Does competition get rid of waste in the private sector?

It is very common to hear comments about the waste of resources when referring to governments and the public sector. Paul Krugman does his best to argue against this popular view by showing that most of what government do is related to services that we demand and value as a society (it is not about hiring civil servants that produce no useful service). As he puts it, the government is an "insurance company with an army". But critics will argue that even if this is the case, the functioning of that (public) insurance company is extremely inefficient. In fact, we all have our list of anecdotes on how governments waste resources, build bridges to nowhere and how politicians are driven by their own interest, their ambitions or even worse pure corruption. If only we could bring the private sector to manage these services!

In addition to the anecdotal evidence there is something else that matters: we tend to use framework that starts with the assumption that in the private sector competition will get rid of waste. An inefficient company will be driven out of business by an efficient one. An inefficient and corrupt manager will be replaced by one who can get the work done. And we believe that the same does not apply to governments (yes, there are elections but they do not happen often enough plus there is no real competition there).

But is competition good enough to get rid of all the waste and inefficiencies in the private sector? I am sure there are many instances where this is the case but I am afraid there are also plenty of cases where competition is not strong enough. And just to be clear, I am not simply talking about large companies that abuse monopoly power, I am thinking of all the instances where the competitive threat is not enough to eliminate inefficiencies. 

I think this applies to financial institutions: the financial crisis has undermined our perception that these institutions were acting in the benefit of their shareholders (even Alan Greenspan said so). Profits and rents going to that sector (and to a reduced group of individuals) did not seem justified by the value they added. Why don't we see entry of new banks? Why don't we see new entrants taking over this market, finding the necessary funding to build scale and attracting the depositors or investors of the current established institutions? Why don't we see new CEOs rising to the leadership of these institutions with a platform that promises to behave in a different way and possibly be much better at maximizing the creation of long-term value? It must be that competition is not strong enough.

Same in the healthcare sector: How good is the private sector at managing healthcare? Are medical doctors truly competing with each other (in both quality and price)? Luckily we can find some data here from Uwe Reinhardt on excess costs in US health spending that include among other things $190 billion of excess administrative costs.

But this table looks to me like an exception, but not an exception in the sense that we do not find similar waste in other sectors, we simply do not know about it, we do not even attempt to measure it (at least at the macro level). And the reason why we do not bother measuring it is because we assume that markets and competition must make this number close enough to zero. Maybe it is time to challenge this assumption.

Antonio Fatás

The only uncertainty is why some cannot see facts.

The idea that policy uncertainty is the main reason why advanced economies and Europe in particular are not recovering fast will not go away. Marco Buti and Pier Carlo Padoan in Vox bring back this argument in their attempt to figure out why the recovery in Europe is so weak. 

They explore the differences between the Eurozone and US recoveries to understand what are the factors that explain the divergence in performance ("the growth shortfall of the Eurozone compared to the US is striking"). So what are the differences between the two economic regions? Three according to the authors: policy uncertainty, weak financial system and lack of investment opportunities.

The evidence? 

1. Measures of uncertainty are correlated with growth. But as many others have argued, measures of uncertainty are (in most cases) endogenous to growth. 

2. Reform in the years 1998-2003 is a good predictor of the potential growth gains in the five years that followed (2003-2008). I am not sure how relevant this is to explain the post-2008 growth performance but let me argue that the chart presented in the blog post is not too convincing either. Here it is:

First, notice that their measure of growth is potential (not actual). Second, while the estimated regression suggests a positive correlation, when one looks at the Euro countries, there is no obvious correlation between the two variables. And if we compare some of them to the US (this was the comparison that the authors wanted to understand), the evidence runs contrary to their argument. Spain or Italy or France or even Greece improved their (product markets) regulation much more than the USA or Canada but their (potential) growth performance was significantly weaker.

So while talking about uncertainty and reform always sounds right, the evidence is either weak or inexistent.

But what about alternative explanations? Could it be that policy, in particular fiscal policy, can explain differences in growth performance since 2008? It must be that the evidence is not that strong, otherwise how could it be that is nor mentioned in their article?

Here is my attempt to provide an alternative explanation to the cross-variation in GDP growth rates.

I compare the change in real GDP in the 2008-2012 period with the change in real government consumption during the same years. This variable is an indication of the fiscal policy stance during those years. I include all OECD countries in the sample (removing some, including only the Euro countries makes no difference to the slope or fit of the regression). The correlation is very strong with a a coefficient that is not far from 1.

