New Economist

Rethinking free trade?

Is support for free trade losing ground amongst economists? Business Week Washington bureau chief Jane Sasseen writes of an apparent shift in mood: Economists Rethink Free Trade:

..something momentous is happening inside the church of free trade: Doubts are creeping in. We're not talking wholesale, dramatic repudiation of the theory. Economists are, however, noting that their ideas can't explain the disturbing stagnation in income that much of the middle class is experiencing. They also fear a protectionist backlash unless more is done to help those who are losing out. "Previously, you just had extremists making extravagant claims against trade," says Gary C. Hufbauer, a senior fellow at the Peterson Institute for International Economics. "Now there are broader questions being raised that would not have been asked 10 or 15 years ago.

So the next President may be consulting on trade with experts who feel a lot less confident of the old certainties than they did just a few years ago. From Alan S. Blinder, a former vice-chairman of the Federal Reserve and member of the Council of Economic Advisers in the Clinton Administration, to Dartmouth's Matthew J. Slaughter, an international economist who served on President George W. Bush's CEA, many in the profession are reevaluating the impact of globalization. They have studied the growth of low-wage work abroad and seen how high-speed telecommunications make it possible to handle more jobs offshore. Now they fear these factors are more menacing than they first thought.

No one is suggesting that trade is bad for the U.S. overall. According to estimates by the Peterson Institute and others, trade and investment liberalization over the past decades have added $500 billion to $1 trillion to annual income in the U.S.

Yet concern is rising that the gains from free trade may increasingly be going to a small group at the top. For the vast majority of Americans, Dartmouth's Slaughter points out, income growth has all but disappeared in recent years. And it's not just the low-skilled who are getting slammed. Inflation-adjusted earnings have fallen in every educational category other than the 4% who hold doctorates or professional degrees. Such numbers, Slaughter argues, suggest the share of Americans who aren't included in the gains from trade may be very big. "[That's] a very important change from earlier generations, and it should give pause to people who say they know what's going on," he says.

The Stern report revisited

Australia's Productivity Commission today published a very useful assessment of the Stern report on climate change. The 125 page staff working paper by Rick Baker, Andrew Barker, Alan Johnston, and Michael Kohlhaas, The Stern Review: an assessment of its methodology, provides both an excellent summary and a balanced assessement of the report's analysis and recommendations. Press reports picked up on this particular connclusion:

The Review’s ‘urgent’ language can be explained by it being as much an exercise in advocacy as it is an economic analysis of climate change. It is not surprising, therefore, that reaction to it has been mixed.

Bias? To be sure. But the Commission paper remains broadly supportive of Stern's approach. They acknowledge the immense analytical challenges confronting Stern and his colleagues:

Rarely do analysts confront cost–benefit analyses with dimensions so long-term, uncertain and non-marginal. This places extraordinary strains on analytical techniques that generally have been devised for more conventional projects, and almost inevitably means that value judgements and ethical perspectives become more prominent.

The authors argue (p.xvi) that the Stern report has made an important contribution to the climate change debate:

There appears to be an emerging view that the Review has made a valuable contribution by establishing climate change as an economic issue that can be assessed through the ‘lens’ of a cost–benefit framework. Moreover, the Review team continues to engage with its critics and to expose its work (including rebuttals of critiques) to scrutiny. In some instances, its responses indicate acceptance of criticisms levelled. In this respect the Review continues to be important as a catalyst for engendering further analysis, development and refinement of the economics of climate change.

And conclude that:

Some of the criticisms of the Review are justified. The assertiveness with which some of the headline messages are delivered is not always matched by the caution attached to the evidence and analysis presented within the body of the report. And, relevant questions remain about the way the analysis was focused. It is based on a single high emissions scenario, inclines towards more pessimistic assumptions on damage costs, and adopts unconventional parameters for discount rates. These traits tend to escalate the present value of future costs and thereby elicit urgency in mitigation measures.

