Dani Rodrik's weblog

Looking forward to 2009?

It will be a watershed year, ushering a new world economic order--with the disorder most likely coming first.  I just don't have the foggiest idea what this new order will look like.

It will be a time when we will all have to change our tune and have to think out of the box. I for one will worry more about growth in the advanced countries than in the developing world, will be warning against the dangers of protectionism, will be singing the praises of the IMF (if its recent actions and pronouncements are a guide), and will fret about too much state intervention. Changing times require changing lines...

Here are four things that will determine how much doom and gloom is yet to come:

Will the U.S. policy response be “bold” enough? Barack Obama has promised that it will be, echoing at least part of FDR's famous call for “bold, persistent experimentation” at the height of the Great Depression in 1932. In particular, he will need to go beyond Keynesian policies of fiscal stimulus to heal the deep wounds to economic confidence that lie at the root of the present crisis. So far, confidence-building measures have been limited to financial markets,  but the needs of Main Street are no less important. Workers who worry about being laid off are unlikely to go on a spending spree regardless of how much money fiscal stimulus puts in their pockets. Just as banks are hoarding cash, households will try to preserve wealth by increasing their saving. To counter this, incentives targeted directly at preserving employment will have to be part of the solution.

Will Europe get its act together? This could have been Europe’s moment. After all, the crisis originated in the U.S. and left American policy focused on its domestic troubles, opening up room for global leadership by others. Instead, the crisis has demonstrated the deep divisions within Europe—on everything from financial regulation to the requisite policy response. Germany has dragged its feet on fiscal stimulus, stymieing what should have been the second leg of a globally-coordinated fiscal action plan. Alas, the best that can be hoped at this stage is that Europe will not undermine the global fiscal stimulus which even the International Monetary Fund—the guardian of fiscal orthodoxy—regards as absolutely essential.

Will China hold together? China is a country of enormous tensions and cleavages beneath the surface, and these will find more occasion to erupt into open conflict in difficult economic times. Experts on China differ in their estimate of the rate of economic growth the country needs to create employment for the millions that flock into its urban areas every year. But it is virtually certain that China will fall short of this threshold in 2009. The question is whether policy actions to date will do enough to stem a socially and politically dangerous slowdown in the economy.  Whichever way the Chinese leadership responds, future generations may remember 2009 less for its global economic and financial crisis than for the momentous transformation it will have caused in China.

Will there be enough global economic cooperation? When domestic needs become paramount, global economic cooperation suffers. But the costs of protectionism in trade and finance are especially large at moments like these. So far the International Monetary Fund has reacted with new-found vigor, establishing a much-needed short-term lending facility and warning against too little fiscal stimulus. The World Trade Organization, meanwhile, has wasted valuable time on the irrelevant Doha round. It should have focused its efforts on monitoring and implementing the commitment made by the Group of 20 countries not to raise trade barriers.

Did I say happy new year?

An interview

Romesh Vaitilingam sends me a link to this, which was recorded a year ago. I had forgotten all about it. I don't recall what I said, and the volume on my laptop is too low for me to understand what I am saying even at full volume.  But I am sure at least some of what I said must be true.

Self-discovery in practice

It is remarkable to see something in theory work so well in practice.  Ricardo Hausmann and I wrote a paper several years ago called "Economic Development as Self-Discovery," where the idea was that entrepreneurship in a developing country consists of discovering the underlying cost structure--what can and cannot be produced profitably.  Initial investors in a new line of economic activity face a great amount of uncertainty, since foreign technology always needs some local adaptation.  Plus, their cost discovery soon becomes public knowledge--everyone can observe whether their projects are successful or not--so the social value they generate exceeds their private costs.  If they succeed, much of the gains are socialized through entry and emulation, whereas if they fail, they bear the full costs.

Some of the what I have been seeing in Ethiopia is a picture perfect illustration of this process at work.  Most notable in this respect is the flower industry, which was started by some courageous entrepreneurs who had observed the success of the industry in nearby Kenya and wondered if it could be made to work in Ethiopia as well.  Even though much of the technology is standard, local soil conditions make a lot of difference to the economics of growing flowers, and a whole range of other services--from daily cargo flights to high-quality cardboard packaging--has to be in place before the operation can succeed.  To its credit, the Ethiopian government understood the need to subsidize these pioneer firms, through cheap land and tax holidays, and the industry took off.  Exports have reached $100 million from zero in just a few years.  There are now around 90 flower farms in the country, with latecomers the beneficiary of the tinkering that early investors have undertaken.   

A somewhat similar story in an earlier stage of development is playing out in textiles.  The largest investment here to date is being undertaken by a foreign firm--a Turkish one as it turns out.  Once finished, the operation will be fully integrated from spinning to finished garments and will employ 10,000 workers.  All the output will be exported.  The Turkish investor is a bit of a risk-lover, by his own admission.  He told me that there are many firms in Turkey waiting to see how he will do.  If he succeeds, you can be sure a good many will follow in his footsteps.

