Gaffe of the week

From today's New York Times:

Correction: August 29, 2014 

An earlier version of this article misstated the trading value of the dollar to the ruble on Friday morning. It was trading at more than 37 rubles to the dollar, not at more than 37 dollars to the ruble.

--Leon Taylor 

tayloralmaty@gmail.com

Out of control

Do Central Asian researchers use outdated methods?

Kazakhstan’s ballyhooed campaign to become one of the 30 most competitive economies by 2050 is mystifying.  “Competitive” is a fashionably vague word.  The government can declare victory whenever it wants, by defining competitiveness in a way that puts the country in the top 30.  In fact, Kazakhstan might be there already if it just used, as its measure of competitiveness, the corruption index of Transparency International.       

Sarcasm aside, the government’s strategic plan is an old-fashioned industrial policy.  The idea is clear: The more factories we have, the more we can produce.  To support new factories, let’s create a market for their output by discouraging imports.  The fact that import substitution was an abject failure in Latin America in the Fifties and Sixties, and that the Asian tigers like Hong Kong, Singapore and South Korea have demonstrated the potential in export-led growth, which Kazakhstan already has, seems lost on Astana.

Most disheartening of all, the government is ignoring a half-century of statistical research suggesting that the most powerful cause of economic growth may be knowledge.  Just building more factories won’t accomplish much if we don’t have workers to run them.  If they already have their hands full, then the new factories will be excessive.  To use them, we must empower our workers to produce more.  That requires know-how.  A strategic plan focusing on human capital would emphasize education and research, particularly research about research itself.

Along these lines, the government could take a long step toward competitiveness (defined as potential economic growth per capita, and measured by the potential value of output per worker) by jettisoning clumsy methods of research.  Exhibit A is the control group.

To be precise

The idea is familiar.  To test a new treatment for cancer, divide up the patients into two identical groups.  One takes the treatment; the other, a placebo.  The treatment passes the test if the share of patients surviving the cancer is larger for the first group than for the second (the control group).  Statistical tests can detect whether the difference in survival rates may well be just a matter of chance.   

The method is simple but flawed.  First, use of a control group may destroy more information than it provides.  In principle, the two groups should be identical; in reality, they vary, even if slightly, in such key traits as age, sex, and record of health.  Pooling the two groups, by permitting all subjects to undergo the experimental treatment, tells us more about how the success of the treatment (perhaps measured as the number of days of survival) varies with age (say), given all other factors.  Enlarging the dataset also avoids such problems as a high probability that the treatment did work although we concluded that it didn’t.  (In statistical parlance, the difficulty is that the “power of the test” is low.)

Yes, comparing the success rates of the two groups tells us a little, but only a little.  In the pooled approach, we could extract the same information from the constant, known as the intercept, in the estimated statistical equation.  The intercept captures the amount of success in the treatment that is not related to the explanatory variables like age and sex.  (For the gory details, see the Notes.) 

Another possibility is to use the equation from the pooled group to determine the sub-samples for which success of the treatment is smallest – say, men over the age of 80.  This would be more informative than just determining whether the treatment is a success in a group with the same average age as the control group.

One argument for the control group might be this:  Patients who are willing to try an experimental treatment are unusually pro-active about recovery, so they are likely to take other steps to get well, some of which may succeed.  If we pool all patients, then we might wind up attributing to the experimental treatment, success that was really due to the other steps.  We could avoid this problem by randomly assigning patients to one group or the other regardless of their enthusiasm for the studied treatment.

The problem with this argument is that pro-active patients are likely to tell the doctor about the other steps that they have taken if they are asked.  With this information, we can introduce explanatory variables into the pooled equation – variables that control for the steps.  If this is not possible, we can still control for the bias due to the self-selection of patients into the experiment; we would use statistical methods that control for the omitted information.  The best-known such model in economics is “heckit,” named after the Nobel-laureate econometrician James Heckman.

