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. 

Below average

Which measure of income best gauges a nation’s economic success?

To characterize a dataset simply, economists usually figure the average value (the “mean”).  If the Budapest String Quartet dined at the Four Seasons individually for $50, $75, $100 and $25 (that one for a glass of water), then one may measure their average gastronomical pleasure as the mean of their checks -- $250 divided by 4, or $62.50.  In general, the mean for n data points xi in a set is the sum of x1, x2, x3, …, xn, divided by n.

The mean is particularly useful when the likelihood of some number depends on its distance from the mean, regardless of whether it is higher or lower.  For example, if the mean grade in a classroom is a C, then the likelihood of an A, which is two letters higher than the mean, may equal the likelihood of an F, two letters lower than the mean.  In the presence of such symmetry, the mean can tell us a lot.  (And we could learn a lot more if we had a measure of how widely dispersed the grades were.  For example, are many grades Bs and Ds, or do they tend to be As and F’s?  But for now, let’s ignore dispersion).

Not all data follow a symmetric distribution.  In most nations, household income is skewed to the right, because we have a few billionaires.  Their treasures push up the mean income to a point that most of us consider unrealistic for a “typical” family.  It would seem to make more sense to use, as a measure of average income, the figure that is just above 50% of the household incomes (and, of course, just below the other 50%).  This is the median.

A trifling' trillion

The median has other fortes.  In a dynamic economy, the distribution of household incomes may change every few years.  It will remain skewed to the right, but the length of the skew may vary.  (Just wait until we pick up a few trillionaires.)  If we want a summary statistic that will hold true for more than a few years, then the mean won’t do.  The trillionaires will cause it to skyrocket.  The median, however, won’t change as long as it is just below half of the household incomes, regardless of how large some of those incomes may be.

Consequently, a growing gap between mean and median income may tip us off to rising inequality in the distribution of income.  In the United States, mean family income grew much more rapidly than its median counterpart over the Eighties and Nineties, concluded Arnold Katz of the Bureau of Economic Analysis in the U.S. government.  Over the long run – from 1969 to 2009 – mean family income grew 1.08% per year; median family income, only .69%.  Both figures were adjusted for price changes.

In Kazakhstan, mean income grew far more rapidly than in Europe and Central Asia in general for several years up through 2012, when it was $9,780 for KZ, reported the World Bank (the Notes have details).  This raises the possibility that income inequality grew relatively rapidly in Kazakhstan.  Without more data, it is only a possibility.

What does the mean mean?

The median has a hidden weakness:  It cannot reflect uncertainty about the income of a given household.  As we know all too well, the amount of money we make depends partly on chance.  The owner of a Cajun restaurant in New Orleans early in 2005 could not have predicted that a hurricane would blow away her assets.  Surely our notion of average income should take such uncertainty into account.  We may want a summary statistic for the income of each household – and then a statistic that summarizes all of those statistics. 

In that case, the median would not suit us, because it does not reflect that every household income may vary according to circumstance.  It just gives us the income that is at the midpoint of the entire distribution.  Yes, we could compute a median for each household, since its income varies from one scenario to another; but it is not clear how all of these medians would relate to the national one.  For the mean, however, the relationship is crystal clear.  The mean of the distribution is the sum of the means of all the households; it takes individual uncertainty explicitly into account.  Suppose that mean income is $10 for one person and $30 for another.  Then the mean income for this distribution of two people is $40 divided by 2, or $20.

So is mean income a better measure of economic success than median income?  Not necessarily.  Consider an economy of three households.  Family A earns $10,000; B, $20,000; and C, $3 billion.  For the distribution, the median is $20,000, and the mean is just over $1 billion.  Does the high mean mislead us about the economy’s success?  Yes, if C had opportunities that A and B didn’t.  The median would be more accurate.  No, if all three families enjoyed the same opportunities but fortune smiled on C.