These are the discovery efforts that have been going on.  One must presume that there are many more that could be taking place, but which are not, because it is difficult for pioneers to capture a large enough part of the social surplus they generate, even with the subsidy programs in place.    

An Ethiopian puzzle

I am in Ethiopia, and it is good to see how much the environment for private economic activity has improved since my last visit a few years back.  The economy has been booming since 2003, growing at Chinese rates.  But there are ominous signs that the good times will be interrupted by an old-fashioned macroeconomic crisis.

Most seriously, the economy is running out of foreign curency, with reserves falling well below two months of imports. The National Bank has so far not depreciated the currency by much and has been effectively rationing foreign currency instead. Talk about a foreign exchange shortage is everywhere.

The gap between the black market and the official exchange rate has widened to--wait, there is no black market!  Yes, that is right.  From all accounts, the rationing of foreign currency has not led to a burgeoning parallel market. To be precise, the government has cracked down on what there was of it, and that seems to have done it.

Which raises the question: is it just a matter of time before the black market takes off, or are Ethiopians such law-abiding people and their government so capable of making regulations stick that we should talk about an "Ethiopian exceptionalism"?

A proposal: employment-linked tax incentives

One important unknown about the fiscal stimulus plan is how much bang for the buck it will provide.  Call it the Keynesian multiplier or whatever else you want, the issue is the magnitude of employment and real GDP a given fiscal spending can generate.  Much of the discussion about the stimulus plan focuses on the amount of stimulus needed, the composition of the spending boost, and the extent to which you need tax reductions to complement the spending boost.

My main worry about the efficacy of the fiscal stimulus--aside from the international spillovers in case it is not supported by equally ambitious fiscal plans elsewhere--is this: households that face considerable employment uncertainty, and hence about their to future income prospects, are unlikely to go on a big spending spree. Just as banks are hoarding cash, households will try to preserve wealth by increasing saving at the margin.  This reduces the marginal propensity to consume, and renders the fiscal boost rather ineffective.

Why not try to deal with the looming unemployment problem, and the huge sense of risk and uncertainty it creates, more directly?  What I have in mind is subsidizing employment directly by providing employers incentives to keep people on the job.  We could imagine for example a scheme whereby firms received tax incentives on a sliding scale in relation to the size of their payroll. If you reduce your payroll, you get nothing. If you keep it unchanged, you get tax benefits. If you increase it, you get even more tax benefits. 

This would allow firms to dismiss employees who are not performing and would not interfere greatly with the normal churning of the workforce. Firms could still lay off workers, but they would now have an incentive to hire enough new workers to make up for the reduction in their payroll.

The idea is to target employment more directly and to deal head-on with the most severe consequence of a recession: job loss or the fear thereof.  We have had a lot of thought on how to increase confidence in the financial system.  We also need to think some of about the loss of confidence on the part of ordinary workers. 

So call this a worker confidence enhancement plan.

Some things are very hard to understand

For instance, how Naomi Klein was able to feel good about Argentina in 2002:

The only time she has ever felt a whiff of utopia was in Buenos Aires, in 2002, when the political system had virtually disintegrated—during the time that she and Lewis were filming “The Take.” “That moment in Argentina was an incredible time because a vacuum opened up,” she says. “They had thrown out four Presidents in two weeks, and they had no idea what to do. Every institution was in crisis. The politicians were hiding in their homes. When they came out, housewives attacked them with brooms. And, walking around Buenos Aires at night, there were meetings on every other street corner. Every plaza where there was a streetlight, people were meeting under it and talking about what to do about the external debt, I swear to God. Groups of one hundred or five hundred people. And organizing buying groceries together because they could get cheaper prices, setting up barters because the currency was worthless. It was the most inspiring thing I’ve ever seen.”

This is the same Argentina which had just collapsed into a severe economic crisis, with a more than doubling of the share of population in extreme poverty and a 10 percent decline in GDP.  I wonder how many Argentines were feeling equally euphoric. 

Does mercantilism work in a Keynesian world?

Yes it does. And not just in theory, but also in practice.

The evidence comes from the 1930s, and from the work of Ben Bernanke himself (along with other scholars like Barry Eichengreen).  The important finding is that countries that devalued their currencies by getting off the gold standard were able to recover more quickly, thanks in part to an increase in their net exports relative to countries that stayed on gold.  Note that a currency depreciation amounts to a policy of combining import tariffs with export subsidies--hence the mercantilist intent and effect.

Interestingly, Bernanke finds that the increase in net exports came from the increase in exports, while imports did not decline more than it did in countries remaining on the gold standard.  He speculates that the reason has to do with the increase in income (thanks to the depreciation) which pushed demand for imports higher and offset the substitution effects. 

I am writing all this partly in response to Tyler Cowen's comment that any theory that suggests import protection can be a good thing must be a deeply flawed theory.  The experience with currency devaluations during the 1930s shows that the theory is in fact quite OK.

