Evidence of sticky wages

Econ 101 teaches us that prices adjust to clear supply and demand. Accordingly, in the aftermath of an economic boom when wages have risen, as recessions strike and unemployment rates climb, businesses lower wages which in turn lowers production costs and boosts investment and further hiring. In other words, high unemployment rates do not persist since wages fall proportionately to clear any labour market over-supply.

This has been used as a justification to oppose any government intervention to clear markets suffering from recessions. If the markets clear by themselves, it is argued, then where is the need for any discretionary fiscal policy intervention by governments. Though markets may deviate from the equilibrium, it is only a matter of time before the aforementioned dynamics takes over and restores stability.

However, as we have seen with the Great Recession and persistent high unemployment rate in the US, labour markets are not so accommodative. It is obvious that labour market does not clear so easily. In fact, the New Keynesian schools have long talked about "frictions" and "stickiness" with wages and prices which come in the way of markets regaining their earlier equilibrium. Economists like George Akerlof have pointed to downward wage rigidities, especially in conditions of low inflation.

In this context, an excellent study by researchers from the San Francisco Fed highlights the magnitude of this problem. They used individual-level survey data from 1980-2011 from the Current Population Survey (CPS), the monthly survey conducted by the Bureau of Labor Statistics used to measure the unemployment rate, to demonstrate the salience of downward nominal wage rigidity. They write,

Despite a severe recession and modest recovery, real wage growth has stayed relatively solid. A key reason seems to be downward nominal wage rigidities, that is, the tendency of employers to avoid cutting the dollar value of wages. This phenomenon means that, in nominal terms, wages tend not to adjust downward when economic conditions are poor. With inflation relatively low in recent years, these rigidities have limited reductions in the real wages of a large fraction of U.S. workers. 

In the current American context, since inflation is low and therefore keeping wages constant cannot reduce real wages, the only way for employers to lower wages is to actually cut nominal wages. The graphic below is an excellent illustration. The dashed black line shows a symmetric normal distribution, while the blue bars plot the actual distribution of nominal wages in 2011. The blue bar that spikes at zero shows that a large number of workers report no change in wages over a year. The prominence of this psike shows that disproportionately large numbers of employers simply kept wages fixed over the year. This proposition is also supported by the fact that the gap in the normal distribution and the actual wage distribution is much higher on the left side. This gap suggests that the spike at zero is made up mostly of workers whose wages otherwise would have been cut.

Similarly, the researchers also compare the trends in such wage rigidity over the past 30 years. They compared the proportion of workers in the same job who report no year-over-year wage change and find that their share rises in recessions and persist well into the recovery. Further, this proportion has risen sharply in the Great Recession for all categories of workers. They find that from 2007 to the end of 2011, the fraction of workers experiencing no yearly wage change rose to 16% from 11.2%. This is five percentage points higher than the average size of the spike at zero from 1983 to 2007.

The same trend is observed among all categories of workers.

See also Paul Krugman (also here) and Mark Thoma. 

Regulations in the services sector

Econ 101 teaches us that restrictive regulations distort the market and creates conditions for rent-seeking. Such regulations act as entry barriers that stifle competition and confers undue benefits on the existing producers or suppliers or owners at the cost of their prospective competitors and other consumers.

Accordingly, labour market qualification norms in service sector or product standards in manufacturing and agriculture can act to screen out potential competitors. Zoning regulations place restrictions on new residential and commercial developments, thereby keeping real estate prices artificially high. Similarly, excessive and extended copyright protection are an effective legal monopoly, transferring money from consumers to the original developers. In all these cases, apart from keeping out competitors, the regulations help the incumbents earn a premium, an economic rent, at the cost of their consumers.

The FT chronicles restrictions on taxicab permits in Milwaukee, Wisconsin, that promotes rent seeking,

It would cost $150,000, over and above the price of the vehicle itself, to buy from its existing owner one of only 321 cab licences in issue by the city... Licences are so expensive because the limit on competition makes each of Milwaukee’s taxis unusually profitable: their extra earnings are an example of an “economic rent”. These are reflected in the literal rent of up to $1,000 a week that a driver must pay for a fuelled and licensed cab...

The Milwaukee cab licences are together worth $48m – and since 1991 more than half of them have migrated to companies owned by one family: the Sanfelippos. Even at their own more modest price estimate of $80,000 their permits are worth as much as $13m.

The NYT writes about Germany's "dual economy", especially in its service sector,

On one side, we have this very dynamic, innovative, competitive and refreshingly unsubsidized export sector. On the other side, there is a much less glamorous services sector which depends on barriers to entry, subsidies and not developing and reaching out for new activities... This economy is overregulated, intended to insulate insiders from competition and deeply resistant to change... German economy features some of the same flaws... including protected professions and zoning laws that favor existing businesses over new ones...

For example, two years after a promised deregulation of domestic transportation, intercity long-distance bus service is still effectively prohibited in Germany. The decades-old ban shielded the government-owned rail company, Deutsche Bahn... years of training are still required to qualify as a house painter, chimney sweep or bicycle mechanic, to name a few examples... restrictions on advertising and fees limit competition among architects, lawyers and engineers.

In contrast to these strongly regulated service sector markets, India appears like a Chicago economists' dream. Service sector is virtually unregulated, even in the organized economy, and most of these professions have virtually no entry barriers. Ever heard of standardization or courses to become a barber, painter, plumber, or electrician? The only facade of regulation is maybe a vocational skill diploma or a driving license. For sure, it has kept prices down and people move in and out of these occupations without any hinderances. However quality has suffered.

But the market for each of these services has been getting increasingly differentiated. Those equipped with some professional training or certification command a higher premium by signalling their expertise and the assurance of better quality of service delivery. Incidentally, in all these services, market differentiation has followed the emergence of organized service delivery. In other words, as these markets move away from freelance individual-run service delivery towards organized firm-based service delivery, standardization and certification becomes important screening and signalling mechanisms and entry barriers emerge.

The challenge is to find the right mix of standardization. On the one hand, the entry barriers should not be so prohibitive as to stifle competition and constrain job creation. On the other hand, there should be some appropriate level of screening that ensures quality is not significantly compromised. A two-tier market, like in India, in the organized and unorganized sectors respectively, for each of these services, may in someways be a satisfactory compromise.

Modern Macroeconomics Family Tree

Dylan Matthews (via MR) provides a short history of modern macroeconomics and this nice family tree of the subject.

Saving capitalism from capitalists

Karl Smith points to Don Boudreaux's post in Cafe Hayek where he argues that Paul Krugman undermines the apparently self-evident free-market principle (that markets increase human welfare) by reinforcing the misconceptions held by the "economically untutored instincts" of the "general public".

The underlying presumption is that the primary objective of economists is to "defend the case for free markets and free trade from the many vulgar misperceptions that prevent people from seeing the full play of market forces". In other words, public economists should defend free markets whose benefits are not very evident to the general public. Furthermore, deviants are purveyors of "vulgarnomics" – economics as popularly understood by the economically untutored.

