Thursday, 23 February 2017

Vote buying with intergovernmental grants (my paper published in Public Choice)

When I started working in the academia a few years back, my friend and co-author Josip Glaurdić asked me which journal would I like to be published in the most? Without hesitation I said: Public Choice

Well, that goal has now been accomplished. I have a publication in one of my all time favorite political economy journals! You can read the paper on this link, it's been published online first. Next big goal: Quarterly Journal of Economics (I will also accept American Economic Review, Journal of Political Economy or American Political Science Review). 

Our paper is on the political bias in the allocation of intergovernmental grants in Croatia. Here's the abstract: 
"Instead of alleviating fiscal inequalities, intergovernmental grants are often used to fulfill the grantors’ political goals. This study uses a unique panel dataset on more than 500 Croatian municipalities over a 12-year period to uncover the extent to which grant distribution is biased owing to grantors’ electoral concerns. Instead of the default fixed effects approach to modelling panel data, we apply a novel within-between specification aimed at uncovering the contextual source of variation, focusing on the effects of electoral concerns on grant allocation within and between municipalities. We find evidence of a substantial political bias in grant allocations both within and between municipalities, particularly when it comes to local-level electoral concerns. The paper offers researchers a new perspective when tackling the issue of politically biased grant allocation using panel data, particularly when they wish to uncover the simultaneous impact of time-variant and time-invariant factors, or when they cannot apply a quasi-experimental approach because of specific institutional contexts."
Basically, we have taken a new spin on a well-researched topic in the field of political economy: does central government allocate local government grants based on selective political criteria? There is a multitude of papers on this for various countries (just check out our references), with the overreaching conclusion being: yes, there is a political bias in the allocation of intergovernmental grants (intergovernmental meaning the flow of funds from the central to the local government). It happens for two main reasons: 1) central government helps its local co-partisans (mayors from the same party as the national government) retain office by giving them more money to buy votes in local election years, and 2) the central government helps itself (increases its own chances of re-election) by giving more money to important districts in national election years. An important district can be either a swing district, where voters often switch from one party to the other, or a core district, where voters always vote for the same party. The literature has found evidence of both. We find that money mostly goes to core districts. Politicians thus want to get as many votes as possible in districts where they are already strong. 

So what makes our paper special? The standard literature approach was mainly to uncover the within unit variation of grant allocation over time. This means that they wanted to see which factors' changes over time affect how much money does a local unit of government get. When uncovering the effect this way the literature usually discards any between-unit variation, i.e. it cannot make any inferences between local units. To clarify here is a sentence from the paper: "For example, finding that larger vote shares for the government within counties result in more allocated grants over time—clearly a within effect—often is misinterpreted as the between effect and generalized into a cross-sectional conclusion that counties received more grants because the government garnered a larger share of the votes in a previous election."

A few clarifications before moving on: A panel dataset means having observations on multiple units over time. This is opposed to a cross-section where you just have observations on multiple units in one fixed time period. Having panel data is great because it allows you to eliminate any changes across units that stay fixed over time (like gender, geography, demographics, or any slow-changing variable like institutions), and focus only on estimating the effect of the changing independent variables on your outcome of interest. It is a very neat way of making correct inferences in the social sciences. 

What we wanted to do is to use our panel dataset to explore the variation both within and between our units of interest. So not only the standard within effect in a municipality over time, but also the cross-sectional effect of the differences between units to see which non-changing factors also could affect our outcome. In our own words:
"We test how the effects of political considerations on grant allocation change over time within each entity and how they vary across them. The within-between approach thus allows for the inclusion of potentially influential time-invariant variables, which the fixed effects approach eliminates, as a separate between-entity effect, in addition to keeping all the benefits of the fixed effects estimation. Disentangling the within- and between-entity effects is important as it not only provides a more substantive interpretation, but also enables the researcher to correctly identify the source of variation by not confusing which of the two effects is driving the estimated relationship. By utilizing this particular approach our goal is to offer researchers a new perspective on tackling the issue of grant allocation when one wishes to test for the simultaneous impact of time-invariant and time-variant variables, and when a quasi-experimental setting is unfeasible owing to specific circumstances of the observed political system."
The within-between approach is a new method referenced to a great paper by Bell and Jones (2015)


What do we find? As I've said before, there is a clear conclusion that there is a significant political bias in the allocation of intergovernmental grants. The national government favors municipalities that support them in the national elections, and those that were won over by their co-partisan mayors. They give more money during election years (both national and local), and they support core municipalities rather than swing municipalities. 

The within-between approach was most helpful in examining the interaction effect of votes for government and turnout. This is best seen on the figures below:

In our own words: 
" Fig. 1 it is obvious that higher national turnout is conditioning only the within-municipality changes in grants in a positive way, whereas the between effect goes in completely the opposite direction (and also is insignificant). In other words, the government rewards only those municipalities wherein they gain support through higher voter turnout rates across time. 
In Fig. 2, representing local level estimates, the conditionality of turnout on a between-municipality level is shown to be crucial for concluding that mayors who win on higher voter turnouts are likely to receive larger grants. The within effect plays no role here, so the conclusion regarding the effect of mayoral alignment and turnout on grant allocation is valid only on a between-municipality level. In other words, aligned mayors who win their posts with high voter turnout rates do not get more intergovernmental grants (they do get more such funds, but not conditioned on turnout), while aligned mayors already holding power do get more money if they can increase voter turnout. Both findings make sense, since winning over a new municipality is good for the national party regardless of turnout, while for existing incumbents establishing their dominance with even more support is likely to be rewarded. None of these conclusions would have been possible without the use of the WB approach."

