The other side of the coin

Can austerity work?

European officials are backing away from tax increases and spending cuts – “austerity” – but cannot make clear to the public what they want to do, reports The New York Times.  “European Union officials insist that their economic policy has never been as dogmatic or narrowly focused on spending cuts as critics claim, and say they have long since moved beyond just austerity,” writes Andrew Higgins.  “But unable to speak plainly in any of the union’s 23 official languages, they have had trouble explaining their efforts in a manner that ordinary people can understand.”

Let’s try English.

Consider an economy with many jobless workers and closed factories.  The solution may be to spend more, raising the demand for what workers and plants produce.  If households won’t step up spending – perhaps fearing that they will need the money later – then the government can do so.  This may not cost the economy, because the workers and plants weren’t producing anything, anyway.  The government is not crowding out any production.

Now suppose that all workers and factories are producing.  Then additional spending won’t stimulate output, because the economy is already producing as much as it can.  Prices will rise, not output.  One solution is to accommodate the rise in demand by expanding the economy’s capacity, by building factories and educating workers.  This will require people to tighten their belts and to put more money in the banks, which will lend the savings to producers for construction and education.  (Firms acquire plants; workers acquire learning.)  In other words, people should save more and spend less. 

If the government now spends more, then it will crowd out some of this investment.  By borrowing more from banks, the government strips them of savings that otherwise would have been loaned to the producers.  Unless the government’s projects are more valuable than the private ones, economic growth will slow down, because the economy is adding capacity slowly.

A hole in the ace

The first problem – a lack of demand – affects the short run.  The second problem – a lack of supply – affects the long run.  The government can address both problems, each at the appropriate time.

Some policymakers argue that austerity can help the economy immediately by giving the government credibility.  Before people will invest, they want to be sure that the government will keep its word.  If it spends freely, racking up debts, then people may fear that it will tax them eventually, regardless of earlier promises, in order to settle its accounts.   But lowering the debt-to-GDP ratio is not the only way that the government can demonstrate its credibility.  (GDP is gross domestic product – the size of the economy.)  If it has a history of borrowing only in recession, or when it has a worthwhile project like building needed highways, then investors may conclude that the government can pay off its loans out of the tax revenues generated by the new economic activity, not by taxing them.

Much of Europe remains in recession, which may call for a short-run solution.  Kazakhstan faces a long-run problem.  Its economy has been growing 8% per year, on average, since 2000, and the unemployment rate now is only about 5%.  The economy needs more capacity, but the government’s history of reneging on tax deals with foreign investors is not likely to attract them.  Oil deposits will, but that’s the only ace that the government happens to be holding.--Leon Taylor, tayloralmaty@gmail.com

         

References

Andrew Higgins.  Europe facing more pressure to reconsider cuts as a cure.  The New York Times.  April 26, 2013.

Bombarding the market door

Who is the entrepreneur in Kazakhstan?

“The rich,” observed the American novelist F. Scott Fitzgerald, “are very different from you and me.” 

“Yes,” chortled Ernest Hemingway, “they have more money.”

When it comes to entrepreneurs, the difference is in more than just the width of the wallet.  The entrepreneur thinks outside of the box and takes outsized risks.  He is the oddball who transforms the economy.  Joseph Schumpeter, himself a failed banker before becoming the world’s most famous economist after World War II, credited the entrepreneur with “creative destruction,” tearing old markets apart to make room for new ones.  (Who uses a slide rule any more?) 

Economists were too enamored of price-cutting as a way to compete, Schumpeter said.  Economic growth depends instead on new ideas:  “Add successively as many mail coaches as you please.  You will never get a railroad.”  The idea man is the entrepreneur.  “As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position….In capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control, for instance)—competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door….”  

The problem with capitalism, Schumpeter wrote in Capitalism, socialism and democracy, was that entrepreneurs would become all too successful.  They would enable the economy to grow so rapidly that everyone would become wealthy.  Ordinary people who lacked the entrepreneur’s taste for adventure would appeal to the government to protect their wealth.  The government then would regulate the economy so heavily as to rule out the possibility of more breakthroughs by entrepreneurs. 

From that perspective, economic growth in the United States and the European Union may soon peter out – and the roaring successes of the future may be the transition economies like Kazakhstan, if their governments will get out of the way.  In any case, Schumpeter had underlined the critical question: Who, exactly, is the entrepreneur?          

This year, an economics graduate student at KIMEP University tried to answer that question.  Yuriy Shivrin surveyed 557 Kazakhstanis about why they preferred to work for themselves or for others.  He drew upon a dataset amassed by the European Bank for Reconstruction and Development, along with the World Bank, in 2010. 