The point, of course, is that we should provide both the mean and the median of the income distribution – and let the user choose.  The charge that conservative analysts use the mean in order to overstate the economy’s success is not always justified.  Neither is the corresponding charge against liberals.  –Leon Taylor, tayloralmaty@gmail.com

Notes

1.        The World Bank adjusted its estimate of mean income in Kazakhstan, which is in U.S. dollars, by using a three-year average for the exchange rate and by controlling for differences in inflation rates between Kazakhstan and a composite of the euro area, Japan, the United Kingdom, and the United States.  This is the Atlas method.  It tries to avoid sharp fluctuations in the exchange rate that occur in the short run for reasons unrelated to economic capacity.
2.  To measure the inequality of a national distribution of income, economists widely use the Gini coefficient.  It ranges from 0 to 100, where higher numbers denote more inequality.  (In principle, the coefficient ranges from 0 to 1, but practitioners often multiply this by 100 for easy comparisons.)  The coefficient measures the disparity between a group's share of the population and its share of income.  If x percent of the population always has x percent of national income, then the coefficient is 0, denoting perfect equality.  On the other hand, if 99% of the population has 0% of the nation's income, then the coefficient is nearly 1.

The World Bank reports a coefficient of 29 for Kazakhstan in 2009.  By comparison, the coefficient was 40.1 for Russia that year -- and 54.7 for Brazil, a country famous for income inequality.  Gini coefficients elsewhere in Central Asia are fairly low:  36.2 in Kyrgyzstan and falling; 30.8 in Tajikistan.

Good reading

Bulmer, M.G.  Principles of statistics.  Dover.  1979.  A genial introduction.

Katz, Arnold J.  Explaining long-term differences between Census and BEA measures of household income.  Bureau of Economic Analysis.  2012.  bea.gov 

World Bank.  World Development Indicators.  worldbank.org

Unreal

 Do low interest rates signal trouble?

Some shock waves from Europe’s economy reach as far as Kazakhstan.  Two weeks ago, the European Central Bank announced a negative interest rate for regional banks holding their deposits there.  These banks will have to pay for the privilege of lending their money to the ECB.

In a sense, negative interest rates have been common around the world since the financial crisis of 2008.  This refers to interest payments measured in terms of the goods and services that they can purchase – that is, to “real” interest rates.  In economics, “real” refers to quantities as opposed to money.  A real interest rate of 5% indicates that the lender can buy 5% more of autos and bottles than he could have done by spending the principal rather than lending it.   When the real interest rate is negative – say, -3% -- then the lender loses purchasing power despite the interest paid to him.  He can buy 3% less of goods than he could have done by foregoing the loan.

The ECB’s novelty was a negative money interest rate. I’ll explain.

Depositors to a bank are its creditors, since it can put their dollars to work by lending them out or by purchasing assets like government bonds.  (Indeed, a loan is an asset, since the lender can expect it to pay off.)  The ECB is no exception, although it does not make commercial loans as a rule.  A negative money interest rate of, say, 1% means that banks must pay the ECB 1% of their deposits there.  This is in addition to the loss of purchasing power that the depositors suffer by leaving their money at the ECB rather than spending it.

Why might this affect Kazakhstan?  Because the market for financial assets is global.  All assets enable their holders to consume more tomorrow by consuming less today.  If you buy a 5% bond for $10,000, then you give up $10,000 of spending today – on a long Caribbean cruise, perhaps – in order to earn $10,500 for spending next year (add a few lobster dinners to that cruise).  The rate of return on any financial asset – we might as well just call it the “interest rate” – tends to converge on a common global rate, because the assets market is fast-moving (“liquid,” if you will).  If the common rate is 5%, then a 6% asset will quickly attract buyers, pushing up its price and thus reducing its rate of return.  (Confused?  See the Notes.)

The Bankers’ Ball 

Today in the West, most interest rates are close to zero, largely because the central banks in the wake of the financial crisis printed money as if tomorrow would never come.  Increasing the supply of anything will lower its price; otherwise, the additional units can’t be sold.  The price of holding a tenge is the interest rate, since you must give up the interest payment if you choose not to lend out the money.