For a moment let us ignore the sheer arrogance and anti-liberalism inherent in this premise and focus on the economics of the example of trade with China that Boudreaux has presented. He outlines the following "unseen" as inherent in free trade which the untutored general public should be enlightened about,

"The fact that many of these low-priced Chinese goods, used as inputs in America, allow some American producers to profitably expand their output; the fact that monies American consumers save because of lower-priced Chinese goods can be spent buying other goods and services, some of which are ‘made in America,’ that would otherwise be out of reach; the fact that that if Beijing truly is keeping the value of the renminbi too low the result will be inflation in China – which will eventually raise the prices Americans must pay for imports from China; and, most importantly, the fact that there’s very little difference from the perspective of Americans in China’s government subsidizing our consumption of Chinese-made goods and some natural source (say, a technological breakthrough) that lowers our cost of buying Chinese-made goods."

An analysis of each of these presumptions (Bourdeaux calls them "facts") reveals the following.

1. While the low-priced Chinese imports (used as inputs) by certain American producers will help expand their production, it will also come at the cost of local producers of such inputs and their employees. There is nothing "factual" about how the balance of costs and benefits will play out. The relative costs and benefits to each stakeholder is sector and market specific and can be assessed only through empirical analysis.

2. The causal relationship between the wealth effect (a net increase in their real disposable incomes) arising from purchasing cheaper Chinese goods and the savings being used to buy "made in America" goods (and presumably creating more jobs in the US) too is not as "factual" as is made out. While the wealth effect is undeniable, the same cannot be said about the latter. It is a subject of empirical assessment, with impacts varying across sectors and the environments.

3. The argument that Beijing cannot keep renminbi undervalued for too long since it would lead to inflation in China and eventual rise in export prices and erosion of Chinese export competitiveness is fallacious. While it may be literally correct to claim that Beijing cannot keep its currency undervalued for too long, it does not answer the question, "how much is too long"? There are too many imponderables to answer this with any degree of accuracy.

There is also fairly credible enough evidence to suggest that there is more to China's export boom than its undervalued currency. This would appear to question the apparently "factual" causal relationship between the value of renminbi and Chinese exports.

4. The last (and "most important") argument that Americans should not be bothered about the Chinese government subsidies keeping prices low for American consumers and equating its effect with that arising from a technological breakthrough is similarly misleading. Substantively, there are political economy effects, with profound impacts on market dynamics, associated with the former that stands out in stark contrast to the apolitical nature of the latter.

Ultimately, trade in a particular good is beneficial to a country only if

1. the labour market and local business dislocation due to more competitive imports is offset by the combined positive effect of the consumer and producer surpluses from cheaper imports and the successful transition of the capital and labour dislocated to other more competitive and value-generating sectors.
2. the balance is achieved within a reasonably short period of time.

Upholders of unbridled free markets assume that cumulated over all the sectors of the economy, this balance is a net positive and the transition happens quickly. As the aforementioned analysis of China-US trade reveals, the reality is far more complicated than simple causal relationships. And there is always the cautionary advice from Keynes, "In the long run we are all dead"!

Free-marketers fail to acknowledge that the emergent socio-economic outcome from any trade is determined by factors that go beyond the confines of standard macroeconomic models and are also determinant on several exogenous factors - initial social, political, and economic conditions; quality of governance; policies followed by competitors and partners etc. Further, a comprehensive assessment of the impact of these policies would require going beyond stage one and exploring the secondary effects of the multiple elements of a policy change like trade liberalization.

Most importantly, there are several social, political, and economic frictions that invariably come in the way of the natural flow of economic forces and prolong the transition period. Often, this transition settles at a less than desirable equilibrium, which generates a net negative balance.

Such illiberal intolerance becomes inevitable once we assume that an economy has to be shaped around defined principles and models which characterize a particular ideology. However, this assumption is flawed since, as we all know by now, it is impossible to straitjacket any social system into clearly defined principles and models. In the circumstances, prescriptions grounded rigidly on those principles fail the twin-test of efficiency and fairness.

Arguments that are driven by fixed assumptions and which refuse to acknowledge opposing views tend to stifle the free market in ideas. They pose the biggest danger to free-market capitalism. The objective of any economist or politician should not be to uphold any particular ideological system but to explore and adopt a system that ensures fair and efficient allocation of resources among its citizens.

My short point is not to refute the superiority of the market mechanism as the most welfare enhancing system known to man. But we should clearly and upfront acknowledge the numerous failings of the market system and respond with policies that can address these failures. This is necessary to increase the credibility and public acceptability of free-market capitalism. Unqualifed support for ideologically rigid policies will only increase the already growing alienation and distrust of free-market capitalism.

As Raghuram Rajan and Luigi Zingales famously wrote, "capitalism needs to be saved from capitalists".

Update 1 (15/1/2012)

"Capitalism’s real gravediggers, it turns out, are not Marx’s revolutionary proletariat but its own delusional cardinals, who have turned ideology into faith."

Arundhati Roy in FT

Price controls are back?

The Andhra Pradesh government has announced its decision to set up a price monitoring committee to control inflationary pressures.

Taking serious note of the rise in the prices of essential commodities, Mr. Kiran Kumar Reddy announced plans to form a price monitoring committee to tackle the situation. The new mechanism will not only deal with people involved in hoarding and black-marketing of produce with an iron hand, but also play a key role in fixing prices.

"Fixing prices"? Hmm!!

Confession of the week!

In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought.

Lawrence Summers

Summary of the conservative argument

(HT: Paul Krugman)

Examining the failure of economic thinking

Mark Thoma is spot on in this passionate assessment of what ails the modern economic system,

"It's distribution, not production that has failed us over the last 30 or 40 years. We produce far more than we ever have, and we will continue to increase our ability to squeeze more and more out of the resources we have. We have the ability to produce enough stuff. But the distribution of the things we produce has been tilted toward the top. Instead of wages rising with productivity as our textbooks say they should, wages have stagnated and the rewards have gone elsewhere. Thus, while the pessimism of the past was about production not being able to keep up with population - many classical economists looked forward to a long-run outcome of a dismal, stationary state with most people struggling at subsistence wages - the pessimism of the present is driven largely by a failure of distribution. The haves get more and more, and the have nots get less and less even though overall output is rising... Pessimism about breaking through the wealth and power structures that stand in the way of change is understandable, as is the desire of the winners in our increasingly two-tiered society to keep the focus on growth rather than distribution."

The remarkable achievements of the past few decades - rapid advances in information and communication technology, spectacular economic growth in emerging Asia etc - is confirmation of the fact that markets have allocated scarce resources very efficiently. But the growing evidence of failures and sufferings across the world is ample proof that market systems have failed to ensure fairness in allocation of these resources.

Fortunately, many of these market failures are the inevitable consequence of the process of efficient allocation of scarce resources and they can be atleast partially mitigated by appropriate public policy interventions and through formal and informal social and political institutions. Progressive taxation, social safety nets, subsidies and concessions, and institutionalized regulatory restraints are some of the commonplace policy options used to address such failures in distribution or achieve fairness in allocation. Political parties in democracies, social interest groups, trade unions etc have played significant role in creating an environment that promotes fairness in allocation.

Traditionally, governments have intervened, often very aggressively, with such policies to address failures in the fair distribution of resources. The vibrancy of social and political institutions have also played a major role in containing the excesses emerging from the dynamics of untrammelled free market. However, the disruptive socio-economic changes of the past couple of decades have unleashed forces which have considerably undermined the tenuous balance between efficiency and fairness.

