The Great Wall and Chinese Reforms

Last week China's Vice Premier Li Kequiang mentioned that reforms in China have now entered "a crucial stage and cannot be delayed." And a few days earlier Prime Minister Wen Jiabao explicitly referred to the need of a second phase of growth and talked about how "political structural reform" needed to follow economic reform. In its absence "such a historic tragedy as the Cultural Revolution may happen again." These two quotes fit nicely with an article we published three years ago about how China needed to increase the pace of reforms to eventually join the club of rich economies.

The argument that institutional quality is important for growth is not new and many have written about it, but our emphasis is on the changing relationship between institutions and growth at different stages of development. In the early phases of growth the relationship between institutions and income per capita is very weak (no need for radical reform) while it becomes very strong for higher levels of development.

We just updated our original chart with more recent data (2010) and the result is shown below (institutional quality is measured as the average of the six governance indicators produced by the World Bank; GDP per capita is adjusted for PPP).

The conclusions of our previous work remain. The chart suggests that there are two phases of growth. A first one where institutional reform is less relevant. When we look at the chart we see almost no correlation between quality of institutions and income per capita for low levels of development. To be clear, not everyone is growing in that section of the chart so it must be that there is something happening in those countries that are growing (moving to the right). Success in this region is the result of good "policies" in contrast with the deep changes in institutions that are required later (you can also call them economic reforms as opposed to institutional reforms).

The second phase of growth takes countries beyond the level of $10,000-$12,000 of income per capita. It is in this second phase when the correlation between institutions and income per capita becomes strong and positive. No rich country has weak institutions so reform becomes a requirement to continue growing.

In our original article we called this region "The Great Wall". Economies either climb the wall to become rich or they hit it and get stuck. Economies that illustrate the notion of hitting the Wall are the former Soviet Union that collapsed after not being able to "go through" the Wall with its institutional setting; or Latin American economies such as Venezuela or Argentina which have incomes around that level and do not seem to be able to take their economies to the next step.

We named that threshold "The Great Wall" as a reference to China: a country that over the last decades has displayed the highest growth of income per capita in the world with a set of institutions that are seen as weak (at least relative to advanced economies). China is once again highlighted in our updated chart above and what we can see is that, while it is still in the first phase of growth, it is getting closer and closer to the Wall. It is therefore not a surprise that in the last weeks we have heard senior officials in China talking about the challenge of the next phase of growth.

Characterizing the two phases of growth and making explicit the necessary reforms that are needed to go from one to the other is not an easy task and it is likely to lead to different policy recommendations for different countries. For a very detailed analysis of institutional reform, I strongly recommend the recent book by Daron Acemoglu and James Robinson Why Nations Fail. Their work highlights the need to develop inclusive institutions to allow for the second phase of growth (you can read their thoughts at their blog and find there a link to their book). Others have presented alternative views of how to think about the different phases of growth, as it is the case of Dani Rodrik, who emphasizes the role that different sectors play in this transition.

Antonio Fatás

The missing long-term perspective on government debt.

When looking at the challenges of government debt in Europe the severity of the problem can look very different depending on the perspective one takes. If we focus on the last 5 years we see that:
1. The government of Spain has more than doubled its (net) debt measured as a % of GDP.
2. In the same period of time Italian (net) debt has also increased by about 20 percentage points of GDP.

The situation seems unmanageable and justifies a quick and radical reaction by those two governments.

But if we go back a few more years and plot the evolution of government (net) debt for these two countries in comparison to France and Germany, the message is much more comforting. [Data is Net Government Debt as % of GDP from the World Economic Outlook, IMF]

Not only the level of debt is not high by historical standards (in the case of Italy is lower than back in 1996) but it is not far from the other two European countries. Just business as usual. Spain will be slightly above Germany in the coming 5 years but still below the level of France, that has increased at a much faster pace during the last two decades.

A similar analysis can be done for other advanced economies, including the US, and one finds that the level of government debt is certainly high and has increased as a result of the crisis but it is nowhere the levels that are implied by the panic we have observed in markets and politicians when dealing with this issue.