Tuesday, 31 January 2017

This Trumpian neomercantilism is ridiculous!

Protectionism never helped anyone. Particularly among the developed nations. I have yet to encounter a case of a rich country becoming even richer after imposing tariffs and trade restrictions. Even when looking at firm-level data over the long run, protectionism never helped. In many cases it arguably made them even less efficient (I provide a real-life example below). The notion that tariffs (taxes on imports) and quotas (limits on import quantities) are in general bad for the economy that imposes them could even be called a stylized fact of the profession. And it is one of those rare 'facts' a vast majority of economists would agree with; even those who like to emphasize that free trade has both winners and losers, and even those who cite the successes of South Korea or China in using state protectionism of infant industries to gain a competitive advantage abroad (although there are a lot more factors explaining their success - plus I have yet to see a good piece of research defending this argument). 

So why then, if the experts are practically unanimous, are calls for protectionism so attractive and can become so politically salient? One reason is because people don't trust experts anymore, but even when they did, they still had a misunderstanding of trade. Trade is just one of those topics everyone seems to have an opinion on, usually the wrong one. I've written before on the ills of the so-called mercantilist fallacy. This fallacy usually attracts anyone who suffers from a zero-sum game mentality. Your gain must imply my loss. If we trade with China and have a trade deficit (we import more than we export), we're "losing to China". This is the same variant of the classic saying that "exports are good while imports are bad". If I export then I get money, if I import I lose money. 

Let me emphasize just how ridiculous this argument is. Saying that imports are bad and exports are good is like saying that selling is good (cause we get money when we sell something) while buying is bad (cause we lose money when we buy something). Far from it! Both transactions are good, because when you buy/import you do it either to resell it at a higher price or consume it. If the transaction is voluntary it is by definition beneficial, both for the seller and the buyer, regardless if the seller/buyer is a foreigner. 

Also, governments, i.e. countries do not import nor export. Companies do. They sell (export) and buy (import) on the international market. In fact, the determinant of the demand for imports comes directly from the consumers themselves. Or companies buying intermediary products that are cheaper abroad. If we as customers have a greater benefit from consuming foreign rather than domestic goods, then there will be a company that will offer them to us. It will import foreign goods knowing someone back home will buy them. We as consumers therefore determine the demand for imported goods. Whether it's clothes or food, that almost any country can produce on its own, or cars and IT goods that most countries cannot.

How the import tariff affects US consumers

So how does all this link to the new US President? Well, it's got to do with the most recent set of ideas on trade policy coming from the experts in the Trump administration (btw, should we trust these experts over all the others? I guess we should, they do work for the President, right?).

Take for instance their idea for imposing a tariff of 20% on all imports coming from Mexico. Guess who will pay the ultimate price of that 20% tariff? Yes, you've guessed it - US consumers! How? Let me explain it in very simple, Trumpian terms.

I am a distribution company (let's call me 'the Middleman') which sells electric equipment (let's call it 'Stuff') all across the US. I don't make them myself, I just sell them. So when I buy the Stuff I want to sell, my main motivation for purchase will be a good (i.e. low) price. I buy most of the Stuff from Mexico, from a firm called Mexico Stuff Manufacturer (MSM) and then sell it to local shops across the country. MSM gives me a good quality product and at a lower cost than if I were to buy domestically.

Now the tariff is implemented at 20% on all imports from Mexico. If I want to buy the Stuff from MSM again I have to pay 20% more. That's not very good news for me given that this would eat up almost my entire profit margin. In other words if I buy the Stuff at a higher price I have to increase my selling price to the shops to stay in business. 

Or, if I don't want to do that I can always find a new supplier, perhaps someone in the US - call it US Stuff Manufacturer (USSM). The thing is, the reason I didn't go there in the first place was because USSM was charging me more than MSM for the same quality Stuff. Now that their prices are, let's assume, equal, I am basically at a standstill since whoever I buy from I still have to charge a higher price to the shops. So I decide to stick with the devil/supplier I know. In each case, whatever I choose to do, my prices will have to go up. 

So I go to the shops and sell them the Stuff at a 20% higher price. What do they do? They push that same price increase on the final consumer and charge them the extra 20% they had to pay me. They're in the same business I'm in - they buy the Stuff from me, and resell it at a higher price to the final consumer. 

But why would the shops pay the higher price? Why would they be the price-taker in this case? Because they are in the exact same position I'm in - they have no choice. In either case, if they buy from me or if they decide to switch and get the Stuff from USSM directly they still need to pay a higher price than before - a price that will always be shifted to the final consumer. The example holds even if the price of Mexican Stuff is now higher than the price of US Stuff, because the price at which we buy the US Stuff for will still be higher than the old pre-tariff price of Mexican Stuff. 

This is why a tariff on imports has the equivalence of a tax on domestic consumers buying foreign goods. This might sound like an attractive way to nudge consumers towards buying more stuff produced domestically, but we're talking about individual preferences here. If I like a foreign car, if I think it's more fuel efficient, I will buy a foreign car, regardless of what my government wants me to do. I would hate to have the government limiting my free choice and telling me what to buy! (Wasn't this the biggest issue some Americans had with Obamacare?)

