Minimum wage – maximum unemployment?

Does the minimum wage bite the hand that it is intended to feed?


According to its supporters, the minimum wage – the lowest wage that employers can legally pay – protects workers who are too weak to negotiate a tolerable paycheck on their own with employers. Critics of a wage floor point out that a high wage may attract more workers than firms want to provide. In theory, in an unregulated labor market, this imbalance is temporary. Eventually, the excess workers – the unemployed – will offer to work at lower wages. This will force the market wage to fall until no excess labor remains. But if a law prevents the market wage from declining, then unemployment will persist. The minimum-wage law hurts the workers that it was ostensibly designed to protect.

Applied to Central Asia, this argument may have its flaws, both theoretical and empirical. It assumes that the labor market is competitive: Employers and employees are so numerous that no one of them can affect the market wage. This is determined instead by their collective decisions. In this setting, no employer can pay another worker less than she is worth, since she has lots of other opportunities. But as a former Soviet satellite, Kazakhstan still has many areas that are dominated by a single employer -- so-called “one-company towns,” which may have numbered in the dozens in mining, metallurgy and agriculture during the Nineties, noted two World Bank economists, Martin Rama and Kinnon Scott. Kazakhstan may have even more company towns than is typical in the Commonwealth of Independent States, because Soviet industrial subsidies per capita were larger here. The power of these companies over Kazakhstan’s labor market is suggested by a finding of Rama and Scott that wages rose when a large company moved into a small town and fell when it left.

Bad company

In company towns, given an unregulated labor market, the worker must either accept the employer’s pay offer or not work at all. Thus the employer may set the wage well below the worker’s value in production; to induce her to accept the offer, he needs only to leave her slightly better off than she would be when unemployed.

In addition, the boss may refuse to hire many worthy workers. The reason given by economic theory is that he usually pays the same wage to all workers of a given type (for example, all recent high-school graduates applying for jobs at his plant). To hire another worker, he must raise his pay offer, since she had refused a job at the earlier, lower wage. But if he raises pay for this worker, he must also do so for all of his other workers of the same type. The cost of doing so may exceed the value of the additional worker to the plant; and so he won’t offer to hire her.

In a company town, a minimum wage may raise the workers’ pay without threatening their jobs, since each employee would still add more value to the firm than she cost. Also, the boss may hire more workers, because he no longer perceives a large expense in raising their wage. He must pay the minimum wage (at least) to all workers, so he will hire anyone who is worth that wage.

A simple example may help clear up these ideas. Suppose that the employer dominates the local labor market. A worker now applies for a job. Suppose that she would be worth $10 an hour to the employer but would be willing to work for as little as $3. Then the boss will offer her only $3 and pocket $7 as profit. Now suppose that the government sets the minimum wage at $9. The boss would still hire the worker, since she more than pays her way: But his profit on her labor will drop to $1 ($10 minus $9). The other $6 of profit now go to the worker.

Real wage, real world

Empirically, the claim that the minimum wage creates unemployment is controversial. The most common conclusion is that the minimum wage increases unemployment, holding all else constant. But some statistical studies conclude that the minimum wage has no effect on unemployment – or may even reduce it. One reason may be that governments rarely adjust the minimum wage for inflation. As prices rise, the amount of goods will diminish that, say, a thousand tenge can purchase. If the government does not increase the number of tenge in the minimum wage, then eventually its real value may fall below that of the wage that would clear the labor market. In that case, the minimum wage has no effect on workers; it’s just a wage floor, and the market pay that they actually receive already exceeds it.

In December 2010, the government set the monthly minimum wage at 13,728 tenge (about $92 at the current exchange rate).  This is 2.5 times the “poverty line” (so called because a person making less than this is deemed by the government to be poor), according to the news source Interfax-Kazakhstan. The minimum wage is higher for manual laborers as well as workers in hazardous industries, noted analyst Kanat Berentaev; in that case, it may affect those markets more than others. The labor ministry has said it would increase the minimum wage by 2015 as it restructures the policy, reported neweurasia.net . Perhaps, as officials redesign the minimum wage, they may wish to analyze what, if anything, it has actually accomplished. – Leon Taylor, tayloralmaty@gmail.com


Good reading


Ronald G. Ehrenberg and Robert S. Smith. Modern labor economics: Theory and public policy. Ninth edition. Boston: Pearson Education. 2006. Surveys work on the minimum wage.

Robert H. Frank. Microeconomics and behavior. Third edition. McGraw-Hill. 1998. Discusses the effects of the minimum wage in a labor market dominated by one employer.

