Going beyond Keynesianism to avoid another global crisis

High income countries are facing a “new normal” (a combination of low growth, high unemployment and low returns on investment). Some of the European countries are facing sovereign debt crisis and may require restructuring. Middle-income countries are experiencing short-term capital inflows, putting appreciation pressure on currency and equity and real estate markets prices. Surge of food, fuel and commodity prices is hurting the poor. With these economic problems what can be done to avoid another global crisis?

Justin Lin argues that “a global push for investment along the line of Keynesian stimulus is the key for a sustained global recovery; however, the stimulus needs to go beyond the traditional Keynesian investment.” But the problem lies in avoiding the Ricardian trap—a situation where the government spending fails to boost aggregate demand as people expect increases in taxes in the future (and save now) to pay for existing deficit that funds government spending. Lin suggest:

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To avoid the Ricardian trap, it is important to go beyond conventional Keynesian stimulus of “digging a hole and paving a hole” by investing in projects which increase future productivity. So the investment will increase jobs and demands for capital goods now and increase the growth and government’s revenue in the future. The increase in revenue can pay back the cost of investment without increasing household’s future tax liability.

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Krugman argues that this still misses the point:

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It’s one thing to have an argument about whether consumers are perfectly rational and have perfect access to the capital markets; it’s another to have the big advocates of all that perfection not understand the implications of their own model.

So let me try this one more time.

Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.

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Are Nepal’s policies “mercantilist/economic nonsense”?

Here is my latest piece about Nepal’s Industrial Policy 2010, Trade Policy 2009, and Nepal Trade Integration Strategy (NTIS) 2010, and how they are trying to address trade related problems in Nepal. It is largely based on criticism of a paper authored by Malcolm Bosworth, who argues that unilateral trade liberalization with an increase in imports should be the main trade policy agenda of Nepal. I find this (bad) recommendation not suited to Nepal’s context. He argues that Nepal’s existing industrial and trade policies are “mercantilist/economic nonsense”. I will have detailed, specific comments on other arguments raised by Bosworth in later posts.

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Mercantilist nonsense?

On February 28, 2011, the United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP) organized a high level national policy dialogue on Nepal’s long-term direction in global and regional trade policy in Kathmandu. High level officials and experts working on trade related issues participated in the program, which was aimed at increasing national awareness and knowledge on “trade policy options to increase engagement in global and regional trade and derive benefits from such trade for development.”

The main highlight was a paper authored by Malcolm Bosworth, international consultant for the study and visiting senior research fellow at Crawford School of Economics & Government, Australian National University. By interacting with high level Nepali officials for few days and banking on inputs from a national consultant, Bosworth has written and fiercely advocated trade policy agendas for Nepal that are suicidal and largely detached from the dynamics and ground realities of the Nepali economy.

Let me touch upon a few of the many outrageous and ludicrous recommendations emanating from Bosworth’s paper. His main message is that unilateral trade liberalization, especially those geared toward increasing imports, should be the main trade policy agenda of Nepal. He argues that imports are as important as exports and the former has to be at least equally promoted as the latter. Furthermore, Bosworth maintains the current industrial and trade policies – which he says are “mercantilist nonsense”—are discriminatory because they promote one sector/product over the other, and seek market concessions abroad to increase exports. According to him, the increase in trade deficit is not a trade policy problem, but that associated with saving-investment imbalance, particularly domestic investment being higher than domestic saving. He recommends Nepal to eschew attempts to address trade and balance of payments (BoP) deficits using trade policy. To Bosworth Nepal Trade Integration Strategy (NTIS) 2010 is against the spirit of ‘welfare enhancing’ trade policy, which to him is unilateral liberalization to increase imports and non-discriminatory in terms of sector or product promotion.

Given Nepal’s structural problems (which are very likely not related to saving-investment imbalance), macroeconomic fragility and socioeconomic dynamics, Bosworth’s arguments defy rational economic logic. He assiduously extols the discredited “one-size-fits-all” policy recommendations and the Washington Consensus.

The reality is that unilateral trade liberalization will further worsen our BoP deficit and deepen macroeconomic instability, which might force Nepal to knock on the door of the IMF once again. Nepal already imports almost six times more than it exports. In 1976, trade deficit on goods and services was negative 3.4 percent of GDP, which swelled to negative 21 percent of GDP in 2009. This is simply unsustainable even in the medium-term. So far remittances have been partly neutralizing the effect of rising imports on overall BoP. But, this too is volatile because any disturbances in remittances inflow would further exacerbate the already fragile macroeconomic situation. Just two years ago when the global economic crisis led to a decline in growth rate of remittances inflow, our BoP became negative.