But isn't government consumption a component of GDP? Isn't the correlation always there? Yes and No. Yes, there is plenty of endogeneity in my chart and if you want to get the numbers right you need to read all the literature on fiscal policy multipliers (which will tell you that the effects are in fact stronger than what the casual analysis above shows). But, No, we also know that many of these countries implemented explicit cuts in government spending in response to changes in their interest rate and the financial markets reaction to sovereign debt crisis. So there is a significant exogenous component to government spending in that picture, enough to be used as an explanatory variable. And remember that there are those who believe that this correlation should be zero or even negative -- those who believe in zero or negative fiscal policy multipliers. So when Greece (bottom left dot) cut government consumption by 17%, they expected private spending to increase by at least the same amount. But it did not happen, private spending also fell and GDP has fallen by almost 25% during that period. 

The chart above is just a reminder of how strong the evidence is in favor of the hypothesis that fiscal policy can explain most of the relative underperformance of some economies in the post 2008 period. The evidence is certainly much stronger than any of the factors that Buti and Padoan present. But somehow fiscal policy did not make it to their list of top three factors.

Antonio Fatás

The Euro counterfactual

Since the financial crisis started we have heard many commentators telling the Euro countries: "I told you so, this was a very bad idea". The argument is that the Euro area is not an optimal currency area - a jargon used by economists to argue that the costs of having a single currency are larger than its benefits. While until 2008 things have looked fine, the crisis is the real test for the Euro area and it has failed. And it has failed because of what any standard macroeconomics textbook tells you: that once you give up your exchange rate you lose a stabilization tool and when a crisis that is asymmetric in nature comes along you suffer a prolonged crisis as the only way out is to let prices and wages fall (internal devaluation), a painful and inefficient process.

In a recent post, Paul Krugman reminds us once again of these arguments by comparing Ireland during the current crisis to Thailand or Indonesia during the Asian crisis. His argument is that the Asian economies recovered quite fast from their crisis while Ireland has not (and Greece has not even started any recovery). As Kevin O'Rourke puts it, Ireland looks like Thailand without the Baht.

The arguments seem solid and the evidence strong but I am somehow skeptical that we can that quickly conclude that the Euro was a failed experiment and that life without the Euro would have been better (and maybe I am reading too much into those posts and they are not really going that far in their statements). 

What one wants to do is build a counterfactual: where would Greece or Spain or Ireland be if they had never joined the Euro? What would their currency have done for them before and after the 2008 crisis? Unfortunately we cannot build such counterfactual so the best we can do is to look for similar examples (such as Thailand during the Asian crisis). But let me argue that if one extends the set of examples and anecdotes some of the data does not speak that clearly against the Euro.

Before I start let me make two points:

1. I have no disagreement with the argument that rigidities in prices and wages make an internal devaluation a painful way to get out of a recession. A depreciation is a much faster way to reset relative prices. This is what I teach to my students.

2. I agree that the Euro area comprises a set of countries that are performing way below their potential. A combination of failed reforms, lack of economic leadership, a not very proactive central bank is producing a growth rate that is below potential (both before and during the crisis). 

The point that I am trying to make is that among the list of problems that the Euro countries have, the Euro itself might not be the biggest one. While a devaluation could have helped established a faster recovery, its effects would have been uncertain and possibly small. I reach that conclusion by looking at data the same way Krugman and O'Rourke do. It just happens to be that I look at different data. Are my comparisons much better than theirs? Not sure (this is just a blog post, not a research paper). But I find them more relevant even if I have to admit that we have a great deal of uncertainty here, that our knowledge about the potential performance of countries with flexible versus fixed exchange rates is limited. And by knowledge I mean empirical not theoretical. We understand very well how exchange rates work but my reading of the literature is that we are not very good at quantifying these effects.

Below is a list of random and unconnected empirical facts that suggest that the Euro itself might not have caused as much damage as the comparison between Thailand and Indonesia to Ireland and Greece might suggest. 

1. Comparing across countries with different GDP per capita is tricky. It is hard to imagine Ireland to grow at rates similar to Thailand and Indonesia at any point in time after 2008 given that Irish GDP per capita is as high as that of Germany or the US (in 2012 and according to the IMF GDP per capita in Ireland is higher than in Germany; In contrast, in 1996 the GDP per capita of Indonesia was less than 10% of the US level). Finding a better comparison is difficult. Very few advanced economies adopt fixed exchange rates or go through large devaluations. But we can still find some anecdotal evidence.