Kanat Berentaev. The strike of oil industry workers: analysis of reasons and ways of solving the situation (short thesis). Center for Analysis of Public Reforms. Online at algadvk.kz .

Martin Rama and Kinnon Scott. Labor earnings in one-company towns: Theory and evidence from Kazakhstan. The World Bank Economic Review 13:1, pages 185-209. January 1999. On line.




References



Interfax-Kazakhstan. Kazakh ministry of labor adjusts poverty line for Q1 2011. January 6, 2011. Online.

neweurasia.net . Minimum wages in Kazakhstan and abroad. January 5, 2010. Online.

A wail of two cities

Do the cities of Kazakhstan attract more workers than they need?


Why is the unemployment rate in Kazakhstan’s two major cities – Astana and Almaty – unusually high?

Generally, these rates – which measure the share of the labor force that is looking for work -- have exceeded the national rate since 2005, according to data from the national statistical agency. Almaty's rate was a sixth higher than the national one in 2009 and remained a tenth higher in 2010. Astana's rate is usually lower than Almaty's but was still a twentieth higher than the national rate in 2010.

Among the oblasts, the only unemployment rate that has been as consistently as high as those of the cities is that of Mangistau, in west Kazakhstan’s “oil country.” It was a fifth higher than the national rate in 2005-6 but then dropped sharply, beginning to rise again in the national slowdown of 2009. (For the figures, see the notes below.)

One might expect a low unemployment rate in cities, because they attract employers. If the firm sells in a national or global market, then it will receive the same revenues regardless of where it locates in the country. So it should put down its roots wherever it can produce most cheaply. Typically, that place is a city, for several reasons.

First, a firm can cut its costs by locating near others in its industry. This cluster of producers generates enough demand to support specialized inputs nearby. When two flour mills locate side by side, they attract a pool of flour workers. Both mills will benefit, since they no longer need to recruit workers in distant cities.

Similar reasons may help explain the growth of high-tech industries in the United States, such as Silicon Valley in California or Route 128 near Boston. For example, computer manufacturers sometimes need workers to repair instruments. It usually isn’t worth the factory’s while to simply keep repairmen on payroll for a task that may take just a few weeks each year. But if several manufacturers locate near one another, then they can support a fulltime firm devoted to instrument repair. Such factors may also help explain why, in the Eighties, over half of the steel industry concentrated in Pennsylvania, Ohio and Indiana; and nearly half of the auto industry in Michigan, concluded the American economist Gerald Carlino.


Going steady


Workers may also prefer the cities, since labor conditions may be more stable there than out in the country. The urban economist Arthur O’Sullivan explains why. When firms in the city step up hiring, the wage will begin to increase. This, in turn, will attract immigrant workers, who will vie for jobs by bidding the wage back down. Similarly, when urban hiring declines, wages will begin to fall. Many workers will respond by leaving. Since they no longer bid down the local wage, this will drop only a little. In short, the urban wage is fairly steady over time, whether firms are demanding more workers or fewer. Now consider an isolated rural area, where workers must take any jobs that they can find, almost irrespective of the wage. Changes in firms’ demand for labor can touch off sharp changes in the wage, since there is no moderating change in the number of workers.

So, workers who prefer steady wages may move to the cities. In turn, this expansion of the urban labor force may attract employers, creating jobs.

Why, then, is the unemployment rate so high in Almaty?


Do bright city lights blind?


The traditional explanation of unemployment is that high wages are attracting more job seekers than firms want to hire. In a free labor market, the jobless eventually will offer to work for less than the going wage, eliminating the unemployment. But minimum-wage laws – which ban low wages – may destroy jobs for unskilled workers whom firms would employ only for rock-bottom pay. (Whether minimum-wage laws are actually so damaging is controversial. For a crisp introduction to the debate, see the text by Ronald Ehrenberg and Robert Smith.) However, it is not apparent that wages are too high in Almaty but not in the rest of Kazakhstan. The minimum-wage law is national.

Perhaps Almaty workers are willing to put up with a little joblessness in exchange for the city’s amenities – the “bright city lights.” Unlike the steppes of Kazakhstan, Almaty offers a myriad of shops and schools. This may also help explain why the unemployment rate is higher in Almaty than in Astana, which is not yet as diverse as its sister city.