Of course, there is an alternative and much more negative reading that one gets when looking at a longer historical perspective. Government debt is high and governments knew about it twenty years ago and they have not been able to do much about it! Yes, a crisis did not help their efforts but governments need to plan for crisis; one cannot just make budgetary plans assuming that there will never be another recession.

This reading provides a much more pessimistic assessment of fiscal policy in advanced economies. But the solution requires a long-term framework in order to deal with the inability to match spending and income in a way that keeps debt levels sustainable. We have done very little progress to address this issue and this should make us panic. But it is not the deficit in 2012 or 2013 that should worry us, they will be irrelevant in the long term. We do not need short-term austerity we need a way to deal with long-term sustainability.

Antonio Fatás

The austerity recovery

Both Europe and the US have witnessed so far very weak recoveries from the past recession. There are many reasons why the recovery has been unusually slow: a weak real estate market, debt overhang, the fear of sovereign crisis. Some of these arguments are hard to quantify but there is one factor that is much easier to measure: the role of fiscal austerity. Although it is easy to measure, the facts seemed to have escaped the public debate for months. For a while it was common to hear the perception that government spending was constantly increasing due to successive stimulus packages approved by governments. More recently there is growing concern with the potential role of austerity in slowing down the recovery but so far it has not triggered any clear action.

Here are three charts summarizing some key facts for the US economy. I compare below the last two recoveries: the one that started in the fourth quarter of 2001 with the one that started in the second quarter of 2009. Just to be clear, the 2001 recovery was also a slow one from a historical point of view, but it still can be an interesting benchmark. What you see below are levels relative to the quarter when the recovery started (variables are in nominal terms).

We start with GDP and we can see that 11 quarters after the recovery had started the economy was doing significantly better in the 2001 recovery than in the current one. So this recovery is even slower than the "slow" 2001 recovery.

But what if we just exclude the government sector and only measure non-farm private business sector output. The chart below shows that the two recoveries look similar from today's perspective. The 2009 recovery was stronger in the first quarters but 11 quarters after the recovery had started we are in the same position.

And finally, what about the role of governments. I plot below government consumption and investment (which are the two components of governments that enter the GDP calculations) for the last two recoveries. Here the difference is striking. While government spending was strong during the 2001 recovery growing by about 16% in the 11 quarters that follow - faster than other components of GDP; in the 2009 recovery government spending has barely grown and has remained flat or even falling over the most recent quarters. 

The analysis I am doing is clearly not complete. Each of the variables I plot are not independent. The behavior of private business output depends on government spending. How private output reacts to government spending is a source of debate as the answer depends on what economic theories you believe about the fiscal policy multiplier. But that debate cannot change the simple accounting exercise that the previous three plots do. Compared to previous US recoveries, the current one is unusual in the sense that government spending (a component of GDP) has been much weaker than in previous recoveries.

Antonio Fatás

The overvalued Euro

Over the last months the Euro has drifted from about 1.45 USD to below 1.30 and some commentators see this as the sign of the decline of the Euro, driven by all the economic problems of European countries. It is not uncommon to read about the "weak" value of the Euro today. Before referring to a currency as "weak" it is always good to check whether the Euro is today undervalued by comparing it to its history.

Unfortunately the history of the Euro is short (post 1999) so what I have done below is to simulate the US dollar / Euro exchange rate starting in January 1975, where the German Mark has been used as a reference for the Euro prior to January 1999 (the German Mark has been "converted" to Euros so that the scale can be read as US dollars per Euro). I will refer to the Euro during the pre-1999 period even if we are really talking about the strength of the German Mark, relative to the US dollar.

The Euro has fluctuated from a high value of 1.59 in July 2008 to a low value of 0.59 in February 1995. Are these numbers comparable? Not quite. Currencies are expressed in nominal terms so they are likely to move over time when inflation rates are not the same in both countries. In this particular case, we have witnessed an upward drift of the Euro over the years because inflation was on average lower in Europe. This trend can be captured by estimates of Purchasing Power Parity (PPP), in red in my chart. But even when we take into account this trend, the value of 0.59 in 1985 was a significant undervaluation of the Euro (the German Mark then) in comparison to PPP (around 0.95). Same for July 2008, the value of almost 1.6 represented a large overvaluation of the Euro relative to its PPP value (below 1.2).