The control-group method is becoming obsolete.  Once upon a time, it was valuable because researchers couldn’t gather much data.  If we can’t control for many possible factors influencing cancer, then we might as well just compare the performance of two somewhat similar groups of patients; it’s better than nothing.  Today, however, computers and the Web enable us to analyze millions of observations.  --Leon Taylor, tayloralmaty@gmail.com

Notes

Consider the regression equation

Y(i) = a + b*X1(i) + c*X2(i) + …. + z*Xk(i),

where Y measures the number of days of survival despite cancer for patient i, i = 1, 2,…, n.  Xk(i) is an explanatory variable for patient i, and the intercept is a. 

Denote X1 as the independent variable identifying patients who took the experimental treatment.  Set X1(i) equal to one if patient i has taken the studied treatment; otherwise, set X1(i) = 0.  For patients who have not taken the treatment, the intercept is simply a.  This is the average number of days of survival for patients who didn’t take the treatment, when we set all explanatory variables equal to zero.  For patients who have taken the treatment, the intercept is a + b, since X1(i) = 1 for all of these patients.  If the treatment is successful, then b should be significantly greater than zero.          

Quote of the week

"Core inflation, which excludes volatile items such as food and energy, has been fluctuating around 0.8 per cent [per year, in Europe] since November. Yet each month...[Mario Draghi, president of the European Central Bank] repeats the mantra that 'inflation expectations are firmly anchored' at close to 2 per cent. He reminds me of Cato the Elder, the Roman senator, who ended all of his speeches in the Senate with the remark that Carthage needed to be destroyed. The difference is that Cato was right."  --Wolfgang Münchau, "Draghi is running out of legal ways to fix the euro," Financial Times, August 17

[For European inflation data, go to https://www.ecb.europa.eu/stats/prices/hicp/html/inflation.en.html --lt]

Lose change

And no, that’s not a misspelling in the title

Kazakhstan seems short of change.  Anyone who frequents the shops and restaurants knows that cash transactions are often inexact, because the cashiers lack coins and small bills.  They lack them because the government doesn’t provide them.  It prints a plethora of 10,000-tenge bills but not enough 200-tenge bills to satisfy demand. 

This shortage particularly threatens small businesses.  A large retailer completes many sales each day, so the those in which it incurs a slight loss offset those from which it receives a slight gain.  On net, the lack of liquidity (that is, of ease in spending) costs it little.  A small firm, however, has only a few sales each day, so it is likely to face a relatively large gap between the amount billed and the amount received.  The business must usually resolve this in favor of the customer to keep from losing her to a large rival.  Suppose that the sale is for 4,500 tenge and the customer can provide only either 4,000 or 5,000 tenge, with no change from either side of the transaction.  Either the seller will lose 500 tenge, or the buyer will lose 500.  Then the cashier will probably settle for 4,000.  This gnaws away at the firm’s already-slender profits.  In addition, unlike the large firm, the small one lacks the wherewithal for debit or credit cards, which could have avoided the illiquidity.  In short, although the government sings the praises of small businesses, it has created a stiff obstacle to their success.        

The shortage of small denominations may occur because the government doesn’t forecast reliably the demand for loose change.  And why should it?  The government profits more from large-denomination bills than from small ones.  The 10,000-tenge bill costs only a few tenge to print but can purchase, say, 10 compact discs.  By exchanging these bills for goods, services or debt, the government makes out like a bandit.  Its potential profits from minting a 1-tenge coin are less glorious.

Ingratiating inflation

The government may lack skilled forecasters, although useful models exist.  In theory, the demand to hold tenge depends largely on income, the interest rate, and the cost of going to the bank for a withdrawal.  The government has data about all three of these factors.  Specializing this model to, say, 200-tenge bills is not difficult.  Suppose that the individual’s total demand for money is 10,000 tenge per week.  The cost of withdrawing and storing 50 200-tenge bills is greater than the corresponding cost for one 10,000-tenge bill; but the smaller bill is 50 times more liquid than the larger one.  Calibrating the money-demand model for the high transaction cost and high liquidity of the 200-tenge bill could help forecast demand for small bills…if you have a forecaster.