This is consistent with the Review authors’ apparent belief that, although catastrophic outcomes may be unlikely, the implications for future generations, were they to arise, would be so detrimental that it would be remiss to fail to give them sufficient weight. There is nothing especially wrong with this view — as one critic has conceded, the Review’s conclusions may well be proved right but for the wrong reasons. However, the Review presents itself to decision makers as yielding conclusions underpinned by conventional, rational economic analysis. In fact, the authors’ concerns about catastrophe in conjunction with their attendant ethical perspectives, permeate many stages of the analysis. More sensitivity analysis to highlight the consequences of alternative views and value judgements would have been valuable.

Anyone interested in climate change should read this paper. It is available free online.

The U.S. Earned Income Tax Credit: a primer

Bruce D. Meyer from Chicago University's Harris School of Public Policy Studies recently prepared a primer on the Earned Income Tax Credit for a conference organized by the Economic Council of Sweden. The paper, The U.S. Earned Income Tax Credit, its Effects, and Possible Reforms (PDF), is a useful primer on the subject. Here's what it covers:

In this paper, I first summarize how the U.S. Earned Income Tax Credit (EITC) operates and describe the characteristics of recipients. I then discuss empirical work on the effects of the EITC on poverty and income distribution, and its effects on labor supply. Next, I discuss a few policy concerns about the EITC: possible negative effects on hours of work and marriage, and problems of compliance with the tax system. I then briefly discuss some possible reforms to the structure of the current EITC.

And this is how Professor Meyer concludes:

In summary, the evidence indicates that the income distribution features of the EITC are quite good. It targets resources at those below the poverty line, particularly families with children. The empirical evidence on labor supply and marriage indicates that the incentives of the EITC are remarkably favorable given the resources transferred. However, there are still substantial opportunities for reform along several dimensions.

The reforms mooted include modifications to the tax schedule to reduce marriage penalties, simplifying eligibility criteria for the credit, and providing a more generous credit for single childless individuals or non-custodial fathers.

Why not target unit labour costs?

Perhaps I am missing some fatal flaw, but I have found  econoblogger KNZN's arguments in favour of central banks targeting unit labour costs quite persuasive. It has the advantage over inflation targets of excluding exogenous shocks. It also forces the monetary authorities to take more account of productivity. Here is the nub of KZNZ's arguments:

The main purpose of this approach is to have a simple and easily understood (by the market) answer to the question of how to react to supply shocks. The appropriate response to supply shocks is a matter of great controversy in macroeconomics: should a central bank accommodate supply shocks and let the inflation rate rise temporarily in order to avoid a recession or a slowing of growth (or a boom, in the case of a favorable supply shock), or should it lean heavily against the inflationary impact (or the deflationary impact) of supply shocks in order to pursue an unchanged target inflation rate? The labor cost target settles the question: if the shock is to domestic productivity or to the labor market, then lean against the inflationary impact; if the shock is entirely outside the domestic labor market and production process, then accommodate (except to the extent that you expect the shock to have indirect effects on productivity and the labor market, such as might arise, for example, from sticky real wages).

The main arguments against this approach I can think of are:
1) the objection that this would put undue focus on wage bargaining
2) estimates of unit labour costs are subject to considerable revision - unlike the CPI.

Mark Thoma's post is, as always, worth reading. Your views welcome.

Learning the lessons from Sweden's budget crisis

In the early 1990s Sweden's long-lived economic recession posed a crisis on three fronts: an exploding budget deficit, high interest rates and record-high levels of unemployment. While other countries may have balked, Sweden implemented the painful foscal measures required - and they paid off.

In a new Breugel essay Jens Henriksson, a senior official in the Swedish Finance Ministry at the time, draws on his experience of one of the most dramatic consolidation episodes of the post-WWII period. In 10 Lessons about Budget Consolidation, Henriksson gives a truly fascinating and informed first-hand account. Here are the first two paragraphs:

In its Economic Outlook of December 1994 the OECD projected that the Swedish public debt would explode. By the year 2000 the public debt was expected to hit a record 128 percent of GDP2. Today we know that the gross debt for 2000 turned out to be less than half that figure at 53 percent. And within a few years the budget deficit, from a high of over 11 percent of GDP, turned into a large surplus.

But getting there was not an easy task. During the consolidation of public finances, I had the opportunity to work in close contact with different ministers of finance in Sweden. This paper relates what this experience taught me about the political economics of budget consolidation.

