What is disastrous in the short run: Inflation or Deflation?

The consensus among economists is that deflation is disastrous in the short-run but the fear of inflation is legitimate in the long run. We need more (prudent) Keynesian dosage in the economy!

The rough consensus was that in the near term, as Western economies struggle to recover, the bigger worry there is deflation. But as the time horizon lengthened, more experts cited inflation, because it seems the most plausible exit strategy for governments trying to deal with crushing debts.

Using monetary policy to generate the growth necessary to push inflation much above 2% would be difficult, since short-term interest rates are already below 1%. Fiscal policy is turning contractionary as America’s stimulus expires and much of Europe implements austerity measures.

Monetarists downplay the output gap and focus instead on the vast amount of money that has been created as central banks buy bonds or extend loans to banks. They worry that this money, which today is largely being hoarded by the financial industry, will eventually be loaned out into the real economy, prompting prices to rise. Yet this concern is probably overblown.

After all, central banks can still raise interest rates, no matter how big the monetary base is, and they also have ways of withdrawing the exceptional liquidity measures put in place during the crisis. The European Central Bank successfully “sterilised” its recent purchase of government bonds by enticing banks to deposit an offsetting amount of money with the central bank. The Federal Reserve will start testing a similar system on June 14th.

Even if inflation could be created, would it reduce the real government debt, the presumed purpose of such a policy? Not easily. First, for most countries the greatest long-term fiscal threat comes from unfunded retiree benefits, which by their nature are indexed to inflation. Second, the maturity profile of most countries’ marketable government debt is relatively short: over half of America’s and more than 40% of that of Germany, France and Italy matures within three years. Britain, at 20%, is the exception. This means that unless investors are repeatedly surprised, inflation will lead to higher nominal interest rates as debt is refinanced, and in turn to an unchanged real debt. If governments set out to create inflation, investors are likely to notice and react.

The latest crisis has demonstrated that price stability is no guarantee of financial and economic stability—indeed, a narrow obsession with prices may have led central bankers to neglect asset bubbles and the condition of the banks. Yet in practice price stability has not been dislodged from the centre of central banks’ attention.

RTAs are a blessing

Freund and Ornelas argue (full paper here) that regional trade agreements (RTAs) are more of a blessing than a burden. This runs counter to Jagdish Bhagwati’s argument that RTAs undermine free trade. They find that trade creation tends to be the norm in RTAs, which counts to nearly 300 now, and trade diversion an exception; and when trade diversion is observed, its magnitude is relatively small.

It means that there is more trade creation than trade diversion with RTAs.Why so? They argue that it is because governments choose partners well considering factors such as proximity, similarity in GDP and its composition, and difference in factor endowments. Moreover, RTA partners not only lower tariffs on trade between/among them but also lower tariffs on  imports from countries outside the bloc. In fact, RTAs go beyond the mandate of trade liberalization among the partners.

The RTA creates “leakage” in the trade-policy redistributive channel. External protection also becomes more costly, because of the costly trade diversion that accompanies the RTA. As a result, external tariffs tend to fall after the formation of an RTA, both because the economic marginal cost of external protection rises and because the political-economy marginal gain from external protection falls.

[…] The increasing wave of regionalism has been largely beneficial to the world trading system. Most empirical analyses indicate that trade creation, not trade diversion, is the norm, both because governments choose well when forming RTAs and because they adjust other trade policies to moderate the distortions from discrimination.

Here is a list of RTAs so far. More on RTAs here.

From Governance to Growth

This note introduces an evolutionary approach to economic and governance reform. It lays out two especially prevalent trajectories that differ starkly from one another in how they prioritize and sequence economic growth, state building, and the development of civil society and political institutions. The first trajectory focuses initially on investments in state capacity. The second initially prioritizes smaller, more catalytic entry points and addresses specific capacity and institutional constraints as and when they become binding. Over the longer term, both trajectories endogenously generate incentives to strengthen institutions that underpin economic competition and political accountability. But over the short to medium term, the strengths of one trajectory are mirrored as the weakness of the other. For many low-income countries, the combination of rapid growth plus a seeming excess of either order or chaos may thus be in the (medium-term) nature of things, rather than an aberration that requires fixing. 

See more on Brian Levy's Development trajectories: An evolutionary approach to integrating governance and growth

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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