In such circumstances, prescribing a policy to increase imports by unilaterally liberalizing trade (and if necessary going beyond the rules set by the WTO to increase imports) is suicidal. Trade liberalization in unproductive imports—especially on luxury goods and branded items— will not increase welfare in a country where approximately 78 percent of the population lives below $2 a day. It would sensible if we liberalized further on capital goods imports, which would at least contribute to the productive capacity of our economy.

Pretty much every country in the world uses trade and industrial policies in one form or the other to aid their industries and export-oriented sectors. For Nepal, the domestic welfare emanating from trade and employment, and increase in purchasing power matters more than the welfare of citizens of other countries, i.e. we should not make ourselves worse off by making someone else better off. If possible, we could make ourselves better off by at least not making others worse off. But, this is idealistic given that in reality there are always tradeoffs. Our policymakers should not believe in the ideology that unilateral trade liberalization creates high welfare gains and less deadweight loss globally. Even if they did, the welfare from such liberalization is not equally distributed across and within nations. The Nepali government has responsibility to think about enhancing welfare of its citizens by playing by the rules set under international treaties, including the WTO.

If trade and industrial policies, that do not violate WTO rules, increase welfare of Nepali people, then there is nothing wrong in implementing them. An ultra-liberalization policy recommendation that tries to unsuccessfully debunk established evidence on the effectiveness of trade and industrial policies to abet domestic industries/specific sectors and products adds no value to the ongoing discussion about and efforts to mainstreaming our trade policy into overall economic policy.

It seems that rather than doing exhaustive stocktaking and writing a report based on reality, the analyst has tried to use a template of trade policy report used elsewhere. In fact, Bosworth forgets to replace “PNG Government” with “Government of Nepal” in the report (page 79, para 2). It is very likely that he inserted some discussion about Nepal’s trade situation by getting inputs from a national consultant and then projected it on top of a trade policy report already prepared for Papua New Guinea. Unsurprisingly, if you look at the presentations of the lead author and national consultant Dr Pushpa Raj Rajkarnikar, the latter seems to have comprehended and reflected Nepal’s trade situation and constraints more clearly than the former.

One appreciable aspect of Bosworth’s report is that he acknowledges that no degree of market opening abroad will boost Nepal’s exports if the supply-side constraints are not addressed. Supply-side constraints such as intermittent blockades, labor disputes and lack of adequate infrastructures (road transport and electricity) are eroding our competitiveness and preventing diversification of exports basket. That said, he again fails to read what Industrial Policy (IP) 2010, Trade Policy (TP) 2009 and NTIS 2010 are trying to address, i.e. supply side constraints in key sectors that have high chances of being successful domestically and abroad, and also have high socioeconomic benefits.

These policies are trying to facilitate structural transformation and diversification that Bosworth wrongly claims will only happen if trade is fully liberalized. When markets are riddled with coordination failures and information externalities structural transformation will not happen just by swinging the wand of liberalization. It only happens in ideal situation, which is hard to get by in Nepal. The recent literature on product space and the role of state in facilitating structural transformation is inconsistent with Bosworth’s recommendations. The government’s role as a facilitator in reducing coordination and information hurdles in order to accelerate economic activities is equally important in bringing about structural transformation as is the role of the private sector.

No doubt, Nepal’s existing policies have shortcomings in terms of achieving the aims that they are supposed to. But, they definitely are not “mercantilist/economic nonsense”. Making such outlandish, baseless claim shows the shortcoming of analysts, especially those ‘parachute analysts’, who drop in on Nepal for few days, interact with few officials and experts, and write reports based on templates. If their remuneration is counted as a part of Aid for Trade (AfT) initiative, then it is better not having them because the net value addition is probably negative. And, for now, promoting exports is more important than encouraging imports.

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[Published in Republica, 2011-03-10, p.6]

Country specific effects of fiscal stimulus

Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh (2011) analyze a quarterly dataset on government expenditures for 44 countries (20 high-income and 24 developing) from 1960 to 2007 and argue that the impact of government fiscal stimulus depends on key country characteristics:

1. The output effect of an increase in government consumption is larger in industrial than in developing countries. Only after a lag of two to four quarters does output rise in response to an increase in government consumption, and the cumulative output response is not statistically different from zero. Furthermore, increases in government consumption are less persistent (dying out after approximately six quarters) in developing countries than in high-income countries. But, only in developing countries is the multiplier on government investment significantly higher than the multiplier on government consumption. Thus, the composition of expenditure may play an important role in assessing the effect of fiscal stimulus in developing countries.
2. The fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates.The differences in the responses to increases in government consumption in countries with fixed and flexible exchange rate regimes are largely attributable to differences in the degree of monetary accommodation to fiscal shocks in these nations. The results imply that the central banks' response to fiscal shocks is crucial in assessing the size of fiscal multipliers.
3. Fiscal multipliers in open economies are lower than in closed economies. Economies that are relatively closed, whether because of trade barriers or larger internal markets, have long-run multipliers of around 1.3 to 1.4, but relatively open economies have negative multipliers.
4. Fiscal multipliers in high-debt countries are also zero. When the outstanding debt of the central government exceeds 60 percent of GDP, the fiscal multiplier is not statistically different from zero on impact and it is negative in the long run.

