A couple of students from UMass Amherst find a fault in the results by Ken Rogoff and Carmen Reinhart weakening their claim about the proportion of debt to GDP and its deleterious effects. It seems, now that this link appears to be tenuous, the case for austerity in case of many debt ridden EU countries is significantly weakened and finally the Keynesians of the world win the intellectual battle. Certainly, Paul Krugman seems to think that in successive blogposts on the Rogoff affair!
So is the case for austerity for these debt ridden EU countries really that tenuous? Should they be allowed to continue to inflate their way out? I do not think so. A clear picture of what plagues EU can be found here. The theoretical and empirical evidence against government spending as a way out of economic problems is overwhelmingly in support of austerity. Empirical work by Barro clearly shows that even with huge government spending shocks, the expenditure multiplier tends to just a little over or equal to 1. Moreover, theory tells us that polices that alter the incentives people face will tend to work far better in stimulating the economy in the desired direction. Even if there is deficient private demand, just filling in the gap will just do that- plug the hole. It does not affect the behavior of private sector in the long run. For example we know that the 2008 tax rebate did not move current consumption at all. Savings went up and people paid down the debt that was accumulated in the past. Sometimes even seemingly well intentioned policies can have opposite effects. Casey Mulligan makes an interesting case for this in his latest book, “The Redistribution Recession”.
There might be some case for government spending or inflation tax in developing countries. The presence of a substantial informal sector and significant positive returns on investment in public infrastructure are the cases in point. But you cannot have the same prescription for every country, and hence the Keynesians or Left thinkers especially in developing countries should not take shortcomings in Rogoff and Reinhart’s work as their victory. Increased government expenditure on employee salaries is still unproductive and deficient private demand (if present at all) may still not be corrected with it. And that replication of results should be still taken seriously before we base policy prescriptions on them.
An article published at Macroscan on the dilemma of the Indian government about whether to deregulate the price of oil or not, the author argues for not to do so. However, I think he needs more than the analysis he is basing his argument on. The simulation is based on Tinbergen style simultaneous equations model of the Indian economy. So my 5 cents to the debate are as follows:
There are several general equilibrium effects of an oil price shock that have to considered. How are people going to react to the change in price of oil? In the first place, shielding the consumers from oil price shocks has distorted consumer decisions. Combined with shoddy public transportation system, it has lead to a higher demand for private transportation vehicles. If government passes on the oil price changes to the consumer, the consumers might respond to the relative price changes. Over the period of time there will be further demand for efficient public transportation and the reliance on oil for private transportation might actually go down leaving the net effect on GDP close to zero. Also, reduction the oil subsidy will reduce the over fiscal deficit and lower the inflation tax. The government might decide to channel that expenditure somewhere else like better schools or highways! But to account for such kind of changes you will have to simulate a micro-founded general equilibrium model and not a Tinbergen style simultaneous equations one (NIPFP working paper No. 2012-99) which does not allow for equilibrium responses from economic agents (the famous Lucas critique!). I think right assessment of what should be the appropriate policy in the case of oil price deregulation cannot be made till such analysis is undertaken. You still might have a case for not deregulating the price of oil but it would be based on a more robust analysis.
Recently, the Governor of the Reserve Bank of India (RBI), Dr. Subbarao emphasized the need to move to electronic payments system in India from its current primarily cash based one. It seems to be a reasonable proposition coming from a central banker especially such transition might mean a better control over an economy with a large informal sector. However, is it economically feasible to have such a transition in India right now? Dr. Subbaroa’s answer is yes and he cites other emerging economies like Brazil that use way less cash than a typical Indian does. But I believe that the nature of payment systems practiced only partly depends on deliberate policies and a whole lot on the economics involved. This is especially true for the retail transactions which was the focus of Subbarao’s statement.
Cash is preferred in many transactions in India as a significant number of people lack access to banking facilities. The RBI has time again pursued various initiatives to spread the banking access, but such efforts have not meant much in terms of transforming retail payments. The way commerce is organized in India (a large number of small sellers- large scale retailing is a new and urban phenomenon) make electronic payment systems prohibitively expensive. Further, use of electronic platforms like Visa or Mastercard for payments subjects the economy to economics of two sided markets. There are many issues involved, and most resolutions suggest a preferred cash used in equilibrium for a country like India (For a review of economics of two sided markets see Rysman 2009. For a non-technical discussion of payment systems in India see Waknis (2010)).