Some statistical evidence suggests that urban amenities attract consumers. In the past 20 years, cities with more restaurants and live-performance theaters have grown more quickly, in the U.S. as well as in France. The main amenity is good weather, as measured either by January temperature or by the amount of rain and snow. One statistical study finds that, among counties in the U.S., weather may explain more growth in population or in housing than does any other determinant. "No variable can explain [U.S.] state and city growth over the past 80 years as relably as temperature," concluded economist Edward Glaeser in surveying the literature.  This makes sense. You can’t find a substitute for good weather. (Astana, take note.)

To measure the value of amenities, economists look at housing rent. People are willing to pay higher rents in cities because they receive higher wages there and because they enjoy the fruits of urban living. If rents are rising more rapidly than wages, then the city’s amenities must be growing more valuable. Via this reasoning, Glaeser, Jed Kolko and Albert Saiz found that large U.S. cities with higher amenity values grew more rapidly than did other cities over the Eighties.

Or maybe Almaty workers tolerate spells of unemployment in order to have steady wages during their long periods of employment. They may dislike a pay cut more than they would like a pay raise of the same size; that is, they are “risk averse.” Whether this explains Almaty’s high rate of unemployment may depend in part on whether jobless workers here can rely more on some source of income – the family or the government – than can the unemployed in the rest of Kazakhstan. But even if this were true, one would still have to explain why workers in Almaty are more risk-averse than those in the remainder of the country.

Another possibility is that migrants to cities are too optimistic. Hearing of an economic boom in Almaty, they may happily conclude that they will surely find a job there now. But over time, potential migrants should become better informed about employment, if only by keeping in touch with friends and relatives in the cities. The rate of unemployment in the cities (relative to the national rate) should fall. In Almaty and Astana, it has actually risen for nearly a decade. The mystery continues. -- Leon Taylor, tayloralmaty@gmail.com


Notes


The following ratios are for the unemployment rate in the given region, divided by the national unemployment rate. All underlying data are from the national statistical agency.

a. Almaty: 2003, 1.01; 2004, 1.05; 2005, 1.04; 2006, 1.05; 2007, 1.08; 2008, 1.11; 2009, 1.17; 2010, 1.09.

b. Astana: 2003, .95; 2004, .99; 2005, 1.01; 2006, 1.03; 2007, 1.05; 2008, 1; 2009, 1; 2001, 1.07.

c. Mangistaya Oblast: 2003, 1.1; 2004, 1.17; 2005, 1.2; 2006, 1.19; 2007, 1.17; 2008, 1.03; 2009, 1.08; 2010, 1.1.


Good reading


Ronald G. Ehrenberg and Robert S. Smith. Modern labor economics: Theory and public policy. Ninth edition. Boston, Massachusetts: Pearson. 2006. Chapter 4 discusses minimum-wage laws.

Arthur O’Sullivan. Urban economics. Sixth edition. Boston, Massachusetts: McGraw-Hill. 2007.

Edward L. Glaeser, Jed Kolko, and Albert Saiz. Consumer city. Journal of Economic Geography 1, pages 27-50. 2001.

Edward L. Glaeser.  Reinventing Boston: 1640-2003.  National Bureau of Economic Research working paper #10166. 2003.  Online.   Published in the Journal of Economic Geography  5(2), pages 119-153.  April 2005.


References

Gerald A. Carlino. Productivity in cities: Does city size matter? Business Review, Federal Reserve Bank of Philadelphia, Nov.-Dec. 1987.

Alfred Weber. Alfred Weber’s theory of the location of industries. Translated by C.J. Friedrich. University of Chicago. 1929. Weber pointed out in 1909 that firms choose the cost-minimizing location. A related work is August Losch’s The economics of location, 1944.

The great indoors

How important is outdoor work to Kazakhstan?


The government of Kazakhstan is disgruntled about the economy, which doubles the average resident’s income every seven years or so. It has launched a program of “forced” innovation and industrialization (“accelerated” may be a more accurate translation) in order to diversify away from production of oil, gas and other raw materials.

Less publicized is the fact that the economy is already diversifying. Like higher-income economies, it produces more services than goods. Oil and gas still dominate exporting but only because of their high prices.

One gauge of the economy’s maturation is the declining importance to it of outdoor work. A modern economy emphasizes brains, not brawn. Where the latter matters, the season’s weather may affect sharply the number of workers.

In Kazakhstan, weather effects on employment are mild for a transition economy. For 2011, the number of workers and job-seekers – i.e., the labor force -- varied between 8.6 million and 9 million, depending on the season: Lowest in the winter and highest in the fall. But the largest monthly workforce (October) is only 367,000 more than the smallest (January and February), just 4.2% of the mean size for the year. Employment too was steady across the months. In 2010, seasonal effects on the labor force and on just the employed were even smaller than in 2011.