We also see in the chart that episodes of overvaluation or undervaluation relative to PP are persistent. A strong Euro in the late 70s was followed by a very weak Euro during most of the 80s. During the 90s the Euro was in general above PPP estimates. Before the official launch of the "real" Euro in 1999, the German Mark was already heading down and this trend continued leading to another episode of undervaluation of the Euro. An episode that was stopped by a join intervention of the US Fed and the ECB in November 2000. Since then the Euro became stronger and stronger until it reached its peak of 1.6 in July 2008.

The financial crisis of the Fall 2008 and the flight to quality that it triggered raised the value of the US dollar (and made the Euro weaker). Since then we see two waves where the Euro picks up again but later loses all the gains.

The value of the Euro today remains above the PPP estimate (so we can still call it "overvalued") and by historical standards, the value in Feb 2012 is very far what we could call a special year. The recent swings are also consistent and similar to movements we have seen before. So we do observe today a large amount of volatility in this exchange rate but something which is not really new for this market. And the current value of the Euro seems very reasonable when compared to some of those extreme episodes of over- or undervaluation that we have witnessed before.

Antonio Fatás

New treaty, same old flaws.

The European Union member states (with the exception of the UK and the Czech Republic) agreed yesterday to a new Treaty on "Stability, Coordination and Governance". The text of the agreement can be found in the web site of the European Council. My first reaction after reading the document was that I must have made a mistake and clicked on the wrong (old) document. It is very difficult to see the differences with the current economic policy framework. And, unfortunately, all the flaws of the previous system are still there.

Here is my list of concerns about the agreement.

1. Wrong title. The agreement is mostly about fiscal sustainability not about stability, coordination and governance. The assumption is that anything that produces lower deficits and debt is good for stability. And that if all countries do it together, even better (this is the coordination part). Fiscal sustainability is necessary but putting all the emphasis on it can be counterproductive.

2. Numerical limits at the center of the fiscal policy framework. The agreement relies again on strict numerical limits to enforce fiscal discipline. So far this has not worked and it is difficult to imagine why it would work going forward. The agreement says that countries cannot have deficits that are larger than 0.5% of GDP. The number is defined as "structural" meaning that they allow the budget to be adjusted for the business cycle. This is, obviously, a good idea, but its implementation is full of technical complications that the agreement ignores. Why 0.5% of GDP is the right number for all countries? It makes no sense to impose the same number to all countries except that is makes things easier to remember.. The agreement allows countries to run larger deficits when their debt is low, which makes some sense. But what about other circumstances? There is the room for exceptions, which sounds very reasonable but it goes against the notion that we are producing a simple set of numerical rules (now it is not so easy to remember anymore).

3. Not enough stress on good years. The main failure of fiscal policy in European countries in the last decade has been not to generate large enough surpluses in good years. By focusing so much on the deficit limit of 0.5% we simply ignore that the real issue is on how to generate those surpluses and we put all the emphasis on the bad economic years where getting thins right is so much harder. We have not learned much from the last 10 years.

4. Limited focus on governance. Despite the fact that the word governance appears in the title of the agreement, there is very little change in terms of governance and enforcement. The agreement will be enforced by the governments of the member countries. These are the same actors that can potentially be the sinners. There will be times (as in the years around the 2002/2003 recession) when most countries will violate the agreement (including Germany and France). What happens then? The agreement talks about automatic fines. Fines that are paid to whom? To the potential group of offenders? Do we really believe that if we had had in place an automatic fine imposed on Greece for having violated the deficit limit we would not be in a crisis today?

Providing an economic policy framework to manage the Euro area is not an easy task and I am glad that I was not part of the negotiations that have taken place over the last days. But the agreement shows that we have learned very little from the previous experience. We insist on maintaining a system that does not work and that only provides a distraction to other economic policy issues that, if we try hard enough, we might be able to solve.