So how does the government handle the excess demand for monetary change?  By condoning inflation.  As prices rise, a bill or coin buys less than before.  If a CD now costs 2,000 tenge rather than 1,000, then the purchasing power of a 2,000-tenge bill falls from two CDs to one.  As the purchasing power of coins and small bills converges on zero, people will stop demanding them.  Already the 1-tenge coin is little more than a nuisance; the government has had to shrink it so much that it is hard to pick up.  Some day it may be phased out.

We’d rather reduce excess demand for small denominations by providing the amount that people want rather than by destroying their value.  The 1-tenge coin is useful because it is liquid…as long as prices haven’t risen clear out of sight.  Permitting inflation to destroy the coin diminishes the value of money as a unit of account. 

Those, at least, are my thoughts for a penny.  –Leon Taylor tayloralmaty@gmail.com

  

Notes

As economists use the term, “money demand” refers to the demand to hold money – say, in your wallet or checking account – and not to the demand to spend it immediately.  Money demand rises with income, since richer people will want to spend more eventually and so must have cash at hand.  It falls as the interest rate rises, since you would exchange your money for assets, like bonds, that pay off at the rate of interest.  Finally, money demand rises as the cost of a bank trip rises, since you would withdraw a lot of money from your saving account now in order to avoid another costly trip later. 

This “transactions” model of money demand assumes that all denominations are perfect substitutes; that two 5,000-tenge bills will always trade immediately for one 10,000-tenge bill.  In reality, small denominations are often more scarce than large ones, especially in a transition economy, so they are imperfect substitutes.  

Any good textbook on intermediate macroeconomics, like Mankiw’s, discusses the transactions model, which was developed by Baumol and Tobin.

Good reading         

William Baumol.  The transactions demand for cash:  An inventory theoretic approach.  Quarterly Journal of Economics.  November 1952.

N. Gregory Mankiw.  Macroeconomics.  Seventh edition.  2010. Worth Press. 

      

 James Tobin.  The interest elasticity of the transactions demand for cash.  Review of Economics and Statistics.  August 1956.

Devaluation: If at first you don’t succeed…

Is another weakening of the tenge in the works?

In the past week or two, rumors of another devaluation of the tenge have flown throughout the Internet and now the newspapers.  The central bank, the National Bank of Kazakhstan, devalued the tenge by about a fifth in February, for the first time in five years; another devaluation, coming on the heels of such a large one, could connote trouble.

Circumstantial evidence of an impending devaluation is mixed at best. In principle, a speculative attack on the tenge could force the Bank’s hand, but it is not clear that a serious attack is underway.  If currency traders believe that the tenge will lose value, then they will sell it now while it is still worth something.  These sales will cause the market exchange rate for the tenge to weaken (that is, to rise).  But at present, the tenge is trading at 182 to the U.S. dollar; that is much stronger than what corresponds to the National Bank’s target rate of 185.  Also, if most traders were selling the tenge short, then the Bank would have to defend it by purchasing it in exchange for such foreign currencies as dollars.  The Bank’s  forex reserves would fall.  In reality, the Bank’s reserves rose for several months after the February devaluation.  They have fallen since May but remain higher than in January, reported a business weekly in Kazakhstan, Panorama.  In general, the evidence for an ongoing attack is not clear. 

Sanctions and panics

A devaluation might make a modicum of sense if the new sanctions against Russia, administered by the West because it suspects Kremlin plotting in Ukraine, would otherwise eviscerate Kazakhstan’s economy.  But that isn’t clear, either.  Yes, Russia is Kazakhstan’s leading partner in trade, but it accounts for only roughly a sixth of Kazakhstani trade.  Another of Kazakhstan’s leading partners, China, may profit by the sanctions to the extent that it competes with Russia in export markets.  Increased exports from China would raise its income and thus its demand for imports from Kazakhstan.  Ironically, Kazakhstan could profit from the sanctions, too.  Although it would sell less oil than before through Russia, it could sell more to China, with which it has a direct pipeline, if Beijing comes to doubt Russia’s reliability.