What if the goods being traded are perfect substitutes? 

In other words what if I can easily switch between domestic and foreign brands, so that by imposing a higher price on Mexican Stuff, consumers will just switch to US Stuff as it will now be more price competitive? In theory yes, in reality - no. Why? Just look at the composition and current prices of the goods the US imports from Mexico

Source: CNN Money
Can the US produce all this stuff? Sure it can. In fact, it does, and it exports the same stuff to Mexico (see for yourself). Why is there then a demand for these products to come from Mexico? Price competitiveness due to lower wage costs in Mexico could be only one reason (the example above explained how that works). Another very important one are individual preferences. 

Of the top of my head I can remember a very similar protectionist policy applied by the US back in the 1980s against Japanese imported cars. There was a voluntary export restriction imposed by the US government in 1981 limiting the number of Japanese cars to be imported in the States to 1,68 million per year. It was later raised to 1.85 million and to 2.3 million by 1985. It was finally lifted in 1994 (read more here or here). What happened? The policy directly lowered the supply of Japanese cars on the market. With demand remaining high what was the effect? Prices went up. US consumers did not stop buying Japanese cars despite their higher price. They were simply better than US cars. More fuel efficient to be exact. Who profited from this policy? Only one group: Japanese car companies. That's right, the end effect of a protectionist policy aimed to protect the US car industry made Japanese car companies richer. (This is, mind you, an example from the classical textbook by Krugman and Obsfeld on International trade)

Finally, I don't see why Mexico is complaining. Or China. A 20% tax on imports from Mexico and an alleged 40% tax on imports from China is only going to benefit the companies in these countries. Sure, they might sell lower quantities of their products, but they will more than compensate this with higher prices. 

Who will pay the price for this? US consumers. Protectionism is a tax on them. So when Trump says he will force Mexico to pay for 'the Wall' by imposing a tariff on their imports, I hope these examples helped illustrate what this means - it means that US consumers will ultimately pay for the Wall through a tax they won't even realize hit them. 

Tuesday, 27 December 2016

2016: a bad year for predictions

Talk about Black Swans, 2016 was full of them! From elections to markets, from hacking to terrorist attacks, it was one unexpected event after another. Each a complete shocker in its own way. Especially in sports and politics. Portugal winning the Euro football tournament, Leicester winning the Premier League, Britain coming in second at the Olympic game medal count, or the Chicago Cubs winning the World Series were as big as Black Swans as Brexit or Trump. 

It goes without saying that a year of Black Swans was a terrible year for forecasters. Even the biggest names of the 'industry' have stumbled and failed to predict the biggest disruptive events of the year: Brexit and Trump. Not my company. We got Trump spot on. Just to remind my readers, we called 47 states including the most important swing states like PA, FL, NC, and OH for Trump. Our unique prediction method, that was further perfected since Brexit, has hit bull's-eye!
Our almost perfect prediction for Trump
Oraclum Intelligence Systems
I cannot say the same for myself however. I usually make my prediction at the beginning of each year. So far I boasted some big hits like the UK general election of 2015, the success of anti-establishment parties in the EU 2014 elections, the Scottish referendum, oil prices, interest rates, year-on-year economic growth projections, and even Germany as the winner of the 2014 World Cup

But this year it's been quite a few misses for my beginning-of-the-year predictions. The very title of my January 1st blog signifies the extent of the miss - "women in charge". I predicted that by the end of the year Hillary Clinton is expected to join Angela Merkel, Janet Yellen, and Christine Lagarde (and Irina Bokova as the UN secretary general) to have five out of ten most powerful political positions be held by women. That was a big miss. Hillary lost, Bokova lost, Yellen will most likely be replaced by Donald Trump, and Merkel is facing a tough election next year (although she will probably hold on). The woman I did not see coming was Theresa May, the new UK PM. Even if I had predicted Brexit back then I would have said that Cameron would have been replaced by Boris Johnson, not Theresa May. Again, a true Black Swan. 

Brexit was another big miss. I was categorical in saying that Britain won't leave the EU. I wasn't even sure the referendum would be held this year (this wasn't decided until February, as Cameron wanted to move quickly to capitalize on his general election victory). I had a bunch of rational explanations on why the Brits will not vote Leave. All of which apparently biased by my liberal worldview. I wrote a comment on this after the event, making a couple of other bold predictions on the way. I just can't get enough of predictions, apparently.  

In the US not only was I very bullish on Hillary, I didn't even predict Sanders to give her a run for her money. I did give Trump the biggest probability to win the Republican presidential nomination (I had Rubio second), but I still gave Hillary 55% to clinch the Presidency in November. Interestingly enough I didn't change my mind on Hillary's chances until the last few days of the campaign when I saw our model estimating a Trump victory. It was a shocker, but we did get it right. The lesson was to trust my data, not my guts. 

The second lesson from this was that with election forecasting I should wait for the last few weeks before the elections to figure out how the voters feel. After all I now possess a powerful method to do just that, so I will refrain from making any more election predictions a year in advance. Plus, I'll rather sell this info to our clients rather than boasting on my blog. 

Oh, and I also missed my sports predictions. I said that either Germany or Belgium will win the Euro, but in the end it was a final between Portugal and France, won by - surprise, surprise - Portugal. For the Olympics I was right that the US will win the most medals but I never even dreamed that the UK will come in second. In front of China! Now that was a surprise. 