As the concentration of economic power and resultant widening of economic inequality has accelerated spectacularly in recent years, many of these traditional checks and balances have either been dismantled wholesale or their strength considerably eroded. Across the world, thanks to the spectacular growth of financial market incomes, the past few years have seen the emergence of a class of uber-rich elite, whose economic power has found reflection in the traditional political institutions. In other words, economic power has spawned political power.

This has had two fold impact. It has loosened the restraints put by social and political institutions. More worryingly, these changes have seriously undermined the resolve of governments at all levels to step in to rectify market failures. A false consciousness has been sought to be created that the big winners are the beneficiaries of a competitive merit race, and the outcome is a reflection of the natural order of things. Such explanations brush under the carpet the ovarian lottery that increasingly defines a major chunk of life's outcomes.

The strong opposition, not only in the West but also in many emerging economies, to increasing taxes on even the richest, withdrawing concessions to corporate groups, stronger regulation of financial markets, and expanding the role of government, even if only to provide basic social safety cushions to those most affected by economic shocks, is a reflection of this changing dynamics of social and political power.

Unfortunately, as a profession, economics has failed to either anticipate or do anything meaningful to highlight the implications of this failure. It has been too concerned with studying "efficient allocation of scarce resources" that it appears to have forgotten that the sustainability of this allocation depends on it being fair.

I am inclined to believe that this skewedness in focus among economists is attributable to two factors - limitations of mathematical models and ideological bias. Modern macroeconomic research is heavily dictated by mathematical formalism. However, unlike issues of efficiency (which is essentially a maximization problem, subject to certain constraints), those of fairness in distribution is not easily amenable to mathematical modelling. Fairness involves the exercise of human judgement, in some form or other, to bring about a desired final state of the system.

Then there are the ideological biases of economists, most of whom work in free-market democracies. Unlike the ideal systems of modern economic theories, the real world is full of imperfections, where the ideal world assumptions do not hold. In the circumstances, fairness demands interventions that seek to re-distribute resources and thereby correct the business as usual state of affairs in the system. But such remedial interventions, more often than not, go contrary to the ideological principles that underpin the theoretical foundations of these economists.

Update 1 (2/10/2011)

Mark Thoma argues that there is a need to revisit the socio-economic and political power balance, but is not sure how it will happen. He writes,

"Congress has no interest in doing so, things are quite lucrative as they are. Unions used to have a voice, but they have been all but eliminated as a political force. The press could serve as the gatekeeper, but too many outlets are controlled by the very interests that the press needs to take on and this gives them the ability to cloud most any issue. Presidential leadership could make a difference, and Obama’s election brought hope for change, but this president does not seem inclined to take a strong stand on behalf of the working class...

Another option is that the working class itself will say enough is enough and demand change. There was a time when I would have scoffed at the idea of a mass revolt against entrenched political interests and the incivility that comes with it. We aren’t there yet – there’s still time for change – but the signs of unrest are growing and if we continue along a two-tiered path that ignores the needs of such a large proportion of society, it can no longer be ruled out."

The Great Macroeconomic Policy Debate - How to restore growth?

The biggest macroeconomic challenge now is to manage a recovery from the stubbornly persistent economic slowdown. But a fierce ideological battle is on about what strategy is required to achieve economic recovery.

Everyone agrees that across both US and large parts of Europe, household, bank, and government balance sheets are suffering from huge debt over-hang. As households cut back on consumption and banks refuse to lend, businesses are postponing investments. The high unemployment rates show no signs of coming down and the economies remain stuck at the trough, far longer than the aftermath of previous recessions. Governments, the only other agency capable of engineering a turn-around, are faced with huge sovereign debts and battered fiscal positions. With interest rates at zero bound and even extraordinary quantitative easing measures already having been tried out, monetary policy appears to have limited traction. So what is the way out?

Conservatives are unambiguous in their advocacy of fiscal austerity and placing deficit reduction at the center of the macroeconomic agenda. They fear about the dangers of inflation taking hold and bond-market yields rising. They claim that the fiscal and monetary expansion of the last decade or so has produced several excesses that need to be wrung out before any meaningful economic recovery can begin. To this extent they advocate immediate re-balancing of public finances with policies to cut government expenditures, raise revenues (albeit without raising taxes), and carry out structural reforms.

They admit that while this will generate some short-term pain, it will be for the long-term good. They argue that this will generate "contractionary expansion", restoring market (business, investor, and consumer) confidence and shaping expectations and thereby encouraging business investments. See Robert Barro (academician), Stephen King (Business), and Wolfgang Schauble (politicians) advocating austerity and fiscal consolidation over expansion.

Liberals differ and propose further fiscal and monetary expansion as the only way out of this mess. The argue that the high persistent unemployment rates should be the central focus of policy makers. They point to historical evidence from US in 1930s and recently from Japan, to argue that unless governments undertake aggressive Keynesian stimulus spending and unconventional monetary expansion, the economy risks being stuck at the bottom for a long time.

They also point to the evident inability and reluctance of businesses to invest in such uncertain and weak environments, especially that of the job-creating but credit constrained small businesses. They see government spending as the only source of generating additional aggregate demand. They also argue that the ultra-low interest rates provide an excellent opportunity for governments to invest in infrastructure and other long-term spending so that the platform for longer-term growth is laid at the cheapest cost. They see little evidence of government spending crowding out private borrowing, inflation emerging as a concern anytime soon, or bond-markets catching cold. See Martin Wolf (Journalist), Mark Zandi (Business), Adam Posen (policy maker) and Dani Rodrik (academician) advocating expansionary policies.

There are also some others who have refrained from taking an explicit position, preferring to suggest specific measures. Some like Ken Rogoff have rightly argued in favor of policies that directly address the issue of cleaning up household and bank balance sheets. To this extent they advocate inflating away debts with a slightly higher inflation target, something which Olivier Blanchard, the IMF Chief Economist too had advocated earlier. However, the efficacy of higher inflation targeting has been questioned on credible enough grounds by Raghuram Rajan.

Interestingly, both sides invoke the magisterial historical examination of sovereign debt crisis, induced by various factors including banking collapses, by Carmen Reinhart and Kenneth Rogoff. Conservatives point to their finding that high-levels of growth dampen growth. Liberals point to their findings about the deep nature of recessions that follow banking collapses and argue that government support therefore is essential for expediting recovery.

All these views carry considerable ideological baggage and are evidently constrained by the need to accommodate their respective ideological predilections. Warts and all, the main issue is about which mixture of policies would be most effective in enabling a sustained recovery. An objective assessment reveals inconsistencies or practical difficulties with both sides.

The problem with the conservatives' position is that if all the actors - governments, businesses, financial institutions, and households - are badly constrained, then where would the thrust for recovery come from? Their argument is that debt restructuring and the dynamics that get generated could restore market confidence and thereby pull the economy up the recovery path. But, given the depth of the problems, will it carry the momentum required to pull the economy out? Even traditionally conservative institutions like the IMF have raised serious doubts about fiscal austerity arguing that it could hurt incomes and job prospects. Further, the experience in the current recession with such policies is hardly encouraging.