2. The European countries were in a crisis also during the years 1991-1993. A crisis that brought their system of fixed exchange rates down. Some countries abandoned the fixed exchange rate and devalued while others stayed. This is the closest we have to an experiment of countries leaving the Euro area (yes, the experiment is not perfect, the crisis was much smaller, but it can help us understand the role of exchange rates). Below is a chart with the path of GDP that different countries followed.

There are 9 countries in the chart. Some of them let their currencies be devalued (and a subset of those completely left the system). These are represented by dotted lines. The others stayed within the system and their value of their currencies remained fixed to each other (they are represented by the solid line). The chart reveals that there is no clear pattern between the two groups. Growth differences do not seem to correlate well with the behavior of exchange rates. It might be that only those who devalue "had to devalue", possibly, but what is remarkable is how similar the growth patterns are for all countries.

3. Here is a second piece of evidence from the most recent crisis. Both Spain and the UK have suffered the consequences of the 2008 financial crisis. Both are large economies that before the crisis saw real estate prices booming. But once the crisis started one them let its currency depreciate (the UK) by about 30% relative to the Euro while the other (Spain) was stuck with a currency that it did not own. The theory says that the UK should have benefited from a strong boost in exports as a result of the depreciation of its currency. Below is a comparison of exports (real) after the crisis erupted at the end of 2007.

Contrary to our priors, Spanish exports have grown faster than UK exports. So it seems that the depreciation did not help that much the UK (or the lack of control of your currency did not hurt Spain that much either).

4. So maybe exports in Spain did not behave that badly but isn't unemployment extremely high, at levels that are as high as during the Great Depression in the US? Yes, they are, but unemployment rates in Spain were also extremely high when Spain had a currency (the peseta).

	Annual Employment Growth	Unemployment Rate
1980-1998	0.81	18.87
1999-2012	1.45	14.00

Above is a table that summarizes the Spanish labor market before and after the Euro. In the pre-Euro years unemployment was on average 18.9%. After the Euro, it has been "only" 14%. Employment growth before the Euro was 0.81%, after the Euro 1.45%.

None of the above facts provide a perfect test of what life without the Euro would have been for some of the Euro countries but they, at a minimum, question the conclusion that the recent financial crisis has clearly proven that the creation of a single currency in Europe was a really bad idea. For some of these countries life is hard and volatile (with or without the Euro).

Antonio Fatás

What $3.4tn will not buy you.

Paul Davies at FT Alphaville argues that the $3.4tn in foreign reserves that China holds cannot be used to address with their problems of bad debt. The article follows a series of  reports by the FT on the increasing and unsustainable amount of debt that we see in China these days. As an example, here is a chart from one of those earlier reports.

From the chart we see increasing levels of debt by all sectors of the Chinese economy. So China looks like the US now... or not. The data on debt is just a partial view on the balance sheet and the potential instability of a financial system. It measures liabilities, it does not look at assets. 

What happens if we look at the value of assets in the Chinese economy? They are increasing at a faster rate than debt. How do we know that? Because we know that China has been running a current account surplus, a sign that income exceeded spending and therefore the country was a net saver. 

The accumulation of current account balances does not exactly correspond to the net foreign wealth of a country because there can be valuation changes over time. I might save $100 today and buy shares in the stock market or a foreign government bond. My wealth tomorrow might change by more or less than $100 depending on how the prices of those assets change. Pierre-Olivier Gourinchas and Helene Rey have produced some neat analysis on how these two magnitudes differ for many countries, here is their chart for China.

The red line corresponds to the accumulation of current account surpluses (expressed as $ of GDP), this is the flow of saving. The blue line is the actual value of their "net foreign wealth". In the case of China the blue line is below the red one which means that China has suffered valuation losses in their external balance sheet; the value of their assets has appreciated less than the value of its liabilities (this could be partially due to the fact that their assets tend to be riskless while their liabilities tend to be of the form of FDI).

Where do foreign reserves enter into the picture? The accumulation of foreign reserves comes from two sources: the funds generated from current account surpluses and the (net) investment flows into China. For example, when a multinational invests in China (FDI), that flow, if unmatched by any other flow, leads to an accumulation of foreign reserves. As Paul Davies points out in his article, those reserves cannot be simply considered wealth of China because FDI represents a liability. Correct. The right number is the one where all assets and liabilities are taken into account, which is the blue line in the Chart above, the net foreign asset position which stands just below 30% of Chinese GDP (about $2tn). This number is indeed lower than the total amount of foreign reserves that China holds ($3.4tn). 

