Fiscal Trajectories

Between the Earth and the Sea

The volume of Economic Research currently being published on the efficacy of a Fiscal Stimulus on the economy has drastically increased since the onset of the 2008 Financial Crisis. On the one side there is the debate on the varying degree to which fiscal expenditure increases output: the Fiscal Multiplier (FM). Some like Ramey (2009,11), Barro and Redlick (2010,11), Hall (2010) inter alia think the FM lies between 1 and 0. Others like Summers and Delong (2012), Krugman (2012), Auerbach and Gorodnichenko (2012), Romer and Romer (2010, 2011), inter alia, believe the FM is greater than 1.

On the other side is the Ricardian versus Keynesian debate on the exact impact of Fiscal Stimulus on real wages, consumption, and investment; the former advocating a negative effect as consumers adjust their behaviour for future tax increases; and the latter supporting a positive effect which is explained by the recessionary state-contingent phase of the business cycle and animal spirits.

The entire debate is far from settled. Yet its outcome is ever more important; given the differing mindsets settling in across the Advanced World. Plans for reducing budget deficits in Germany and Britain are drowned out by calls in France, Southern Europe, and the US to increase spending to counteract recessionary and contractionary forces.

Some of the best papers are by Ilzetzki et al (2010) and Auerbach and Gorodnichenko (AG, 2012); both claim the FM is situation and time specific. Using a new methodology, the Smooth Transition Vector Autoregression, AG (2012) argue in a recessionary environment Fiscal Stimulus has shown to rapidly increase output, consumption, and investment on past occasions in the OECD and the US.

Queen Elizabeth once asked economists at LSE, whilst opening the New Academic Building, why did they not see the credit crisis coming? The failures of Macroeconomics in accounting for the erroneous DSGE modelling, which lacked any assumptions on financial intermediation and behavioural asymmetries, have been addressed by going back to basics. Using underused Econometric Methodology and Economic History in providing solutions to old problems.

Yet the metaphor given to the FM by some is apt. Imagine if the economy was a rocket; how can one build a rocket if the simulated trajectory is anywhere between the earth and the sea. Up to know, Economics is far from a pukka branch of Human Knowledge. It is then behooved of future Economists to provide the tools and advice necessary to prevent severe busts; like the one we are currently witnessing.

Links of the Week

This Week's recommended Economic Writings:

• Skidelsky on China
• American Diagnosis
• Exports dissected 
• Sir Viv Richards at 60 (Not Economics)

The Golden State

new found riches

In some ways, Australia has it all. Recently recognised as the happiest advanced economy in the world, the Lucky Country has been riding high on a decade old commodity boom; which she can amply provide for from her vast deposits of metal ores found adjacent to countless mining towns dotted around Western Australia. So much so Australia was left unscathed by the 2008 Financial Crisis and unemployment has recently dipped below 5%; a luxury that seems a far distant memory in Western Europe and the US. 

The fortuitous ride is set to continue as Australia may soon become the first major economy to claim for its citizens a per capita income above $100000; putting to shame the previously diminutive relationship it had with the mother lode, Britain; Sydney and Melbourne, already the regional financial centres, are hoping to make further inroads into financing and servicing the vast hordes of soon-to-be consumers in India, Indonesia and China. 

Yet for all its claims to fame, from sporting glories to a competitive can-do zeitgeist, Australia is suffering from early signs of Dutch Disease; when by exporting minerals and metals to sate the hungry appetites of emerging economies she crowds out other value added exporting industries; complementary to which, the Aussie Dollar is going from strength to strength at the expense of some of Australia's nascent services and manufacturing sectors. Partly the appreciation is due to some speculative activity caused by the recession-busting healthy returns on Australian assets, property, and bonds; which is further worsened by an overzealous Central Bank, the Reserve Bank of Australia.  

unlucky for some

Sir Robert Menzies, an Anglophile Prime Minister of Australia during and after World War II, once made a famous speech of the Forgotten People; citing the strengths of the Australian spirit and liberal middle class. Australia now can truly claim to be in the League of Nations, both politically and economically. Like Britain of old and some new, Australia is punching very much above her weight.