As several estimates of growth required to bring unemployment in the US to normal levels and also bridge the yawning output gap show, the scale - magnitude and time - of growth required to restore normalcy in the medium term is substantial. In the absence of a strong engine or anchor, what will be the source of this growth? The justifiable fear then is that the recovery process could go on for years.

The fundamental premise of the liberals' argument is that it is necessary to do everything possible to pull the economy out of recession. They fear, based on historical precedent, that in the absence of aggressive expansion, the unemployment problem will assume structural nature and become a socio-economic problem, and a lost decade will be inevitable. I am inclined to believe that this fear too has strong justifications. However, some of the liberals policy measures are not fully supported by fact and appear to based more on hope than objective considerations.

Their hope is that aggressive fiscal and monetary actions will buy enough time for the markets to repair battered balance sheets of all parties and set the stage for a sustainable recovery. But what if it does not? The trillions of dollars so far spent on fiscal and monetary stimulus in the US had not had the expected impact (there could be a counterfactual problem here). What is the certainty that more rounds of stimulus will work? More critically, it is possible that the amount of stimulus required to make any meaningful dent is so large as to make it fiscally and politically impossible. In the circumstances, expansionary policies would be merely throwing money down the drain.

So, if the fears of inaction appear well-justified, and the possible policy alternatives are fraught with deep uncertainty, then are the developed economies set to suffer a long and tortuous period of restructuring, high unemployment and low growth? Is this the inevitable cost of the excesses that got built-up over the past decade or so? Is it desirable to have a medium-term period of de-leveraging that is necessary to wring out the excesses and distortions, rebalance balance sheets, and achieve normalcy? In the meantime, is it appropriate if public policy refrains from anything proactive (either expansionary stimulus or austerity) and confines itself to the provision of a basic minimum social safety to those worst affected by the economic weakness?

Unfortunately this approach too appears untenable. It presupposes a longer period of high unemployment rates and economic weakness. However, there are widespread concerns about its long-term impact on the labour force itself. Longer the people stay unemployed, greater the difficulty to rejoin the workforce. Skills will atrophy and productivity will decline. The socio-economic impact of this will be pernicious. The long-term impact on America's labour force and the economy in general will be damaging. See also this excellent study by Alan Krueger and Andreas Mueller.

Then there is also the danger of Japan. That country ahs been stuck in the trough for nearly two decades now and no end appears in sight. Though there are considerable dis-similarities, there are exists striking similarities - similar asset crashes, huge public debts, aging work-force, and possibly a nominal zero-interest liquidity trap. The magnitude of the downside associated with these risks are so huge that not doing anything proactive appears unwise.

In view of all the aforementioned, and given the extremity risks, inactivity may not be desirable. But there is no clarity on which strategy is most effective in stimulating a recovery. In the circumstances, the only alternative may be to throw everything at the problem and hope that some mixture of policies does enough to put the economy in the recovery path.

More on the Dark Age - overcoming the obsession with mathematical models?

John Kay argues that the fundamental challenge for economics profession today is to abandon its exclusive focus on deductive model-based approach with its focus on rigour and consistency (and expressed exclusively with the tools of mathematics) and embrace elements of real-world observations based inductivism which also draws heavily from cross-disciplinary research (which are not exactly amenable to being reduced to mathematical models). He writes,

"Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds... deductive reasoning is the mark of science: induction – in which the argument is derived from the subject matter – is the characteristic method of history or literary criticism.



But this is an artificial, exaggerated distinction. Scientific progress – not just in applied subjects such as engineering and medicine but also in more theoretical subjects including physics – is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works. Not within the economics profession.



There, deductive reasoning based on logical inference from a specific set of a priori deductions is 'exactly the right way to do things'. What is absurd is not the use of the deductive method but the claim to exclusivity made for it. This debate is not simply about mathematics versus poetry. Deductive reasoning necessarily draws on mathematics and formal logic: inductive reasoning, based on experience and above all careful observation, will often make use of statistics and mathematics.



Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.



The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it."

The central challenge as the mainstream in the profession see it is to develop a model (preferably one that can be simulated on a computer) of the economy which is not only able to explain why events happen as they do but also make reasonably accurate predictions of them. Kay explores the various possible interpretations that have sought to correct the obvious flaws in the standard DSGE models, consequent to the soul-searching that followed the sub-prime crisis and its aftermath.



In response to the crititicism of the Lucasian DSGE model, its Chicago supporters have sought to make it even more complex in order for it to be more realistic! They have introduced more parameters to represent the complex problems that abound in the real world, which takes into account market frictions and transaction costs. Another response has come from those like Joe Stiglitz who while retaining many of Lucas assumptions have introduced greater importance to information imperfections (for example, Ricardian equivalence's assumptions of households having information about future budgetary problems is now questioned).



Some others, from the complexity economics school, have put forward agent-based modelling solutions, based on specific behavioural and other heuristics generally observed in the real-world. All these solutions satisfy the "requirement" of being mathematical and computer simulatable. However, questions about their real-world effectiveness remain.



Without offering any specific model, John Kay argues in favor of a less mathematics based approach. He writes,

"Another line of attack would discard altogether the idea that the economic world can be described by any universal model in which all key relationships are predetermined. Economic behaviour is influenced by technologies and cultures, which evolve in ways that are certainly not random but that cannot be fully, or perhaps at all, described by the kinds of variables and equations with which economists are familiar. The future is radically uncertain and models, when employed, must be context specific."

The crux of the debate is that all conventional approaches to explaining and forecasting macroeconomic phenomena assume that it has to be contained in a logically consistent and theoretically sound model. It assumes that it is possible to collapse all the different (and there are a maddening array of them) scenarios into this one comprehensive model.



Therefore, the supporters of the Lucasian school try to formulate a single model that can satisfactorily explain all the different types of economic recessions. Accordingly, it seeks to use the same model, with its standard set of assumptions, to explain aggregate demand slumps caused by as widely varying factors as the routine ones (say, monetary policy induced) to those spawned by banking crisis and resultant balance sheet damages.



The result is a failure to satisfactorily explain the present balance sheet recession, especially in conditions of persistent high unemployment rates and zero nominal interest rates. In response, the freshwater economists have either adopted a postion of ostrich like denial or have tried to tinker with the existing models, introducing newer parameters and assumptions to explain market frictions, and in the process drawing them further away from reality.



What if there is no such magic model that can be formulated? Is it possible to forecast macroeconomic outcomes with any great degree of accuracy, beyond estimating the broad trends? What if the degree of relevance of each assumption varies widely across different contexts, to be so irrelevant at certain times as they are relevant at other times, and in which case the model itself should assume a completely different character? More importantly, is there really a need to have a universal, one-size-fits-all model?

The counterfactual problem in public policy

Heads I win, tails you lose! This aphorism could well describe the debate on many intractable public policy issues, those where conclusive answers are difficult to come by. Supporters claim that it would have been worse without the intervention. Critics denounce the intervention as a failure since the problem persists. The challenge with all such issues is the difficulty of establishing the counterfactual. Let me illustrate this dilemma with three examples.