This might mean that in a least developed country like Nepal, the government can do a lot to jack up growth rate. First, government investment has to be high as consumption level is already high in Nepal. This means investment in infrastructures, education, health and research & technology. Second, since Nepal has a fixed exchange rate with India, and if the central bank rolls out monetary policy that is consistent with fiscal stimulus, the resulting fiscal multiplier could be large. Also, given the idle resources and massive unemployment, fiscal stimulus (with good governance on the use of money) would produce sizable impact on the economy.

About, high-debt argument, Krugman disagrees with the 60 percent of GDP threshold (Reinhart-Rogoff argue that debt over 90 percent of GDP leads to drastically slower growth. Krugman dismisses this idea.)

How to ensure stable growth in post-crisis Asia?

By raising consumption and investment or reorienting investment from tradable to nontradable sectors. These changes in investment could be facilitated by financial reforms that enhance domestically oriented firm’s access to credit, stronger incentives for corporate restructuring, policies to bolster the business climate and reduce uncertainty, and by improvements in infrastructure that raise the returns to private investment.

More on this on a paper by Nabar and Sayed 2011.

Higher food prices are here to stay

Thomas Helbling and Shaun Roache (2011) argue that higher food prices are here to stay not because of weather factors, but due to the ongoing structural change in international food markets. The weather-related supply shocks will normalize after production increases during favorable weather conditions. But, what will be hard to change is the fact that consumers in emerging and developing countries are getting richer and changing their diet, particularly eating more high-protein foods such as meat, dairy products, edible oils, fruits and vegetables, and see food. These products are more income elastic than staple grains. So, supply adjustment to the structural increases in demand for major food commodities will take more time than adjustments related to weather-related supply shocks. Improved technology and higher yield growth could compensate for the such scarcity in the long term. But, for the short term, higher food prices could find a new normal that is higher than previous thought.

What is causing the rise in food prices?

• Food is not traded as extensively and readily as manufactured goods, because of protectionist agricultural policies. Since most food is not traded, international food prices are only one determinant of domestic food inflation.
• Structural changes in diet in emerging and developing countries, i.e. more consumption of meat, and more demand for animal feed to rear cattle.
• Increasing use of food grains to produce biofuels. High oil prices and policy support (for production of biofuels) have boosted demand for biofuels. In 2010, the production of corn-based ethanol absorbed 15 percent of global corn crop. Meanwhile, high oil prices directly increase cost of production of food because fuel is used to produce inputs such as fertilizers.
• Over the past decade, global productivity growth (the amount of crop produced per hectare) has fallen for rice and wheat compared with the 1980s and 1990s. Ceteris paribus, less productivity growth means higher prices. For farmers, average prices have to increase to provide enough incentives for increased supply. But, with lower yield growth, production increases have to come from using more land (higher acreage).  Meanwhile, low yield growth and limited land availability amid rapid demand growth could lead to shifts in international trade patterns.

• Food prices are pushed up due to a series of weather-related supply shocks since mid-2010. Droughts and wildfires decreased wheat production in Russia, Ukraine, and Kazakhstan; a hot and wet summer led to lower-than-expected corn harvest in the US; and La Nina weather episodes hit rice production in Asia. Worse, shortfall in production led to the imposition of grain export restrictions in Russia and Ukraine. Patterns of protectionist trade policy has been observed after the supply shocks.
• Stock-use ratio (stocks relative to consumption) are low, causing food price volatility. Reluctant inventory holders withhold release of grains due to fear of future shortages, thus affecting food supply and prices in the market.

Public investment and economic growth

Public investment on infrastructures, education and health are prominently featured in developing country’s fiscal budget. But, how fruitful are these investments? Does increase in public investment leads to growth? The World Bank (2007) argued that public spending on infrastructure, education, and health yields positive effects on growth. Similarly, the Commission on Growth and Development (2008) noted that fast-growing countries are characterized by high public investment, defined as 7 percent of gross domestic product (GDP) or more.

