KENNETH ROGOFF ON FINANCIAL CRISIS

Kenneth Rogoff of the Harvard University, former chief economist at the IMF, has drawn a perspective on current financial crisis (link) that boosted macroeconomic instability in the U.S and the rest of the world, facing surgining inflation rates (link), asset bubbles and declining output growth.

WHAT IS THE COST OF POLITICAL CORRECTNESS

Inside Higher Ed published an interactive article about political correctness by discipline. The article can be read here.

LESSONS FROM MONETARY POLICY: 1930 AND 2007

Martin Feldstein (link) and Barry Eichengreen (link) offer a closer perspective on the comparison of the state of monetary policy at the beginning of the Great Depression and in the light of recent frictions in financial markets.

CLASSICAL LIBERALISM, PUBLIC CHOICE AND ECONOMIC DEVELOPMENT: THE CASE OF SLOVENIA

I recently listened the serie called "Intelekta" (link) on Radio Slovenia. The topics of the talk was classical liberalism and its direct and indirect effects on economic growth and development. Nobel laureate fromm 1973 and an imminent philosophical and economic thinker, Friedrich August von Hayek once famoulsy noted that society's course will be changed only by the change in ideas. Once ideas meet the minds of the individual initiative, the politico-economic measures will follow. Slovenia, still the wealthiest post-communist economy, enjoys moderately high standard of living while the future prospects of economic development are hampering the growth of output and productivity. My research (link) has shown an alarming evidence of Slovenia's score on economic growth and development: back in 1991, the relative gap in terms of standard of living between Slovenia and Estonia stood at 35-41 years, taking purchasing power parity and current prices into account. In 2007, the gap between Slovenia and Estonia reduced to 13 years. In simple terms, this implies that in 13 years, the level of living standard in Estonia will surpass the standard of living in Slovenia. In this briefing paper, I intend to draw a perspective on Slovenia's economic development and empirically alternatives to statist economic policy and Bismarckian welfare state.


The Empirical Side of Economic Policy

Back in early 1970s, David Nolan of the MIT, composed a chart, showing how each political ideology is derived from the mathematical treatment of marginal changes in two variables - personal and economic freedom. Today, this matrix is called Nolan chart (link). The usefulness of this matrix is of the high purpose since it can show revealed preferences of political parties as vote-maximizing agents in an oligopolistic political market. Kenneth Arrow, a Nobel-winning economist, devised an impossibility theorem, the assertion of which is that it is impossible to devise a constitution or voting system which offers more than two reasonable choices to the individual, or that will guarantee to produce a constant set of preferences for a group which correspond to the preferences of the individuals making up that group. Hence, the paradox of voting is that it is impossible to have rational and at the same time egalitarian choice. Assume a two-agent utility-maximizing model in the political market where both agents strive to maximize election output. Because both groups face a monotonic utility function, which means practically the same preferences under different set of policy measures, the empirical intuition is under what rules the agents will react. In Social Choice and Individual Values, Kenneth Arrow, proposed the rules of social choice (link). Unless clear rules are given in the game of economic policy, limiting the scope of government action, the use of discretion would always arise and be made permanent. This simple theorem referes to Arrow's general impossibility theorem and to the rules determining social choice. The behavior of utility-maximizing political agents is shown in the graph. The utility function y = u(x) is downward sloping. This movement reflects the fact that the first choice done by a political agent will inherently reduce the utility his competitor. It means that the support for one measure, say tax reform, will not be strong enough to pass it through. Each utility-maximizer in the political market will inevitably seek to maximize the utility sum of each square by reducing the utility of the competing agent per se. What determines the voting outcome is the rule of the margin - meaning that higher majority rule of one group will entail greater feasibility of social choice. From an empirical point of view, that could be the reason why political system with smaller number of utility-maximizing political agents tend to score higher on the scale of political freedom and quality of governance. In theoretical terms, the paradox of voting is that higher majority rule implies the full-scale fluidity of individual preferences transmitted into the machine of collective choice. Notably because individual preferences of choice can be fully processed only by the market mechanism, the collective choice always entails a contradiction in terms. Instead, it should be noted that transitivity and non-coercion are the main determinants of the welfare choice, not the aggregation of preferences.