However, if the rumor mill continues to work overtime, then it may compel the Bank to devalue.  Suppose that a currency speculator believes that others will sell the tenge short.  Then he may do the same, even though fundamental factors imply a strong tenge, because opinions rather than facts may drive the forex market.  Apropos of this, the 20^th-century economist John Maynard Keynes likened the stock market to a beauty contest that English newspapers of his day conducted among readers.  A paper would run photographs of the local talent and invite readers to vote for the most beguiling.  The contest would be won by the reader who identified the most popular belles.  Keynes pointed out that the best strategy was to choose not the most beautiful contestants but the top vote-getters.  If most readers were English, then the most popular contestants were likely to be English, not foreign-born.  This analogy suggests that the Bank may not be able to fully control the exchange rate in the medium run. 

The Bank’s best policy is to publish accurate data.  This became clear in February, when a social-media message led to runs on three banks in Kazakhstan.  Especially vulnerable to media attacks are short-run dollar loans to commercial banks, since they rely heavily on these to finance their own loans to domestic borrowers.  The Bank can blunt media attacks, because it is still the most trusted official source of financial data in Kazakhstan – as well as one of the few sources to publish information on the Web in English.  The Bank lost face when it devalued in February after promising that it wouldn’t; providing good information today may help restore its credibility.  But another stark denial by the Bank of future devaluation, without evidence to back up its position, may have perverse consequences.  –Leon Taylor  tayloralmaty@gmail.com

References

John Maynard Keynes.  The general theory of interest, employment and money.  Online.  1936.  The beauty-contest story is in Chapter 12.

Oksana Kononenko.  Genprokuratura napomynla ob otvetstvennocty za cluxy o deval’vatsy tenge.  Panorama, page 2.  August 8, 2014.     

Now or never

In the Great Debate over inflation, where are the moderates?

Reading newspapers, or watching vitriolic newscasts, you may feel caught between Scylla and Charybdis:  Either inflation will run riot tomorrow or it will never come.  Conservatives contend that excess money must quickly raise prices in general.  Liberals counter that since 2009, when central banks ‘round the world printed money ‘round the clock, inflation has remained muted.

Neither position is respectable, even for a straw horse.  let's consider the conservatives' claim first.  Yes, an increase in money supply may raise demand for a nation's production.  We all like to spend.  But in an   economy with excess capacity, the additional spending may raise output rather than prices.  Today most national economies are not producing as much as they can, so they are able to step up production without driving up unit costs and prices.  A worker won't demand a pay raise if two of the unemployed are waiting to take his place.

In addition, the slowdown since 2009 has been unusually severe, and people aren't sure what will happen next.  Until the smoke clears, they may hoard cash rather than spend it.  This may be particularly likely in Tajikistan, which relies heavily on the earnings of its emigrants.  The demand for immigrant labor is more volatile than that for native workers.     

Now turn to the liberal claim.  Inflation depends not only on the money supply but also on the credibility of the central bank, since this shapes public expectations and therefore prices.  If a reliable bank vows to soak up excess money before prices begin to rise, then people may act accordingly.  They won’t demand pay hikes for anticipated inflation – hikes that themselves would generate inflation.  The expectation of stable prices will fulfill itself.        

In the United States, the governor of the Federal Reserve in the late Seventies, Paul Volcker, established the Fed’s credentials as an inflation fighter by creating a recession -- the worst, at that time, since the Great Depression of the Thirties.  Volcker demonstrated that the Fed would sometimes accept higher rates of unemployment in exchange for lower rates of inflation.  The next two governors, Alan Greenspan and Ben Bernanke, benefited by his bitter medicine.  Their monetary expansions created little inflation, partly because people didn’t expect them to. 