The hits

It wasn't all misses. I had some good wins. Such as the economy, which unlike politics was rather predictable last year. Ireland was, as predicted, the best performer of the year in the EU, while Greece was the worst. The developed world grew more robustly, although the recovery is still slow, particularly in Europe. The US continued a steady growth trajectory and unemployment fell below 5%. The Fed raised interest rates only slightly in December, while other central banks (ECB, BoE) went for the opposite following the massive political uncertainty in Europe.

Oil prices did not go above $60, China did not go into recession as many were screaming early this year, and Putin came out of the year stronger than ever. Japan is still stagnating, and India overtook China as the fastest growing economy. All of these were good predictions, the kind that were slightly easier to make. 

Oh and here's one big hit - I predicted no terrorist attacks during the Olympics in Brazil or the Euro in France. This was a bold prediction but I was confident nothing would happen given the level of security usually associated with these events. Terrorists will not get away with it if everyone is paying extra careful attention to spot them out. 

Interestingly, with all the Black Swans that happened this year none of them went 'under the radar'. In other words Brexit or Trump had a realistic chance of happening, even if many estimated those chances to be low. Leicester or the Cubs on the other hand - those were the true under-the-radar Black Swans.

Anyway, if you think this year was hard to predict, think of how difficult the next one will be. No one has an idea of what a Trump presidency will look like. No one has an idea how Brexit will turn out (I'm sure Britain will Leave, the question is under which circumstances). Politically it could be another shocker with elections coming up in Germany, France, and the Netherlands. The last two could bring leaders that could spell and end to the EU itself. What about Syria and the EU refugee problem? Will Putin and Trump solve these issues? What about the potential US trade war with China? We're in for quite a ride! 

Tuesday, 29 November 2016

Is technological progress at the heart of stagnation?

In the previous text I presented several economic hypotheses explaining why the developed world has entered what could possibly be a prolonged period of economic stagnation. In today's text (note: long read) I will present my own opinion, arguing that what we are experiencing is a temporary slowdown which could last for several decades, but one that could also provide the greatest opportunity for the next huge boost in living standards. I hypothesize that the underlying factor behind both the current temporary stagnation (particularly in productivity and real wages) and the upcoming rise in living standards is - technology

As I've emphasized several times on the blog before, I believe we are currently, for the past 30 years, in the period of the Third Industrial Revolution. And in our times, it's only heating up, with the potential to bring to some new disruptive innovations that could change our world as much as the previous two industrial revolutions had. The technological progress we are currently undergoing will, without doubt, be disruptive. As it always is. But in its disruptive nature it will bring greater benefits for the future generations. Automated work being replaced by robots will surely lead to job losses. But in a new economy, the job losses could be offset by a series of new opportunities and entirely new careers. Which ones in particular, we can't really tell at this moment. But just like the first two industrial revolutions brought completely new jobs and changed the world as we know it (more than 95% of jobs that exist today didn't exist before the 18th century), so will the Third bring in new jobs and new possibilities we can't even imagine. Social networks have already introduced new types of occupations (social network experts being the most dubious one). Various bloggers and youtubers have managed to turn their hobby into a money making venture. Firms are just beginning to exploit the Internet, and its users are just uncovering the various ways they can make money on it. None of this was even conceivable back in the 1990s when our remote Internet usage was often wrapped around in frustration with our dial-up connection (remind yourself of that glorious sound, I know you want to!). Today so much more opportunities await. 

The good thing about this inevitable change is that it tends to be gradual. This meaning that even if robots and automated work start replacing low-skilled jobs, this will all still happen during a prolonged period where it will be possible to maintain a generational switch.

What does this mean in particular? Let's take the example of the taxi market and the driverless car (or if you want - Uber, which is the intermediate step). Naturally if driverless cars all start hitting the streets they will almost immediately take away all the jobs from the taxi drivers. Which is likely to cause them to rebel, quite legitimately so. One always has an incentive to protect their job and their immediate interest. A good way to achieve a peaceful transition would be to allow the technological breakthrough to enter gradually by having the taxi drivers operating and overseeing the driverless cars at first. This would, on one hand, correspond to a permanent barrier to entry for any new driver, however all the current drivers would keep their jobs. Until retirement or until they find another job, whichever comes first. Each current driver would therefore still be driving/riding the driverless car and providing for example local advice to tourists. This would then be a perfect way to tell whether or not the passengers really enjoy the conversation and demand for the actual person to be in the car, or do they just prefer the robot to take them where they need to go without speaking to it. It's all about having choices! And in this way to minimize the despair of potential job losses imposed by the new technology. But I digress. 

The current slowdown is essentially of temporary effect as we're currently in a transitional period from the old industry-driven economy (including the service industry) to the new digitally-driven economy. The industry-driven economy still rests upon the old industrial classification paradigm: the primary sector (agriculture, fishing, and mining), the secondary sector (manufacturing, production), and the tertiary sector (services). So far in the history of the West we have witnessed the transition from an agricultural-dominant economy to a manufacturing-driven economy (the First Industrial Revolution in the 18th century), a shift from manufacturing to rapid industrialization in the 19th and beginning of the 20th century (the Second Industrial Revolution driven by mass innovation), and a shift from industrialization to services in the final part of the 20th century following a period of rapid globalization.