There are lessons here for all countries facing budget problems - not just those intent on he cutting back the sizxe of the state. As he notes:

It is not a paper about how to get rid of the welfare state. On the contrary, it is about how to strengthen the economic foundations for whatever kind of social model that is preferred. The budget consolidation in Sweden was dramatic but it preserved,preserved, and in many ways modernised and improved, the
welfare system.

Previous post
* The joys of fiscal consolidation, 25 May 2007

UPDATE: See also a new Cleveland Fed discussion paper by O. Emre Ergungor, On the Resolution of Financial Crises: The Swedish Experience (PDF)

Sweden was one of the Scandinavian countries experiencing a severe financial crisis In the late 1980s and early 1990s. I review the policy choices and external factors that pushed the country’s financial system over the edge and then examine the steps the government took to make its resolution of the crisis one of the most successful in the past 30 years.

Globalisation - has the tide of opinion turned?

Reading recent debates about economic inequality in the United States, one senses the tide of opinion amongst both academic economists and the 'commentariat' has shifted. Concern is mounting, as are calls for action - even from traditionally orthodox sources. A similar trends now seems to be happening with the globalisation debate - and the two are not unrelated. Let's look at a few recent examples.

First, academic economists are becoming more concerned - and I don't just mean Paul Krugman or Joe Stiglitz. Former Council of Economic Advisers Matthew Slaughter and co-author Kenneth F. Scheve call for A New Deal for Globalization in the latest issue of Foreign Affairs magazine. Here's the abstract:

Globalization has brought huge overall benefits, but earnings for most U.S. workers -- even those with college degrees -- have been falling recently; inequality is greater now than at any other time in the last 70 years. Whatever the cause, the result has been a surge in protectionism. To save globalization, policymakers must spread its gains more widely. The best way to do that is by redistributing income.

The authors make explicit the link to living standards:

U.S. policy is becoming more protectionist because the American public is becoming more protectionist, and this shift in attitudes is a result of stagnant or falling incomes. Public support for engagement with the world economy is strongly linked to labor-market performance, and for most workers labor-market performance has been poor.

Second, respected global newspapers which in the past have stoutly defended the benefits of free trade and globalisation are now acknowledging the need to address the downsides as well. A recent Wall Street Journal piece by David Wessell, The Case for Taxing Globalization's Big Winners, which cited the Slaughter and Scheve paper, concludes:

What to do? To preserve political support for the globalization dividend, spread the benefits more broadly by taxing winners more and losers less.  ...Counting on the inevitability of globalization is imprudent; politics and policy can interfere. Expecting market forces to reverse the recent trend toward ever-bigger winnings for those at the top is unwise; the forces are too strong.

Taxing winners isn't without risk; as Mr. Summers says, globalization makes it easier for them to "pick up their marbles and go somewhere else." But using the tax code to slice the apple more evenly is far more palatable than trying to hold back globalization with policies that risk shrinking the economic apple.

Likewise, the Financial Times recently editorialised that Globalisation needs more than PR to be sold to its losers:

Globalisation has many virtues. Chief among them, it has contributed to an unprecedented accumulation of human wealth over the past decades and has helped lift a record number of poor out of poverty.

Yet globalisation has also created losers, particularly among the middle and lower classes in rich countries. Governments need to do more to help the groups most hurt. ...Governments need to be more active in helping the losers in rich countries. Instead of trying to safeguard industries in vulnerable sectors, governments need to be more inclusive and protect citizens.

...Many people do not mind that Bill Gates or Warren Buffett are worth billions. Both earned their wealth under the set of rules that apply to most others in rich countries. But the worry is that the global market system works to the disadvantage of people in already low-paid, low-skilled jobs in developed economies.

So government policies should focus on enabling the individual to feel as confident as possible within the global system. This could be through funding additional training or other means to help those who have lost their jobs to re-enter the market quickly. It might also imply a more progressive tax system, partial wage insurance, and untying social benefits such as basic healthcare from jobs to avoid undue fears of unemployment.

Third, even international orthodox defenders-of-the-faith such as the OECD and World Trade Organisation are starting to voice doubts. WTO head Pascal Lamy, for example, has been muttering about the dark side of globalisation. According to Reuters, last week he said in Beijing:

The speed of globalisation is affecting our social fabric in a much harsher way than in previous stages of globalisation. If globalisation has benefited some individuals, it has also weakened the position of many others, in particular the weakest and poorest among us, whether in developed or developing countries.