Adjusted for inflation, inflation rates tend to be higher in Kazakhstan than in the West, probably because people view investment here as risky and demand payment for the risk.  By adopting a negative interest rate, the European Central Bank is pressuring rates in the post-Soviet world to fall, since investors will bid up the price of post-Soviet assets.  For a while, the post-Soviet banks will smile, since Westerners are lending them more dollars than before.  (To the Westerner, these loans are assets.)  But the banks, giddy with new dollars, may make the same mistake that they did in 2007 – lending out the dollars recklessly.  If the financed projects fail, then the banks will be unable to repay Westerners.  Once again, the banks will flirt with insolvency.

Of course, the banks will assure us that they lend with the utmost prudence, that any shortfall of dollars is temporary.  That’s what they said in 2007, too.   –Leon Taylor, tayloralmaty@gmail.com           

Notes

1.  Consider a bond that costs $10,000 to buy and that pays off $500 in interest each year.  Its annual rate of return is $500 / $10,000, or 5%.  If its price rises to $20,000, then its rate of return will fall to $500 / $20,000, or 2.5%.  In general, the price of an asset relates inversely to its rate of return:  When one rises, the other falls.

              

Reference

Jack Ewing and Neil Irwin.  European Central Bank breaks new ground to press growth.  The New York Times.  June 5, 2014.

Dancing bear slips on oil slick

How will the Ukrainian crisis affect the tenge?

The answer depends on how the conflict will affect world demand for Kazakhstani oil.  This, in turn, depends on Russia.  The central bank of Kazakhstan attributes both of its tenge devaluations since 2009 largely to the weakening of the Russian ruble, notes a Kazakhstani business weekly, Panorama.  Since the National Bank believes that the ruble influences demand for tenge, currency speculators will act accordingly.        

On one hand, Russian belligerence – perhaps not entirely a new phenomenon – has convinced Europe to seek alternative sources of oil, including Kazakhstan.  This should strengthen the tenge.

On the other hand, European sanctions have induced the Kremlin to find other buyers for its oil.  This week, Russia signed a $400 billion pact to pipe natural gas to China for 30 years.  Kazakhstan is losing market share, which should weaken the tenge.  (The president of Kazakhstan, Nulsultan Nazarbaev, has just signed an agreement in Beijing for an oil and gas pipeline.  Isn’t that a coincidence?)

What is the overall impact on Kazakhstan?  Well, consider the net change in world demand for Russian oil.  As a matter of logic, it must be negative.  Had it been potentially positive, Russia would have reallocated the oil itself, from Europe to China; the goad of a Ukrainian crisis would not have been necessary.  On net, then, Kazakhstan is gaining oil buyers, so the tenge should strengthen.

Finally, consider Russian demand for Kazakhstani oil.  Western sanctions have reduced Russian income and subsequently Russian demand for oil imports.

The size of these three impacts will depend on how currency speculators perceive the future of Ukraine.  Much hinges on Sunday’s presidential election.  If it favors the pro-Russian element, or if it is marred by violence, then speculators will probably anticipate civil war, increased sanctions against Russia, and a strengthened tenge.  Otherwise, they will look for a weakened tenge. 

In any case, we won’t have to wait long for the forex denouement.  Every speculator will expect her colleagues to act immediately on the electoral outcome and will act accordingly – the textbook case of a self-fulfilling prophecy.

That’s the crystal ball (never mind the cracks) for 2014.  By next year, continued sanctions may so increase oil prices as to drive up production costs in Europe.  Output prices would rise, output demand would fall, and the continent may return to recession.  This would eviscerate demand for Kazakhstani oil.  But it is hard to believe that Europe would pursue sanctions beyond the point of shooting itself in both feet.   –Leon Taylor tayloralmaty@gmail.com   

References

Delovoy Kazaxstan [Business Kazakhstan].  Prorivnoy vyzyt v Podnebecnyu [A breakthrough visit to the Heavenly Kingdom].  May 23, 2014.  A good example of a time-honored tradition in Kazakhstani journalism – regurgitating press releases.   

