3 Letters from Economists

Fiscal sustainability is no doubt the next looming concern, not least for those advanced economies that have stretched their budgets in dealing with the 2007 financial crisis.

On the Valentines day, Besley, Goodhart, Pissarides, Vickers, Muellbauer, Rogoff , Sargent and others, cosigned a letter stating:

In order to minimise this risk and support a sustainable recovery, the next [British] government should set out a detailed plan to reduce the structural budget deficit more quickly than set out in the 2009 pre-budget report.

The exact timing of measures should be sensitive to developments in the economy, particularly the fragility of the recovery. However, in order to be credible, the government’s goal should be to eliminate the structural current budget deficit over the course of a parliament, and there is a compelling case, all else being equal, for the first measures beginning to take effect in the 2010-11 fiscal year.

Then on Feb 18th, followed 2 more letters.

Layard, Allsopp, Blinder, Hendry, Solow and Vines argued:

We disagree.

First, while unemployment is still high, it would be dangerous to reduce the government’s contribution to aggregate demand beyond the cuts already planned for 2010-11 (which amount to 1 per cent of gross domestic product). History is littered with examples of premature withdrawal of the government stimulus, from the US in 1937 to Japan in 1997. With people’s livelihoods at stake, a responsible government should avoid reckless actions.

Second, Britain’s level of government debt is not out of control. The net debt relative to GDP is lower than the Group of Seven average, and on present government plans it will peak at 78 per cent of annual GDP in 2014-15, and then fall. Moreover British debt has a longer maturity than most other countries, and current interest rates on government debt at 4 per cent are also low by recent standards.

Third, since the crisis began, private households and businesses have had to increase their saving in order to reduce their debts. It is this saving that finances the government deficit. If the government did not take up the slack, there would be a deeper recession.

Of course there needs to be a clear plan for reducing the government deficit. But the existing one for next year appears sensible. What is needed then is much more detail for the following years, and a radical plan for the medium term. That is what the debate should be about.

The last letter signed by Skidelsky, Marcus Miller, Blanchflower, De Grauwe, DeLong, Freeman, Hammond, Kirman, Manning, Richard Smith, Stiglitz and others also disagreed with Tim Besley and co.:

We believe they are wrong.

What they fail to point out is that the current deficit reflects the deepest and longest global recession since the war, with extraordinary public sector fiscal and financial support needed to prevent the UK economy falling off a cliff.

There is no disagreement that fiscal consolidation will be necessary to put UK public finances back on a sustainable basis. But the timing of the measures should depend on the strength of the recovery. The Treasury has committed itself to more than halving the budget deficit by 2013-14, with most of the consolidation taking place when recovery is firmly established. In urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!

They seek to frighten us with the present level of the deficit but mention neither the automatic reduction that will be achieved as and when growth is resumed nor the effects of growth on investor confidence. How do the letter’s signatories imagine foreign creditors will react if implementing fierce spending cuts tips the economy back into recession? To ask – as they do – for independent appraisal of fiscal policy forecasts is sensible. But for the good of the British people – and for fiscal sustainability – the first priority must be to restore robust economic growth. The wealth of the nation lies in what its citizens can produce.

Lord Keynes certainly won't be disappointed by sons of the land.

EE432 2010: Topic 4 Materials and Solution to Problem Set 2

• Reading pack for topic 4: Credit and Banking
  
• Solution to problem set 2
  

EE432 2010: Topic 3 Materials and Problem set 2

The reading pack for topic 3 is now available for download

• Topic 3 materials
  

The following problem set is due on Friday 19th next week.

• Problem set 2

Friedman's Interviews

To follow up on our discussion of the natural rate hypothesis, here are some Milton Friedman's thoughts on more general topics. Admire the brilliance but keep an open mind and retain your critical thinking!

On greed...

Where does a pencil come from?

The Great Depression and monetary policy

What about market failures?

Policies must be judged by their results, not their intentions (reposted; this is a 30-min full interview)

Discrimination? Market solution vs affirmative actions.

Why drugs should be legalized

EE432 2010: Topic 2 Materials and Problem Set 1

Here are the materials for topic 2, New Classical Macroeconomics, including the lecture notes.

• Topic 2 reading pack

And here is problem set 1, to be handed in on Wednesday 10th February, i.e. next week.

• Problem set 1

As you know, we are some way behind our schedule, and there are a lot to catch up. It's important to concentrate in the weeks ahead, as the mid-term is coming up in a month time. Make-up classes are being arranged, and I'll let you know once that's confirmed.

Myths vs Reality

FT has just posted this piece, 'Ten myths of Indian economy' by Shankar Acharya, a very prominent economist in India. Quite a lot of these apply equally well to Thailand. Reasonable thoughts on economics is surprisingly something of a rarity in policy circle...we should have more people like him over here.

Economic policy in India, and perhaps in other countries, is constrained by powerful prevailing myths and prejudices. Sometimes these myths simply reflect lazy thinking or an apparent immunity to facts. Sometimes they are shored up by strong vested interests. Sometimes all three. Whatever the reason it is hard to dispute the potency of myths in economic policy making. Here are my 10 favourites, some old, some new.
1. Higher minimum support prices for food grains are good for farmers. Not so. Yes, they are good for a powerful minority of farmers who have sizable marketable surpluses and ready access to government procurement programmes. But the majority of Indian farmers (especially poorer marginal farmers) are hurt by higher food prices for the simple reason that they are net buyers of food grains. And when you add in tens of millions of landless labour, it is quite clear that inexorably higher MSPs for wheat and rice are often quite damaging for rural households.

