads to more investment. So fiscal expansion increases future potential, rather than reducing it.

in the short run fiscal expansion leads to higher GDP, which leads to higher revenues, which offset a significant fraction of the initial outlay. A billion dollars in stimulus probably leads to only $600 million or a bit more in additional debt.

Crowding in raises future GDP — which raises future tax revenues. And the rise in revenues relative to what they would have been otherwise offsets at least some of the burden of debt service.

Zoellick calls for "Responsible Globalization"

Robert Zoellick, President of the World Bank Group, gave a speech today at SAIS. He shared his views on the crisis, especially what's up after the global financial crisis. He blames the rational choice theory and the lax oversight by central banks. He argues that the US won't have the same economic clout as it had before the crisis. China, India, Brazil and other developing nations will emerge more stronger than ever. This won't mean that the US will totally lose its clout. It will still have influence over economic and political matters but not to the extent prevalent before the crisis. He opines that that addressing large deficits and controlling inflation would determine the strength of the dollar and the US economy. Trade protectionism due to the global financial crisis has been a "low-grade fever but the temperature is rising." Similar point was also made by other economists as well. He also called for harmonization of the Doha Round with regional agreements. The IMF's managing director also gave similar speech last week.

Some seeds of today’s troubles were sown by the responses -- or lack of them -- to the financial crises of the late 1990s. After the Asian financial crisis, developing countries determined they never again wanted to be exposed to the tempests of globalization. Many “insured” themselves through managing exchange rates and building huge currency reserves. Some of these changes contributed to imbalances and tensions in the global economy, but for years governments muddled through amidst generally good growth.

...the alluringly simple design of “rational markets” theory led regulators to take a holiday from the realities of psychology, organizational behavior, systemic risks, and the complexities of markets and humans.

The current assumption is that the post-crisis political economy will reflect the rising influence of China, probably of India, and of other large emerging economies. Supposedly, the United States, the epicenter of the financial crisis, will see its economic power and influence diminish.

The future for the United States will depend on whether and how it will address large deficits, recover without inflation that could undermine its credit and currency, and overhaul its financial system to preserve innovation while adding to safety and soundness.

Over 10 to 20 years, the Renminbi will evolve into a force in financial markets.Countries and markets may also experiment with financings denominated in Special Drawing Rights –or SDRs— which reflect a portfolio of major currencies. [...] Of course, the U.S. dollar is and will remain a major currency. But the Greenback’s fortunes will depend heavily on U.S. choices. Will the United States resolve its debt problems without a resort to inflation? Can America establish long-term discipline over spending and its budget deficit? Is the country restoring a healthy financial sector capacity for innovation, liquidity, and returns, without producing the same risk of big bubbles and institutional breakdown? The dollar’s value will also depend on the extent to which we see the return of a dynamic, innovative private sector economy.

Central banks performed impressively once the full force of the crisis hit. But there are reasonable questions about how they handled the build-up, including asset price inflation and significant failures of supervision. We have yet to see whether Central Banks can handle the recovery without letting inflation get out of control.

On the protracted Doha Round:

The Doha Round could cut, discipline, and even eliminate some agricultural subsidies that for years were left outside the rules-based trading system. It could modestly open markets for manufacturing and agricultural goods in developed and major developing economies. It could “bind” barriers of major developing countries at much lower levels, increasing the sense of mutual contributions and limiting the risks of big jumps in tariffs. The Doha Round could also open service markets and cut developed country tariff peaks that limit basic manufacturing and value-added production in poorer countries. The Round could correct rules that have been bent to limit trade too freely. These are real gains and would demonstrate the capability of developed and major emerging economies to compromise to achieve a mutual and systemic interest.

We need more help for the poorest countries that have been less able to seize growth opportunities from trade. [...]The new agenda needs to build on early efforts by WTO’s Director General, Pascal Lamy, supported by the World Bank Group, to link trade facilitation to aid for trade. To capitalize on lower barriers to trade, poorer countries need: regional integration to build bigger markets and access for land-locked countries; energy; infrastructure; logistics systems; ready access to trade finance; assistance with standards; and streamlined customs and border procedures.

On Africa's potential:

Over time, Africa can also become a pole of growth. The messages I hear in most African countries are the same: Africans want energy, infrastructure, more productive agriculture, a dynamic private sector, and regionally integrated markets linked to open trade. It is a message one might have heard in a devastated Europe 60 years ago.

China’s African prospects -- which include resource development and infrastructure -- are likely to be complemented by others. Brazil is interested in sharing its agricultural development experience. India is building railways. These are the early days of a trend that will build.