Hence, one of the most important challenges of our generation is to ensure that the benefits of globalisation are more fairly and widely shared, and in particular that they reach more people in developing countries.

The OECD's Employment Outlook 2007, likewise, included a chapter called 'OECD workers in the global economy: increasingly vulnerable?'. You have to pay for the report, but the 4 page editorial, Addressing the globalisation paradox (PDF), provides a good summary. The accompanying press release stated:

Rather than seeing globalisation as a threat, OECD governments should focus on improving labour regulations and social protection systems to help people adapt to changing job markets. That is the message from the 2007 edition of the OECD’s annual Employment Outlook. It reviews the possibility that offshoring may have reduced the bargaining power of workers, especially low-skilled ones. Whether real or threatened, the prospect of offshoring may be increasing the vulnerability of jobs and wages in developed countries.

...Globalisation requires mobility to ensure that workers are not trapped in jobs with no future. The report praises the so-called “flexicurity” approach adopted in Austria and Denmark to address this. In Austria, for example, workers have individual savings accounts, instead of traditional severance pay schemes, that move with them as they move jobs. If they lose their job, they can choose to withdraw funds from the account or save the entitlements built up towards a future pension.

Job losers should be compensated through social protection systems which are employment-friendly, the report notes. This can be done by providing adequate benefits hand-in-hand with “activation” policies which increase re-employment opportunities. Experience of Nordic countries and Australia shows that such policies, if well-designed, improve the job prospects of laid-off workers, thereby easing their fears about globalisation.

Addressing the labour arbitrage debate, the chapter authors concede that globalisation could "permanently increase" job insecurity for workers by making their employers more vulnerable to external shocks. But Angel Gurría, OECD secretary-general, moved to calm fears by saying that people's fears of losing jobs to foreign countries were often overblown: "Without job losses people are fearing the job losses." He called for politicians and journalists to foster a well-informed discussion of the benefits and costs of globalisation. "The story has to be told better," Mr Gurría said.

The FT was unimpressed. In its leader (cited above), it agreed that "better public relations may go part of the way", but governments still need to do more to help the losers. As Dani Rodrik notes:

You know something is going on when the FT berates globalization's cheerleaders for their complacency.

All just straws in the wind, perhaps. But I think I can can hear a gale coming...

The joys of fiscal consolidation

'Fiscal consolidation'. Who but an economist could love such a clunky, unsexy phrase? But then, I am an economist; and so is the OECD. Their latest Economic Outlook includes a special chapter on: Fiscal consolidation: lessons from past experiences (PDF). The authors argue that alhough "fiscal consolidation is required in most OECD countries", it "remains a challenge' for many of them. Translation: they're spending too much and/or not taxing enough. The chapter looks for some lessons from on a dataset covering a large number of OECD fiscal consolidation episodes starting in the late 1970s. Here are their main findings, along with my own summary titles:

1. Facing a crisis helps

Consolidations were larger when the initial situation was difficult: Large initial deficits and high interest rates have been important in prompting fiscal adjustment and boosting the overall size of consolidation. These results may reflect that public awareness of fiscal problems and needs can help in overcoming resistance to consolidation, a hypothesis which is also supported by the observation that qualification for euro area membership significantly increased the probability of starting consolidation. The policy implication would be that consolidation may be helped by the provision of transparent information and analysis of the fiscal situation.

2. Spending cuts work better than tax hikes

Expenditure based consolidations tended to be larger and last longer: An emphasis on cutting current expenditures has been associated with overall larger consolidation and a large weight on social spending cuts increased the chances of stabilising the debt-to-GDP ratio. This could be because expenditure cuts, as opposed to revenue increases, are more likely to trigger lower interest rates and a sympathetic response of private saving, helping to bolster activity. But it could also reflect that governments more determined to consolidate are more willing to cut current expenditures, including social spending, possibly thereby also demonstrating a commitment that makes substantial consolidation more feasible.

