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August 1, 2010

Pareto

1. State of Macroeconomic Models in India
The Planning Commission has put up an amazing report explaining the various macro models used for eleventh plan.

In the first chapter Dr. Kirit Parikh provides an excellent summary of the models used for the Eleventh plan and their findings. Plus there is an appendix which details the various macroeconomic models used in all the eleven plans so far. One keeps wondering about state of macroeconomic models in India and this is an excellent way to begin.

The opening chapter begins with the idea that how Indian economy has moved from a central planning model to a market driven one. This has led to changes in economic models as well.

The question that comes to mind is what is the role of planning in the changed economic environment? The answer is that India still has wide disparities in income, wealth, access to public goods, infrastructure shortages etc. So there is always a need for government action and plan to address these disparities and shortages. So there is a shift from setting industry targets to facilitating industry and general life by planning for providing public goods.

What was the strategy for the eleventh plan? There were fours factors:

  • Macroeconomic consistency: What growth rate is possible? What about Savings, investments, current account deficits, budget deficits etc?
  • Oil Price levels
  • Impact of global slowdown
  • Resources for inclusive growth: As 11th plan focuses on inclusive growth, various social programs would be needed. Hence models need to look at whether resources are available? What would be the impact on growth? Fiscal deficits?

Then he discusses the various models in general and then the models used for eleventh plan. There are 5 models by various agencies: Planning Commission, ISI Bangalore, IGIDR Mumbai, IEG Delhi and NCAER.

How these 5 models look at the above four factors? Most predict growth rate in the range of 8.4% to 9.4% for the eleventh plan period. Read the report for more details.

2. Break up of the Euroarea: Scenarios and Possibilities
As crisis in Europe built up, there were questions over possible scenarios for European Monetary Union. How will the countries manage the crisis given they have single currency and single monetary policy? What are the possible options? Should it break up?

In this context Barry Eichengreen (The Break up of Euroarea NBER working paper 13393), explores the possible scenarios of break up of Euro area. The paper was quite a foresight as it was written well before the crisis in 2007.

Eichengreen says it is unlikely that one or more members of the euro area will leave in the next ten years. And scenario of total disintegration of the euro area is more unlikely.

He points there are all kinds of issues- technical, political and economic – each very difficult to overcome. In technical he highlights the difficulties of reintroducing a national currency. There have been previous examples of monetary unions introducing their own currency like Germany in 1923-4 and Russia in 1990s. But changing over from an old money to a new one is more complicated today than in Germany in the 1920s or the former Soviet Union in the 1990s. Computer code must be rewritten. Automatic teller machines must be reprogrammed. Considerable advance planning will be required for the process to go smoothly (as was the case with the introduction of the physical euro in 2002).

In political reason, he says abandoning the euro will presumably entail lengthy political debate. And, all the while, there will be an incentive for agents anticipating the redenomination of their claims into the national currency, followed by depreciation of the financial-market collapse. Limiting the negative repercussions would be a major technical and policy challenge for a government contemplating abandonment of the euro. The political costs are likely to be particularly serious. The Treaty of European Union makes no provision for exit. Exit by one member would raise doubts about the future of the monetary union and likely precipitate a further shift out of Euro-denominated assets, which would not please the remaining members.

The economic obstacles revolve around the question of how debt servicing costs, interest rates spreads, and interest-rate-sensitive forms of economic activity would respond to a country’s departure from the euro area.

3. Labor Markets in Europe in this recession
One of the key factor differentiating US and Europe economies is the flexibility of labor markets. Labor markets in US are seen as more flexible than Europe with latter having a large public sector, unions etc. In a recession this flexibility works both ways. Some praise US economy as companies can fire labor easily and criticize Europe for not able to do so. However, there are some who praise some European economies like Germany which have better policies that does not let unemployment become a huge problem.

ECB July Bulletin has this interesting article on how European labor markets have fared in this crisis.

The recent financial crisis and the ensuing recession have taken a heavy toll on euro area labour markets. Employment losses have been considerable and heavily concentrated in a few sectors. Despite a large contraction in employment, euro area wages have been slow to react, reflecting institutional rigidities. Moreover, there has been considerable cross-country heterogeneity in labour market reactions to the downturn in activity. Various policy measures have been enacted, aimed at maintaining employment through the crisis. This article argues that a timely dismantling of many of these measures would help to accelerate the restructuring process. Without sectoral reallocation and greater wage flexibility, the euro area may take many years to generate sufficient employment growth to absorb those workers currently displaced.

It nicely summarises labor situation in each economy. Needless to say huge divergence. Germany there is hardly any rise but Spain huge rise. There is an interesting chart which plots GDP and employment on x and y axis. Ireland is an outlier on both the fronts. Finland output has declined sharply but not much in employment. Malta is not effected on both the fronts. So as said huge diversity.

4. Comparing fiscal federalism between US and Europe
Bruegel Research Fellow Zsolt Darvas writes this superb paper looking at differences and similarities between US and Europe federal fiscal system.

He points states in US are in as bad a fiscal mess like Europe but have been ignored so far. The CDS spreads of US states had risen higher than Euroarea countries in the earlier phase of the crisis. But nothing happened and barring California, none of the states have been seen as a problem. And in Euroarea hardly any country has been spared.

Why is this? He looks at following questions:  Why has the euro area been hit so hard?

How would a more federal European fiscal union closer to the US model have helped?

How do the euro area’s fiscal architecture reform plans stand up in the light of the US example?