The match game


Similarly, the monthly unemployment rate in 2011 steadied between 5.3% and 5.6%, varying by only a twentieth of the mean annual rate. Unemployment is highest in the winter but probably not by enough (18,000 jobless workers more than in the best month) to justify special benefits for those out of work because of the season. Overall, the seasonal effect on unemployment in 2011 was less than half that of 2010; and the average unemployment rate (for January through November) dropped from 5.8% to 5.4%. Thus the labor market may be improving its matches of the jobless to jobs, although it isn’t clear whether the improvement is due to a strengthening economy or to better information for job hunters.

From only two years of data, we cannot conclude that seasonal employment in Kazakhstan is becoming moot. Some seasonal effects were larger in 2011 than in 2010. But estimates using quarterly data for 2003 through 2008 confirm that seasonality effects have been waning steadily over the long run in Kazakhstan. They raise the possibility that the government’s industrial policy addresses a problem that entrepreneurs already are solving. – Leon Taylor, tayloralmaty@gmail.com


Notes


1. All data are from Kazakhstan’s agency on statistics (www.stat.kz) unless otherwise noted. Quarterly estimates may be more accurate than monthly ones, since the government has actually surveyed the labor market each quarter.

2. I measure the seasonal effect on the labor force as the ratio of the difference between the largest monthly size of the force and the smallest number, relative to the mean size for the year. For example, in 2010, the labor force was smallest in January (8,448,400 members) and largest in June (8,667,900). The variation was thus 8,667,900 minus 8,448,400, or 219,500. The mean size of the labor force over 2010 was 8,611,200. As defined here, the “seasonal effect” was 219,500 divided by 8,611,200, or 2.5%. Seasonal effects for the "employed population" (which includes the self-employed as well as employees) and for the unemployment rate are measured similarly.

We may measure seasonal effects in other ways, such as the ratio of the standard error to the mean. The measure that I use here puts more weight on extreme seasonal effects.

Seasonal effects do not always arise from weather.  Holiday spending may also affect employment. But it is probably safe to say that, in Kazakhstan, weather affects significantly the seasonal effects as measured here, even if it is not the only determinant.

My estimates of seasonal effects in 2003 through 2008 are:

For the labor force: 2003, .082; 2004, .032; 2005, .026; 2006, .019; 2007, .022; 2008, .015.

For employees and the self-employed: 2003, .098; 2004, .042; 2005, .034; 2006, .026; 2007, .029; 2008, .021.

For the unemployed: 2003, .086; 2004, .078; 2005, .063; 2006, .073; 2007, .067; 2008, .060.

For the unemployment rate: 2003, .17; 2004, .107; 2005, .086; 2006, .092; 2007, .094; 2008, .075.

The wheel deal

Which is more dangerous – the steering wheel or the driver?


In 2006, Kazakhstan banned the use of cars with the steering wheel on the right-hand side. It argued that such vehicles, designed for countries in which people drive on the left-hand side of the road, lead to accidents here, where we drive on the right-hand side. Banning the cars would lower the rate of accidents per mile driven.

In 1975, a Chicago economist, Sam Peltzman, identified the flaw in this argument: Drivers decide for themselves how much risk to take. They buy cars with a right-hand steering wheel because they cost a few thousand dollars less. They understand that the cars are dangerous on Kazakhstani roads, and so they take precautions. If they are forced to buy cars with a left-hand steering wheel, then they will no longer have reason to drive like the little old lady from Pasadena. They may press the pedal to the metal in order to reach their destination more quickly. This is risky driving, but risk has benefits as well as costs. In short, a ban on right-hand steering wheels might not avert accidents.

Here’s the intuition. A driver will speed a bit more if the benefit to him (getting to the concert on time) exceeds the cost (a possible crash). Requiring him to drive a safer car reduces the cost for every speed. So he will drive faster.

Peltzman was writing about the decision of the United States government in the 1960s to mandate seat belts and other safety features that reduce the chances of injury in a given accident. He pointed out that wearing the seat belt may tempt the driver to speed, making an accident more likely. The overall chance of injury to the driver may not fall. In fact, if speeding endangers pedestrians, then the total number of injuries – to drivers, passengers and pedestrians – may rise.

From his statistical work, Peltzman concluded that requiring seat belts, and steering columns that absorbed energy, had not saved lives.  “The one result of this study that can be put forward most confidently is that auto safety regulation has not affected the highway death rate.”