The most famous counterfactual problem of our times is the debate on the impact of expansionary policies implemented in the US in the aftermath of the Great Recession. Conservatives point to the persistent high unemployment rates and weak economic conditions, despite the extraordinary fiscal (more than $ 1 trillion) and monetary expansion (zero bound rates and $2.3 trillion QE), as conclusive proof of the failure of expansionary policies.

They reinforce their argument by pointing to the failure of the now infamous recovery projection, estimating future unemployment rates with and without a stimulus plan, made in January 2009 by Christina Romer and Jared Bernstein, then part of President Barack Obama's team. Their way-off-the-mark estimates suggested that unemployment would approach 9% without a stimulus, but would never exceed 8% with the plan.



In May 2011, using the latest figures available from the BLS, the unemployment rate reached 9.1%. In contrast to the Romer and Bernstein projections which estimated that the unemployment rate would be around 8.1% for May without a recovery plan, or 6.8% with a stimulus plan, the actual rate was 9.1%. The actual unemployment rate has been consistently above Romer and Bernstein’s worse case scenario for the economy – and by a considerable margin. Critics of the stimulus invoke this as proof of its complete failure. After all, though a massive and unprecedented monetary and stimulus was enacted, it appears to have had no impact in terms of improving the economic conditions.

Supporters of the stimulus in turn point to other statistics to put forward their claims about how the stimulus created employment, supported the poorest, propped up aggregate demand, and helped local governments. They argue that in the absence of the stimulus measures, the counterfactual, the economy would have plunged into a full-blown depression.

Further, economists like Paul Krugman have consistently held that the actually enacted stimulus policies have been severely deficient and have been advocating much larger doses of expansion to mitigate the high unemployment rate. In the absence of the required magnitude of expansion, they claim, it is unfair and incorrect to blame the expansionary policies for the economy languishing.

Such counterfactual problems are pervasive in economic policy making. This is especially so given the impossibility of localizing and quantifying the impact of specific policy interventions. In the circumstances, if the intervention fails to yield the desired result, critics will denounce it as a failure. Supporters will find that establishing the counterfactual, the scenario in the absence of the stimulus, is fraught with insurmountable difficulties.

Another example of such analysis is the debate about the benefits of metro-rail in New Delhi. Critics argue that despite the massive investments in the Metro, the Delhi traffic remains as bad as ever, even worse. This argument is made on the assumption that the Delhi Metro was set up with the objective of lowering traffic congestion in the city. Now that the final outcome shows no signs of traffic improvement, they argue, the Metro project has failed.

Supporters naturally point that without the Metro Delhi would been uninhabitable. They argue that the Metro has taken 1.7 million people out of the roads, and thereby ensuring that those many people stay out of city roads. They argue that the success of the Metro is a function of how many people it is able to attract and how fast its network expands. The persistent congestion is only a reflection of the fact that the Delhi traffic has been growing at a pace faster than even the growth in the Delhi Metro traffic.

Such criticisms are commonplace with infrastructure investments. They most often fail to produce tangible and immediate impact, and leaves all stakeholders unsatisfied. When the power deficit is a few gigawatts, the commissioning of a few hundred megawatts of power generation capacity has limited impact on the load-shedding situation. Similar situation arises with even major new water and sewerage treatment capacity expansion, since the requirements are massive. The problem is most acute with transportation, since traffic always appears to worsen. In the absence of any salient impact, municipal councils have no incentive to sanction scarce resources in such sectors.

Finally, the left-wing critics of economic liberalization in India point to the persisting high poverty rates and social deprivation and blame it on the neo-liberal policies of the past two decades. They argue that these policies have exacerbated social tensions, widened economic inequality, dismantled social and economic protections and therefore weakened the nation economically.

This too is a classic counterfactual problem. There are two issues here. One, serious commentators question the nature and extent of liberalization undertaken by successive governments, claiming that they have been too little and limited in scope and piecemeal and stop-start. In the absence of, leave alone the full breadth and scope, atleast even some reasonably acceptable level of liberalization, they argue, how can we blame liberalization for the current state of affairs?

Second, they argue that in the absence of this limited economic liberalization, the economy would have been in doldrums. They point to the undoubted macroeconomic gains of recent years as proof of this. How do we know what would have the state of affairs in the absence of the liberalization policies? See Ananth's excellent take on the critics of economic liberalization, including on other dimensions.

In all three cases - stimulus measures in the US, Metro railways in New Delhi, and economic liberalization in India - there is a classic cognitive bias at work, availability bias. People observe salient outcomes - the poor state of the economy, despite the stimulus spending; poor state of Delhi traffic, despite the Metro; and the persistent high poverty levels, despite economic liberalization - and conclude that these interventions failed to achieve the outcome. However, the reality clearly (albeit less so clearly in case of stimulus) points to all having had considerable effect in mitigating the respective problems, though the exact magnitude of their impacts is difficult to quantify.

Then there is another issue here. In all three cases, the opponents frame the debate by equating the particular intervention with the text-book case of the underlying concept. Accordingly, for example, they define the stimulus as was implemented in the US was the classic Keynesian stimulus, and therefore its apparent failure to get the economy out of the recession is conclusive evidence of the failing of the underlying Keynesian concept itself.

Similarly, critics' definition of the success of metro rail as measured by the resultant reduction in congestion rate, means that an actual increase in congestion is taken as proof of its failure. For neo-liberal critics, Manmohanomics is the embodiment of economic liberalization and since it did not "eliminate poverty", as promised, it has failed!

The Indian growth story in a graph

This is a follow-up on yesterday's post. It is also a simplified theoretical representation and requires empirical validation (would be great if there was some serious empirical research along these lines!).

The graphic below represents a two factor economy, consisting of physical infrastructure and human resources. It traces the evolution of the two-factor production possibility frontier (PPF) and aggregate demand of the economy over the 1995-2010 period.



As can be imagined, from the discussion in the earlier post, the economy can be assumed to be operating well within the PPF in 1995 (point A) and moving closer to PPF by 2000 (point B). It has gone slightly beyond the PPF by 2005 (point C). However, by 2010, the aggregate demand (point D) has gone well past the PPF for the year. The economy is clearly over-heating. Note that the PPF has expanded by more or less the same pace. This trend is clearly unsustainable.

Free trade and social safety nets - two sides of the same coin?

Uwe Reinhardt has a series of superb posts defending free trade and advocating social safety nets. This is appropriate at a time when both are under attack from ideologues and opinion makers on both sides of the political spectrum. About the benefits of free-trade, he writes,

Relative to a status quo of no or limited international trade, permitting full free trade across borders will leave in its wake some immediate losers, but citizens who gain from such trade gain much more than the losers lose. On a net basis, therefore, each nation gains over all from such trade.

The objections to this has both external and domestic dimensions. Externally, critics argue, and rightfully too, that countries apply these principles selectively and breach them through a variety of trade restrictions. This needs to be addressed through mutually agreeable international trade negotiations. While progress on this has been halting, it is the lesser challenge.

More importantly, and of immediate concern to politicians across the world, is the fact that free trade creates losers. The uncertainty that comes with being vulnerable to such disruptions amplifies the opposition. Further, the losers are much larger in number than the winners.