Real GDP Forecast of Africa

Things Fall Apart

Africa is a manichaean continent. In forecasting the Real GDP of Africa, I had some hurdles to overcome; the least of them being the appalling unreliability of the present GDP figures of some African Economies.

The GDP figures of those economies in North Africa, which have gone through tumultuous dethronements, are with the exception of Libya all ex ante. For North and South Sudan, I interpolated the ex ante GDP with respect to their original GDP shares of 'Sudan'. For other African Economies, it is unwise to predict let alone forecast what is going to exactly happen. And for others still, I feel there would be so much potential to realise the fruits of growth but, alas, some African Economies, like the D.R.C or Burkina Faso, utterly lack the institutions, governance, infrastructure, and markets to grow.

As such, the forecasts of all economies in red font are considered to be incalculable and with a high chance of being either over- or under-estimations. Overall, I categorise the economies into high, medium, and low growth 'types'; with respective real growth rates of 7%,3%, and 1%. Real Appreciation occurs only for high growth types. Whereas low growth types see a depreciation of their currencies and medium types no real movement at all. Once again many African economies de facto use other currencies, like the US Dollar or the South African Rand, for their dormant economies; such that it is difficult to predict their future trade flows, terms of trade, and the capital and current account convertibility of their economies.

By 2020, South Africa would account for more than a quarter of the continent's output with 4% of Africa's population. However, no economy would be considered as fully developed and/or with a high living standard for the majority of its population. By then, most African Economies would have seen further relative divergence from the growth paths of other developing economies across the world.

Ultimately, Africa suffers from a chronic lack of infrastructure and well-functioning institutions, like proper judicial systems and coherent legal codes; much of what is left is from the days of the Empire. Chinese investment is at best sporadic and ill-conducive to cross border pan-African trade. There are no North-South, East-West Rail links let alone uniform trade corridors in Africa. Economies like the Niger and the Central African Republic are landlocked and deprived of markets, trade, and growth; without which they will never see any form of industrial development.

The want of African Growth is not an 'African Problem'; it is a source of global defection en masse to confront existing destitution and poverty; "an unworthy, timid ignorance obstructing our progress".

Uncovering Currency Movements

Making a fortune through Economics' follies

The initial inspiration for this Weblog's title, Uncovered Interests, is a pun on some of the work I have been doing lately; looking at a puzzle in Exchange Rate movements which has occupied an enormous bulk of research in International Economics in the past few decades. The Uncovered Interest-Rate Parity (UIP) Puzzle stems from the striking ability to profit on relative Currency movements with respect to returns on home and foreign investments.

Above, the table shows the 'Fama Regression' (Fama 1984) which under perfect conditions of arbitrage should yield 0 for the first column, Zeta, and 1 for the third column, Beta; the second and forth columns are the range for the respective co-efficients. Under UIP, exchange rate movements, s(t+1)-s(t), between two currencies over time should correspond to the relative home and foreign nominal interest rate differentials, i-i*. The table measures the UIP of the G6 economies against the US over a thirty year period from 1979 to 2009.

Yet in the past forty years of flexible exchange rates for the advanced economies the exact opposite has occured. When British Interest Rates are higher than US Interest Rates, the Sterling has appreciated against the Dollar as opposed to depreciating under UIP. Only Italy comes close in the table above to confirming UIP; but there is a wide gulf between theory and practice.

So it appears then that the UIP puzzle may be related to country-specific idiosyncratic factors; some of the future work requires uncovering, no pun intended, micro-factors. Looking in specific at the behaviour of foreign exchange traders and investors as they react to market fundamentals. Other factors could include finding cohesive unified models for investor risk premiums; and looking at hidden factors such as the positive correlation between short term bonds and interest rates.

Real GDP Forecast of Brazilian States

Cien anos de soledad

In Gabriel Garcia Marquez's One Hundred Years of Solitude, the town of Macondo represents the lost Latin American spirit and will power to define one's future and to invent the world according to one's visions. The dominant theme is of the inescapable repetition of history; like Macondo, Brazil's identity as an economic giant in the 21st Century is much talked of.