Now we are facing something different - a shift beyond the standard paradigm. Disruptive technological progress will rapidly change our patterns of production and of specialization. It will be nothing like the world we knew so far. Just like the first two industrial revolutions brought us to a state of the economy not known to us before. In the 16th and 17th century having a locomotion and machines was unimaginable. In the 18th century having electricity, cars, airplanes, and modern medicine was unimaginable. After WWI having computers and traveling to space was unimaginable. 40 years ago a cell phone was unimaginable, while a mere 15 years ago a smartphone was unimaginable. True, there were always visionaries who offered their overly enthusiastic views of the future by simply extrapolating the current levels of technological progress. In the 1960s visions of the future included flying cars, intergalactic travel, jet-packs, and personal robots, all by the year of 2000 (check out some of the futurist visions from that time - some of them actually did come to existence; also read this piece to see which predictions came true).

How the Internet has changed things - for the better

Why don't many people see this obvious advantage of the technological progress so far? A famous quotation from Nobel prize winner Robert Sollow: "You can see the computer age everywhere except in the productivity statistics" is actually true. There is a productivity paradox where the advances in computing power haven't really made workers more productive. This is contrary to the idea that automation of work should increase total factor productivity. Essentially the idea is that despite all the benefits the Internet has brought to us (instant global communication, entirely new business and marketing models, different consumer behavior patterns, social networking, even spontaneous mass gatherings), it has made only marginal improvements in well-being, at least compared to the non-internet age of the 1980s. The technology skeptics cite similar examples where modern technologies only offered marginal improvements over the products we enjoy today. For example, whereas the first invention of the car was a huge advantage over a horse, its further improvements, after reaching a certain level of speed and safety, were marginal. Airplanes are a similar example. Yes, today they tend to be much safer, but flight times are still similar to what they were 50 years ago. The smartphone was an improvement over the regular cell phone, but not as much as the cell phone was an improvement over the landline, and both not as much as the regular landline was an improvement over letters and telegrams.

However all these examples are missing the point. We are still at the very early stages of the Third Industrial Revolution - the Digital Revolution. We are slowly entering the Information age. The Internet has made much bigger changes than standard economic indicators would suggest. Particularly since most of them were indirect. The Internet has, without doubt, changed the patterns of firm specialization and has increased the rate of trial and error as well as innovation. The vast availability of information online can improve business strategies and force businesses to adapt to the Internet revolution. Those that don't, lose customers. No matter what industry they are in. In the upcoming decades this will become even more obvious. Furthermore, the Internet has had a key role in promoting economic opportunity for all, particularly for the underprivileged. To start a business all you need is a laptop and an internet connection (of course, this varies from country to country depending on the scope of regulations). Most importantly the Internet and the increasing socialization it has brought with it can be used to foster democracy and the empowerment of the middle classes. That is one of its, by far, biggest advantages. Social networks and the Internet can do more in overthrowing dictators and holding politicians accountable in democracies than the media ever could. (Obviously they can also be used in an opposite capacity - by distributing fake news and encouraging bubble behavior; but to be fair, fake news and living in bubbles happened way before the Internet). 

For all these reasons, in the upcoming Information Age, the Internet should be free for all - a global public good. Free access to the Internet should be a human right (the UN has done a lot in promoting this idea, there is even an initiative to implement the Internet as a basic human right, but some disagreements still remain). Nevertheless, its creation of economic opportunity, its role in fostering democracy by empowering the middle classes, its ease of access to education (online courses can do wonders!) are more than enough to declare it a human right and offer it as a global public good. This is something that the future might hold for us - free Internet, worldwide. (Although, don't be so sure on the "free" part. We have access to electricity and clean water, but both still come at a cost).

Learning from Japan

Even with all those advantages at hand, we have currently reached a ceiling with our pre-IT revolution models of economic growth. Japan is perhaps the best example. A huge booming economy for 30 years following the recovery after WWII, it was hit by a housing bubble burst in 1990 and has experienced very low to zero economic growth ever since. In the past 26 years Japan grew, on average, by 0.7%. Its lost decade of the 90s has turned into two lost decades and is now in the middle of a third. Its public debt is the largest in the world, and by a long shot (public debt to GDP is 230%, higher than even Greece, with debt to GDP at 170%). For the entire 26-year period inflation has been close to 0, borderline deflation, as have their interest rates. Needless to say Japan has done a series of monetary and fiscal stimuli to prompt up their economy throughout this period, but nothing has worked. The consequences of both are highly visible in their over-expanded monetary base and huge debt.

But in reality, there is nothing wrong with Japan. Yes its economic indicators are terrible, yes the population is ageing which is always a problem in countries with high debt levels, but Japan remains one of the richest countries in the world. Their GDP per capita (PPP) is around $38,000 which is quite a lot for a country with 127 million people. The only comparable in population size is the US with a GDP per capita (PPP) of $55,000. But beyond GDP, Japan ranks highest in many of the measures of living standards and well-being. By life expectancy they are no.1 in the world (84 years on average!), their human development index, prosperity index, happiness index all put them among the top performers. Their health care and education system are flourishing, they have low crime rates, and decreasing inequality. One conventional economic indicator - unemployment - always managed to stay low, at around 4%. And their levels of innovation and technological adaptation are arguably among the world's highest if not the highest. The vast majority of the population is therefore enjoying really good living standards. It seems that low GDP growth, ongoing deflation, and high public debt (as long as it is held by the domestic population in a country stable and rich enough to have a huge demand for its debt, particularly domestic in this case), don't really hamper living standards. The two and a half decades of stagnation have not apparently taken their toll on well-being.