The sharp contrast between the winners - with the over-sized gains of a handful of mostly high-profile individuals and businesses - and losers - deprived off their livelihoods and left to fend for themselves - provides fuel for political backlash. In the circumstances, it is reasonable that the losers are adequately compensated or atleast cushioned against their vulnerabilities. And it is only right that winners give up a share of their gains to assist their less fortunate brethren, who have been made to suffer losses due to factors beyond their control. He writes,

Suppose the Jones family is hurt financially by low-cost imports from abroad, while the Smith family is hurt equally by home-grown disruptive innovation – such as the displacement of travel agents by online booking of airlines and hotels or of airline ticket-counter personnel by online check-in. Should only the Jones family be compensated for its loss because it involves foreign trade?

A far better approach would be to have in place a solid, general economic safety net that helps all families whose economic base is disrupted through forces beyond their control, whether such disruptions originate in foreign trade or domestic developments. Unfortunately, too many economists decry that approach as a welfare state – and that makes selling the case for free trade that much harder.

Who should be compensated and by how much? Who should pay for compensating the losers and how much? While economists can help answer these questions, the larger decisions are essentially political in nature. Economists would do themselves, their profession, and the issue of free-trade itself a lot good if they realize this and not stray deep into such re-distribution debates. Efficiency is a question of economic analysis, while fairness is a matter of moral and political judgement.

Counterfactuals and economic analysis

As the debates on monetary and fiscal policy options during the sub-prime crisis and Great Recession have shown, macroeconomic theories can rarely explain with certainty whether one set of policies are superior to another or are certain to succeed in a given circumstance.

For every example of success with a certain set of policies, opponents are quick to show failures with them. They also point to apparent successes with an alternative set of policies. And in any case, no two situations are the same. Such debates usually end in a stalemate over the relative merits of two opposing theoretical and ideological positions. Further, in such ideological battles, even blatantly untenable views have remarkable persistence. Ideologies are not easily buried.

Since successes or failures with a specific set of policies are rarely cut-and-dry, post-mortems of economic policies too are never non-controversial. For example, despite overwhelming evidence about how TARP and ARRA prevented a complete financial meltdown, created employment and off-set deeper output contraction, sceptics refute the evidence.

Supporters who claim success with a set of policies would face opposition from those arguing that an alternative approach would have yielded better results. Even more, they would argue that conditions would have been better off without those policies - Wall Street would have recovered faster and stronger if there were no bailouts.

Supporters will counter by saying that the recovery would have been more swifter and stronger if their prescriptions were applied in full. For example, economists like Paul Krugman have long argued in favor of much stronger fiscal stimulus measures to mitigate the hardships of the Great Recession. Counter-factuals can only be debated about, never satisfactorily, leave alone conclusively, proven.

The NYT reports of the latest example with such from Europe.

Another missed opportunity for Europe? Over the last year, the European Union and the International Monetary fund have pledged 640 billion euros ($890 billion) to bail out distressed economies on the Continent’s periphery. Yet the interest rates on benchmark bonds in Greece, Ireland and Portugal remain at or near their record highs.

Critics of the bailout will surely see the persistent high interest rates as arising from an inability to convince the confidence fairies and a failure of the policy itself. Supporters would argue that there would have been sovereign defaults from Greece and Ireland in the absence of such bailout backstops.

In simple terms, economic policy are equally handicapped in explaining their policies both ex-ante and ex-post.

Update 1 (28/9/2011)

Paul Krugman has this excellent description of the counterfactual debate on stimulus spending in the US.

Ricardian equivalence in insurance

Ricardian equivalence refers to the argument that consumers internalize the government's borrowings by cutting back on their spending (or increasing their savings) in anticipation of higher taxes in future. Conservative economists have invoked this to argue that government deficit spending cannot stimulate aggregate demand.

The NYT has an article raising the issues concerning insurance industry in the aftermath of the Japanese earthquake and tsunami,

"Moody’s said ratings for all of the major reinsurers were stable, and many reinsurance analysts said they saw one bright spot in the disaster: prices for reinsurance have been declining for several years, and while the earthquake will hurt the results of companies for one quarter, it might spur new demand and higher prices.

Reinsurance contracts are often renewed in April, and Keefe, Bruyette & Woods issued a report on Tuesday suggesting that losses from the earthquakes in Japan and, recently, New Zealand would lead to firmer prices on California earthquake and Florida hurricane insurance."

This is classic rational expectations (or cognitive biases) operating from both ends of the market. Property owners, atleast in earthquake prone and coastal areas, swayed by the availability bias generated by events in Japan, will be more inclined to insure their assets in a more comprehensive manner. Similarly, insurers would increase the actuarial risks associated with such events and price their premiums upwards.

Assuming that the actual risks remain the same (taken on a historic scale), the insurer can therefore hope to claim higher profits in future (though this is partly reduced the higher premiums that re-insurers are themselves likely to charge). To this extent, insurers will be able to recover a large portion of the current payouts from these higher future premiums. This begs the accounting question about what is the real long-term impact of such earthquakes on the insurance industry.

Re-thinking macroeconomic policies - a graphical summary

The sub-prime mortgage crisis and the Great Recession have questioned several underlying assumptions of modern macroeconomics. Paul Krugman famously called it the "Dark Age of Macroeconomics" and many standard macroeconomics text books are currently undergoing wholesale revisions in the light to these experiences.

What should be the role of Central Banks, especially in ensuring financial stability? What are the policies and instruments that can be deployed by central banks? What should be the optimal inflation target? What are the exit routes available for central banks from extraordinary monetary accommodation? Do central banks have a role in stabilizing output, that goes beyond interest rate changes, especially when faced with deep recessions?

What regulations are required to ensure greater stability and improve the crisis-resilience of banks? What can be done to contain the build up of systemic risks and limit the contagion effects of deleveraging and resultant liquidity crisis? How do we mitigate the moral hazard concerns arising from financial bailouts? What type of financial market regulations are required to limit the possibility of asset bubbles?

What are the fiscal policy options for governments faced with an economic recession and zero-bound in interest rates? How should fiscal policy be organized during such recessions? Which policies deliver the greatest bang for the buck? How can we swiftly deploy stimulus measures in the face of political paralyses and gridlocks? Should governments restrain from stimulating the economy, when faced with zero-bound recessions, with short-term fiscal measures for fear of deficits and debts?

What is the role of global macoreconomic imbalances in causing and sustaining asset bubbles? What is required to prevent the build up of such imbalances? How should cross-border financial flows be regulated? What is the optimal capital account policy for emerging economies? What sort of international monetary system is required to satisfactorily resolve cross-national financial crises?

I have tried to consolidate the learnings from events of the last three years and the post-mortems and other research that has gone into more satisfactorily understanding and explaining macroeconomic policy making. The result is this graphic. While I must admit that it is highly simplified (all such beautiful flow-charts are meant to simplify complex policy eco-systems), it only seeks to broadly highlight all the different elements of a post-crisis macoreconomic policy framework.

It is clear that the mandate of central banks have to expand beyond inflation targeting and include financial market stability. And when faced with deep recessions, central banks have a credit policy role, whence it could become a lender, buyer, and insurer of last resort. Fiscal policy becomes critical when monetary policy loses traction and when interest rates are at the zero-bound. Its main instruments are automatic stabilizers and discretionary spending measures. The specific instruments of each policy, as indicated in the chart, are illustrative and is meant to merely guide discussion.