His results were surprising.  Urban middle-aged respondents with no children especially wanted to become entrepreneurs.  Gender and a natural tendency toward optimism were not significant factors in this desire.  Among existing entrepreneurs, single middle-aged men with no college degree particularly wished to keep working for themselves.  They didn’t perceive the 2008 financial crisis as an obstacle.  And among wage workers, urban respondents with children expressed a particularly strong wish to avoid self-employment, partly because they apparently feared a repeat of the 2008 financial crisis.

Perhaps the most striking finding was that college-educated workers weren’t eager to strike out on the entrepreneurial path.  But Schumpeter predicted this, too.  Under capitalism, he said, college professors would try to make a name for themselves as political dissidents.  After all, their specialty was the production of opinion.  Nobody ever accused Schumpeter – who himself was an iconoclastic economics professor at Harvard – of being dull. --Leon Taylor, tayloralmaty@gmail.com

Disclosure: I advised Shivrin’s master’s thesis.  The other reviewers were Altay Mussurov and Eldar Madumarov, economics professors at KIMEP University.  

Good reading 

Joseph Schumpeter.  Capitalism, socialism and democracy.  Third edition.  Harper. 2008 [1950]

The pollution market in Europe—blue or green?

Do low permit prices signal market failure?

The New York Times worries that that the market for buying and selling air-pollution permits in Europe generates too many greenhouse gases.

“ …The penny ante price of carbon credits means the market is not doing its job: Pushing polluters to reduce carbon emissions…,” write Timesmen Stanley Reed and Mark Scott.

Actually, that’s the European Union’s job.  The market’s job is to provide the amount of cleanup mandated by the EU as cheaply as possible, in terms of resources used up.  If we can abate another ton of carbon emissions with the toil of one worker rather than two, then let’s do it.  The second worker can do something else useful, like research.

The permit market is unusual.  Most markets determine the quantity as well as the price of the product offered.  If the demand for roses rises in February, then the resulting price increase will induce florists to sell more roses.  But the market for pollution permits sets only the price.  The number of permits is determined by EU authorities.  If they print too many permits (that is, demand too little cleanup), then that’s their fault, not the market’s.

Why not use a conventional market for permits?  Because it won’t work.  The producer of cleanup technology cannot collect a payment from everyone who benefits from it, so he will supply too little technology.  One solution (maybe) is to have the government require polluters to clean up by issuing them just a few pollution permits.  Polluters will demand more cleanup equipment when it’s cheaper than permits.  The producer of the equipment can easily identify the major polluters, so he can collect enough money from them to make production of the equipment worthwhile.

The sweet smell of excess

The Times writes:  “When the emissions trading system was started in 2005, the goal was to create a global model for raising the costs of emitting greenhouse gases and for prodding industrial polluters to switch from burning fossil fuels to using clean-energy alternatives like wind and solar.

“When carbon prices hit their highs of more than 30 euros in 2008 and companies spent billions to invest in renewables, policy makers hailed the market as a success. But then prices began to fall. And at current levels, they are far too low to change companies’ behaviors, analysts say.”

The Timesmen – excuse me: “analysts” -- have the story backwards.  The new cleanup technologies have reduced polluters’ demand for permits.  It’s often cheaper now to switch to a clean fuel, like natural gas, than to buy a permit to burn carbon-loaded coal.  Since polluters no longer want permits, their price has fallen.  That’s a sign of success.

This matter is vital for Central Asia.  As transition economies continue to grow rapidly, they will emit more and more pollution.  We would like to reduce emissions without destroying too many jobs.  A permit market induces cleanup by those polluters who can do so most cheaply.  If Central Asia refuses to set up permit markets because it misunderstands the European experience, then it will probably revert to the old “command-and-control” policy in which each polluter cuts back emissions by the same percentage, regardless of the expense.  That would waste resources – a luxury that poor countries cannot afford.   –Leon Taylor tayloralmaty@gmail.com

                       

Good reading

Wallace E. Oates, editor.  The RFF reader in environmental and resource management.  Resources for the Future.  1999. 

References

Stanley Reed and Mark Scott.  In Europe, paid permits for pollution are fizzling.  The New York Times.  April 21, 2013.  Repetitious and disorganized.

Permit market blues

 Does the pollution market pollute?

A few days ago, the European Parliament refused to pull many pollution permits off the market.  This sparked accusations that the permit market somehow worsens pollution – a mindset akin to that of the Incan emperor who throttled the bearer of bad tidings.