       

Panorama.  Pervi kvartal etovo goda odnym yz camix profytsytnix dlya tekushevo scheta strani  [The first quarter of this year is one of the best for the country’s current account].     May 16, 2014.     

Perlez, Jane.  China and Russia reach 30-year gas deal.  New York Times.  May 21, 2014.

      

Just another brick in the Wall

  

Frederick Kempe.  Berlin 1961:  Kennedy, Khrushchev, and the most dangerous place on Earth.  2011.  Putnam’s.  579 pages.

As Russia dismembers Ukraine with surgical skill, the West fulminates.  Is no effective response possible?

Well, Western Europe and the United States were in similar straits in 1961, when the Soviets proposed to close the East German border.  Maybe that episode holds a clue to solving today’s predicament. Frederick Kempe, perhaps the most skillful storyteller among Cold War historians writing in English, describes the conflict in Berlin 1961.

Kempe hews to the conventional line that U.S. President John Kennedy had bungled talks in Vienna concerning the Allies’ occupation of Germany, tempting USSR Premier Nikita Khrushchev into building a wall in Berlin and sending missiles to Cuba.

It seems to me that JFK had done as well as could have been expected.  Khrushchev’s goal was to keep East Germany from collapsing from the flight of hundreds of thousands of its skilled workers to the West, via Berlin.  “The…drain of workers was creating a simply disastrous situation in the [German Democratic Republic], which was already suffering a shortage of manual labor, not to mention specialized labor,” he reflected in his memoirs.  The obvious solution was to turn over Berlin to East Germany, whose leader, Walter Ulbricht, had never met a repressive measure that he didn’t like.  (“Whoever supports free elections supports Hitler’s generals!” he bellowed to hardhats in East Berlin in 1961.)  But the turnover would have been a highly visible act of bad faith with the three Western Allies who had occupied Berlin with the Soviets since the end of World War II. 

Khrushchev was desperate to resolve this paradox when the newly elected Kennedy, two months before the summit, unwittingly handed him a fifth ace – the Bay of Pigs debacle.  The Soviet premier well knew how to play that card; he had used the U-2 foul-up to loudly avoid concessions to President Dwight Eisenhower in 1960.  Who could possibly deal with such conniving capitalistic imperialists?  Where’s my hat?  Kennedy was a loser the moment that his jet touched down in Vienna. 

Hammer, sickle and whim

For the talks, the best of his options, all of them bad, would be to admit his error in the Bay of Pigs and to stress that, nevertheless, if the Soviets fought at Berlin, the West would fight back.  And that’s what Kennedy did, albeit diplomatically.  It was Khrushchev who heard only what he wanted – i.e., that the Americans would condone any Soviet whim.  “There was nothing [Kennedy] could do – short of military action – to stop us,” Khrushchev recalled later in his memoirs.  “Kennedy was intelligent enough to know that a military clash would be senseless.  Therefore the United States and its Western Allies had no choice but to swallow a bitter pill as we began to take certain unilateral steps.”     

Kennedy’s own sense of failure from the talks probably stemmed from his attempt on the first day to lecture the world’s leading Communist debater on the evils of Communism.  He should have known, from the Kitchen Debate of Vice President Richard Nixon in 1959, where all of that was going to lead. 

Khrushchev was a shrewd psychologist, but his blustering in the City of Grace had less to do with the youth and inexperience of his antagonist than with the fact that, in the truest sense, the Soviets had already lost Berlin.  “Whatever might be happening in other parts of the world, in Berlin the West was winning,” said Britain’s Prime Minister, Harold Macmillan, at the time.  “It was a very poor advertisement for the Soviet system that so many people should seek to leave the Communist paradise.” 