Kahneman on the financial crisis and behavioral economics

The present issue of Finance & Development profiles Daniel Kahneman, who was awarded the Nobel Prize in Economics in 2002 for pioneering work that focused on the integration of aspects of psychological research into economic science (which is now labeled as behavioral economics). Especially after the global financial crisis, this field of study has been more relevant now than ever. Behavioral economists have shown the limits of human cognition and busted the ideology that human beings are always rational agents. Behavioral economics challenged standard economic rational-choice theory and injected more realistic assumptions about human judgment and decision-making. He propounded “prospect theory”, which basically says that individuals often make divergent choices in situations that are substantially identical but framed in a different way.

Standard economic models assume that individuals will rationally try to maximize their benefits and minimize their costs. But, overturning some of the traditional tenets, behavioral economists show that people often make decisions based on guesses, emotion, intuition, and rules of thumb, rather than on cost-benefit analyses; that markets are plagued by herding behavior and groupthink; and that individual choices can frequently be affected by how prospective decisions are framed.

“One of the main ideas in behavioral economics that is borrowed from psychology is the prevalence of overconfidence. People do things they have no business doing because they believe they’ll be successful.” Kahneman calls this “delusional optimism.” Delusional optimism, he says, is one of the forces that drive capitalism.

“Entrepreneurs are people who take risks and, by and large, don’t know they are taking them,” he argues.In the United States, a third of small businesses fail within five years, but when you interview those people, they individually think they have between 80 percent and 100 percent chance of success. They just don’t know.”

He argues that there is a need for stronger protection for consumers and individuals; there is a need to look beyond the markets because failure of markets has much wider consequences; and there is always limits to forecasting because of tremendous volatility in the stock markets and financial systems (huge uncertainty).

Noam Chomsky on crisis and hope

A very interesting and provocative article by Noam Chomsky:

As the fate of Bangladesh illustrates, the terrible food crisis is not just a result of “lack of true concern” in the centers of wealth and power. In large part it results from very definite concerns of global managers: for their own welfare. It is always well to keep in mind Adam Smith’s astute observation about policy formation in England. He recognized that the “principal architects” of policy—in his day the “merchants and manufacturers”—made sure that their own interests had “been most peculiarly attended to” however “grievous” the effect on others, including the people of England and, far more so, those who were subjected to “the savage injustice of the Europeans,” particularly in conquered India, Smith’s own prime concern in the domains of European conquest.

The distribution of concerns illustrates another crisis, a cultural crisis: the tendency to focus on short-term parochial gains, a core element of our socioeconomic institutions and their ideological support system. One illustration is the array of perverse incentives devised for corporate managers to enrich themselves, however grievous the impact on others—for example, the “too big to fail” insurance policies provided by the unwitting public.

There are also deeper problems inherent in market inefficiencies. One of these, now belatedly recognized to be among the roots of the financial crisis, is the under-pricing of systemic risk: if you and I make a transaction, we factor in the cost to us, but not to others.

The architects of Bretton Woods, John Maynard Keynes and Harry Dexter White, anticipated that its core principles—including capital controls and regulated currencies—would lead to rapid and relatively balanced economic growth and would also free governments to institute the social democratic programs that had very strong public support. Mostly, they were vindicated on both counts. Many economists call the years that followed, until the 1970s, the “golden age of capitalism.”

The “golden age” saw not only unprecedented and relatively egalitarian growth, but also the introduction of welfare-state measures. As Keynes and White were aware, free capital movement and speculation inhibit those options. To quote from the professional literature, free flow of capital creates a “virtual senate” of lenders and investors who carry out a “moment-by-moment referendum” on government policies, and if they find them irrational—that is, designed to help people, not profits—they vote against them by capital flight, attacks on currency, and other means. Democratic governments therefore have a “dual constituency”: the population, and the virtual senate, who typically prevail.

The synergy of running corporations and controlling politics, including the marketing of candidates as commodities, offers great prospects for the future management of democracy.

One of the reasons for the radical difference in development between Latin America and East Asia in the last half century is that Latin America did not control capital flight, which often approached the level of its crushing debt and has regularly been wielded as a weapon against the threat of democracy and social reform. In contrast, during South Korea’s remarkable growth period, capital flight was not only banned, but could bring the death penalty.

Where neoliberal rules have been observed since the ’70s, economic performance has generally deteriorated and social democratic programs have substantially weakened.

The phrase “golden age of capitalism” might itself be challenged. The period can more accurately be called “state capitalism.” The state sector was, and remains, a primary factor in development and innovation through a variety of measures, among them research and development, procurement, subsidy, and bailouts. In the U.S. version, these policies operated mainly under a Pentagon cover as long as the cutting edge of the advanced economy was electronics-based.

The crucial state role in economic development should be kept in mind when we hear dire warnings about government intervention in the financial system after private management has once again driven it to crisis, this time, an unusually severe crisis, and one that harms the rich, not just the poor, so it merits special concern.

