Irrational faith on rational models

Watch this video (Mind Over Money) from PBS.

It is good to be reminded again and again the faults of rational models, its relation to the financial crisis, the warnings, the dismissal (from neoclassicals) and the way back to Keynesian ideas.

Nepal’s Industrial Policy 2010: Good but inadequate reform

My latest piece is about the new industrial policy 2010 of Nepal. Nepal desperately needed an updated industrial policy to reflect the changes the national and the world economies have gone through in the past two decades. Here is my argument for why the industrial policy of 1992 should be changed. Here and here are my initial reaction when the cabinet endorsed the new industrial policy two weeks ago. Read the full text of Nepal’s industrial policy 2010 here.

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Industrial Policy 2010: Good but inadequate reform

Despite the never-ending political uncertainty, something good happened in the economic policy front. A long-awaited industrial policy (IP) to buttress the domestic industrial sector was endorsed by the government two weeks ago. This new IP replaced the outdated IP of 1992.

The main objectives of the new IP are to promote industrial activity, increase employment generation, and boost per capita income. The government hopes to increase contribution of the industrial sector to the economy and expects a reduction in poverty. Though the new IP has numerous progressive and encouraging policy agendas, it is also riddled with loopholes and inconsistencies. It looks like a typical government document formulated without adequate consultation with associated parties and without prior appraisal by independent agencies.

The new IP makes it clear that the 1992 IP did not do a good job in promoting the industrial sector. The contribution of the industrial sector to GDP is decreasing, especially after the start of Maoist insurgency. Furthermore, it is paradoxical that the annual growth rate of the industrial sector is declining after the implementation of the 1992 IP. The dream of laying out a foundation for structural transformation, thus absorbing surplus agricultural and unemployed labor in the industrial sector, has remained a fairly tale.

Let me start with some of the salient features in the new IP. It promises flexible labor policy, including the ‘no-pay-for-no-work’ principle. It allows easy exit from business for promoters, freeing them from long-term labor and other liabilities. Tax and income rebate incentives and easy credit are offered to export-oriented firms. It promises tax holidays for 10, 7, and 5 years to firms that invest respectively in highly underdeveloped (21 districts), undeveloped (15 districts) and less developed (24 districts) areas. As always, it aims to promote Special Economic Zones (SEZs) and institute ‘one-window’ policy for all industrial activities.

It aims to promote value-added industries and facilitate supply and adoption of new technology to increase production and productivity. The government promises to purchase goods that are produced by domestic firms if there is 30 percent value-addition in the final product. Furthermore, it offers to establish a bunch of bureaucratic organizations to promote trade. It aims to upgrade technical and skill-related aspects of the existing administrations related to the industrial sector.

Great! It looks like a good IP, at least better than the previous one.

However, there are some inconsistencies and poorly-formulated plans that are worth mentioning. The document is indecisive in identifying the priority sectors, is ambiguous, and might distort incentives instead of enhancing them. Let me explain.

Despite numerous incentives, the IP is not clear if the overall strategy is either to ‘lead the market’ or to ‘follow the market’ or to do both. There is a danger that it might end up being an import-substituting policy in some sectors rather than promoting and sustaining competitive-edge of our industries. This is evident from the government’s willingness to impose anti-dumping duty and countervailing duty (CVD) on imports. If we injudiciously impose tariff and non-tariff barriers, then other countries might follow suit, especially on our exports. It will have negative impact on some sectors, as was seen when India imposed CVD, which it repealed recently, of 4 percent on Nepali exports. The most troubling aspect is the absence of sunset clauses in most of the proposed incentives. It might foster the dependence of the industrial sector on seemingly perennial concessions from the government.

There is no clear-cut identification and preference of industries based on national priority. The whole exercise looks like a spray-gun strategy trying to encompass everything under the roof of the industrial sector. Since the economy is resource constrained, both financially and in human capital, it should have promoted the industries that matters the most. It means tackling the binding constraints head on.

Our biggest constraint on economic growth is a lack of infrastructure, chiefly transport, energy and communication. The IP should have given utmost priority to addressing this constraint. This sector would be an obvious ‘winner’ with very little distortion of incentives. Why? Because domestic demand for infrastructure, energy and communication is higher than supply, offering a huge potential profitable markets. Moreover, there is tremendous demand for energy from neighboring Indian states. Bhutan is following this strategy and is growing at a phenomenal rate. There is no reason why we cannot do it.