The Broad findings are:

  • A higher level of fiscal federalism would strengthen the euro area, not least because it could help to constrain member state-level fiscal policy, allow the resolution of banking issues, and would give less opportunity for conflicting responses. But a higher level of fiscal federalism is not inevitable.
  • Current fiscal reform proposals (strengthening of current rules, more policy coordination and an emergency financing mechanism) will if implemented result in some improvements. But implementation might be deficient or lack credibility, and could lead to disputes and carry a significant political risk.
  • Introduction of a Eurobond covering up to 60 percent of member states’ GDP would bring about much greater levels of fiscal discipline than any other proposal, would create an attractive Eurobond market, and would deliver a strong message about the irreversible nature of European integration.

It has a very interesting comparison of how taxes are collected and distributed in US vs. Europe. US federal government collects two-thirds, the states one-fifth, and local government the rest. As state budgets receive some direct funding from the federal government, the state and local government share of total spending is somewhat higher than 40 percent.States have a high level of autonomy, there is a great deal of variation in tax rates and structures, and tax competition between states is high.

In EU sovereign countries provide the bulk of the EU budget in the form of contributions largely related to their gross national income and value added tax revenues. EU countries have full autonomy in setting their budgets and tax competition is pervasive, much like US states.

There is indeed a huge difference between the EU and the US. In the US, federal taxes collected from states range from 12 to 20 percent of state GDP, and federal monies received by states range from nine to 31 percent of state GDP (not considering the District of Columbia). In the EU, most member states contribute to the common budget by amounts equivalent to about 0.8-0.9 percent of their GDP, and receive EU funds in the range of 0.5-3.5 percent of their GDP. As a consequence, fiscal redistribution is much higher in the US than in the EU.

Contribution of Financial Sector to Economy: Miracle or Mirage?

Andrew Haldane of Bank of England gives an intriguing speech on the topic. In this speech/paper, Haldane breaks the miracle of financial sector and calls it a mirage instead.

He says though we have seen the worst crisis since Great Depression, financial firms continue to show great results. Direct contribution of the UK financial sector rose to 9% of GDP in the last quarter of 2008. Financial corporations’ gross operating surplus  increased by £5.0bn to £20bn, also the largest quarterly increase on record. At a time when people believed banks were contributing the least to the economy since the 1930s, the National Accounts indicated the financial sector was contributing the most since the mid-1980s. How do we address this puzzle?

He points to a couple of key points:

  • We need to present all financial sector contributions after adjusting it with risk. As high risks lead to higher returns, without adjusting risks we will see only blown-up results.
  • As measuring risk has always been tricky, we need to work on it.
  • Most growth etc in finance has anyways come from increasing leverage, taking advantage of loose regulation and trading tail risks. The moment we adjust all this with a proper measure of risk, miracle becomes a mirage

5. Fiscal austerity lessons from South East Asian Crisis: Don’t do it
There is an ongoing heated debate amidst economists and policymakers over whether countries should be pressing ahead with fiscal austerity?

Adam Posen of Bank of England in an article points to lessons learnt from South East Asian crisis in 1997-98. He says fiscal austerity measures back-fired then. Indonesia and Thailand were made to pass these plans which in turn hurt the much sounder and advanced Korean economy as well. The direct effects of contraction in its neighboring trading partners hurt Korea. Korea also suffered competitively from depreciations and wage falls in its region.  Worst of all, financial panic prompted in part by worries about the exposures and funding of Korean banks fed a downwards spiral.

IMF stepped in and implemented sharp fiscal tightening as in the case of Thailand and Indonesia. The austerity had significant contractionary effects, because lack of confidence in Korean solvency beyond the panic was unjustified.  No benefit accrued from these measures – interest rates dropped when the panic ended, but not through a consolidation channel.  The contraction in South Korea was longer and deeper than it had to be as a result. The impact was not limited to South East Asia and was partly responsible to put pressures on Russian default.

The lessons from the crisis had wider and long-term implications  SE Asian nations built forex reserves to face such crises in future. This led to a set of policies responsible for global imbalances which are partly responsible for this crisis!

Posen points the same mistakes are being repeated now in Euro-area economies. South Korea in the end was able to recover through a significant currency devaluation and expansion of trade.  That is not available to Euroarea economies, especially if the major trading partners within the Euro Area contract their own demand and compress their own wages.

6. Behavioral economics version on why prices are sticky
Dan Ariely, Anat Bracha, and Jean-Paul L’Huillier have written a short paper showing how people make pricing decisions.

In many situations,  people look at others while making a decision. So, while buying a car we often see whether our friends and relatives have purchased the same and ask them about their experiences. On considering a job offer, we see others who recently accepted/rejected job offer at the same company.

In this paper the authors examine if relying on the behavior of others can also occur in the case of pricing decisions for goods that are private value goods. In goods whose prices are not known, we can understand people relying on others. But what about private goods whose values are well-known? The authors provide experimental evidence showing that bids in private-value auctions indeed depend on the bids made by others—a relationship we expect to find in common-value but not in private-value auctions.

The paper has interesting implications. First, it explains why firms hire celebrities/public opinion shapers for their advertisements. As people see they are endorsing the product, it is worth a buy.

Second, economists often say prices are sticky and do not change much. This is explained
by using many research techniques and survey data on prices and consumer behavior. Now, this study shows people cannot assign their own subjective valuation into monetary units and instead rely on the prices others are willing to pay. In such a case prices will be sticky.

This is behavioral economics version of explaining why prices are sticky and why we have celebrities endorsing products.


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