New Economist

Explaining the UK's 'great moderation'

..under inflation targeting the United Kingdom has enjoyed, so far, the most stable macroeconomic environment in its recorded history, with the volatilities of the business-cycle components of real GDP, national accounts aggregates, and inflation measures having been, post-October 1992, systematically lower than for any of the previous monetary regimes/historical periods since the metallic standards era.

But where does this remarkable stability come from? A forthcoming article in the Journal of Money, Credit, and Banking by ECB economist Luca Benati explains: The 'Great Moderation' in the United Kingdom (PDF). The paper compares the likelihood of two main rival explanations – the ‘good luck’ versus ‘good policy’ debate. Benati's main results are summarised below:

So, was it good luck? Based on our results ..it looks like it was indeed. To recapitulate, results from counterfactual simulations show that (1) the Great Inflation was due, to a dominant extent, to large demand non-policy shocks, and to a lesser extent–especially in 1973 and 1979–to supply shocks; (2) imposing the 1970s’ monetary rule over the entire sample period would have made almost no difference in terms of inflation and output growth outcomes; and (3) alternatively, mechanically ‘bringing the Monetary Policy Committee back in time’ would only have had a limited impact on the Great Inflation episode.

The results are, literally, shocking. But how to reconcile these findings with other recent analysis that points to a key role for the Bank of England's independence and inflation targeting regime?

Although in line with the literature on the U.S., these results are quite striking, in particular in the light of the more traditional, narrative approach which suggests that the monetary policy regime has been an important factor in explaining the Great Moderation in the United Kingdom.

One interpretation that could reconcile the two sets of results is based on the ‘indeterminacy hypothesis’ advocated, for the United States, by Clarida, Gali, and Gertler (2000) and Lubik and Schorfheide (2004). In a nutshell, the idea is that monetary policy was not sufficiently stabilising around the time of the Great Inflation, and therefore allowed self-fulfilling sunspot shocks. As our work in progress shows, this could have generated results qualitatively in line with those produced herein, as well as in the related work for the United States.

India's strong rupee

India's strong rupee is an enviable problem to have, according to the Economist Intelligence Unit:

In some ways, the present strength of the currency, which is now hovering just above the symbolic Rs40:US$1 mark, is an enviable problem. It suggests that the country's attractiveness to foreign investors is increasing and signals optimism about the Indian economy more generally.

...the rupee's appreciation has benefited the economy by making imports cheaper. This is no small benefit--containing inflation has been high on the policy agenda during the past year, as the annual inflation rate (as measured by the point-to-point change in wholesale prices) rose to 6.1% in January 2007, compared with 4.2% a year ago. The inflation rate has subsequently moderated. This may offer the RBI some comfort in its battle against inflation, but the bank's new, stricter inflation target (4.5-5% in 2007/08, down from 5-5.5% in 2006/07) suggests that there will be one more increase in interest rates by the end of 2007.

Why is the currency so strong?

The main reason for the rupee's appreciation since late 2006 has been a flood of foreign-exchange inflows, especially US dollars. The surge of capital and other inflows into India has taken a variety of forms, ranging from foreign direct investment (FDI) to remittances sent home by Indian expatriates. In each case, the flow seems unlikely to slacken.

But it's not all good news:

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.

The perils of inflation targeting

Inflation targeting is popular amongst central banks, but not everyone is a fan. Axel Leijonhufvud writes about The perils of inflation targeting over at the VoxEU website. He fears it fuels cheap money and asset bubbles.

An expansionary monetary policy and an historical conjuncture that happens to produce no inflation will lead to asset price inflation and deterioration of credit. At some stage, central banks will have to mop the liquidity or see inflation do it for them.

Of course the Fed does not (yet) have an explicit inflation target, but it has managed to help produce two notable asset bubbles in the past decade all the same.

The money clippers

The latest New Yorker has a nice piece by John Cassidy about Harry Kat, professor of risk management at the Cass Business School, who has spent the last few years studying hedge fund trading strategies and returns: Hedge Clipping.