The proposed “one-village-one-product” strategy seems nonsense, politically-charged and populist policy. It is a catchy slogan which basically means one village specializing in one product. This discounts the possibility of creating synergies among production processes and techniques, i.e. very little possibility for economies of scale and harmonization of products and production structure. How are we going to decide a product each village will specialize in? Similarly, will there be enough resources, financial and human capital, to bring about such specialization? This kind of open-ended and wooly strategy dilutes the very purpose of having a well-directed, specific and incentive-enhancing IP.

It offers varying incentives to industries willing to operate in less developed districts. This will not lead us much far because businesses, by nature, try to concentrate in places where their counterparts and complementary industries are operating. A firm will be disinclined to operate in less developed districts despite offer of good incentives, which might not offset the increase in cost of production incurred by operating in less developed areas. Simply constructing roads up to factory sites won’t suffice for the promotion of industries in rural areas.

Furthermore, rather than coming up with brand new programs, it would had been better to upgrade or overhaul the existing ones such as the promotion of the IT park, expediting the establishment of SEZs, and importing technologies to update the outdated technological base of the industrial sector.

There are endogenous and exogenous variables contributing to the decline of the industrial sector. The endogenous variables are utter ignorance and lack of domestic firms to increase price and quality competitiveness of products, and a habit of doing business under other’s tutelage rather than their own intellect and sound management. The business community relied more on concessions, of various nature and degree, derived by coaxing politicians rather than banking on their own ability to discover the potential to intrude and expand in new markets. This habit and nature of doing business became self-reinforcing once the nexus between business community and politicians became stronger. Additionally, it choked product specialization and diversification, further necessitating the need to seek political blessing for survival in the competitive market. It was evident from the failure of numerous export-oriented firms, the most infamous being the textiles and garment industry.

The most binding constraints on industrial activity are the exogenous variables such as lack of infrastructure and energy, deficient human resources, deteriorating labor and industrial relations, political instability and policy inconsistency. The state has to address these constraints decisively. Else, the IP’s effectiveness will be very minimal.

[Published in Republica, May 29, 2010, pp.6]

But this is a Keynesian situation...

Martin Wolf blasts OECD's report, which myopically argues that  "a weak fiscal position and the risk of significant increases in bond yields make further fiscal consolidation essential. But, we are not in a normal situation. This is a Keynesian time.

Above all, the private sector is forecast by the OECD to run a surplus – an excess of income over spending – of 10 per cent of GDP this year. On a consolidated basis, the UK’s private surplus funds nearly 90 per cent of the fiscal deficit. Thus, fiscal tightening would only work if it coincided with a robust private recovery. Otherwise, it would drive the economy into deeper recession. Yes, that is a Keynesian argument. But this is a Keynesian situation.

I agree that there needs to be a credible path for fiscal consolidation that would lead to a balanced budget, if not a surplus. That will be essential if the UK is to cope with an ageing population in the long term. I agree, too, that the path needs to be spelled out. Given the high ratios of spending to GDP – close to 50 per cent – the best way to proceed is via tight, broad-based, long-term control over expenditure. But a substantially faster pace than envisaged by the last government might threaten recovery: the OECD, for example, forecasts economic growth at 1.3 per cent this year and 2.5 per cent in 2011. Even this would imply next to no reduction in excess capacity.

Is Nepal “a yam between two boulders”?

Excerpts from a Foreign Affairs article on the influence of India and China in Nepalese political and economic spheres.

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The Nepali crews that inch closer to China, bringing heavy trucks to a valley that has known only foot traffic, are at the forefront of a potentially major strategic shift in the region: Nepal, long a dependable ally and client of India, is building economic and political ties with China. Good roads are just one sign of this relationship and, as Rhoderick Chalmers, an International Crisis Group analyst in Kathmandu, explained to me, could "prevent India from using its ultimate sanction of economic blockade on Kathmandu." If China can begin supplying many of the goods that Nepal now receives from India -- especially petrol, diesel, and kerosene -- then India's leverage would be severely limited.

Although one new highway will not in itself push Nepal from India's sphere of influence -- history, economics, and above all, geography will see to that -- the mere fact that India may one day have to compete for Nepal's attention is a sign of Kathmandu's political reorientation. In 2006, as Nepal's monarchy teetered, Maoist leaders and pro-democracy parties signed a comprehensive peace agreement ending a decade-long civil war. Since then, Kathmandu has been building a nascent democracy while wedged in a proxy battle between China and India -- with the United States and Europe watching closely.

As Nepal inches toward a draft constitution and lasting peace deal, it is counting on India, its longstanding patron and a fellow Hindu-majority state. New Delhi remains Kathmandu's biggest supplier of essential goods, including gasoline, and the Nepalese are addicted to Indian films, music, and other forms of pop culture. Although new roads in Nepal's northern reaches may one day extend the country's economic linkages to China, for now the majority of all trade flows are to and from India in the south.