(In this light, the National Bank of Kazakhstan may have trouble controlling inflation, because its volte-face on devaluation early this year destroyed its credibility.  If the Bank feels free to renege on the exchange rate, how likely is it to keep its promise of low prices?)   

Brother, can you spare a car?

This doesn’t mean that the Fed can cash in on the Volcker cure forever.  Perhaps the most widely accepted premise in macroeconomics is that a national economy tends over time to produce at full capacity, since workers and capital owners cannot profit by remaining idle for long.  When the U.S. economy finally returns to full production, any Fed prodding of additional spending will raise prices, since the additional output will burden the factories and so prove costly.

The absence of inflation since 2009 is not evidence of its demise.  We’ve seen this movie before.  In the early Forties, to finance World War II cheaply, the Fed printed money and the government controlled prices or quantities.  When the government liberated the economy after the war, prices surged – although economists had predicted that they would collapse.  

(Their idea had been that as folks become richer, they will spend a smaller share of their income.  Economic recovery must end in sustained stagnation and low prices.  Economists had overlooked the public’s demand, pent up during the war, for such durable goods as automobiles.  When the war ended, consumers scrambled to make up for lost time.  Even after this splurge, consumption did not drop sharply, because it depended in the long run on long-run income, which is slow to change.)              

What’s wrong with inflation?  The consumer’s usual answer is that higher prices reduce the amount that she can buy with her paycheck.  Eventually, she will persuade her boss to give her a pay raise, since the high prices of his output increase his revenues.  Meanwhile, her standard of living will fall.

The standard error

Another problem is that inflated prices mislead us.  In principle, the price of a bag of potato chips reveals to us the cost of producing the bag as well as its value to the consumer.  If the price is 30 tenge, then the bag could not have cost more than that to manufacture, or the factory would not have provided it; and the consumer could not have valued it at less than 30 tenge, or she would not have bought it.  By raising the price, inflation deceives us about the bag’s value.  The producer, observing the price hike, may conclude that the demand for chips is rising, so he will produce more.  Only eventually, after noting price increases throughout the economy, will he realize that the price of chips rose because of inflation rather than an increase in the demand for treats.  To correct his error, he will scale back production – firing workers and paving the way to recession.

Most public critiques of inflation focus on extreme cases in which prices rise by millions or billions of percent.  Clearly, hyperinflation destroys the economy by disabling the price mechanism, which is as vital to markets as an engine to an automobile.  The classic example is Germany in 1923, where hyperinflation cleared the path for Hitler, who vowed to use his storm troopers to prevent alleged price increases by the Nazis’ usual suspect, the Jewish merchant.  Such textbook discussions imply that inflation is rarely destructive.  In truth, even modest inflation can damage.  Though the distortion in the amount produced of a particular commodity may be small, a national economy includes hundreds of thousands of goods and services.

Inflation is not always pernicious.  John Maynard Keynes, who was more critical of high prices than non-economists realize, pointed out that we may prefer slight inflation to slight deflation.  One reason is that the agent of economic growth, the entrepreneur, must borrow in order to build his innovation.  When prices are rising, the real cost of a 500,000-tenge loan will fall since those tenge, now returned to the lender, will buy fewer products than they did when the entrepreneur took out the loan.  Conversely, when prices fall, the real cost of the loan to the borrower will rise.  This will discourage attempts at innovation. 

This may help explain why the European Central Bank has targeted an inflation rate of 2%.   Inflation of 7%, the going rate in Kazakhstan, may be a bit harder to justify.  –Leon Taylor, tayloralmaty@gmail.com           

Good reading

John Maynard Keynes.  A tract on monetary reform.  Online.  1923.  Keynes was a monetarist, urging controls on money supply, well before he became a Keynesian.  Of his books on economics, A tract is his most readable.