So what's the story here? Japan has simply reached a level of very high living standards combined with a strive for technological innovation that has perhaps even worsened some productivity numbers and possibly GDP growth as well (although there are a number of reasons why GDP growth was low in Japan). The IT revolution took huge proportions in Japan. Anyone who's ever been there speaks of its technological superiority and a number of "cool gadgets". Few of these gadgets have raised GDP, but they have contributed to the well-being of the population, and more importantly, they have opened vast new opportunities for its population. It takes time for these to be seized in order to produce a high magnitude well-being effect.

The Third Industrial Revolution IS at the heart of the current stagnation...

The point is that we are currently experiencing a stagnation caused by a series of factors, one of which is certainly the technological revolution. I've written on that before on multiple occasions. Essentially, technological progress began by shifting jobs and changing the patterns of specialization and production. This will go on for several more decades. But the further it unfolds, the more benefits it will bring that will be immediately noticeable to us. In other words, think of the current stagnation in wages and productivity (and hence economic growth) as an indirect consequence of the upcoming and ongoing technological progress. It takes time for the people to recognize the new patterns of specialization and to exploit the opportunities for new jobs. With the start of the IT revolution in the 80s we've already noticed a series of new jobs being created. It all started with companies like IBM, Dell, HP, and Apple to provide the hardware. Then came Microsoft and revolutionized the software (Apple made it even cooler later on in the second coming of Steve Jobs). Then the Internet giants started emerging: Google, Facebook, Amazon, YouTube, eBay and many others. (The criticism these companies get is that while they replaced many old jobs in manufacturing, it wasn't actually a one-for-one replacement. They created much less jobs than what manufacturing companies created.)

All these new companies emerged in the very beginning of the IT revolution (some even before like IBM). Expect many more of these to come in the following decades. Don't necessarily expect new search engines, software manufactures, online retailers, or social networks. No, the new high tech companies will be about something completely different. They will most likely strive on the benefits provided by all these companies before them (we all have laptops, running on either Windows or Mac, and we all use Google, Facebook, YouTube, etc.).

...but it will also set the stage for the next big boost in living standards

The current level of technological development set the stage for the Next Big Thing. They didn't replace all the lost jobs, and were on that front mostly disruptive innovations. For now. However the foundations have been laid. These foundations are supported by the current (temporary) industry giants. And most importantly they provide the nurturing environment for growth, for new companies that one day will be even greater and will perhaps not only change the jobs market, they could profoundly change our way of life (e.g. robot manufacturing companies, or nanotech companies, or AI producers, or fusion energy companies - a bit too much? Or is it?). In 50 or 100 years from now we may look down on manual labor and automated work as relics of the past. And no one will complain as everyone will find such jobs meaningless and will have the time to pursue their most desired careers. It might sound a bit idealistic from today's point of view but who knows. Cars, trains, and airplanes sounded idealistic back when the First Industrial Revolution was underway, but today we know of no better form of transportation. At this point, we can only imagine.

Now, all this is just a theory. I can devise a multitude of examples and arguments in support of it, but I cannot really test it. Yet. Time will tell basically whether or not this thinking has any merit at all. I do however carry a slightly optimistic bias in believing that we live in awesome times and are on the verge of a breakthrough that most of us simply aren't aware of. My optimistic bias makes me a bit subjective towards the impact of technological progress on future living standards, but drawing simply from historical patterns and the possibilities being uncovered to us, the IT revolution is nothing to be feared.

Sunday, 20 November 2016

Explaining our current stagnation

Ever since the financial crisis of 2007-2009 and its subsequent (slow and modest) recovery many have claimed the world has entered into a state of prolonged stagnation. In addition to economic growth being relatively low (and therefore not enough to close the potential GDP gap caused by the crisis), real wages are also stagnating, unemployment is still high (although in relative decline), inflation is close to zero, while productivity growth is sending troublesome signals for some time now. This is particularly true of Europe, as it bears the strongest resemblance to Japan, and is on a good course to repeat Japan's (still ongoing) two decades of stagnation (more on emulating Japan in my next text). 

We all know the story. I, for one, have told it many times on the blog (see herehere, here, here, here, here or here). After the financial crisis, which usually tends to cause prolonged and slow recoveries, many governments adopted stimulus and bailout programs in 2009 that all but destroyed their public finances at the time. In retrospect this was a textbook Keynesian solution in times of crisis - in order to restore confidence and replace the lack of private sector investment the government should step in and provide as much liquidity and stimulus as possible. And most of them did. The US, the UK, almost all European countries, even some Asian countries (like China) were forced to adopt stimulus packages as an immediate response to boost confidence. In addition central banks did their part and lowered interest rates to historical lows to provide the much needed liquidity to the banking sector (whose reaction was mainly to hoard this cash, not let it flow in the system). But this doesn't work, the conventional wisdom teaches us, since you can only lower rates so much, forcing you to fall into a liquidity trap. And the only thing that can get you out of a liquidity trap is more government spending.