What the theory does not consider fully, which was rather my point, is that mercantilist policies--Keynesianism in one country--has adverse effects on others.  My net exports can increase only at the expense of yours.  Similarly, the worse thing about Smoot-Hawley was that it led to a vicious cycle of protectionism everywhere. 

So the implication is not that we throw the theory overboard, but that we foresee its global implications and apply the requisite remedy: a globally coordinated fiscal stimulus, which requires in turn that we provide the developing countries with the liquidity and fiscal resources needed to get on board.     

Some unpleasant Keynesian arithmetic

How much of a boost to economic activity will a fiscal stimulus provide?  For those who believe that we have entered a Keynesian world of shortage of aggregate demand--me included--the answer depends on the Keynesian multiplier.  The size of this multiplier depends in turn on three things in particular, the marginal propensity to consume (c), the marginal tax rate (t), and the marginal propensity to import (m).  If c=0.8, t=0.2, and m=0.2, the Keynesian multiplier is 1.8 (=1/(1-c(1-t)+m)). A $1 trillion fiscal stimulus would increase GDP by $1.8 trillion.

Now suppose that we had a way to raise the multiplier by more than half, from 1.8 to 2.8.  The same fiscal stimulus would now produce an increase in GDP of $2.8 trillion--quite a difference. Nice deal if you can get it.

In fact you can. It is pretty easy to increase the multiplier; just raise import tariffs by enough so that the marginal propensity to import out of income is reduced substantially (to zero if you want the multiplier to go all the way to 2.8).  Yes, yes, import protection is inefficient and not a very neighborly thing to do--but should we really care if the alternative is significantly lower growth and higher unemployment?  More to the point, will Obama and his advisers care?

Being the open economy that it is, I fear that the U.S. will have to confront this dilemma sooner or later. In an environment where the dollar has already appreciated against the Euro and even more significantly against emerging market currencies, fiscal stimulus here will produce an even larger current account deficit.  If American consumers decide to spend 40 cents of a dollar of additional income on cheap imports from China and other foreign countries, the multiplier will be a mere 1.3.  How long will it take before politicians of all stripes cry foul over the leakage through the trade account and the "gift to foreigners" that this represents? And they will have Keynesian logic on their side.  

The way out of this dilemma is to get the rest of the world to engage in fiscal expansion at the same time--so that the gift is returned.  The good news here is that China is playing along and hopefully the Europeans will too (if they can convince Germans to get over their weird obsession with fiscal conservatism).   

But most developing nations are constrained by weak fiscal fundamentals.  They cannot play the fiscal stimulus game because their borrowing capacity is limited: external finance is drying up and domestic financial markets cannot absorb the increase in public debt without a sharp rise in interest rates.

So unless we come up with a solution to the credit constraints in the developing world, we are going to either endanger the effectiveness of Keynesian policies in the U.S. and other advanced nations, or risk a sharp increase in protectionism.  Not a pleasant choice.

Two solutions suggest themselves.  One is to enlarge global liquidity by creating new SDR allocations and handing them over to developing nations to increase their spending. The other is to institute a Tobin tax on foreign currency transactions and pass the proceeds on to the developing nations.

Exceptional times, exceptional measures. 

Does globalization erode social safety nets?

Economic theory and intuition suggest that as economies become more globalized, the ability of governments to undertake redistributive policies and to engage in social spending erodes.  After all, a large part of the tax base--corporations, financial intermediaries, and skilled workers in particular--become internationally mobile and can evade taxes needed to finance those public expenditures. 

This is important because historically countries that are more exposed to international trade have actually had larger public sectors, in part to insulate their citizens from shocks originating from abroad.  This fact, along with the lack of an obvious decline in the overall tax take in major advanced economies, has led many observers to think that the hypothesized decline of the welfare state has not in fact taken place.

Giuseppe Bertola and Anna Lo Prete have now brought new evidence to bear on this question, and their findings bear out the simple intuition.  As they put it, "as technological progress and multilateral trade liberalisation have made borders less of a barrier to economic activity, the scope of redistribution policies has become smaller."  Here is the chart that goes along with their result:

Another interesting argument Bertola and Prete make is that private finance seems to have partly filled the whole left by public transfers.  The claim is that more developed financial markets are able to supply the insurance and consumption-smoothing provided traditionally by the welfare state in very open economies.  They use the share of house prices financed by mortgages as an indicator of financial development.

I am sure this argument made a lot more sense a year ago, when the authors were doing their original research, than it does now. It will take a while until we think of finance, and housing finance in particular, as a source of insurance and stability. 

Bertola and Prete are aware of this of course.  So they conclude thus:

Financial markets are indeed in trouble and, if our perspective on past developments is correct, their fragility does not bode well for globalisation. The breakdown of private financial markets excites calls for stronger redistribution. If redistribution is national (as it has to be as long as politics are national), it will only be sustainable if national borders become less permeable to economic activity.

Indeed. Welcome back to the political trilemma of the global economy.