Building a safer driver


Peltzman’s analysis was sophisticated, but a few technical glitches may be more apparent now than in 1975. The dataset contained observations that varied with time: An accident rate for 1961, another for 1962, and so forth. Some of his estimated models assumed that the relationships between accidents and variables representing potential causes were stable over time. In reality, the relationships might not have been stable, because the underlying variables – e.g., the accident rate, vehicle speed and income – might have been changing over time independently of one another. In addition, the dataset included observations for each state in the U.S. The unique characteristics of a state may affect auto safety on its roads in ways that a statistical model cannot capture explicitly.

These small potential flaws do not blunt Peltzman’s basic point: Regulation too often takes human behavior for granted. Auto regulators viewed safety as an engineering problem. Build a safer car, and fewer people will die in accidents. Peltzman showed that a regulation – such as requiring safer cars – may itself affect the driver’s behavior, and in perverse ways.

If drivers demand more safety, then they may indeed drive the safer car with care. In that case, the regulation may have the desired effects. But it will be superfluous, since the drivers would have wanted to buy safe cars on the market. Regulators would not have had to force automakers to produce them; the profit motive would have seen to that.

At times, regulation benefits us. The driver may not consider that his ill-maintained engine generates air pollution, since he does not suffer most of this pollution himself. Requiring annual inspections of engines may clear the air.

Even here, regulators could borrow a few tricks from the market. They could issue among drivers the number of permits to pollute (by skipping inspections) that corresponds to the level of pollution that they are willing to tolerate. Drivers who find it easy to reduce engine emissions – perhaps because they have new cars – would sell their permits to drivers who cannot afford to clean up. Thus the government would cut pollution to the tolerable level as cheaply as possible. Peltzman’s point – that regulators must consider behavior – holds again.

In 2007, Kazakhstan’s government canceled the ban on right-hand steering wheels just before elections, noted an English newspaper, The Telegraph. The reason was presumably political. But an economic reason exists as well. -- Leon Taylor, tayloralmaty@gmail.com



Good reading

Sam Peltzman. The effects of automobile safety regulation. Journal of Political Economy 83(4): Pages 677-726. August 1975. Online at www.jstor.org. Fun to read.


References

Gethin Chamberlain. Kazakhstan election a 'foregone conclusion'. The Telegraph. August 12, 2007. Online.

Who makes money?

The central bank doesn't print money.  So what?

Conservative critics of the central bank blame it for increasing prices in general, by “printing money.” The usual liberal response – among non-economists – is that the bank doesn’t print dollars and so isn’t responsible for a surfeit of them.

Of course, the bank doesn’t literally have a printing press. Creating coins and paper money is the job of the government mint. Nevertheless, the central bank determines the money supply, especially in the long run, although its influence is indirect.

The simplest way for the bank to affect money is to cut a deal with the public Treasury, the agency that raises the amount of money that the government has decided to spend. If tax revenues don’t suffice, then the Treasury must borrow. It issues I.O.U.'s -- bills, notes and bonds -- through which it usually pays interest periodically in exchange for loans upfront. It would like to borrow as cheaply as possible, by holding down the interest rate that it must pay. A congenial central bank can make the Treasury’s dream come true by buying the government’s bonds. This increases the overall demand for the bonds -- and thus increases their value for their seller, by reducing the interest that it must pay on them.

Where does the central bank get the dollars (or tenge, or whatever) for buying the bonds? Out of its “reserves,” which essentially are safes holding dollars. These reserves are not truly money, since their locked-up dollars are not available for spending. But once the central bank takes the dollars out of reserves and exchanges them for public bonds, the government can spend them on anything.  So they now become money. The central bank has just increased the supply of dollars, even though it didn’t print them. Similarly, if the bank wants to reduce the money supply, then it can sell bonds in exchange for dollars and stash these back in reserves.

The mild, mild West

Most central banks in the West resort to purchases and sales of bonds – “open market operations” – in order to manipulate the money supply. These days, they rarely cut explicit deals with the Treasury. The central bank in the United States, the Federal Reserve, declared its independence of the Treasury Department more than 60 years ago; the charters of some other central banks prevent them from lending directly to their governments. Nevertheless, in a recession, the central bank may buy bonds – and even commercial paper, a form of short-term loans to businesses – in order to give people more spending money, revving up the economy.