Recently, Arslanalp, Bornhorst and Gupta (2010) studied the impact of public investment on economic growth for 48 advanced and developing economies during 1960–2001. They found that public investment generally has a positive impact on growth. Specifically, on average, GDP grew by 3.4 percent in advanced economies and 4.4 percent—1 percentage point more—in developing economies from 1960 to 2000. Here they summarize the main findings of their paper. They argue that the mixed result is resulting because most of the studies look at investment rate (% of GDP devoted to capital stock). However, the authors argue that the rate of growth of capital stock should be the focus. The capital stock—together with other production factors, such as labor and technology—determines an economy’s production potential. The investment flow in any given period, by contrast, determines how much capital is accumulated and therefore available for production in the subsequent period.

Tackling the issue of depreciation:

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The value of the capital stock is calculated using the perpetual inventory method. In this method, the net capital stock—public and private—is determined by adding gross investment flows from the current period to the depreciated capital stock of the previous period. As a result, the stock data account for the wear and tear on assets.The choice of depreciation rates presents perhaps the biggest challenge to tallying the capital stock data—mainly because country-specific estimates of depreciation rates (how much of the capital stock is used up in a period) are typically not available. Instead of applying a uniform rate to all countries, we differentiate the assumed depreciation by groups of countries reflecting different types of assets typically available in those countries. These assets have different life spans, resulting in different depreciation rates. For example, concrete structures are typically estimated to last longer than assets related to technology, whose investment life may be only a few years. As countries become richer, the share of assets with shorter life spans rises, thereby raising the overall depreciation rate.

The U.S. Bureau of Economic Analysis estimates that overall depreciation rates for public capital in the United States were about 2½ percent per year in 1960 and 4 percent in 2001 (Bureau of Economic Analysis, 2010). We extended this assumption to the public capital stock estimates for all advanced economies in our sample. For middle-income countries, we used a time-varying profile in which the depreciation rate starts at 2½ percent in 1960 and reaches 3½ percent by 2001. We assumed a constant rate of depreciation of 2½ percent for low-income countries throughout the sample period. We confirmed our findings using other plausible depreciation rates.

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The correlation between average public capital growth and average GDP growth is much higher than between the average public investment rate and GDP growth.

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It shows that the public investment rate has been on a downward trend since the early 1970s in advanced economies. In contrast, the public investment rate increased significantly in developing countries in the 1970s, although it returned to its earlier levels in the 1980s. Public capital stock, as a percent of GDP, peaked for advanced economies in 1983 and for developing economies in 1985. The peak levels were 60 percent of GDP for advanced economies and 61 percent of GDP for developing economies.

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How will India’s fiscal budget affect Nepali economy?

The Indian Finance Minister Pranab Mukherjee presented to the Indian parliament a fiscal budget of around US$278.38 billion for the next fiscal yar (April 1, 2011- March 31, 2012). Since Nepal shares an open border with India and has also pegged its currency with Indian rupee, the fiscal policies (both expenditure and tax) of India affect the Nepali economy as well. Here is a list of issues officials at the finance ministry in Nepal will have to grapple with while rolling out next fiscal year’s budget (July 16, 2011-July 15, 2012).

• Inflation in India (expected at 5%) will affect price levels in Nepal. The increase in purchasing power (indirectly) due to subsidies and indexing MGNREGA wages (IRs 100 in real terms) to consumer price index will not help to decrease prices of essential items; it will either maintain status quo or an increase in prices. In real terms, the Indian consumers would not lose that much. But, Nepali consumers will lose (both in real and nominal terms). Also, purchasing power of average families will increase by over IRs 2000 due to upping of personal income tax exemption (at IRS 180,000). The nominal increase in demand will further increase demand in the Indian market. If it affect general prices, then Nepal will also bear the brunt. But, if it increases real expenditure on sectors with idle resources (including travel and recreation), then Nepal might benefit.
• The increase in services tax (hotel, airfares, branded products, etc. of 10 percent) might make Nepali destinations relatively cheaper. However, nothing concrete can be said on this regards as it all depends on relative (cost of production) prices on the sectors concerned between the two countries.
• Indian farm and fertilizer subsides will affect Nepali agricultural prices as Nepal imports a lot of food products from India. Meanwhile, Nepal has agreed to eliminate Agricultural Reform Fee (ARF) for Indian agro-good, making Indian agro products further cheaper in the Nepali market. It might make some agro-products cheaper in the product market. But, it might also erode our agriculture production and employment (especially that of commercial ones).
• The decision to impose higher tariff on gold will further widen gold price differential between Nepal and India. Nepal will have to increase tariff on gold to discourage gold smuggling to India and to not let balance of payments deficit further widen.
• Similarly, prices of fuel have not been revised. So, some price differential on the two sides of the border is very likely, leading siphoning off of fuel from Nepal to India. It will not only affect domestic availability of fuel but also widen trade deficit as Nepal buys fuel at international prices from IOC and sells it in the domestic market at a little deflated price.

I will add more on later posts.