So China is a country of savers and borrowers, like any other. In aggregate, the country saves as reflected by a current account surplus. Its nets foreign asset position is about $2tn, a true measure of the health of the external balance sheet of China. The amount of foreign reserves is not the right measure as it exaggerates the foreign wealth position. And for the same reason, the first chart with the debt numbers provides a too pessimistic view of the Chinese financial health. Both of these figures are just partial views on the Chinese balance sheet.

Given that net foreign wealth in China is positive and increasing, does it mean that there should be no concerns about the increasing debt in some sectors of the economy? No. There are two things to worry about. First, the fact that some (individuals, corporations, government) are accumulating debt could put them at risk even if others in the economy are saving. Financial fragility is not only about the average position it is also about the individual saving/borrowing positions. Second, some of the borrowing goes to fund purchases of domestic assets that might have an inflated value. So even if today when we aggregate assets and liabilities the balance sheet looks healthy, we could have asset values collapsing and sending the net wealth of individuals to a situation that leads to defaults, need for deleveraging and a crisis (as we have seen in many advanced economies). 

Antonio Fatás

Teaching about inflation is fun (but dangerous)

Teaching about inflation is fun. Most people who have never been exposed to macroeconomics before are surprised when you show the correlation between inflation and money growth in a large sample of countries. You then produce some data about some hyperinflation countries that include a picture of some bank note with lots of zeros (thank you Zimbabwe) and the students love it.











The notion that inflation is (mainly) a monetary phenomenon is new to many students and going through the history of inflation and monetary policy regimes is a very rewarding exercise for a teacher.

But there is a problem with the way we teach inflation: in many countries inflation has been under control for decades now. And this control does not come from the fact that monetary policy was anchored to a physical commodity such as gold but from the actions and credibility of the central bank. Here is a nice chart from recent work from Jan Groen and Menno Middeldorp that measures inflation expectations in the US going back to 1970.

After the early 90s the line becomes flat, there is very little to say about either the level or the volatility of inflation. In this environment, inflation is almost constant and the correlation between money supply and inflation is inexistent. But we leave this fact for the last five minutes of the class given how much fun it was to talk about Germany in 1923, Hungary in 1946 and Zimbabwe in 2008.

So given the way we have been teaching about inflation it is not that surprising that for the last five years some have been worrying so much about inflation or even hyperinflation as central banks balance sheets have grown very fast. [There is, of course, the mistake that many do of not understanding the difference between the monetary base and the money supply but I will leave that for another post.]

Next time I teach my macroeconomics course I will spend less time talking about inflation and if I talk about it, I will not show the picture of the one hundred trillion dollars note from Zimbabwe, instead I will spend more time about the incredible stability of inflation in many countries. And I will use the extra time to talk about long recessions and even longer recoveries.

Antonio Fatás

Close encounters with the third phase (of the business cycle)

Macroeconomists analyze business cycles in two different ways:

1. Using a model where crises and booms are driven by shocks (unexpected events).

2. In terms of a a succession of phases (expansions and recession) where the key is to define turning points that represent the transition between phases.

Using a model with shocks allows for a much richer description of business cycles. We can allow for shocks of different size, talk about the dynamic response to shocks, etc.

But it happens to be that some economies (and the US in particular) behave in a way that can be approximated by periods of calm and stable growth rates (expansions) that get interrupted by sudden drops in growth (recessions) that are short in nature. And this is why we summarize the volatility of economic variables around the notion of infrequent and negative events that we call recessions.

Such a simple (simplistic?) description of cycles is used by the NBER business cycle dating committee and has become a very common way to analyze the business cycle in other countries. Not all recessions are alike, some are worse than others. One way to distinguish the severity of recessions is by looking at their length; this is the NBER approach to this issue, longer recessions are seen as "more severe" recessions. How good is this approximation? It might be that the number of quarters is not a good-enough indicator, as you might have two recessions that last for four quarters that look very different. But it happens (in the case of the US) that recessions are mostly short and their shape is similar so the length of a recession has been considered a good-enough approximation to its severity.

In my recent work with Ilian Mihov (summarized in this post at VOX), we question the use of the length of the recession as a good indicator of the severity of crisis by putting forward an additional argument that requires redefining the phases of the business cycle.