The central bank can also increase the money supply by encouraging commercial banks to loan out their reserves. Again, the lent dollars now qualify as money, either as cash or checking accounts. To coax these private banks into lending, the central bank may lower the share of their reserves that it forbids them to lend – the “required reserve ratio.” Or it may lend them its own reserves at a reduced rate of interest, known as the “discount rate.”

The National Bank of Kazakhstan has usually taken this route when it wanted to encourage spending. In recent years, it has increasingly resorted to open market operations. But it faces the same constraint as do central banks in other transition economies – the financial markets in Kazakhstan are still too thin to absorb a lot of bond trades. The consequences of a major bond purchase are not easy to predict.  So the National Bank tended to stick to the tool that it knew best -- the rediscount rate, which has risen slightly to 7.5% in order to contain inflation. 

The Bank's 2011 guidelines identify notes and commercial bank deposits with itself as its "main tools" for stabilizing interest rates.  It has increased slightly the required reserve ratios for commercial banks, which are higher for foreign deposits than domestic ones; but the ratios remain close to zero. 

Even if a central bank did run the mint, it would not control the money supply perfectly, especially in the short run.  The supply depends on the alacrity of private banks in lending and on the share of money that individuals hold as cash rather than as checking accounts.  If banks lend eagerly, and if households prefer bank accounts to fat wallets, then the money supply may increase sharply.  That's because the bank may lend much of Smith's checking deposit to Jones, creating (say) $1.80 for every $1 in the account. 

In Kazakhstan, commercial banks were scorched by the 2008 crisis and remain reluctant to lend today.  Also, Kazakhstanis prefer to pay with cash than with checks.  These facts restrict some factors affecting the tenge supply that are beyond the National Bank's control.  Thus the Bank can manipulate the money supply more precisely than is usual for central banks.  This may help account for its relatively good record of inflation (relative, anyway, to some other countries in the Commonwealth of Independent States, like Georgia): about 9% per year, just outside the Bank's target range of 6-8%.  -- Leon Taylor, tayloralmaty@gmail.com


References

National Bank of Kazakhstan.  Monetary policy guidelines for 2011.  Online.

The charge of the Austrian brigade

Austrian economics and the Real McCoy


Conservative politicians often identify themselves with something that they call “Austrian economics.” This, in their mouths, boils down to the proposition that inflating the money supply will inflate prices.  (One exception is the U.S. presidential candidate Ron Paul, a disciple of Ludwig von Mises; Paul has advocated competition among currencies in order to improve them.)

The link of money supply to inflation is not uniquely Austrian. Most economists accept that when the economy produces at full capacity, attempts to spend additional money will raise only prices since long-run output cannot be increased. They also accept that when the economy is below capacity, a boost in spending may induce producers to hire more workers and reopen factories, increasing output. Competition among these firms will hold down prices. In today’s anemic economies, an increase in the money supply may not hitch up prices right away – but just you wait.

What is Austrian macroeconomics? What does it mean for central Asia?

Austrians -- particularly the late Nobel laureate Friedrich Hayek -- focus on how money affects the structure of the national economy. In principle, any industry should expand to the point that a little more expansion will earn the same rate of return as it would in any other industry. An industry that earns a lower rate of return than others has over-expanded. It should release some men and machines to industries where they would be more valuable.

This process is painful for the bloated industry – and for industries that depend on it. When the faulty industry happens to be finance, its sudden curtailment will slow down the economy in general, since any firm must rely on finance to pay for expansion. (In the United States, firms often pay out of their own pockets – i.e., out of retained earnings – rather than borrow from banks or sell shares of stock. But finance still determines American expansion, since the firm will spend its retained earnings on its own project rather than lend to someone else’s only if it anticipates a higher rate of return to the former.) Austrians want to reduce the corpulent industry as quickly as possible – even if this would trigger a national recession – since delay would distort the economy further and make the inevitable adjustment more painful. Do we want a one-year recession now or a 10-year depression later?

Increasing the money supply may obscure identity of the industries that need to slim down, because the new money does not affect all industries at the same time. The first industries to receive the money may interpret it as an increase in demand for their products – and so may expand. Later, when their input prices rise, they will discover that the supposed increase in “demand” was, in fact, an increase in money supply that will eventually raise all prices. Then they will cut back, laying off workers and padlocking factories.  Inflation leads to mistakes that touch off a business cycle.

Austrian castor oil

To Austrians, the problem with printing dollars is not that it raises all prices. This would increase the household’s income by as much as it did the cost of its groceries (since the wage is also a price), so the household could buy as many goods as before. The problem is that inflation is not general in its early stages. The fact that most prices do not rise immediately after an expansion of money – which seems the case today -- is small comfort; to the contrary, it may lead to mistakes that induce recession.