The Soviets and the West finally arrived at an uneasy coexistence by following Robert Frost’s advice:  “Good fences make good neighbors.”  The Berlin Wall expressed the tacit understanding that the Soviets could do whatever they wanted on their side of town as long as the Allies had a free hand in their own.  Perhaps that détente would work today.  Or is the Kremlin planning a return to Paradise?  -- Leon Taylor tayloralmaty@gmail.com                 

Notes

1.  By disparaging elections, Ulbricht presumably meant that the Nazis had come to power by winning national elections.  But in fact, Hitler received only 37% of the vote in the crucial second round of the presidential election of 1932, noted historian Richard Evans.  

Good reading

Richard J. Evans.  The coming of the Third Reich.  Penguin Books.  2003.  The first book in a detailed, objective and absorbing trilogy.

David Halberstam.  The Fifties.  Ballantine Books.  1993.  Describes the Kitchen Debate. 

Putin’s baby

What’s he up to?

Vladimir Putin has never made bones of his mission to rebuild the Soviet Union.  Early in his Kremlin career, when Western leaders were still bewitched by his soulful eyes, he proclaimed the Soviet breakup to be one of the great tragedies of the 20th century.  His foreign policies – the brutal suppression of the Chechnyan rebellion, the imposition of a customs union on Belarus and Kazakhstan, the manipulation of energy policy in Belarus and Ukraine, the protests of proposed U. S. missile bases in Poland and the Czech Republic, the invasions of Georgia and Ukraine – all make sense only when viewed as steps toward a new USSR.  We’re back in a Cold War, and Putin has the advantage.

Doubtless, the Republicans will accuse Barack Obama of “losing” Ukraine, but he had few options.  The West has been losing the ex-Soviet satellites since 1986 at least, when Ronald Reagan and Mikhail Gorbachev in Reykjavik came within a hair of eliminating nuclear weapons.  (They probably would have done it had Reagan not insisted on his “Star Wars” plan to develop an anti-missile system in space.)  They retired the intermediate-range nuclear missiles in Europe – the American Cruises and Pershings, and the Soviet SS-20s.  That reduced the probability of a catastrophic war but raised the one of a conventional war, since a belligerent no longer must worry about whether an incursion could lead to a nuclear skirmish.  In this light, NATO’s refusal to promptly accept Georgia and Ukraine as members may have contributed to Putin’s decision to invade the latter.

Exit NATO

In the Wall Street Journal, a University of Chicago professor argues that the West is overreacting to the Crimean annexation; Russia just wants protection from NATO.  This does not explain why Putin is bludgeoning some of the small ex-satellites into his ever-strengthening customs union.  Of course, he won’t object to buffers against NATO, but his primary purpose evidently is to revive Russia as a superpower.  In that sense, the West’s unkindest cut was to demote the G-8 back to the G-7.  But this is unlikely to do anything other than reinforce Putin’s resolve to get his own back.

What can the West do now?  Not much.  Western trade pacts with the former Soviet satellites may delay their entry into the new Eurasian Union (for “Eurasian,” read “Soviet”), but we’ve seen the consequences of that policy for Ukraine.  Over the long run, the US must decide whether China truly has replaced Russia as the most likely aggressor.

NATO may remain weak if stagnant Western economies can’t afford it.  Putin may succeed, since only this can retain the support of the silovikii (“strongmen”) -- the domineering military and KGB-rooted bureaucrats who seek to restore Russia to its pre-Gorby greatness.  Putin knows what happened to Nikita Khrushchev when he lost the military’s support in 1964, due to his comeuppance in the 1962 Cuban Missile Crisis.

At least the Cold War gave us a few good jokes.  In one, retold by historian Martin Walker, Brezhnev is “proudly showing his mother and daughters around his luxurious dachas, his hunting lodge at Zavidovo, his vast garage.  ‘It’s wonderful, Leonid,’” his mother mutters.  “‘But what happens if the Communists come back to power?’”  Come to think of it, maybe that’s not so funny.  –Leon Taylor tayloralmaty@gmail.com

References

Steven Erlanger.  Russian aggression puts NATO in spotlight.  New York Times.  March 18, 2014.