2. The move to a Goods and Services Tax will reduce the burden of taxation. I hope not! Or the already enormous fiscal deficit will soar higher. The more thoughtful government pronouncements do speak of a reform which is revenue-neutral or even revenue-enhancing. But there are many who tout the illusory prospect of a lower tax burden. The underlying logic of this reform is not tax relief but rather relief from distorted economic incentives and avoidable hassles and uncertainties, which are embedded in the current system of multiple indirect taxes.

3. There is no role for monetary policy when inflation is driven by supply shortfalls. Not quite. The truth is that the extent and duration of an inflationary bout triggered by a supply shock (such as a drought) does depend on the degree of accommodation offered by monetary policy. If liquidity is excessive, the inflationary consequences will be greater; if liquidity is tighter, price increases will be less. Of course, the act of tightening monetary policy can reduce output expansion. Hence the short term trade-off between inflation and growth is a live issue even when the initial shock is from the supply side. And then there is the problem of expectations: if monetary policy stands pat in the face of supply-induced inflation, then inflationary expectations can fuel the fire.

4. Our labour laws protect labour. Quite the opposite. Present laws over-protect a tiny minority (about 5 per cent of India’s 450m plus labour force, not counting government employees) at the expense of the vast majority of workers. By making it extremely difficult to retrench workers in the organised sector our existing laws massively discourage the employment of new workers in organized enterprises. In effect, these laws are very anti-employment and lead to huge under utilisation and “casualisation”of our most abundant resource, low-skill labour.

5. The exchange rate only matters to exporters. This is a common misperception, even among trained economists. Actually, the exchange rate is the single most important price in the economy, which powerfully influences the relative profitability of all tradable goods and services versus non-tradables (like haircuts in Delhi or restaurant meals in Mumbai). Thus, an appreciation of the rupee (versus foreign currencies) not only makes exports less profitable but also hurts an even greater range of import substitutes, that is goods and services produced for our home market in competition with imports from abroad.

6. Reducing fiscal deficits hurts growth. In the present “fiscally stimulated” environment there is much anxiety that a reduction in the current record high fiscal deficits (over 10 per cent of gross domestic product) will hurt growth. The massive deficits of 2008/9 and 2009/10 were perhaps justifiable in the face of contractionary effects of the global crisis. But these deficits are neither sustainable nor desirable. Actually, the Indian economy has grown fastest during periods when deficits were being reduced (1992-1997 and 2003-2008) and slower when deficits were expanding (1997-2002). This is because less government borrowing usually facilitates more productive private investment.

7. Subsidies on food, fuel and electricity help mainly the poor. Not so. The food subsidy mainly helps better off farmers and consumers in only four or five states where the public distribution system has effective coverage. The great majority of India’s poor do not have effective access to subsidized food grains. Many studies have shown that the huge subsidies on petrol, diesel, LPG cylinders and kerosene mainly accrue to better-off urban households (all those fuel-guzzling cars and SUVs). The large state government subsidies on electricity for agriculture have helped to thoroughly undermine the development of a viable electricity distribution network and kept our villages in darkness. In contrast, note how the rapid spread of mobile telephony did not need subsidies.

8. Foreign capital inflows are always good for our economy. Twenty years ago most Indians believed the opposite, that all private foreign capital inflows were bad and somehow designed to impoverish us. In the last two decades the conventional “wisdom” has swung to the opposite extreme. In fact, as both the Asian crisis of 1997-8 and the Global Financial Crisis of 2008-9 has amply demonstrated, foreign capital inflows into a developing country can be a mixed blessing. Specifically, for India, the capital inflow surge of 2005-8 posed serious problems of an overly appreciated exchange rate, excess domestic liquidity and an asset price boom. The more thoughtful of our policy-makers, including then Reserve Bank governor Reddy, grasped the need for capital account management in such situations.

9. Private provision of infrastructure can effectively substitute for government. Private public partnerships are the ruling mantra of the day. Since government has failed badly in providing adequate power, roads, ports, water, sanitation and so forth, we must turn to PPPs for our deliverance. Or so runs the new myth. Of course, there is a big and useful part that the private sector can play in building up our infrastructure. But the experience from all over the world suggests that the government must continue to play the major role in this area. In particular, PPPs cannot substitute for effective governance in infrastructure provision. Indeed, there is a growing body of experience which suggests that the governance requirements of PPPs are pretty high, if we are not to fall prey to the rip-offs of crony capitalism.

10. The trader (or middle man) is at the root of many of our economic problems. This is one of our really hoary and hairy myths. Whenever the rate of inflation rises, governments blame rapacious traders and deploy regulations to control their stocking and other activities. The truth is traders are essential to the efficient functioning of an economy. Commerce is the lifeblood of economic activity. Of course, individual traders exploit whatever monopoly power circumstances grant them to maximize their profits. But the problem does not lie with traders. It rests with the circumstances and policies which nurture national or local monopolies and oligopolies. The best antidote to monopolistic exploitation is competition. And that is best nurtured through better connectivity (transport and communication) and reduction of regulations and levies which fragment markets and raise barriers to competition, whether from abroad or at home.