This solution was applied throughout. And its main consequence, in only a single year, was that debt levels have risen sharply (to be fair bank bailouts contributed to rising debt levels even more). They almost doubled in the US and in the UK, as in many European countries, while in countries like Ireland and Iceland they quadrupled. Budget deficits also went haywire. The UK in 2010 had the third biggest deficit in the world: -10% of GDP (behind only the revolution-undergoing Egypt and the shambolic Greece). Even for rich and usually fiscally responsible countries like the US or the UK, this was too much. The textbook Keynesian solution might have prevented a deeper slump as some economists claim (this we will never know as we cannot prove it), but it also dramatically increased budget deficits and public debt levels (this we can prove - see my discussion here). Austerity was imposed only after the stimulus and bailout packages (starting in 2010/11), it was not the initial reaction. Many argue that austerity was applied too quickly, before the economies actually recovered, but that too is a discussion for another time. 

The slow recovery is only part of a longer trend of stagnation? 

In order to understand the big picture of why the recovery was so slow, we must look at the trends that have occurred before the crisis. Many claim the stagnation (particularly in productivity and real wages) started long before. The first graph looks at the decline in the growth rate of total factor productivity (TFP) in the US, relative to its 1947-1973 trend. Natural logs are used to emphasize the relative stagnation of TFP. (Btw, the FT Alphaville blog has assembled in one place all the different hypotheses and ideas on why TFP growth started to decline since the 70s).

The quarterly TFP rates for the US from 1947 till 2010.
Graph taken from David Beckworth's blog
The second figure depicts a very modest, almost nonexistent, growth of real wages compared to productivity which has, as shown in the previous graph, experienced its own relative slowdown (the reason the graphs are not comparable is that the upper one uses natural logs, whereas in the lower one the second part of the picture only shows the rate of change from 1979 to 2009). Knowing that productivity rise fell short of its trend-based expectations, it is all the more striking to see the relative stagnation of real wages in the past 30-40 years
In addition, the wage growth was distributed unequally, where the trend for the bottom 90% of income earners was even worse throughout the observed period, not only for the US but for some other developed countries as well (shown here are Australia, Canada, France, Sweden and the UK): 
So what are the structural factors responsible for this 30-year long era of relative stagnation in productivity and real wages? Are these structural factors the same ones disabling our economies from fully recovering from the recent crisis?  

Economists came up with several competing hypotheses, each very interesting in its own way. I will present five of them briefly. 

1) The secular stagnation hypothesis

The first in line is the so-called secular stagnation theory. Its main proponent is Larry Summers. According to this theory, "economies suffer when higher propensity to save is coupled with a decreasing propensity to invest". Excessive savings will therefore lower aggregate demand which puts a downward pressure on inflation and on real interest rates (hence the low inflation and low interest rates we are experiencing) and lower economic growth. Furthermore even when high growth is achieved within this several-decade-long stagnation, it was usually a result of excessive borrowing that translates savings into unsustainable investments and causes bubbles.

I'm having difficulty in buying this argument given that the data shows a clear trend of declining savings rate in the US for the past 30-40 years before the crisis (see graph below). Besides, a bubble could not have lasted that long. It is true that higher savings was a response to the crisis (as you can also see in the graph), and it's also true that the immediate post-crisis consequence was massive deleveraging of a population overburdened with debt, but it certainly isn't a long term trend.

Perhaps Summers is referring to total gross savings, which has indeed been steadily increasing in the past 40 years, but in this case looking at the absolute value is wrong. Even gross savings as percentage of national income have been in a steady decline since the 1980s. To be fair, Summers is perhaps more preoccupied with the last couple of years (given that only in the last 7 years have we had historically low real interest rates):
"Secular stagnation occurs when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central-bank policies. At that point, desired levels of saving exceed desired levels of investment, leading to shortfalls in demand and stunted growth. This picture fits with much of what we have seen in recent years. Real interest rates are very low, demand has been sluggish, and inflation is low, just as one would expect in the presence of excess saving. Absent many good new investment opportunities, savings have tended to flow into existing assets, causing asset price inflation."
However, hasn't China had a massive imbalance between savings and investments for the past 30 years? In times when its economic growth rates were in double digits for decades? It was this circumstance in particular that turned China into the greatest creditor nation in the world (S>I, meaning that EX>IM), while the US became the greatest debtor nation in the world. The US had a much higher propensity to invest than to save, and this imbalance led to a huge current account deficit (just the opposite of above; I>S, mean that IM>EX). The story of trade, unlike what the politicians make you believe, revolves around the relationship between savings and investments; here I fully agree with Summers.

2) The debt accumulation hypothesis  

The next one comes from Reinhart and Rogoff. They tend to blame massive debt accumulation. In other words, a period of sustained and bold optimism in which asset prices kept on rising, meaning that both the public and the private sector may borrow indefinitely. This happened not only in the US, but across the spectrum, as many countries ran large current account deficits prior to the crisis. This was particularly problematic in Europe as the desire to eliminate risk through the introduction of the common currency encouraged borrowing from abroad where high CA deficits were channeled into consumption rather than investment. What explains the slow recovery is deleveraging - a typical reaction to financial crises caused by an excessive accumulation of debt. In fact, in their excellent book "This Time Is Different" the authors point out that banking crises that arose due to an excessive accumulation of debt always imply a very slow and prolonged recovery, not only for the financial centers but also for the periphery.  

However this is still a theory focused only on the explanation of the post-crisis stagnation; it doesn't stretch long enough to explain the puzzling decline in productivity and real wages for the past 30 years. So we move on to the next one.