Kat is suitably unimpressed by most hedge fund managers.

Almost by definition, there can be only a handful of genius investors, Kat continued. “And even if they are there, the chances that you will find them and that they will let you in are very, very slim,” he said. “That’s what I tell people. If you are really convinced that you can find those super managers, then don’t waste your time with our stuff. Go look for them. But if you are a bit more realistic, if you know that eighty per cent of hedge-fund managers aren’t worth the fees they charge, then the rational thing to do is to give up trying to find a super manager, and just go for a good, efficient diversifier instead.”

But they are impressed by him:

Not so long ago, Kat recalled, one hedge-fund manager, a “global macro” investor who specializes in betting on currencies and stock markets around the world, approached him with an offer. “He said, ‘Harry, I want to buy your thing so I can replicate myself. Then I’ll be able to enjoy life a bit more and keep sending my clients bills for two plus twenty. It’ll take them years to figure it out, if they ever do.’ ”

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...

Offshoring financial services: 'Build, optimize and release'

The BBC News reports on a Deloitte study which claims an offshore boost for the UK finance sector

The shifting of UK financial services jobs to developing countries such as India and China has saved the sector about £1.5bn a year, a study suggests.

Accountants Deloitte said the number of financial jobs going overseas over the past four years had increased 18-fold. More than 75% of major financial institutions have operations overseas, compared with fewer than 10% in 2001.

Chris Gentle, associated partner for financial services at Deloitte and author of the study, said: "Financial institutions need to re-engineer business processes, or risk simply transferring offshore the legacy inefficiencies of older, onshore processes."

The Global Financial Services Offshoring Report 2007 finds signs of strong growth and growing maturity:

The offshoring industry is growing up quickly. Most major financial institutions now operate a sizeable, low-cost offshore delivery function. The industry’s cumulative cost savings for the last four years have risen sharply, propelled by an 18-fold increase in offshore headcount.

Over 2006, average total headcount offshore doubled to six percent of total group staff. More than half of all financial institutions surveyed are now saving more than 40 percent for each business process offshored.

But there's more to come: as the industry grows, offshoring and sourcing decisions should not be "based purely on cost arbitrage grounds":

In future, the best offshoring strategies cannot be based solely on financial gains from labor arbitrage. Otherwise the legacy inefficiencies of older, onshore processes may simply be transferred offshore.

...Enter Phase II: The DTT GFSI group’s analysis has identified three phases to an offshoring journey for financial services institutions: Build, Optimize and Release. Organizations can realize the full value from their offshore operations only when all three phases are complete.

As financial institutions enter the second offshoring phase, their efforts are on streamlining migrated business processes. The impact of this application on best practices is becoming evident across all financial services. A select group of financial institutions – offshoring’s stars – has successfully deployed aggressive offshoring strategies, resulting in the transfer of more than five percent of group headcount offshore and achieving bottom line savings in excess of 40 percent. In some instances these savings have been equivalent to three percent of their total cost base. Other institutions, that have failed to apply the best practices have, in some instances, experienced a decline in their operational performance. This has put their prospects of realizing full future value from their offshoring operations at risk.

Deloitte's are clearly using this report to tout for business. But the trends they point to are no less real for that. Six per cent of staff may not sound that much, but if it has doubled in just four years it could easily double again.

Is Doha dead?

To no one's surprise, the Doha multilateral trade round finally appeared to have collapsed on Thursday. The FT's Alan Beattie reported today that World trade talks collapse in acrimony

The chance of a global trade deal being clinched before President George W. Bush leaves the White House shrank dramatically on Thursday with talks between core negotiating partners collapsing again in division and acrimony.

In a near-exact repeat of events last summer, talks in Potsdam, Germany, between the four partners at the centre of the so-called Doha round of negotiations – the EU, US, Brazil and India – broke up with sides still far apart on cutting agricultural subsidies and goods tariffs.