(Please click on the graphic to enlarge)

In fact, the IMF recently brought together some of the world's leading economists to a conference where the Fund and participants urged a wholesale re-examination of macroeconomic policy principles. See also this concise presentation by Olivier Blanchard.

Right Vs Left economists

Three interesting posts, two by Tyler Cowen (left and right) and an excellent summary by Arnold Kling, about the commonest mistakes and biases of left and right leaning economists.

Arnold Kling summarizes how the left-leaning economists can correct themselves,

Look for structural reasons for policy failure, rather than attribute it always to misguided ideology. Consider the implications of imperfect knowledge on the part of government actors. Also, consider that the existence and growth of special interests is at least partly endogenous with respect to policy.

And what the right-leaning economists could do to balance their positions

Look for structural explanations for the growth of the state, rather than attribute it always to misguided ideology. Consider the implications of urban density. Consider that as the economy becomes more complex, the potential dispersion in wealth due to differences in ability, information, and luck becomes very large, while the ability to overcome such differences with sheer effort probably declines.

It may be a good idea to have checklist templates that can enable ideologues and economists from right and left to balance their positions. That is, if they want to do so. In any case, nothing prevents a third party listening to advocacies by such ideolgoues to filter it through the lens of such checklists. How about an "ideology calibrator"?

Update 1 (12/3/2011)

David Leonhardt has this series of links to blindspots of liberals and conservatives on economic issues.

Is free trade efficient and/or good?

Greg Mankiw's recent column in the NYT praising international trade, where he urged Americans to see emerging economies as trade partners and not competitors, has generated an interesting debate about the costs and benefits of international trade.

Uwe Reinhardt highlighted the difference between the way non-nationalistic economists and nationalistic citizens view the issue of gains and losses from trade,

"Many Americans might balk at the lower-priced scarf if it were offered not by an American but by a low-cost manufacturer in Shanghai or Bangladesh... Whether a fellow American gains from a trade or someone in Shanghai does not make any difference to most economists, nor does it matter to them where the losers from global competition live, in America or elsewhere."

He also points to the controversial work of Alan Blinder (see pdf here and here), where he questioned the wisdom of the theory that "every country gains by unfettered international trade" in the context of the threat to American jobs posed by off-shoring of services to emerging economies. Prof Blinder had estimated that 30-40 million jobs in the US are potentially off-shorable and this "may pose major problems for tens of millions of Americans over the coming decades". He also raised the concerns about how America would be able to cope up with its impact, especially given its tattered social safety net.

In this context, David Autor, David Dorn and Gordon H. Hanson (via Mike Konczal) explored the impact of import competition on US local labour markets that were differentially exposed to the rise of trade with China in the 1990-2007 period due to differences in their initial patterns of industry specialization. Controlling for various external factors, they found,

"Increased exposure of local labor markets to Chinese imports leads to higher unemployment, lower labor force participation, and reduced wages. While the employment reduction is concentrated in manufacturing, wage declines occur in the broader local labor market, and are most pronounced outside of manufacturing. Growing import exposure spurs a substantial increase in transfer payments to individuals and households in the form of unemployment insurance benefits, disability benefits, income support payments, and in-kind medical benefits. These transfer payments are two orders of magnitude larger than the corresponding rise in Trade Adjustment Assistance benefits. Nevertheless, transfers falls far short of off-setting the large decline in average household incomes found in local labor markets that are most heavily exposed to China trade."

They also write about the distributional consequences of trade - while it lowers incomes for workers in industries or regions exposed to import competition, gainers include consumers who have increased product variety and industries and regions with expanding exports have higher income growth. They find that the gains from trade with China are between $32 and $61 per person, whereas the deadweight losses are estimated at $52 from the transfer mechanisms in place.

This analysis does not fully capture the benefits. As the article itself mentions, while the benefits of trade are permanent, the deadweight losses of transfers are temporary. More importantly, it does not include the benefits of trade by way of exports (after all, we cannot assess the impact of trade by merely valuing only one side of the equation!).

The critical issue here is not whether free trade is beneficial or not. On the net, it is hard to argue that free-trade is not beneficial and harder still to prove it. But, as the aforementioned study acknowledges and we all know, the benefits and costs of free-trade are not evenly distributed. It is natural that the gainers are happy and the losers are disgruntled and oppose free-trade. The important issue therefore is how the gains and costs are distributed among different people and regions and whether governments can have any role in that.

This raises questions about the relative gains and losses, both in terms of amounts lost and gained and the numbers of people on both sides of the equation. It is here that there is a growing belief, among a larger number of people and regions, that they are being forced to take a disproportionate share of the costs of trade. They accuse a few of disproportionately benefiting from trade. Economics has little to teach us about how to resolve such distributional issues. That is the realm of politics.

The politics of fairness and the sustainability of Pareto optimizing trade demands that the losers be appropriately compensated for their losses. The compensation is usually in the form of some type of transfers from the government to these losers. However, this raises the issue of where the government can find the resources to finance such transfers.

Since the gainers benefited disproportionately, it is only natural that some portion of their excess gains be appropriated by way of say, taxation. In other words, re-distribute a share of the (disproportionate) benefits obtained by the gainers from trade to the losers. This will buy the support of the losers and ensure the sustainability of the Pareto improving trade.

Now free-market economists would argue that this raises questions of how much to re-distribute and to whom. How do we redistribute? Who are the gainers and how much did they gain? Who are the losers, and how much should they be compensated? Yes, the answers to these and more are not simple. But they are not insurmountable.

But the alternative is to accept the losers argument that they do not deserve to lose because of trade and therefore all trade should be stopped (in any case, once you oppose some types of trade, a slippery slope appears, where trade in general gets questioned). After all, and economists understand it better than anyone else, any transaction is economically efficient (and Pareto optimal) only if it makes people better off without making anyone worse off. Free-trade, minus re-distribution, clearly leaves the losers worse off and is both inefficient and not a Pareto improvement.

Such re-distribution can be made less distortionary and with minimal deadweight losses if it is structured so as align the incentives of all the parties. The losers, getting the transfers, should have incentives in place to search for newer jobs and acquire new skills that can help them find a job quickly or recover their income losses. Similarly, the gainers should be taxed for the disproportionate gains, arising from easy arbitrage opportunities, so that their incentives are not distorted badly.

The important take-away from all this is simple. Free trade is good, but only if it is supplemented with transfers that cushion the losers. Put differently, sustenance of free-trade makes the strongest case for social safety nets. In fact, losers from free trade are just another example of market failures (in so far as an "efficient outcome generates "bad" results). A social safety net can address all these problems, not just those arising from trade failures. And Econ 101 teaches us that social safety nets are in place precisely to resolve such failures. William Polley is spot on

"You see, it is the potential for a Pareto improvement that makes free trade desirable. There are winners and losers. But the winners gain more than the losers lose. So effect a transfer from the winners to the losers that still allows the winners to gain but compensates the losers for what they lost. Only then can you really say that free trade (with the compensating side payment) benefits everyone. If the compensation is not there, then I cannot unconditionally advocate free trade. I must call attention to the fact that some will lose."

See also Mark Thoma (also here), Tim Worstall, and Free Exchange debate the issue.