3) The global savings glut hypothesis

This famous hypothesis was proposed by Ben Bernanke, the former Fed chairmen, back in 2005. According to Bernanke reducing a financial surplus (households pushing savings) or running large deficits (governments or households financing consumption) will result in a (potentially decade-long) boom on the asset market. Bringing this up on an international level, financial surpluses from Asian households and governments were translated into investments and consumption in the West. The analogous story can be told in Europe: the 'interaction' between the savings in the "core" and the deficits in the "periphery".

In essence this hypothesis also begins with the period of low interest rates that reflected higher world savings. I wrote about it in my 2011 paper "The Political Economy of the US Financial Crisis": "There was strong demand for safe assets from Asian and oil exporting countries that contributed to depress the yield on long term government securities issued by advanced economies, the US in particular. A low US savings rate also contributed in steering assets from current account surplus countries into financing US investments and consumption. However, capital inflows were used to finance current consumption rather than investment into productive assets. The US current account deficit started to grow uncontrollably by the end of 1998 and reached its highest level around 2006, while at the same time oil exporting countries and emerging Asian countries experienced high surpluses in their current accounts. This period is matched by the likewise high growth in the US housing market. There is no proof that the current account deficit itself caused the housing boom, but there is evidence that the inflow of foreign capital was mainly used at the time being for the purchase of real-estate, adding to the housing bubble. Excess savings in Asia were being invested into safe assets such as US government securities, which contributed to a high level of capital inflows into the US. High inflows into the US brought about excessive risk taking and exposed domestic financial institutions, companies and households to exchange rate risk. Pushing excess savings towards assets increases the demand for these assets which resulted in an appreciation of asset prices. This put additional pressure on demand as well as on total output. An inflow of foreign savings, combined with low interest rates and expectations of constantly increasing asset prices resulted in the creation of an asset bubble in both houses and securities. An increasing demand for assets motivated the financial market in developing new instruments and securities (derivatives) whose main purpose was to diversify risks." 

4) The long-run decline in growth hypothesis 

The most recent hypothesis, attributed to economist Robert Gordon, does go back long enough to explain the fundamental decline in the total factor productivity growth. In fact, that's what the theory is all about. In his bestselling new book "The Rise and Fall of American Growth", Gordon paints a very pessimistic picture of an exhausted american growth model. He claims that all the life-altering innovations of the past (in particular from 1870 to 1970) will not be repeated in the future, meaning that our TFP as well as our economic growth rates may go down even more (he makes a prediction of long-run economic growth to fall down to only 0.2% - see graph below). Some of reasons of why this could be so (the so called 'headwinds' the economy is facing) are the rising inequality, an ageing population, poor education, and rising debt levels. In brief, Gordon's view is that the technological revolution will not increase our living standards. I personally disagree with this assessment, as I find it unnecessarily pessimistic. I will challenge it thoroughly in my next blog post.

Robert Gordon's projection of average growth until 2100.
What about the origin of the current stagnation? According to Gordon it was a mere exhaustion of innovation. None of the stuff produced in the late 20th and at the beginning of the 21st century (like the Internet, or iPhones, or Google and Facebook) can match themselves to the benefits given to our societies during the late 19th and 20th century - things like electricity, cars, penicillin, running water in homes, the telephone, etc. Many of the 'headwinds' such as the rise of inequality, the ageing of the baby boomers, or rising debt levels are attributed to this very problematic feature and are, according to Gordon, responsible for the relative decline as well as for the even worse future rates of growth. So the current stagnation is a mere beginning of a long trend of close to zero economic growth given that we will fail to emulate the technological breakthroughs of the 20th century. A truly depressing outlook. 

5) The 'low-hanging fruit' hypothesis

Finally, Tyler Cowen in his great book "The Great Stagnation" argues that the US simply ran out of low-hanging fruits which fueled american growth from the late 19th century onward. He makes an interesting claim that these low-hanging fruits brought the country to its current technological plateau and now it's stuck here for a while before a next major revolution happens. 

So what are these low-hanging fruits the US had and has by now exhausted? Cowen cites the three most important ones: free land and abundant resources (particularly in the late 19th and early 20th century as it attracted many talented Europeans to enjoy the relative abundance); technological breakthroughs from the 1880s to the 1970s (the same ones Gordon mentions: electricity, motors, cars, planes, telephone, plumbing, pharmaceuticals, mass production, radio,TV, etc.), and last but not least smart, uneducated kids (a vast amount of people that educated themselves and massively contributed to economic growth).

All of this is gone now. Moving a student from high school to college today will only reap marginal returns at high costs. Moving a child from a farm to high school back then significantly increased its skill-set and thus opened up room for innovation. This innovation came in the form of massive technological improvements which all greatly increased our living standards; not only in terms of faster transportation or handy appliances - it also significantly improved our health and increased life expectancy. No modern-day innovation can improve our living standards that significantly nor can it expand our life expectancy to a 100 years. The Internet, social networks, search engines and smartphones are all cool and useful stuff, but their impact on our living standards is not even comparable to that of electricity, engines, conveyor belt production, or pharmaceuticals. 

Yet! We have no idea how the Internet will change our life in the future and what opportunities the current technological plateau will open up for us. Remember, we are in the midst of the Third Industrial Revolution - the IT Revolution. It's benefits won't be obvious to us quite yet. My hypothesis is that the IT Revolution is at the heart of the current stagnation. I will defend this argument in more depth in the next post.