China's renewed interest in its southern neighbor is not entirely a quid pro quo. In Kathmandu, mobs of Chinese tour groups visit the tourist enclave of Thamel, where they frequent Chinese-run restaurants, bookstores, and hospitals. Meanwhile, Chinese cultural centers are popping up across the country, notably in the Terai, along Nepal's southern border with India. According to the Chinese embassy in Nepal, projects such as the Birendra International Convention Center -- a gleaming complex near Kathmandu's international airport -- and the capital city's main highway are evidence that "China treats Nepal as its closest neighbor and best friend."

Although the above initiatives aim to signify the softer side of Chinese-Nepali ties, China ultimately appears most interested in stifling "anti-Chinese" activities on Nepal's soil. And given China's single-minded focus, Communist Party leaders in Beijing seem less concerned with Kathmandu's political jockeying than with ensuring that the next government is as pliant as the current one. One strategy, analysts suggest, has been to focus fewer resources on national politics and more on localized economic aid, such as building schools in politically sensitive border areas. Although China may consider a return of communist governance ideal, its principal concern is stability. "For China, the ideological difference doesn't make any difference," said Dhungel, the presidential adviser. "They had very good relations with the king. They had a very good relationship with the Nepali Congress. And I think they will have relations with whoever emerges as a stable force." 

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Review of Major Public Works Programs (PWPs)

This is a summary of Anna McCord’s paper (International PWP Comparative Study) on some of the major public works programs/social safety nets in the world.

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PWPs are implemented under two broad labor market situations: (i) acute, short term fall in labor demand or livelihoods disruption (resulting from drought, flood, financial crisis or recession); and (ii) chronic high levels of under- or un-employment and poverty.

McCord reviews six public works programs: (i) USA’s New Deal programs, (ii) Argentinean Jefes program, (iii) India’s National Rural Employment Guarantee Act (NREGA), (iv) Ethiopia’s Productive Safety nets Program (PSNP), (v) Senegal’s AGETIP (Agence d’Execution des Travaux d’Interet Public, and (vi) Ireland’s Community Employment Program. She compares and contrasts these PWPs with South Africa’s Expanded Public Works Programs (EPWP) and offers some recommendations.

Broadly there are four types of objectives of social protection programs:

• PWPs offering short term employment to fend off temporary labor market disruptions (Indonesia’s Padat Karya program)
• PWPs promoting labor intensification of government infrastructure spending to boost aggregate employment (social protection objective indirect; direct objective is employment creation)
• Large scale government employment programs which tend to offer some form of employment guarantee in response to chronic or sustained levels of elevated employment (such as the New Deal, NREGA, Jefes, PSNP)
• PWPs that enhance ‘employability’ of workers through the provision of skills formation and workplace experience (Irish Community Employment Program)

Usually large scale social protection programs, such as AGETIP, fail to attain substantial coverage and suffer from limited impact and seemingly inappropriate conception and design. NREGA avoids this danger of form over substance, in part due to close scrutiny to which it is subjected as a consequence of the highly organized role of civil society in monitoring anti-poverty interventions.

For measurement of the effectiveness of PWPs, the microeconomic impact of program participation (current and future earning and/or reemployment prospects) and the macroeconomic impact (net effect on aggregate employment and unemployment) are evaluated. The effectiveness of a PWP intervention in terms of its contribution to social protection is contingent on the appropriate duration of employment and the extent to which it enables livelihoods protection and/or accumulation to take place.

PWPs that are more likely to be successful in alleviating poverty in the context of persistently high levels of unemployment and poverty provide a guarantee of ongoing or repeated episodes of employment on a massive scale. Some form of job guarantee is included in the program.

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Social protection consists of all initiative that provides income (cash) or consumption (food) transfers to the poor, protect the vulnerable against livelihood risks, and enhance the social status and rights of the excluded and marginalized. (see Devereux and Sabates 2004). The World Bank considers risk coping, risk mitigation and risk reduction as key components of social protection.

Social protection can be carried out through wage transfer (cash, food or inputs), asset benefits, and training or work benefits.

If employment were offered on a sustained basis, or were guaranteed in times of need, as in NREGA, with no sustained benefits accruing from the assets created,the program would confer prevention social protection, or risk mitigation. If there are sustained benefits accruing from assets created from sustained employment programs, then it could be termed as promotive/transformative social protection (social risk reduction).