I’ll explain why.  But first, some background:  Most power plants burn coal or oil to generate electricity.  The combustion produces steam that turns a giant wheel, creating mechanical energy that is transformed into electrical energy.  A by-product of the burning is carbon gas, which the plant releases into the air.  The carbon accumulates in the stratosphere, sealing in heat.  This “greenhouse effect” threatens to reshape weather patterns and to melt polar ice, creating floods.

To restrict carbon emissions, the European Union prints a limited number of pollution permits.  Plants (and others) can buy and sell these permits among themselves.  The reason for this policy is to reduce pollution as cheaply as possible.  Plants that can decrease carbon emissions cheaply – say, by shifting to a cleaner fuel, like nuclear energy – sell their permits to plants that can’t control emissions easily.  As a result, most of the cleanup is by plants that clean up cheaply.

For example, suppose that Plant A can reduce carbon emissions by a ton for 50 euros.  This would cost Plant B 100 euros.  Then A can sell its permit to B for 75 euros.  This reduces the real cost of cleaning up the ton by 50 euros (100 minus 50).  The savings can preserve jobs and hold down electrical bills.

Is a monopoly in the making?

Moreover, the permit market gives us vital information.  The permit price reflects the cost to the polluter of reducing emissions by a ton, since he will buy a permit only if its price is below the cleanup cost.  If cleanup is cheap for most firms, then they will refuse to buy a permit until its price falls.  That’s the situation today.  Economic anemia in Europe, stemming from the difficulty of governments in paying their bills, has slowed production, so the European economy is using less electricity than it otherwise would.  The demand for permits has fallen sharply, and their price approaches zero. 

This is not the fault of the market.  It simply is telling us that Europeans don’t value more cleanup because economic stagnation has already reduced pollution.  If some Europeans want more cleanup anyway, then they can buy lots of permits and donate them to a bonfire.  This, more or less, was the proposal from the European Commission – to yank permits off the market and possibly reissue them later.  The Parliament voted it down. 

In fact, we might get too much cleanup in the years to come.  Since permits are cheap now, an agent could corner the market by buying them up and then releasing only a few later, at a price that is high because of their artificial scarcity.  Without permits, many power plants won’t be able to produce, so we may get too little electricity.

Central Asia is not a player in the permit market.  But it should follow its performance in order to learn about the European energy market.  Compared to coal, oil is a costly but cleaner fuel (though not as clean as natural gas).  A fall in the permit price indicates that the demand for oil – as a substitute for coal – is falling because additional cleanup of carbon emissions is not valued as highly as before.  

Moral of this story: Beware of Incan emperors.   –Leon Taylor, tayloralmaty@gmail.com

Good reading

Robert N. Stavins, editor.  Economics of the environment: Selected readings.  Fifth edition.  W. W. Norton.  2005.

References

Stanley Reed.  European lawmakers to vote on tougher carbon measure.  The New York Times.  April 15, 2013.

Stanley Reed.  Europe vote sets back carbon plan.  The New York Times.  April 16, 2013.

The best things in life are free (like money)

Is Santa Claus a central banker?

The National Bank of Kazakhstan, which manages the nation’s money supply, decided last week not to raise the interest rate at which it lends money to commercial banks. The annual refinancing rate is 5.5%, a historic low. In February 2012, the rate was 7.5%.

This decision is even more generous than it seems. The real value of money depends on what it can buy. When prices rise throughout our economy, the amount of goods that a thousand tenge can purchase falls. At present, prices are rising by roughly 7% per year (which is within the Bank’s target range). A bank that borrows from the National Bank must pay back the loan, plus 5.5% in interest after a year. However, by spending the loan immediately on goods, the borrowing bank avoided the price increase of 7%. So the loan was worth 1.5% to the borrower, even though it had to pay interest. It profited just by borrowing.

The National Bank’s largesse raises some problems. Since banks can make money just by borrowing from the National Bank, some will try to borrow all that they can. At the moment, this is not a concern, because the commercial banks in general are not too active. In 2012, they borrowed little from the refinancing window, the Bank notes. In fact, giving them money may help us, since they may turn around and lend it to businesses and households. This could spur spending in what, for Kazakhstan, is a phlegmatic economy, growing only 5% per year. But if the economy returns to its usual torrid rates of growth (on the order of 9% or 10%), then additional spending by borrowers may raise prices rather than output.

Buddy, can you spare a tenge?