Using the same forecasting model I used for India and China, I have calculated the Real GDP forecast for Brazilian States. Current Regional Inequality of growth in Brazil is between the tropical and sub-tropical/temperate states; compared to the South-West and North-East divide in India, and Coastal versus Interior in China.

Brazil in general is difficult to forecast due to her pugnacious labour force and temperamental political system. However from the outset, the economy is driven mainly by the significant gains of one state alone: Sao Paulo.

I assume the Brazilian Real will undertake a real appreciation against the US Dollar of 1% per annum. My second assumption is mainly sub-tropical/temperate states, below the latitude of Minas Gerais, will grow the fastest at a real annual growth rate of 6%; whilst other states, reflecting the lack of high-productive and underused labour and capital will tread along a 2% or 3% growth path.

By 2019, Brazil would be by far the second most dominant economy in the Americas; second only to the US. Sao Paulo State and Rio de Janeiro will comprise half of Brazil's GDP with less than a third of her population. However, like India and China, Brazil's economic development would leave behind casualties in her wake. The Income per capita ratio of Brazil's richest and poorest state, Federal District and Piaui respectively, is 9:1.

Only through industrial development would the tropical Amazonian states grow faster than 3% and converge to the income levels of the southern subtropical states; a path of development which would come unfortunately at some expense of the pristine environment. But given the option of relative stagnation and being hijacked by the resource curse, and the tried and tested formula of economic convergence, it is a sacrifice worth making.

Real GDP Forecast of Chinese Provinces

Between another rock and a hard place

I conduct a similar forecasting exercise for Chinese Provinces, Autonomous Regions, Municipalities and Special Administrative Regions as I did for Indian States. Unlike in India where the regional economic divide is between the South-West and North-East States, the axis for Chinese regional inequality is between the interior and coastal provinces.

Along that line I assumed coastal and some interior provinces, like the megalopolises of Chongqing and Beijing, will register an average annual real growth of 8% between 2011 and 2021; whilst interior provinces will grow at 4% or 2%, depending on respective institutional and historical factors. Trade between Chinese Interior Provinces like Yunnan, Xinjiang, or Heilongjiang and their neighbours in South-East, Central and South Asia is barely existent; despite the centuries of interlinking trading networks, like the Silk Route.

The second assumption is for a 3% annual real appreciation of the Renminbi/Dollar between 2011 and 2021; this is due to the increasing future capital convertibility of the Chinese currency in international transactions, foreign exchange markets, and capital investments. If we assume parallel relative inflation rates between China and the US, the Renminbi/Dollar rate should be 4.7 by 2021, compared to the present rate of 6.4.

By 2021, many parts of Coastal China would have attained advanced world living standards. Beijing and Shanghai, with respective real GDP of $726 and $870 billion dollars (in 2011 prices) each, would be amongst the top five global command centres along with London, New York and Tokyo. Furthermore, three Chinese coastal provinces will have $2 trillion dollar economies: Guangdong, Jiangsu and Shandong; by 2013, Guangdong, in Southern China, would have reached the trillion dollar mark.

If we include Hong Kong and Macau, Chinese Output, of nearly $20 trillion by 2021, would be slightly larger than the US; the latter by then would have gone through a lost decade, being unable to reach its pre-2008 trend growth potential. However, within China, less so compared to India, regional inequality could be a harbinger for economic trouble and instability; reducing further growth prospects in the 2020s.

Real GDP Forecast of Indian States

Between a Rock and a Hard Place

India is currently set on the growth path to becoming a full-fledged economic heavyweight in the global economy; despite some hiccups currently predicted along the way for her emergence: political stasis, institutional weakness, messy infrastructure, balance of payments deficit, weak capital surplus, and so forth. 

With all this in mind, I forecasted Real Indian GDP in 2009 dollar prices for each of the individual States and Territories. Giving certain, mainly Western and Southern, Indian States and Territories higher real growth of 10% and 5% in the coming years; whilst for economically weak Eastern and Northern Indian States a paltry 2% real growth. The other assumption is of a 3% annual real appreciation of the Rupee against the Dollar between 2009 and 2019; due to rampant inflation, the Indian Rupee is currently falling to a record 55 against the Dollar. However in real terms there should be some future appreciation as India further integrates into the global economy and Indian capital markets deepen in the coming years.