For example, global oil prices rose 65% from 2009 ($60 per barrel) to early 2011 ($95), according to the United States Energy Information Administration. Does this increase merely signal the rise in demand for oil that one would expect from a recovering world economy? Or is part of it due to the early effects of a monetary expansion that occurred because national governments fought the 2008-9 crisis by printing money?

Conservative politicians are quicker to accept the Austrian mantle than its implications. It’s easy to blame central bankers for “debasing our money.” It’s not so easy to point out that the Austrian medicine – let bad firms fail – may cost millions of voters their jobs.

Nevertheless, the Austrian model may have anticipated correctly the economic twists and turns around the world for the past five years. The current eurocrisis may have arisen in large part because commercial banks lent to profligate governments that today cannot pay them back.

The Austrian model may also pertain to Central Asia in the long run. To what extent are the region’s economies inefficient because of lingering effects of Soviet policy? In Kazakhstan, has the farm sector contracted to its efficient size? To what extent are monetary policies in the region disguised attempts to prop up faltering industries like banking? The Austrians are politically correct; are they therefore wrong? – Leon Taylor, tayloralmaty@gmail.com


Good reading

F. A. Hayek. The collected works of F. A. Hayek. Volume 5: Good money. Part I: The New World. Edited by Stephen Kresge. The University of Chicago Press. 1999.


References

Paul Krugman. G.O.P. monetary madness. The New York Times. December 15, 2011.

Ron Paul.  Mises and Austrian economics: A personal view. Auburn, Alabama: Ludwig von Mises Institute.  1984.  Online.

The declaration of dependence

Is the National Bank of Kazakhstan independent of politicians?


Should politicians control the central bank, which manages the nation’s money supply?

Proponents of a political bank argue that it would enable the government to coordinate monetary policy (how much money should we print?) with fiscal policy (how high should taxes be?). An apolitical bank might work at cross-purposes with the legislature. Suppose that the solons try to resuscitate a sluggish economy by taxing less and spending more. The central bank could squash this attempt by raising interest rates, discouraging firms and households from borrowing money to spend. William Greider, a journalist who wrote a searing -- if populist -- history of the American central bank, Secrets of the temple, argued that the Federal Reserve should seek the approval of a Congressional oversight committee before doing anything serious.

Most economists oppose a political central bank. They reason that voters vote their pocketbooks. A political bank may inflate the money supply in order to juice up spending, creating jobs and wealth for just long enough to re-elect incumbents. Prices will rise later, destroying purchasing power and leading to layoffs, but who cares? That’s a headache for future politicians.

There is a little evidence of such a political business cycle. United States Democrats accused Arthur Burns of inflating the money supply before the Presidential re-election bid of his friend Richard Nixon in 1972. In South Korea, the government loosened regulations on household loans in time for the presidential election of December 2002. Consumption boomed. After the election, the government clamped down again on household borrowing. Consumption swooned, and Korea entered into its second recession ever, wrote Jahyeong Koo.

Harry’s woodshed

One problem with policy coordination is that it may outlive its purpose. The Federal Reserve had kowtowed to the U.S. Treasury during and after World War II, when it agreed to buy federal bonds in order to keep interest rates below 2½ percent, noted Marvin Goodfriend. (Purchases of bonds raise their price and thus lower their rate of return to the buyers. This yield is essentially the interest rate.) In effect, the Fed had agreed to pay the federal debt by printing dollars, which it exchanged for the Treasury’s bonds. Thus the Fed surrendered to the Treasury the management of the money supply. The Fed had intended to cut the government’s cost in fighting the war, but its understanding with the Treasury continued for years after peace had broken out.

In 1951, the bank declared its political independence when it said it would no longer create money to pay Uncle Sam’s debt. Alarmed, President Harry Truman tried to strong-arm the Fed into financing the ongoing Korean War. He summoned to the White House the Fed panel that oversaw the bank’s bond trades. Truman told members of the Open Market Committee that they had to cut the government’s borrowing costs since it might face a world war. Boosting interest rates instead would help “Mr. Stalin.” After this woodshed rendezvous, Truman announced that the Fed had agreed to pay the debt. The Fed quickly set him straight. Truman reluctantly gave in, because he was in an imbroglio over firing General Douglas MacArthur for seeking to invade China, wrote Robert Hetzel and Ralph Leach.