3. Fiscal rules can help...

Countries with fiscal rules achieved better results: Fiscal rules with embedded expenditure targets tended to be associated with larger and longer adjustments, and higher success rates. This could in principle reflect that well designed fiscal rules are effective or, alternatively, that governments committed to prudent fiscal management are more likely to institute a rule.

4. ...but need careful design

Designing effective rules raises several issues: Fiscal rules need to be adapted to country specific institutions and political systems, but, based on experience across countries, certain common design features seem important for their effectiveness. These include the need to combine transparency with sufficient flexibility to face cyclical (and other) shocks, a wide coverage across various budget items and effective enforcement mechanisms.

The Economist also discusses this chapter, in its post Words of warning:

With a Kantian flourish, Jean-Philippe Cotis, the OECD's chief economist, argues that sticking to tight spending plans should be governments' “categorical imperative”. In fact, the organisation expects no further reduction in cyclically adjusted deficits in the next two years. It thinks America's will rise. And the historical record, presented in a special chapter of the Outlook, is not encouraging.

The chapter looks at 85 budget-tightening efforts undertaken since 1978 and tries to identify the conditions associated with success. Deficit cuts based on reduced spending have tended to be deeper and longer-lasting than those founded—as in the past couple of years—on increased revenues. That may be because lower spending leads to lower interest rates and hence stimulates economic activity. But it may be because it demonstrates a determination to limit the budget. When tax revenues go up, demands for new spending can be hard to resist—so that when revenues go down again, a new hole in the budget opens up.

Several countries have adopted rules designed to keep themselves on the fiscal straight and narrow. These usually place bounds on budget balances. However, the OECD finds they have more effect if combined with rules to limit expenditure—so that extra revenues are not automatically spent, as they might be if the fiscal balance were all that mattered. Balanced-budget rules not linked to expenditure limits, such as America's Gramm-Rudman-Hollings act of 1985 and the European Union's Stability and Growth Pact, have been less successful. Of course, it is hard to know whether fiscal rules stiffen finance ministers' spines or whether they are adopted by governments that already have the necessary political will.

Either way, the OECD's warning is a timely one. Though state counting-houses may be full now, it is not hard to imagine how they might be drained. The demands of an ageing population look staggering, unless today's systems are reformed. In Greece the combined toll of health care, long-term care and pensions is expected to amount to 7.5% of GDP by 2025 and 16.8% by 2050. In Portugal the expected burden is 6.1% by 2025, rising to 15.5% by 2050.

The Outlook has one more gloomy finding for budget hawks. Not surprisingly, governments are more likely to tighten their belts when budget deficits and interest rates are high—at times, in other words, precisely unlike these.

OECD: The song remains (much) the same

The OECD released its draft semi-annual Economic Outlook today. It contained few surprises, sticking to the view that "the US slowdown was not heralding a period of worldwide economic weakness" and expecting a 'smooth' rebalancing, "with Europe taking over the baton from the United States in driving OECD growth".

The "benign" central forecast is for OECD economic growth of around 2.7% this year (upwardly revised from last November's 2.5% estimate). This would be a notch below 2006's OECD growth of 3.0%, but impressive nonetheless.

US growth will slow from 3.1% last year to a downwardly revised 2.1% thus year. In his presentation and summary of the report, Chief Economist Jean-Philippe Cotis admitted there were downside risks from the "tricky" situation in the United States, where an over-extended housing market has slowed the economy. The slowdown "may be of a broader nature, and may involve a mild form of stagflation, with weaker trend productivity growth and output growth translating into more overheating".

But the central scenario is for continued robust growth, not for the US to slump and drag down other economies with it. The slowing US economy is expected to be more than offset by upwardly revised growth forecasts for Japan, the UK, Australia and the eurozone - particularly Germany and Italy.

What was new in this report was a heightened concern about inflation. As the Financial Times report by Scheherazade Daneshkhu, OECD warns on risk of higher inflation, says:

Jean-Philippe Cotis, chief economist, said inflation in the US had been “more persistent than expected” while in many other OECD countries, notably continantal Europe and the UK: “The amount of residual economic slack is also uncertain....This constitutes a challenge for central banks which, on both sides of the Atlantic, should probably err on the side of tightness.