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Case studies:

1) The USA’s New Deal Programs (1933-43)

• Developed in response the depression following the Wall Street Crash in 1929
• Five concurrent centrally administered public works initiatives (1933-43): (i) Civilian Conservation Corps (CCC) in 1933; (ii) Civil Works Administration (CWA), an emergency initiative during the winter of 1933-34; (iii) Works Progress Administration (WPA) in 1935; and (iv) National Youth Administration (NYA) in 1935
• Massive expansion of state expenditure in an attempt to stimulate the economy while also providing enough employment to ensure that the basic needs of all working families were met.
• Infrastructure spending topped 3% of GDP
• At the height of the program, it absorbed over 50% of the unemployed labor force.

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2) The Argentinean Jefes de Hogar Program (2002- )

• Program for Unemployed Heads of Households
• Initiated in 2002 in response to an economic collapse; unemployment rate rose to 24%
• Objective: Income support for families and a reduction in unemployment
• Offered employment in a range of projects created by public or local non-profit agencies; only one participant per household who is not receiving unemployment insurance and other transfer benefits from the government
• Participants received a regular monthly transfer of 150 pesos in exchange for 20 hours of work per week or for attending a school or training program for at least 20 hours per week.
• Total  cost: 1.6 million pesos in 2005 (< 1% of GDP)
• Employed 2 million persons in Spring 2003; 1.3 million, 8.7 percent of total labor force, persons enrolled in April 2006
• Assets created: micro enterprises mainly in agriculture (26%), social and community services (17%), maintenance and cleaning of public spaces (14%), public lunchrooms (11%), educational activities (10%), healthcare and sanitation (5%), etc.
• Evaluation findings: attributed to having reduced poverty and unemployment (though some disagreements linger); initial macroeconomic multiplier effect was estimated by the government at 2.57; enrollment drawn almost entirely from the poor; but now closing the program to new entrants has meant that a significant number of the poor are not covered by it.

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3) Indonesia’s Padat Karya (PK) Program (1998-2001)

• Initiated in 1998 in the wake of East Asian crisis to tackle transient unemployment and impoverishment resulting from the economic crisis
• Made a one-off episode of financial transfer until the crisis was over
• Used work requirement as a crude targeting mechanism
• Approximately 400,000 workers and 58 million days of labor were created between 1998 and 2000; total employment created was equivalent to 7% of the unemployed
• Focused on urban areas of Java and drought-stricken rural areas
• Evaluation findings: termed a model scheme for delivering income support to the poor during economic crisis; but shortcomings such as failing to reach women, minimal consultation with community, no NGO involvement, no transparent mechanism, no long term positive impacts, and no capacity building component; poor coverage and targeting as 64-100% of the participants were non-poor; poor targeting
• Considering a national employment guarantee program

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4) India’s National Rural Employment Guarantee Act, NREGA (2006)

• Offers 100 days of guaranteed employment per annum to at least one member of rural household
• Unemployment benefits given if the state fails to provide jobs within 15 days of work demanded by workers
• Wage is equal to minimum unskilled agricultural wage
• Evaluation findings: varies from state to state as implementation is highly variable, depending on levels of political buy in and also state administrative capacity; issues of corruption; raised wages in the rural areas; almost all of the households that demanded work were given one.

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5) Ethiopia’s Productive Safety Nets Program, PSNP (2005-)

• Initiated in response to chronic food crisis; 5-12 million people depend on PWP transfers for survival each year
• Objective: to provide households with enough income (cash/food) to meet their food gap and to build community assets to contribute to addressing the root causes of food insecurity.
• Offers repeated episodes of employment, for up to five years, and implements complementary livelihood promotion initiatives to graduate people out of poverty.
• The program faces significant problems in identifying, designing, and implementing the scale of infrastructure projects required to absorb the levels of workers anticipated.
• Approximately 7.3 million households members benefited in 2006, which is approximately 2-3 million workers.
• Cost: US$ 915 for the years 2007 and 2009; total transfers (wages plus direct support) are estimated to be US$ 148 million, 16% of the project total.
• Evaluation findings: initially exclusion of poor households; with revision of the program, the exclusion of poor people is not to the same extent; subjected to major problems in terms of the identification and management of sufficient numbers of programs to absorb the requisite amount of labor.

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6) Senegal’s Agence d’Execution des Travaux d’Interet Public, AGETIP (1989- )

• Initiated to quell urban dissent and political instability following contested election victory of the government of Abdou Diof in 1988 and launched in 1990; to alleviate urban unemployment and to improve living conditions of the poor in urban areas through infrastructure development.
• Privately managed public works executing agency that enters into a contractual agreement with the central government for sub-project execution.
• Aim to increase labor intensity and SMME activity in order to increase aggregate employment per unit of spending
• Created 450,000 temporary jobs between 1989 and 2004; 21,000 created in 2004 alone (0.5% of total labor force)
• Evaluation findings: highly successfully project; impacted the construction sector; in 1991, there were 80 engineering firms and 350 construction firms and this had risen to 350 engineering firms and nearly 2000 construction firms by 2004 (although it is not clear if this can be attributable to AGETIP); promoted efficiency in the public works construction and processes.