Antonio Fatás

A matter of faith (in markets)

Alan Greenspan contributed yesterday to the Financial Times debate about Capitalism in Crisis. The title of his article was "Meddle with the market at your peril". Not surprisignly Greenspan presents a strong defense of capitalism and market economies by comparing its success to the failures of other systems (such as planned economies).

I do not think that many disagree with that conclusion. But where the article surprised me is when he talks about the potential failure of markets:

Anti-capitalist virulence appears strongest from those who confuse “crony capitalism” with free markets. Crony capitalism abounds when government leaders, usually in exchange for political support, routinely bestow favours on private-sector individuals or businesses. That is not capitalism. It is called corruption.

This is the only sentence in the article where Greenspan admits that there could be some failure in a market economy. But that failure is driven by bad government behavior! Other than that, markets work fine. I hope his views are not really that extreme and that he is willing to accept some of the market failures that economists have identified in the past and that are taken care of by different forms of regulation. This is to me the interesting debate, the one that identifies market failures and then tries to address them via intervention or regulation. In that debate we might find that government intervention is not always possible or efficient. And I am sure we will find disagreement on the domains where government intervention is necessary or optimal. The other debate, the one that compares "capitalism" with the economic system of the former Soviet Union does not sound too interesting or useful at this stage. And it only leads to statements like the one above that seem to be driven by faith in one of the two systems.

Antonio Fatás

The Big Day for the Fed

On January 25th, 2012, in addition to its regular statement from the Federal Open Market Committee, the Federal Reserve published for the first time two additional documents: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents and a Statement of Longer-run Goals and Policy Strategy. The media and the markets reacted positively to the statement. The most quoted phrase was:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Stock markets gained close to 1%, while yields for bonds with various maturities dropped by about 2 basis points.

The two new documents represent a historical shift in the monetary policy of the US. Put together with the standard FOMC statement, they offer much deeper insights into the way that policy makers think about the state of the economy. There are at least a dozen of points worth discussing: The explicit statement of a self-imposed inflation target; the expectations for future interest rates; the projections for GDP; their views on the natural rate of unemployment, etc. I want to focus only on two topics, which in my view are somewhat missing from the popular discussions: the consistency of the statement with the projections and policy-makers’ views on potential growth.

Economic Projections, January 2012 (excerpt)

Variable	Central tendency
	2012	2013	2014	Longer run
Change in real GDP (%)	2.2 to 2.7	2.8 to 3.2	3.3 to 4.0	2.3 to 2.6
Unemployment rate (%)	8.2 to 8.5	7.4 to 8.1	6.7 to 7.6	5.2 to 6.0

First, if we look at the projections for real GDP growth and for unemployment, it is clear that by 2014 the output gap in the US is not going to close. Hence, it is quite possible that 2014 is even an early date for tightening according to the Fed. It does not necessarily mean that the statement is inconsistent with the projections. As indicated above, low interest rates are expected to be in place “at least” through late 2014. But it is worth pointing out that their “average” belief is that the economy will be still below potential at the end of 2014.

Second, and more worrisome, is the projection of long-term growth rates for the US economy. According to the Fed, the central tendency will be for long-term growth rates to be between 2.3% and 2.6% p.a. This is a significant departure from the historical record. In the post-WWII period, real growth in the US has been at about 3%. Fed’s projections suggest that this may not be the case anymore – indeed this implies a significant slowdown in the potential growth of the US economy. Just to illustrate the implications of cutting off 0.5 percentage points from the growth rate, let’s look at GDP per person in 2010 if the economy between 1950 and 2010 grew by 0.5% less. A simple calculation shows that instead of its current level of $46,844, US GDP per capita would be 26% lower at $34,530.

The dire projections of the slow cyclical recovery expected by the Fed and the downward shift in the potential growth rate have serious negative implications about the US economy. Is the Fed deliberately over-pessimistic, or do they believe indeed that we are getting into the “New Normal”?

Ilian Mihov



P.S. Below is a recent interview on CNBC discussing some of the issues related to Fed’s new communication strategy.