Martin Walker.  The Cold War: A history.  Henry Holt and Company.  1995.

Martin Walker’s Christmas list

What’s wrong with Sovietology?

The West has responded to the Russian incursion into Ukraine in a weak and confused fashion.  That’s partly because the English-language scholarship on the old Cold War is weak and confused, at least in its economic analysis.  Policymakers have nothing better to draw upon.

For example, in his well-regarded Cold War: A history, Martin Walker suggests that the Soviet Union imploded because of inefficient investment in the 1970s.  “[B]y its own doctored statistics the Soviet economy was running faster and faster to stay in the same place.  Each extra 1% in national growth required an increase of 1.4% in national investment, and an increase of 1.2% in output of raw materials.”

This claim is mystifying.  In most economies, returns to a particular input do eventually diminish.  Why must this doom the Soviet economy in particular?

Some background here may help (especially since Walker provides none).  The most common model of national output has two inputs, labor and capital.  The latter refers to the things that we produce (hammers, lathe machines, factories) in order to produce other things (furniture, autos, whirligigs).  Most fits of this model assume that a 1% increase in all inputs leads to a 1% increase in output, a result known as “constant returns to scale.”  For example, a 1% increase in capital may lift output by .7% (which is what Walker is saying); a 1% increase in labor, by .3%.  Thus the total increase in output is .7% + .3% = 1%.  One justification for this model, at least as it applies to a given industry, is that firms eventually figure out how to build a factory that produces as cheaply as possible.  To expand production, they replicate that factory.  Adding a plant to the 100 already in business – an expansion in all inputs of 1% -- will increase output by 1%.

And that may be the end of the matter, except that it’s not clear that Walker knows what he is talking about.  Journalists commonly use “capital” and “investment” interchangeably, but investment really refers to the increase in the capital stock.  In our example, the new plant is an investment that raises the capital stock from 100 plants to 101.  The distinction is worthwhile, because investment does not affect output in the same way as does the capital stock.

The saga of the last computer

To see this, let’s distinguish between two more terms that journalists interchange – “economic activity” and “economic growth.”  “Economic activity” usually means the value of the nation’s production this year; it’s gross domestic product.  “Economic growth” is an increase in economic capacity.  GDP is how much we actually produce; economic growth is how much more we can produce than before.

If Walker is really talking about the impact of investment on economic growth, then his claims are puzzling indeed.  In the usual model, investment at the margin has no impact on economic growth in the long run.  The reason is diminishing returns.  Adding the millionth computer to an office with five workers is probably not too productive.  It would make better sense to bring in computers until one more adds nothing to the office’s capacity to produce.  That happens when the new computer just replaces a worn-out one; that is, it just maintains the current stock of capital.  But economic capacity depends on the total amount of capital and labor available, so it is not affected by the investment of the last computer.

So maybe Walker is talking about GDP.  Certainly, investment will raise this: We’re producing one more computer.  But now it’s not clear why Walker is disturbed that a 1% increase in investment raises GDP by less than 1%.  After all, investment – which is the production of inputs for producers – is just one component of GDP.  We also produce for households, governments and foreigners.  Suppose, for example, that investment comprised 70% of Soviet GDP.  Then a rise of 1% in investment would raise GDP by .7% -- perhaps a bit more, if we include the subsequent rounds of spending. 

Why does any of this matter?  Because Walker seems to assume, as most Soviet scholars do, that physical capital is the key to economic growth.  For more than 60 years, statistical studies have confirmed that the growth rate depends less on the amount of inputs available than on what we know about how to use them (“technology”).  If the Soviet economy was running faster and faster to stay in the same place, then maybe its managers didn’t really know how to run.  Studies of Soviet stagnation could focus on education, training, and incentives to innovators.

And Martin Walker could treat himself to an economics textbook.  –Leon Taylor, tayloralmaty@gmail.com

                   

References

Martin Walker.  The Cold War:  A history.  Henry Holt and Company.  1995.