When a recession is over, the economy has reached a turning point, the trough. It represents a move away from a period of "declining economic activity", the NBER definition of a recession. But what happens afterwards? How long does it take to go back to normal? Where by normal we mean a level of output, employment which is consistent with the notion of trend or full employment. The NBER methodology has never dealt with this question. Once the recession is over, an expansion starts and there is no further communication from the business cycle dating committee until another recession starts. No explicit description of a recovery phase.

Is this approach good enough? It could be if recoveries were symmetric to recessions. If the length of the recovery was directly linked to the length of the recession then we could use the length of the recession phase as an indicator of the full consequences of the crisis. But our research shows that this is not the case and, in addition, the length of the recovery phase is becoming longer over time (at least according to the last two or three recessions).

To understand our point, let's compare three similar US recessions. According to the NBER, the three worst (longest) US recessions after WWII were: the 1973 recession (4 quarters), the 1981 recession (4 quarters) and the 2007 recession (4.5 quarters). The three are almost identical in length. In our research we have dated a recovery phase, defined as the time it takes for the US economy to go back to trend (or "full employment") and we can see that the three recoveries look very different. In particular, the 2007 recovery is already 16 quarters long (and we are not done) while the 1981 recovery was only 5 quarters long and the 1973 recovery was 6 quarters long. In other words, the cost of the 2007 shock is much bigger than that of the 1973 or 1981 ones even if the three recessions looked almost identical.

In conclusion, the use of the recession dates and their length can only provide a very partial and possibly misleading view of the shape, severity and length of crises. If we are using a framework (such as the NBER one) that summarizes business cycles around infrequent and negative shocks that we call recessions, we need to be explicit about what happens in the quarters of years that follow the trough, the turning point as we exit the recession. We are aware that dating the recovery phase can be difficult and subject to uncertainty (and endless debates among academics), but this difficulty should not stop further research from trying to establish consensus around some basic stylized facts about the shape of this third phase of the business cycle.

Antonio Fatás

Emerging markets and commodity prices

There is an increasing debate about the ability of emerging markets to continue growing at the pace at which they have been growing over the last years. The last decade has been remarkable for emerging markets as a group. The chart below compares the growth rate of (real) GDP for the group of advanced economies and for the group of emerging and developing economies (definitions and data coming from the IMF).

After decades where emerging markets were growing at best at the rate of the advanced economies, since 2000 we see a clear gap in growth rates and a strong process of convergence or catching up. The difference is large, as large as 4 or 5 percentage points in many years. 

There are many potential reasons why the fate of emerging markets changed since 2000. From a regional perspective Asia was already doing well in previous decades and continued to grow at a strong or even stronger rate. Some countries in Latin America started growing at decent rates after really weak performance in the previous decades. And African growth rates have been at the highest level in many years.

During those years we have also seen another strong trend in the world economy, the fast growth in the prices of commodities. The fact that these prices have increased can be seen as the outcome of strong growth in the world (fueled by emerging markets). But the causality also runs backwards for some of these countries: it was the strong demand coming from certain economies that pushed prices up and allowed those countries that produce commodities to see growth finally happening. 

The data shows that indeed, the phenomenal growth in emerging markets post-2000 coincided with positive developments in commodity prices. The figure below compares the growth in GDP of emerging and developing countries (from the previous figure) with the growth in the price of commodities during the same years [Note: the series used for commodity prices is Commodity Industrial Inputs Price Index includes Agricultural Raw Materials and Metals Price Indices from the IMF; including food prices or oil prices to the index does not change the correlation at all].

What is remarkable about the data is not that there is a strong correlation in the post-2000 period but also that this correlation has become much stronger than before. For the reasons outlined above it makes sense that these two series are correlated, what is interesting is that the correlation has become strong in the years where growth in emerging markets has taken off. And this cannot simply be the fact that emerging markets matter more in the world economy (and therefore have a strong influence on the price of commodities). If this was the case we would simply expect the other countries (advanced) to have a much stronger influence in the earlier years, but this is not the case. 

To explain the correlation above we probably need a combination of qualitatively different growth during these years that is putting demand pressure on prices while at the same time the producers of commodities (mostly emerging markets) benefit from this demand and grow at higher rates. But regardless of the explanation, it is important to realize how the fate of emerging markets and commodities prices is much more linked than in the past.

Antonio Fatás