Selective application of economic principles—orthodox economics forced on the colonies while violated at will by those free to do so—is a basic factor in the creation of the sharp North-South divide.

People cannot be told that the advanced economy relies heavily on their risk-taking, while eventual profit is privatized, and ‘eventual’ can be a long time.

There was a dramatic increase in the state role after World War II, particularly in the United States, where a good part of the advanced economy developed in this framework.

Returning to what the West sees as “the crisis”—the financial crisis—it will presumably be patched up somehow, while leaving the institutions that created it pretty much in place.

Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here

Aid harmonization in education sector in Nepal

So, the good news is that the aid agencies are harmonizing their effort to better education sector in Nepal. Despite my skepticism about the effectiveness of certain kind of donor funded projects, the intervention in the education sector has produced impressive results.

The program focuses on three pillars of access, inclusion and quality. The program is supported by eight other development partners who will also pool their resources, together with the World Bank and government resources. In addition, five non-pooling partners will support the program directly, adds the statement.

The total cost of the five-year program ending 2013/14 is estimated to be about $2.6 billion, of which pooled development partners have committed approximately $500 million.

As a sector wide approach, the program will finance salaries and benefits for nearly 120,000 government school teachers. It will also finance salaries of around 100,000 community recruited teachers through salary grants. Financing for all additional teachers to be recruited during the program period will be made through a per capita child financing formula that takes into account the number of students enrolled in a particular school, the release added.

I hope aid harmonization will be followed up in other sectors as well. The British government has unveiled $5 billion health care plan for six countries (Nepal being the only one from Asia). I hope other aid agencies harmonize their efforts with that of the British government. DFID has done quite a good job in education and health care sector in Nepal.

Strauss-Kahn on financial crisis and low-income countries

Managing Director of the IMF, Dominique Strauss-Kahn, gave a speech at a CGD event on Sept 17. He talked about how the IMF is becoming flexible in helping developing countries cope with severe shortage of funds after the global financial crisis.

He argued that low-income countries have been hit harder than what was expected in March 2009 and now they remain highly vulnerable and face severe financing problems. These countries have been battered by multiple shocks--food and fuel price shock, global financial crisis, and drought and famine. The IMF estimates that low-income countries’ exports of goods and services could drop this year by 16 percent. A decline in remittances, by up to 10 percent, would further aggravate the plight of poor countries. Additionally, FDI flows to low-income countries might fall by 25 percent in 2009. Almost 17 million people are facing severe food shortages and may need emergency food aid, he said. Moreover, due to the global financial crisis an additional 90 million people will be pushed into extreme poverty.

Strauss-Kahn expects a recovery in 2010 and the developing countries would be able to “ride the wave of rising world demand”. [But, at a time when almost all the countries are aiming to increase exports, it is unclear how much the developing countries would benefit even if the world economy rebounds in 2010.]

He argues that there is something new about domestic policy responses in the developing countries this time-- most of them are “home grown”.

Some of this good news is home grown—always the best kind. Since many of these countries ran good policies, they built foundations to ward off the storm. This is something new. In the past, many low-income countries facing such a financial squeeze would have been forced to slash government spending, put administrative constraints on imports, or simply not pay their bills—making the crisis worse.

But this time is different. Debt positions had improved substantially, creating the breathing space for countercyclical policy. In fact, we estimate that almost two-thirds of low-income countries are at low or moderate risk of debt distress—this flows from better policies, and also from more aid and debt relief.

More than three quarters of low-income countries let budget deficits get bigger as revenue fell. One third also introduced a discretionary fiscal stimulus.Of 27 low-income countries with available data, 26 have preserved or increased social spending—no mean feat in the current environment.

The IMF is increasing funding and making the process much more flexible. He also spoke something about conditionality (apparently, admitting that some conditionalities were in fact counter productive):

It’s no secret that our lending programs attracted some criticism over the years. People said our conditions were too harsh, too intrusive, or even misguided. I accept some of that criticism. We made mistakes, but we always try to learn from our mistakes. Overall, I think the PRGF was a success. Countries with sustained program engagement over the past two decades saw bigger boosts to growth than those without such involvement.

Still, we need to make sure that the medicine does not harm the patient. Over the past few years, we have been streamlining our conditionality, focusing on core policy measures that are critical for macroeconomic stability, poverty reduction, and growth. Too many conditions in too many different areas can reduce effectiveness and lead to a loss of legitimacy. Across low-income country programs, the number of conditions has fallen by one third compared with the beginning of the decade. About 40 percent of these conditions are now focused on improving public resource management and accountability—such as expenditure control and tax administration.

Recent reforms have gone even further. From now on, our loans no longer include binding conditions on specific measures. Instead, programs will focus on meeting the overall objectives of the reforms, giving governments more leeway in reaching their goals.