Why Tendulkar's aborted gym makes a case for higher FSI?

I have written earlier about the need to raise the hugely restrictive and distortionary Floor Space Index (FSI) ratios applicable in Indian cities. FSI is the ratio of the total plinth area of the building to the total land area, and is typically in the 1.5-3 range for Indian cities. In contrast, FSI in most Asian cities varies from 5 to 15 and in many Western cities goes up to even 25. The low FSI is arguably the biggest factor that keeps urban housing prices unaffordable for the large majority of residents of any Indian city.

A high-profile recent example of the colossal wastage and inefficiency of this comes from the Maharashtra Government's rejection of a request by Sachin Tendulkar to construct a gym on the top floor of his new house at Perry Cross Road, Bandra, Mumbai. The reason - the gym would mean that the FSI would exceed the maximum allowable FSI ratio of one.

Now, Tendulkar had purchased the 8998 sqft plot for Rs 39 Cr in 2008. In other words, every square feet of his house sits on some of the most expensive piece of real estate anywhere in the world. In per-capita land area terms, it will certainly be amongst the most under-utilized prime real estate in any of the major global cities. Further, the per-capita land area value occupied by Tendulkar and his family would be amongst the most expensive for any family across the world. Every strand of logical reasoning would support the argument that the draconian FSI ratio regulation of Mumbai is astonishingly inefficient.

It is a classic example of a loss-loss deal. Tendulkar and his family would obviously be dis-satisfied. The government gains nothing, and if anything has foregone a considerable future property tax revenue stream. Any possible economic activity or other benefits generated by way of the gym has been nipped off. (And, maybe Tendulkar would have been able to possibly exercise more with a gym at his house, and be able to extend his cricket career a few more months!!)

Consider this counter-factual. If FSI ratio was say, four, Tendulkar would probably have purchased say, 3000 sq ft of land. He would have spent say, Rs 20 Cr, and invested the Rs 20 Cr so saved in setting up a restaurant, which in turn would create jobs and other economic benefits. The remaining land may have been purchased by a real estate promoter to set up a mall, resulting in more economic activity. Or purchased by someone else - who would now be forced into buying a land that would otherwise have been used for multi-storied weaker section housing - to build his house.

All this would have been economically efficient outcomes. Tendulkar and family would have been happy to get a much larger house built at a lesser cost (in terms of land value). The valuable piece of real estate would have been more optimally utilized, instead of being locked up in a sub-optimal home investment (I am sure that not many economists would claim that building a house on a land worth Rs 39 Cr is efficient allocation of scarce resources!). The overall impact on the economy, in terms of jobs created, taxes generated, and resources more efficiently deployed, would have been substantial in comparison to the present outcome.

In fact, everybody would have been better off even if the government had declared that area a green zone or restricted area (or barred re-development). A park would have benefited large numbers of people and generated much higher utility and overall benefits. Sachin Tendulkar would have invested his Rs 39 Cr elsewhere with higher FSI ratios and built a house which atleast fully met his requirements. Scarce resources, money and land, would have been more optimally utilized!

Sunset for Mugabe in Zimbabwe?

I recently interviewed Peter Jacobs of the University of the Western Cape in Cape Town, South Africa about the political crisis in Zimbabwe.

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In your estimation, is the land reform issue at the root of the political crisis in Zimbabwe?

Indeed, land reform or the absence of a genuine pro-poor land redistribution policy is a major source of the socio-economic and political crisis in Zimbabwe. But it is inaccurate to trace everything to this single driving factor.

The most productive resources remain concentrated in the hands of a few (including the black elite). But the land issue alone cannot explain the depth, breath and long duration of this crisis. Other post-independence economic and social policy blunders plus the dictatorial degeneration of the ZANPU-PF regime must also be factored into this story.

How has the land reform issue been dealt with in South Africa?

In South Africa, land reform is law-abiding and modeled on the willing seller willing buyer template promoted by the World Bank. In other words, it is through the law and the market, the pillars of land reform entrenched in the post-apartheid Constitution, that 30% of white-owned land is to be transferred to blacks.

Fast-tracking land restitution with a tougher expropriation law is becoming increasingly popular among ANC politicians- especially those most likely to seize hold of parliamentary power after the 2009 national elections.

What risks exist for the regional economy as a result of the ongoing crisis in Zimbabwe?

This really depends on who one talks to and at what time. Among most investors, the mood is very gloomy, but they are eager to pour capital into Zimbabwe if there is greater stability.

South Africa’s poor record in attracting long-term fixed capital investment is often blamed on the crisis in Zimbabwe. But it is not easy to support this claim with hard evidence given the many other things happening in South Africa and other neighboring countries. Other resource based economies in the region (such as Angola and Botswana, for instance) have been attracting investors.

For the rural and urban poor, on the other hand, this is a different matter. The region appears to be unable to handle the sharp rise in out-migration from Zimbabwe. This factor, no doubt, has contributed to the mindless violent attacks on nationals from neighboring countries which have erupted mainly in South African slums.

Do you expect violence in Zimbabwe to worsen prior to the June 27 runoff?

The entire state machine is now deployed to terrorize Zimbabweans. And the post-election humanitarian crimes and brutality of the regime go far beyond imprisoning the 2 vociferous leaders of the MDC, Arthur Mutambara and Morgan Tsvangirai.

The worst scenario as the country heads towards the run-off poll on June 27 is a massive intensification of this campaign of violence. In the best scenario, the run-off will take place in a volatile climate of fear, intimidation and the threat of destabilization.

Are the people of South Africa satisfied with the response of their government to what is happening across the border?

South African reactions to the crisis in Zimbabwe can best be described as mixed. Elements within the governing ANC have been speaking out against ZANU-PF, asking it to accept its defeat in the March elections.

This runs counter to the official ‘quiet diplomacy’ approach of President Mbeki and leading state officials. In their view, Zimbabwe is an independent and sovereign state which needs to resolve its internal difficulties without external interference.

Civil society groups, including COSATU which is the trade union federation allied to the ANC, have been demonstrating against the human rights record of the Zimbabwean government. Aside from this ‘indirect lobbying’, poorer South Africans have not expressed or articulated any organized public dissatisfaction towards the way government has handled the Zimbabwean situation so far.

Minority opposition parties in South Africa, like the Democratic Alliance and Independent Democrats, however, want the Mbeki cabinet to shift from its ‘quiet diplomacy’ stance to active support for ‘regime change’.

What should an MDC or a unity government do to address the dire economic conditions inside Zimbabwe?

Let us assume that there is no rigging of the June 27 run-off and the MDC scores a landslide victory. What the MDC needs to tackle in this context, for a start, is to stop the economic meltdown of Zimbabwe, create a free space for civil society to engage in politics and implement a pro-poor redistributive project.

Large-scale capital investment is required to rebuild its physical and social (healthcare, education, etc) infrastructure. Private foreign capital inflows may not be enough to quickly address these needs, yet privatization is core to its economic platform.

To boost food security, it needs an integrated program to redistribute land and agricultural resources to poorer farmers. However, until now, the MDC appears to have woefully neglected drafting a clear proposal on how to resolve Zimbabwe’s complex land question.

photo by babasteve