The second problem is a bit more subtle. The refinancing rate can serve two purposes for the National Bank. One is to signal to lenders how active that the National Bank wants them to be. Lowering the refinancing rate is a way of saying that they should lend more. The second purpose is to provide banks in temporary trouble with emergency funds. The two aims don’t always coincide. The National Bank wants banks to step up lending, but not recklessly. In the last months of 2011, more than three years after the financial crisis, the total share of bank loans that were “standard” was only 25%. The National Bank says, charitably, that the banks in 2012 were recovering slowly.

The National Bank could clear things up by designing two policies for the two purposes. To stimulate the economy, the Bank could inject money into it by exchanging tenge for bonds from the public. It could then devote the refinancing loans to bank rescues.

The National Bank is indeed moving towards “open market operations” of bonds. But its main tool for managing the money supply remains the refinancing rate, probably because the bond market in Kazakhstan is still embryonic. Ironically, the market’s development is stymied by the anemic growth in Kazakhstan’s economy – the very problem that open market operations are supposed to resolve.   –Leon Taylor tayloralmaty@gmail.com


Good reading

National Bank of Kazakhstan. Monetary policy guidelines of the Republic of Kazakhstan for 2013. www.nationalbank.kz


References

National Bank of Kazakhstan. Statistical bulletin. Various years. www.nationalbank.kz

Silk Road Intelligencer. April 5, 2013. www.silkroadintelligencer.com

J-walking

Why do we adjust to new exchange rates so slowly?


In 2008, a real estate bubble burst in Kazakhstan. Foreigners yanked their dollars out of the banks, fearing that they would collapse (and, with foreigners’ help, they did). Because they anticipated (incorrectly) that an ensuing recession would be more severe in Kazakhstan than in the United States, people sold their tenge to Kazakhstan’s central bank in exchange for dollars. Official reserves of dollars emptied.

Without dollars, the National Bank of Kazakhstan would not have been able to defend the tenge against financial shark attacks. And so, in February 2009, the National Bank devalued the tenge, from 120 tenge per dollar to 150 tenge. The Bank hoped that by increasing the tenge cost of buying a dollar, the devaluation would stop the runs for bucks.

The Bank guessed right. But its 25% devaluation sparked controversy for two reasons. First: It cut the value of the banks’ tenge-denominated assets by a fourth, increasing their chances of bankruptcy. Commercial bankers got a Mohawk haircut.

Second: It cut the value (in dollars) of the nation’s sales of goods to foreigners, net of what it bought from them. Before February 2009, Kazakhstan could sell a barrel of oil for, say, 12,000 tenge, or $100. After the devaluation, that barrel was worth only $80.

This problem is general. A devaluation of the tenge reduces the amount of foreign goods that it can buy. A given amount of Kazakhstani goods sold will purchase fewer foreign ones than before. The value of our net sales will fall.

Clinging to contracts

For example, suppose that we trade to Europe 100 barrels of oil for one automobile. Also suppose that we sell in all 1,000 barrels of oil in exchange for 10 autos. After our devaluation, the terms of trade may become, say, 150 barrels for an auto. We thus pay 500 more barrels than before for 10 autos. Our net sales – the “balance of trade” -- fall. Over time, Europeans will realize that the price of our oil has fallen, from 1/100 of an automobile to 1/150, and so they will buy more barrels. This will improve our trade balance. Over time, it will resemble a J – declining, then rising.

The J curve attracted the attention of economists in the early 1970s, when the fall of the dollar failed to increase quickly the value of exports, net of imports, for the United States. Stephen Magee suggested a three-period analysis. In the first period, the old trade contracts are still in force, so the devaluation affects neither prices nor quantities. In the second period, prices adjust to the new exchange rate, but quantities are still fixed. In the third period, quantities finally react to the change in price.

If we devalue our currency, then our balance of trade will improve for sure in the third period, when our lowered prices will increase demand for our exports. Prolonging the first two stages may delay this improvement. That may have happened to Kazakhstan in 2009, when uncertainty about the world economy may have induced oil traders to continue the old contracts.

That year, the response to the weakening of the tenge did not occur rapidly enough for Kazakhstan to avoid an economic slowdown at that time. Devaluations may take longer to work than policymakers realize. –Leon Taylor, tayloralmaty@gmail.com


Good reading
Paul Krugman and Maurice Obstfeld. International economics: Theory and policy. Eighth edition. 2009.  Chapter 16 discusses the J curve.


References


Stephen Magee. Currency contracts, pass-through, and devaluation. Brookings Papers on Economic Activity. 1973.