In creating the Fed in 1913, Congress made it independent in order to keep politics out of the regulation of commercial banks. Each Fed governor serves one term of 14 years (unless she is filling in for an unexpired term). The Fed need not worry that Congress will cut its budget, because it pays its own way. It earns interest on government securities, returning its considerable profits to the Treasury.

Don’t RSVP, please

Not all presidents twist bankers’ arms. In the early years of the Federal Reserve, Woodrow Wilson wouldn’t invite its governors to his White House get-togethers, for fear of influencing them, noted Fed historian Allan Meltzer in an interview.

Some guarantors of bank independence have been more subtle than Wilson. The European Central Bank exists by treaty with the nations of the European Union. They must unanimously agree to any change in the treaty -– a difficult provision that helps ensure the bank’s independence, noted Nobel laureate Finn Kydland and Mark Wynne. In the early Nineties, before the European Central Bank had set up shop, the central banks of Spain, Portugal and Greece were obliged to buy some fraction of the governments’ bonds, thus risking inflation, wrote Joydeep Bhattacharya and Joseph Haslag. Judging from the news of the past year, old proclivities die hard.

Since World War II, it has been evident that countries with political central banks tend toward much higher rates of inflation -– with no gain in output -- than countries with independent banks. In 1956, when the ornery Bundesbank raised its discount rate by one percentage point, Chancellor Konrad Adenauer chastised it: “The guillotine falls on the man in the street.” But the German Miracle followed, noted Hetzel.

In the early 1990s, Kazakhstan’s annual rate of inflation soared above 2,100 percent. Later, when the National Bank of Kazakhstan became independent, it brought down inflation to single digits within seven years, asserted the Bank.

Nevertheless, the government here is conspicuously authoritarian, and questions about the Bank’s independence linger. In her MBA thesis at KIMEP early this year, Ainur Rakhisheva looked at how changes in the inflation rate might have affected changes in the tenge supply from 2000 to 2011. Presumably, if the National Bank is politically independent, then it will tend to respond to accelerating inflation by increasingly tightening the money supply in order to bring prices back down. Looking at monthly data and three-month averages, Ms. Rakhisheva did not find a systematic relationship.

Clearly, this research is a beginning. The Bank may respond to inflation data after a lag of more than three months. Its decision of whether to tighten money may depend partly on whether the economy is already operating at full capacity, forcing it to respond to new money only with higher prices, not higher output. Nevertheless, given the evidence at hand, perhaps one may give the claim of Bank independence the Scots’ verdict: “Not proven.” -– Leon Taylor, tayloralmaty@gmail.com

Disclosure: I reviewed the thesis along with Dr. Mujibul Haque, a KIMEP finance professor. The adviser was Dr. Dana Stevens, also a KIMEP finance professor.

Good reading


Joydeep Bhattacharya and Joseph H. Haslag. Reliance, composition, and inflation. Federal Reserve Bank of Dallas: Economic and Financial Review, pages 20-7. Fourth quarter, 2000.

Douglas Clement. Interview with Allan H. Meltzer interview. The Federal Reserve Bank of Minneapolis: The Region. September 2003.

Marvin Goodfriend. The phases of U.S. monetary policy: 1987-2001. Federal Reserve Bank of Richmond: Economic Quarterly, pages 1-17. Fall 2002. Online.

Robert L. Hetzel. German monetary history in the second half of the twentieth century: From the Deutsche mark to the euro. Federal Reserve Bank of Richmond: Economic Quarterly, pages 29-64. Spring 2002.

Robert L. Hetzel and Ralph F. Leach. The Treasury-Fed Accord: A new narrative account. Federal Reserve Bank of Richmond: Economic Quarterly, pages 33-55. Winter 2001. Online.

Jahyeong Koo. Nature of recent economic distress in South Korea. Federal Reserve Bank of Dallas: Expand Your Insight. April 16, 2003. Online.

Finn E. Kydland and Mark A. Wynne. Alternative monetary constitutions and the quest for price stability. Federal Reserve Bank of Dallas: Economic and Financial Policy Review 1:1, pages 12-13. 2002. Online.

Allan H. Meltzer. A history of the Federal Reserve. Volume 1: 1913-1951. The University of Chicago Press. 2003. Definitive.

References


Federal Reserve Bank of San Francisco. U.S. monetary policy: An introduction. 2004. Online.

National Bank of Kazakhstan. Overview of the monetary policy of the National Bank of Kazakhstan. October 2004. Online.

Ainur Rakhisheva. Independence and central bank efficiency in a case study of Kazakhstan. KIMEP: MBA thesis. Spring 2011.