...It identified “many signs of strong underlying global inflation pressures which could yet feed through into headline inflation”. These reflected increases in commodity prices and the fact that the inflation rate for intermediate industrial goods in most OECD countries had picked up, a surge in shipping costs over the past year and rises in the price of food relative to other consumer prices across most OECD countries.

The strong demand was also a reflection of robust economic expansion, which the OECD expected to continue. It forecast above-average economic growth this year and next in the OECD area due to upbeat business expectations, consumer confidence and “ongoing buoyancy in emerging market economies and favourable financial conditions.”

For those wanting to read the whole thing, a copy of the entire 253 page report can be found here (PDF).

UK tax reform?

One of the issues the incoming Brown government may face soon is tax reform. According to Reuters:

The Confederation of British Industry has pulled together a "Tax Task Force" of leaders from major firms such as ICI, Pfizer, Cadbury Schweppes and Barclays and tax experts to come up with new ideas to reform the current system.

Chancellor Gordon Brown announced a cut in the corporation tax rate to 28 percent from 30 percent from next year in his March Budget, taking it below that of other big economies such as the U.S., Germany, France and Japan.

That, says CBI Director General Richard Lambert, was a step in the right direction, but deeper reform is needed to make the tax system competitive in the long term, especially as firms now have more choice over where they are based and pay tax. A survey by the business group last year showed that one in five UK firms had relocated some of its activities overseas because of gripes over tax.

Before that report, though, we will see the Mirrlees Review report published in January 2008: Reforming the Tax System for the 21st Century. Timed to coincide with the 30th anniversary of the Meade report on taxation, it will cover not only business but almost all forms of taxation. It promises to be a substantial work, with some fo the world's leading public finance experts involved. For those who can't wait until next year, a sneak preview of much of the draft report can be found here.

Globalisation, inflation and monetary policy: it's not all good news

Global factors "are becoming empirically more relevant for domestic inflation determination across a broad range of countries". That is the not-so-surprising conclusion of a new BIS working paper, Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation, by Claudio E. V. Borio and Andrew Filardo. The authors find declining sensitivity of inflation to domestic output gaps, and rising importance of global measures of economic slack.

The authors caution that their "conjecture" is "just preliminary", and that their "results rely critically on a specification that filters out the disinflationary trend from the data"; more research is needed. Nonetheless, if this "more globe-centric view of the inflation process" is correct, what would that mean for monetary policy? Globalisation might increase the risk of monetary policy errors, especially asset bubbles, while weakening central bankers control over real interest rates:

First, the growing importance of global factors would call for more intensive monitoring of external developments. ...Given the lags of monetary policy, it might be important for central banks to respond to developing trends before they show up at the borders and become embedded in price and wage setting behaviour. ...At the same time, measuring global slack conditions is likely to be a challenge. The well-known difficulty of measuring real-time domestic output gaps, and economic slack more generally, would be magnified in the case of their global counterparts.

Second, and more speculatively, one should guard against the risk of systematic errors in policy. If, for instance, the downward pressure on inflation resulting from globalisation was underestimated, the result might be a surprisingly subdued inflation rate alongside unusually low policy rates. This, in turn, might have a number of undesirable side-effects, such as the unwitting accommodation of the build-up of financial imbalances, notably “excessive” credit  and asset price increases that could raise material risks for the economy further down the road. Indeed, global economic developments in recent years bear a certain resemblance to this perspective. Conversely, failure to appreciate the build-up of global inflationary pressures could result in surprisingly strong inflation, with the risk that central banks might fall behind the curve.

Finally, and even more speculatively, questions could ultimately be raised about the very effectiveness of domestic monetary policy. To the extent that, in a proximate sense, domestic inflation became increasingly influenced by global capacity constraints, this could weaken the near-term efficacy of domestic monetary policy levers, because of their limited (ie domestic) reach. ...central banks might find it harder to control inflation in the short term or, at least, may need to adjust their instruments more vigorously. The power of policy could be complicated further by the implications of financial globalisation, which could be weakening the ability of central banks to influence domestic real interest  rates, especially longer-term rates, independently of global conditions.

Previous posts:
* HSBC: Measuring the global output gap 14 February 2006
* IMF: How has globalisation affected inflation? 14 April 2006
* What does globalisation mean for monetary policy? 10 October 2006