Need to harmonize WTO with RTAs

Carnegie Endowment organized an event about WTO and how we can move forward with existing agreements so that the institution is relevant in the days ahead.It was argued that trade negotiations should be flexible to accommodate emerging thorny issues in the developing countries. Stalled trade negotiations could be passed if negotiations focus on liberalizing the sectors that are already moving forward in that direction due to independent initiative from individual countries. If the Doha Round has a slim chance passing in its entirety, then it can be passed by diluting the deal to accommodate new concerns of emerging and developing nations.

Uri Dadush presented a policy brief (WTO Reform: The Time to Start is Now), where he argues that the next round of WTO negotiations should be more flexible and tailored to the needs of individual countries and trading groups. He raised a very interesting perspective that most of the achievements under the WTO were in fact already moving forward in that direction due to bilateral and regional agreements among nations. The WTO just formalized and incorporated those already existing agreements under its framework. The most thorny issues related to subsidies are yet to be sorted out and this is what plagues the protracted Doha Round. Reductions of applied tariffs on trade in goods since 1995 is attributable to autonomous liberalization (65 percent), implementation of the Uruguay Round (25 percent), and regional arrangements (10 percent).

The WTO is increasingly bypassed in trade reform by unilateral, bilateral, and regional processes, and no new liberalization of trade in goods has come from multilateral negotiations since the institution was founded in 1995.

The WTO is nowhere to be found in several areas of crucial concern, including food security, international financial regulation in the wake of the global financial crisis, and climate change.

The WTO must break away from its splendid isolation and move from a single-minded focus on reciprocal multilateral concessions based on consensus and find ways to participate actively in arenas where actual liberalization is taking place.

The Doha Round is more complex and is hard to pass in its entirety because not all countries would agree to its provisions without diluting some of them to fit their national interest. The Doha Round has been complicated by the increased sensitivity of agricultural issues, the complexity of trade-offs in behind-the-border regulations in services sector, the growing number of diversity of trading partners, and the increased influence and assertiveness of large players and of groupings (LDCs). It is hard to reach a consensus incorporating all the members’ concern. This does not mean that consensus cannot be reached. Consensus can be reached in a diluted form, i.e. dealing with easier issues now and leaving thorny issues for later [we already did this one with the previous five rounds of negotiations and the most thorny issues were left to deal with for the Doha Round!]. How many issues can we leave now and then how much can achieve from the Doha Round? Hard to answer. However, Dadush feels that concluding the Doha Round is essential to preserving the credibility of the WTO as an institution and to avoid writing off the gains made in the last eight years of costly negotiations.

At at time when regional agreements are flourishing, the WTO should find a way to honor and incorporate provisions under such agreements within its global system. This will keep on the relevancy of the WTO. Generally, regional agreements are fast to come up with because of it is easy to form a consensus with few players. They are also designed to address country-specific needs and lessen discrimination: a low external tariff, simplified rules of origin, and coverage of all forms of trade. Dadush argues:

Establishing effective rules to govern regional agreements should be the WTO’s long-term objective, but its constructive engagement with regional processes is a prerequisite to achieving that goal.

In fact, the WTO seems to have realized this aspect and is arguing for giving more policy space to individual countries to help them weather unexpected demand and supply shocks. A recent WTO World Trade Report emphasized for inclusion of “trade contingency measures”. The contingency measures discussed in the report include safeguards measures, anti-dumping and countervailing measures, the re-negotiation of tariff commitments, the raising of tariffs up to their legal maximum levels, and the use of export taxes. These are needed because too little flexibility in trade agreements may render trade rules unsustainable. At the same time, too much flexibility may weaken the value of commitments and trade rules. An appropriate balance between flexibility and commitment is required for the success of trade agreements. There are some who argue that RTAs undermine full gains from global trade but evidence is not that strong in the light of increasing South-South trade. There are more gains to be made by encouraging WTO to engage in “opportunistic multilateralism” by strategically expanding existing RTAs into other relevant areas.

Steve Charnovitz, one of the panelist, argued that though judicial and executive branches of the WTO are working fine, it is not the same with the legislative process. He maintains that the existing WTO is out of sync with developments in the real world. Its limits on national regulation are not consistent with the changed market structure in place right now, especially in the new regulatory structure after the global financial crisis. Also, this is an era of huge government subsidies to almost all the crucial sector in an economy. This is not in line with the WTO regulations. Since the situation is bad everywhere and almost all of them are engaging in propping up flagging sectors, no one is complaining. He opines that the WTO should hold public hearing on each new PTA. He wants WTO to have a mix of states, NGOs, and private actors--like IUCN does.

Arvind Subramanian argued that new forms of protectionism is emerging out despite other restrictions from the WTO: exchange rate policies to prop up domestic exports and resource nationalism (export restriction or rice and gas last year).