The collapse makes it unlikely that an outline deal can be agreed before the summer, a step necessary to complete a detailed agreement by the end of the year. ...The failure of the so-called G4 to broker an outline deal will throw the ball back to the entire membership of the World Trade Organisation in Geneva, where the chairmen of the farm and industrial goods talks are preparing draft versions of a deal. But trade officials were pessimistic.

Parties were quick to engage in the blame game, with the US blaming Brazil, and India for failure of G4 talks for being unwilling to open their markets to manufactured products, while Brazil and India charged that the Americans and Europeans were offering too little on agriculture. Meanwhile, US officials are trying to see positives in the trade talks collapse

"By walking away from a bad deal, we are once again able to show the Congress that we can be trusted," U.S. Trade Representative Susan Schwab said on Thursday... Schwab said her refusal to accept an unsatisfactory deal only strengthened the administration's case for renewing "fast track" authority, the law that allows the U.S. president to broker trade deals that Congress votes on with no changes.

Can this really be the end of the Doha round? Most likely - though brinksmanship is a popular strategy in trade negotiations, so one cannot completely rule out the possibility of a last minute breakthrough.

China: poverty down, inequality up

Poverty in China has fallen massively, but other social disparities - particularly income in equality - have grown. David Dollar, the World Bank Country Director for China, writes about Poverty, inequality, and social disparities during China's economic reform

China has been the most rapidly growing economy in the world over the past 25 years. This growth has fueled a remarkable increase in per capita income and a decline in the poverty rate from 64 percent at the beginning of reform to 10 percent in 2004.

At the same time, however, different kinds of disparities have increased. Income inequality has risen, propelled by the rural-urban income gap and by the growing disparity between highly educated urban professionals and the urban working class. There have also been increases in inequality of health and education outcomes.

Some rise in inequality was inevitable as China introduced a market system, but inequality may have been exacerbated rather than mitigated by a number of policy features. Restrictions on rural-urban migration have limited opportunities for the relatively poor rural population. The inability to sell or mortgage rural land has further reduced opportunities.

China has a uniquely decentralized fiscal system that has relied on local government to fund basic health and education. The result has been that poor villages could not afford to provide good services, and poor households could not afford the high private costs of basic public services. Ironically, the large trade surplus that China has built up in recent years is a further problem, in that it stimulates an urban industrial sector that no longer creates many jobs while restricting the government's ability to increase spending to improve services and address disparities.

The government's recent policy shift to encourage migration, fund education and health for poor areas and poor households, and rebalance the economy away from investment and exports toward domestic consumption and public services should help reduce social disparities.

India rising

If the Indian economy has been growig at such a robust pace, why has government debt risen so much? World Bank economists Marina Wes, Brian Pinto and Gaobo Pang answer the question in WB Policy Research Paper 4241: India rising - faster growth, lower indebtedness

Over the past 25 years, India's economy grew at an average real rate of close to 6 percent, with growth rates in recent years accelerating to 9 percent. Yet by 2005-06, the general government debt-to-GDP ratio was 34 percentage points higher than in the 1980s. The authors examine the links between public finances and growth in the post-1991 period. They argue that the main factor in the deterioration of government debt dynamics after the mid-1990s was a reform-induced loss in trade, customs, and financial repression taxes.

Over time, these very factors plus lower entry barriers have contributed to stronger microfoundations for growth by increasing competition and hardening budget constraints for firms and financial sector institutions. The authors suggest that the impressive growth acceleration of the past few years, which is now lowering government indebtedness, can be attributed to the lagged effects of these factors, which have taken time to attain a critical mass in view of India's gradual reforms.

Similarly, the worsening of public finances during the late 1990s can be attributed to the cumulative effects of tax losses, the negative growth effects of cuts in capital expenditure that were made to offset the tax losses, and a pullback in private investment (hence, growth and taxes), a situation which is now turning around. Insufficient capital expenditures have contributed to the infrastructure gap, which is seen as a constraint especially for rapid growth in manufacturing. The authors discuss ongoing reforms in revenue mobilization and fiscal adjustment at the state level, which if successfully implemented, will result in a better alignment of public finances with growth by generating further fiscal space for infrastructure and other development spending.