Interestingly, despite being by far the most populous state with a forecasted population of 223 million by 2019, Uttar Pradesh's (UP) output is at least three times smaller than Maharashtra's and many times poorer; by 2019, UP does not feature in the top five Indian States by Real GDP. The average Indian per capita income is nearly $3000 in 2019 with a wide regional dispersion. 

It is quite clear Maharashtra, Andhra Pradesh, Tamil Nadu, Gujarat and Karnataka, making up nearly 60% of total real GDP in 2019 with a third of the population, are the engines of the Indian Economy. In comparison, States like Uttar Pradesh, West Bengal, and Bihar, with respective per capita incomes in 2019 (in 2009 Dollar Prices) of  $950, $1610, and $648, will be a considerable drag; reflecting decades of continued misrule, corruption and an unwillingness to modernise whilst pandering to a populist illiterate majority. 

There is no doubt, looking at India presently, there are sub-saharan destitute living standards in some parts; whilst there exists pockets of tremendous scientific and technological prowess, which would not go amiss in Silicon Valley, in the richest Indian States. Given this, it is probable the richest states will swell in population through internal migration from rural poor states like UP to urban rich states like Maharashtra; which would come to restrain the potential of the richest states to grow further. What is then crucially required in India in the coming years is policy and institutional reforms to prevent the backsliding of India's Kam Chor States. 

'Post-War' Corrections

The Economist's Buttonwood Columnist, Philip Coggan, has an intriguing post today on the current 'misleading' economic comparison oft-made to the post-WWII recovery. I would contend with his opening paragraphs with the following short criticisms:

i) Britain and Western Europe, especially West Germany, had a negative economic shock immediately following World War II (WWII). The true recovery in Western Europe began in the 1950s after that shock was overcome and pre-1945 corporatist institutions in West Germany were restored (Eichengreen and Ritschl 2008).

ii) Britain had a very low employment share of agriculture in the late 40s, of around 3%. It did not have an economic miracle in Bretton Woods; in fact, growth was paltry due to prevalent inter-sectoral trade unionism and there was almost a very fragmentary sort of social contract that existed within British Industry then. It was only after the 1980s, Britain was able to recover to its pre-WWII trend.

iii) Total Factor Productivity growth was more important to the economic recovery and Wirtschaftswunder than the agricultural structural shift in Post-WWII Western Europe.

iv) Furthermore, in response to Buttonwood 's reply, any permanent positive effects of demobilisation in post-war Britain were offset by the premature conversion of the capital account of the Sterling leading to a crisis in 1949. Financial repression did not immediately come into play despite the lingering effects of war-price controls; albeit, which were not the tools that were finally used to control debt/GDP.

v) An additional response to Buttonwood 's re-reply: the comparison of post-war Britain to our current situation is apt. If debt/GDP falls by outright financial repression from the overall negative conclusion of the following: bondyields - inflation - growth. With high inflation, low growth and financially repressed negative real bond yields [negative real interest rates] Britain was able to significantly reduce its post-war debt in Bretton Woods.

Links of the Week

This Week's recommended economic writings:

• CDS in comic
• Indo-Pakistani Economic Integration?
• Russian Economic History
• Diamond Thesis

NICE years?

Global Background Radiation

The non-inflationary consistently expansionary-NICE- years from 1993 to 2007 provided a stable economic environment; yet in the long run of things, before the advent of the Twentieth Century, inflation had been extraordinarily volatile and negative. The graph above, from Reinhart and Rogoff (2009), confirms this thesis.

For much of economic history, money used for exchange, value, and storage was linked to precious rare metals, like gold and silver. Prior to World War I, the de facto International Monetary System (IMS) had a stable and fortuitous price level for some twenty years between 1895 and 1913. However, holding the nominal value of money on a somewhat fixed supply of metals and concomitantly ensuring credibility of convertibility is toeing a very narrow line indeed. Thus the modern experiments in differing IMS offer much to ponder for Economic Historians, Policymakers and Economists, alike.

