September 1, 2010


A look at pertinent research and opinions about economics

Recession and green consciousness
MATTHEW KAHN and MATTHEW KOTCHEN have found (“Environmental concern and the business cycle: the chilling effect of recession”, NBER Working Paper 16241) that as recession deepens and unemployment rises; people become less worried over global warming and environment concerns. The worries instead shift to unemployment and job issues.

The authors say that effective environmental policy in general and climate-change policy in particular is more likely to succeed during economic booms. One of the main lessons of this crisis is that government should adopt countercyclical policies that create surpluses in boom times which could then be spent in recessions like this one. But this paper shows it is also important that tougher issues like environment are tackled in good times.

Cause, effect and lag
MICHAEL DEBABRATA PATRA and MUNEESH KAPUR have a new paper to help understand monetary policy in India (“A Monetary Policy Model Without Money for India”, IMF Working Paper No. WP/10/83, August 2010). Whenever RBI changes interest rates, the question that is asked is how much time will it take to impact the economy? The paper says monetary policy actions impact economy with a lag of at least three quarters, with inflation taking seven quarters to respond. RBI started increasing rates from March 2010 onwards.

Hence, we should be seeing some impact on economy/demand from June 2010 onwards and on inflation from October 2010 onwards. The recent data releases do point to some moderation but it is difficult to say it is because of monetary transmission alone. For instance both IIP growth for June 2010 and WPI inflation for July 2010 have been lower than market expectations. Banks have also started to raise their interest rates. So, we do see some impact taking place but we can’t say it is because of monetary transmission alone.

The paper also says inflation is inertial and persistent when it sets in, irrespective of the source. Exchange rate pass-through to domestic inflation is low. Inflation turns out to be the dominant focus of monetary policy, accompanied by a strong commitment to the stabilization of output. Recent policy actions have raised the effective policy rate, but the estimated neutral policy rate suggests some further tightening to normalize the policy stance.

Fiscal responsibility (and lack thereof)
WILLEM H BUITER and URJIT R PATEL analyse the outcomes of the FRBM Act over the 5-year period of its operation 2004-05 to 2008-09 (“Fiscal Rules in India: Are They Effective”, NBER Working Paper 15934). The paper says that the central government has missed both the fiscal and revenue deficit targets by some margin. Its fiscal deficit for the terminal year, 2008-09 was 6% of GDP way above the targeted 3% of GDP.

And if we include the off-budgeted items the deficit is around 8% of GDP. Seeing the numbers, authors say that “not only has there been no fiscal correction once off-budget items are included, but indicators mostly deteriorated.” The targets were missed even before the onset of the Global Recession in 2008. The adverse evolution in the center’s fiscal balances was not on account of the operation of automatic stabilizers during a cyclical slowdown. On the contrary, the Indian government’s revenues have been buoyant. The gross tax-GDP ratio increased from 9.7% in 2004-05 to 12.6% in 2007-08 on the back of an almost 9% average annual growth rate. The recent profligacy of the central government has its primary driver in populist spending policies by the ruling coalition leading up to national elections in May 2009. Three stimulus packages, including a reduction in indirect taxes, starting in late 2008 to counter global recessionary headwinds only helped matters along in the same direction.

The authors also review fiscal responsibility legislation at the state level. The research shows that in recent years the states have improved their finances but this space has been usurped by the central government. So, overall deficit levels have only worsened. The authors outline a basic incentive compatible framework for state and central governments to hold each other accountable over agreed pre-determined targets.

Gold and paper
One major lesson from this crisis has been the importance of economic history. One keeps getting excellent papers which gives one lessons from history. It also shows how economic situations do not change much, players might change.

In one such paper, BARRY EICHENGREEN and PETER TEMIN (“Fetters of Gold and Paper”, NBER Working Paper 16202) compare the Euro with the Gold standard. The authors show why the gold standard and the euro are extreme forms of fixed exchange rates, and how these policies had their most potent effects in the worst peaceful economic periods in modern times. As in the Great Depression, this second round of problems stems from the prevalence of fixed exchange rates. Fixed exchange rates facilitate business and communication in good times but intensify problems when times are bad.

In previous research papers as well, the authors have argued how adherence to gold standard turned the crisis into a severe global depression. As central banks mantra was to defend gold standard then they could not inflate the economy by lowering interest rates. And then same is the case with Euro. The paper also touches on the problems of international monetary system. Even then Keynes had visualized the problem as surplus countries continued to make merry and only deficit countries suffered. In gold standard time US was the surplus country and now it is China. Deficit countries like Germany suffered then just like we have the United States and Britain suffering now. In a global system, the surplus countries also need to understand the issues as then only problems will get corrected.

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