A large informal as well as black economy adds to the necessity of cash use in transactions. Lastly but not the least, the level of economic growth itself is a good determinant of the payment system used. While one could argue that Brazil uses less cash than India and hence the later should follow suit, these countries are not exactly in the same league. To further shed light on such cross country comparisons, one probably needs a careful analysis controlling for country specific characteristics to understand the factors that determine the use of electronic payment systems. In addition, questions like do the existing payments systems evolve to address the frictions in payment system and how do they affect economic efficiency also need to be given thought (See Kahn and Rehbords 2009 for a survey of empirical and theoretical literature on payment economics.).
Cash allows anonymity in transactions and in itself can be looked upon as a solution to anonymity of buyers and sellers. This implies that there will be always some transactions that will use cash. The money search literature pioneered by Lagos and Wright (2005) makes this point very well where money as a store of value gets valued in the centralized Walrasian market because the participants are anonymous. This literature is rich and has handled many issues related to payment systems. For an introduction see Williamson and Wright (2010).
So what could Dr. Subbarao do to make it economically attractive for market participants to use electronic payment systems instead of a cash one? Now that is a question worthwhile some thought!
What would Keynes say about the way his ideas are being used and abused to figure out what should policy makers do in the wake of recent financial crisis? I would like to believe he would not repeat his general theory. But leaving the speculation on this question for some other time, I would like to focus on Krugman and Layard’s manifesto for economic sense in today’s Financial Times. Interestingly, while arguing for differences in the European and US financial crisis, Krugman and Layard seem to have a single policy response as a panacea. This according to me actually seems to be a first step towards economic nonsense.
My reasoning is as follows: Among many other things related to how the ECB should function and whether Greece should stay or go, the European crisis is indeed a crisis of excessive public borrowing in countries like Greece, Ireland, Portugal, Italy and Spain. Contrary to this, K and L suggest that excessive public borrowing is a problem only in the case of Greece. To refresh on the EU situation, both of them might do good by reading or watching the work by Fernando Martin and Chris Waller of the St. Louis Fed. Fortunately, K and L get at least part of the US crisis right. They say it was caused by “excessive private borrowing” but leave out the counterpart that this appetite was whetted by the financial system’s need for collateral to settle debts between themselves. While K and L somewhat agree with these differences, their blanket prescription for government spending in both the cases makes little sense. Looking at the level of public debt that the above mentioned countries have, austerity does seem like the only way to go! On the other hand, considering the ‘paucity of good collateral argument’, at least in the long run US government should borrow and spend more.
Now as K and L suggest, is there no evidence for deleterious effects of government deficits and the resulting borrowing on interest rates? The rising yield curves on government debt for countries in EU, (See this interesting chart on Andolfatto’s blog), seem to suggest otherwise. It is probably only US that can still borrow at a lower interest rate without risking an immediate rise in the future interest rate. This is primarily because the US dollar still remains a strong international currency and the ability of the US government to honor its debt is not yet in doubt. So as much one could argue for government spending in the US, especially on retraining programs or on Universities where the unemployed tend to flock, not all countries have the capacity to roll over their debt indefinitely and sustain such expenditure.
So what should be the manifesto for economic sense? Thinking carefully about the nature of the two crises and suggesting policy prescriptions based on such analysis or lumping both these crises together and somehow arguing that government spending is a panacea in both the cases? I pick the former while practical men seem to gobbling down the later keeping with the Keynesian adage of falling for a defunct economist!
The business cycle properties of data in the US says that consumption is much less volatile than the GDP. This suggests that households do engage into consumption smoothing and hence looking at consumption distribution is not a good gauge for what is happening to income distribution. A similar argument can also be made for India and hence the debate on effects of liberalization policies would do better if based on income distribution than just on consumption distribution. C.P. Chandrashekhar and Jayati Ghosh make this point quite well in their recent column in The Hindu Business Line.
According to their analysis the share of wages and salaries in the national income of India has shown a decline since 1991. This decline is evident both as a share of total NDP as well as of Organized sector NDP. It was roughly around 70% for a decade preceding the economic reforms and has declined since to 50% in the year 2009. This might seem surprising given that in the US (and probably most of the developed world ) the share of compensation of employees in national income has remained between 60-70% for last 50 years or so.