The current regime of the IMS was, up to 2007, based on inflation targeting in the advanced economies; as opposed to previous IMS, targeting a stable rate instead of a fixed level of prices was the modus operandi. The future evolution of world inflation is likely to take a turn for the worse in the Twenty-First Century. It is probable that the Fed is going to instil higher inflation expectations in order to record some level of nominal US recovery this decade, which has hitherto been amiss. With the complete integration of the BIIC economies into the world economic order in the coming decades, it will be difficult to maintain a stable global rate of inflation; especially when currently nascent and opaque Chinese Economic Policy is making a hash out of mitigating its existing internal imbalances.

New Year Resolutions

Loosing faith

The early effects of a new year have had a positive effect on equity and capital markets since the onset of the 2008 Financial Crisis. There is a common shared feeling of robustness and onset of a new growth regime which is displayed in the S&P 500 index in the first quarter of every post-crisis year, with 2012 being no different.

This late winter growth comes to a faltering end following the onset of spring. A sudden realisation perhaps the economic climate has changed only to remain the same! The real economy for advanced economies is currently witnessing a tepid recovery. Policymakers and the media realise what the Great Recession lacked in depth it is making up in width; in comparison to the strong cyclical recovery following the Great Depression.

Links of the Week

This week's recommended economic writings:

• Screaming Prices
• African Growth
• Demystifying Trade
• "Nonsense on stilts"
• Krugman re-analysed 

Unemployment Woes

US unemployment fell slightly to 8.1% last month; partly attributed to the fall in the labour force size, which counts those who are working or are looking for work. Employment trends in Advanced Economies looks similarly paltry. British unemployment is set to go up this year, following on the heels of a double dip. Presently, the British economy has barely recovered to its pre-crisis 2007 Nominal GDP level let alone pre-crisis trend GDP level.

In effect, unlike the Great Depression in the 1930s when the US economy recovered to its pre-crisis level, we are seeing a structural shift to a new trend of stagnating non-negative output growth in the advanced world. Even in the Great Depression in the 30s, US unemployment rose from 3.4% pre-crisis to 25% at the trough of the business cycle in 1933, then settling around 15% by 1938. It was not till rearmament and public spending on World War II when US employment recovered to its pre-crisis level. Suppose we have the following simple employment identity:

output growth rate - growth in Labour force size - Labour productivity growth = growth in employment

We are seeing barely any output and labour force growth. Thus, positive labour productivity growth has led to negative employment growth. In other words, we are facing serious long term structural unemployment in the advanced world which cannot be undone unless high output growth brings the economy back to its pre-crisis trend GDP level. Additionally, if we take non-negative Labour force growth, unemployment would rise further. A whole generation of permanently unemployed workers are set to be born in the coming decade; a decade of what will feel like a 'recession' is to follow in the advanced world.

Clash of Civilisations

Chen Diptych

Once in a while a news story captures the silent storm brewing over the Zeitgeist. The curious case of Chen Guangcheng is one of those. Unravelling in the last week in his escape from Shandong province to the US Embassy in Beijing, 500km away; it is retold in this week's The Economist.

Chen Guangcheng's only crime was to reveal the atrocities committed in Sterilisation and Abortion clinics across his province, the outcome of the cruel Chinese One-Child Policy of draconian population control. Without becoming too presumptuous, the outcome of Chen Guangcheng's fate will have a tremendous impact on China and her position in the world.

It is almost a testimony towards Samuel Huntington's Clash of Civilisation Thesis made nearly two decades ago. The glaring contrasts between the political systems, sets of beliefs, and cultures of two very different superpowers. However, at the same time we can see the sui generis forces in action within China itself, namely between the Chinese business elite, disenfranchised migrants, provincial goons, and putonghua mandarins-elect in Beijing.

It may be of some note to my readers that whilst I was in Beijing last summer I observed the US Embassy Compound was the only Diplomatic mission located in the leafy Sanlitun area of Beijing not to be 'guarded' by green-clothed patrols courtesy of the Chinese Military; that may change from now forth.