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7) Ireland’s Community Employment Programme (CEP) (1994- )

• Offers sheltered government funded employment for those not able to find employment in the open labor market.
• Participants offered relatively high wage levels and secondary benefits during their employment, but graduation out of the program very low
• Covered almost a quarter of total unemployment; wage rate was below the minimum wage; 19.5 hours of work a week with payment of € 210.
• Evaluation findings: the program suffers from dual goals of improving the employment outcomes of its participants and of supporting the not-for-profit sector; if CEP is considered a demand-side measure designed to create aggregate employment, then it has been successful but if it is considered as supply-side measure designed to move workers into regular employment, then it is unsuccessful.
• Cost: € 295 million in 2005

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PWPs international comparison

With just a cost of 1% of GDP, India’s NREGA covered 15% of total labor force through PWP jobs. With 2% of GDP, Ethiopia’s PSNP covered 4.8% of total labor force through PWP jobs.

In search of the smoking gun for trade collapse

One of the most striking aspects of the recent recession is the collapse in international trade. This paper uses disaggregated data on U.S. imports and exports to shed light on the anatomy of this collapse. We find that the recent reduction in trade relative to overall economic activity is far larger than in previous downturns. Information on quantities and prices of both domestic absorption and imports reveals a 40% shortfall in imports, relative to what would be predicted by a simple import demand relationship. In a sample of imports and exports disaggregated at the 6-digit NAICS level, we find that sectors used as intermediate inputs experienced significantly higher percentage reductions in both imports and exports. We also find support for compositional effects: sectors with larger reductions in domestic output had larger drops in trade. By contrast, we find no support for the hypothesis that trade credit played a role in the recent trade collapse.

See this paper looking for the smoking gun on the great trade collapse of this decade. Also see this blog for what economists think caused trade to decline more rapidly than the decline in GDP. This paper counter’s Barry Eichengreen’s point that disruptions to the supply of credit from international banks to some developing countries might have been the reason. Another reason economists point out is the disruption in the trade of intermediate goods. The degree of trade of intermediate goods is so high that disruption in one process has a domino effect on others, thus causing a near-complete collapse.

The diminished and still diminishing garment industry of Nepal

Bhuwan Sharma, Op-Ed editor of Republica, has an excellent article on the IPS on the demise of the garment industry. It is a refresher on how Nepal lost the glory of its garment industry after the end of MFA in 2005.

The tiny Himalayan nation’s garment industry in its heydays earned the highest foreign exchange for Nepal and was the biggest export-oriented manufacturing industry of the country.
Export of readymade garments (RMGs) that in 2002/2003 registered over 11.5 billion Nepalese rupees (165 million U.S. dollars) plummeted to about 4.5 billion rupees (65 million dollars) in 2008/2009. An industry that once provided direct employment to approximately 50,000 people, including a significant number of women, now just employs a few thousand people.

The phasing out of the quota system carried out in tune with the 1990 World Trade Organization (WTO) Agreement on Textiles and Clothing (ATC) (also known as Multi-Fibre Agreement), Nepal’s inability to restructure the sector, political instability and the rise of unionism dealt a near-lethal blow to the industry.

The quota reduction was implemented in four phases: 16 percent in 1995; 17 percent in 1998; 18 percent in 2002; and finally 49 percent in 2005, thus ending 40 years of quota-based trading on textiles and clothing.

"The quota phaseout under ATC began in 1995, but its impact on the Nepalese economy was not immediate. This was due to the fact that the RMGs were concentrated on a few products (mainly cotton casual wear), and these products were not under quota restrictions until the last phase of the Agreement," says a report published by South Asia Watch for Trade, Economics and Environment (SAWTEE) and ActionAid Nepal.

Chandan Sapkota, a regular newspaper commentator on trade and economic issues, says: "It was known two decades ago that all quotas in this sector would be abolished. There was ample time to invest and restructure the Nepali garment industry. However, both investors and policymakers turned a blind eye to the necessity for the reorganisation of this industry."

The phasing out of quotas and the country’s inability to prepare itself for a level-playing field has been devastating. While there were 212 manufacturing units in 2000/2001 manufacturing RMG for markets primarily in the United States, EU, Japan and Canada, now only a handful of units remain.