The authors suggest this as an evidence for rising income inequality after the economic reforms and I don’t necessarily disagree with that interpretation.This issue is certainly important to look into and might suggests a role for policy intervention.
However, the contrast with the US suggests that there might be some other factors at play causing the shares to settle at different values in both these countries. One reason for this contrast is that the factor shares could reflect the relative factor scarcity. Capital being relatively scarce in developing countries compared to the developed ones, higher overall returns for it might be expected. The other reason might be the declining importance and presence of unions in the Indian organized sector after reforms than before. If one admits that most of the growth of the organized sector has been because of the rising service sector, then this does makes sense. In addition, the continuing rigidity of labor laws might also mean a lower opportunity cost for ones time further reducing the bargaining power of the workers.
Overall, these empirical regularities and differences in factor shares across countries are definitely worth investigating more.
Update- January 24, 2014: The recent issue of QJE has a paper on this issue. Looks like declining labor share is not just an Indian phenomenon. The authors surmise that the relative decline in price of investment goods explains this trend. You can read it here.
Saint-Paul Gilles of Toulouse School in Paris is one of those economists whom, you cannot afford not to read. If he writes it, you read it period. He has come up with a very interesting paper on the political economy of macroeconomic thinking- again a must read! you can find it here.
A few months back, I came across an interesting presentation by him titled “Endogenous Indoctrination“. He uses interesting techniques to see how indoctrination can evolve in a society and influence voter attitudes where teachers have a certain attitude towards the market system.
Stressing the need to acknowledge the proprietary rights over traditional knowledge and practices:
The controversy over the granting of patenting rights to three new strains of Basmati rice by the U.S. Patent and Trademark Office is used as a case study to analyze the impact of incomplete protection of intellectual property. Results suggest that the introduction of a competing product that may infringe on India’s geographical indicator has lowered the product differentiation of Indian Basmati rice in key export markets.
Mulik, Kranti and Crespi, John M. (2011) “Geographical Indications and The Trade Related Intellectual Property Rights Agreement (TRIPS): A Case Study of Basmati Rice Exports,” Journal of Agricultural & Food Industrial Organization: Vol. 9: Iss. 1, Article 4.
Available at: http://www.bepress.com/jafio/vol9/iss1/art4
I was quite excited about this workshop. It had all the right speakers and almost everyone was eager to listen to what they have to say about the crisis. The workshop was didvided into two parts. In the first part, Timothy Lane from Bank of Canada, Robert Hall from Stanford and the Hoover institution and Narayana Kocherlakota from the Fed Minneapolis presented their thoughts on the crisis.
Timothy Lane’s talk was a good survey of lessons learnt so far from the crisis with a bit of central banker’s perspective. Robert Hall’s speech promised a lot. It was kind of a precursor to what he was suppose to talk the next at the SED plenary session (the plenary talk did not turn out be that interesting though!). One of the important points that he made based on the data was that the zero lower bound on the interest rate may not mean much if the rates faced by consumers are positive and sticky. The second arguement was that because consumption expenditure has been pretty resilient and productivity infact surged during the crisis the real business cycle explainations of the crisis are completely useless.
Narayana’s speech turned out to be the attraction of the evening. Based on the idea that finanical investments by banks pose a negative externality and hence need to be internalized by taxing risk taking, in his speech he carefully laid out the arguement and some thoughts on how to approach its implentation. When Kocherlakota was appointed as the Fed Chief, lot of people had doubts about his effectiveness as a policy maker. But he has time and again proved that clear and disciplined thinking can save the day anywhere. I am sure in the coming days this first rate theoretician will have many interesting things to say and I will be all ears!
The second half of the workshop was a round-table discussion by two Nobel prize winners- Bob Lucas and Ed Prescott and John Murray from Bank of Canada. It contained much of off hand talk by Bob Lucas and a no nonsense presentation by Ed Prescott. In spite of the argument by Bob Hall above, Prescott continued with his RBC story of the crisis. He argued that Hall is wrong because data can be revised any time and mostly contrary to what Hall is saying. Hall argued that Prescott is wrong because his RBC story requires completely unrealistic estimates of Frisch elasticity. The most notable feature of the evening, however, was that in spite of the clash of titans, all the questions after the presentations and the round table were for Kocherlakota and his idea of risk tax. He kind of completely stole the show.