Picture No.1: Political Competition and the Public Choice

Economic Theory and Policy: The Failure of Statism in Slovenia

After 17 years of transition from state-controlled to market-oriented economy, Slovenia is still the strongest economy in Central and Eastern Europe. A detailed view on the scoreboard of economic growth shows that throughtout 1990s, the overall growth of real productivity per head stagged compared to other countries in Central and Eastern Europe. The real reason for rachitic growth of factor productivity is not the insufficient amount of working hours in the market but the size of tax burden. Until the latest minor change in tax rate structure, top marginal income tax rate was 50 percent. Even now, when the top rate on earned income is 41 percent, the rate structure is not inclined towards the growth of productive behavior such as investment, entrepreneurship and labor supply. Additional tax burden levied on workers and entrepreneurs, such as employee social security contribution and mandatory employer social security contribuion, has downsized the potential growth of overall productivity - which is, in all empirical and theoretical aspects, the main determinant of wage level. The unparalelled growth of the corporate state triangle of government, employer associations and trade unions - initiated a collective bargaining which still attempts to determine wages via central-planning mechanism that is not based upon market-clearing price system. The overall consequence of collective determination of wages is that the relative price of labor services is mis-allocated, causing labor shortages and surpluses. At the same time, that is the reason why real private-sector economy in Slovenia is facing labor shortages of skilled labor supply. True, brain-drain is another consequence of labor shortages because of high tax rates that hinder productivity growth and human capital utilization in the real sector. The lack of privatization is reflected in the fact that state control in the Slovenian economy is at the same share as Soviet Union under Lenin when the latter launched New Economic Policy (link). Considering the data, the share of private sector activities in the GDP is, in Slovenia, the smallest in the region. When the last comparison was published, public sector activities composed 35 percent of the GDP compared to the regional average of 20 percent. The most alarming threat to Slovenia's macroeconomic stability is the expected increase in net financial liabilities and transfers into inter-generational accounts through pension and health-care system. From a rational and sustainable perspective, capital market is the best guarantee of savings utilization for the old-age as the long-run sustainability of the rate of return on portfolio investments determines the level of old-age income, not transfers such as "pay-as-you-go" or income distribution that skews the productivity of the labor supply. When all aspects of statism are taken into the empirical and methodological account, it does not seem surprising why Slovenia's comparative economic performance stalled while other economies in the region, such as Slovakia and Estonia, faced significant rates of output growth. If Slovenia's long run output growth rate increased from 3,0 percent to 4 percent in the long run, the gap in the standard of living between Austria and Slovenia would shrink from 58 years to 22 years, ceteris paribus. Perhaps that is the best possible evidence that stable and free institutions, pro-growth economic and tax policy, limited government spending, free world trade, the absence of government intervention is superior to cradle-to-grave welfare state and economic policy based on government intervention. Adam Smith once wrote that "...the highest level of prosperity occurs when there is a free-market economy and a minimum of government regulation." So true.

Rok SPRUK is an economist.

THE MYTH OF SOVEREIGN WEALTH FUNDS

Edwin M. Truman highlighted the revealed preferences of sovereign wealth fund establishment. The article can be read here.

GERMANY'S GDP DECLINED

German GDP contracted by 0,5 percent as reported by Financial Times (link):

"Germany’s economy contracted less than feared in the second quarter but the underlying pace of activity has still dropped sharply... Gross domestic product in Europe’s largest economy declined by 0.5 per cent in the three months to June, the country’s statistical office reported on Thursday. A fall had been expected after a surprisingly robust first quarter – when GDP rose by 1.3 per cent, according to the latest revised figures. But leaks from Berlin had suggested the drop could be as large as 1 per cent... Still, the underlying slowdown highlighted the impact of soaring oil prices in curbing global demand for German exports and reducing consumer spending. The latest contraction was the first for almost four years, the statistical office said... Germany’s weak performance is expected to drag down eurozone GDP figures due later on Thursday and which are expected to show the first quarterly contraction in the 15-country region since the launch of the euro in 1999. Concerns about recession – two quarters of negative growth – are now widespread across the eurozone. Earlier this month, Jean-Claude Trichet, European Central Bank president, warned that the second and third quarters would be “particularly week” and this week, Lorenzo Bini Smaghi, an ECB executive board member, said the period of weakness could be “protracted”. However some analysts warned against excessive pessimism. “The German economy is not likely to fall into recession in the third quarter. We expect a small rise in GDP with a rebound in private spending after the sharp decline in oil price,” said Sylvain Broyer at Natixis in Frankfurt."

ANOTHER EVIDENCE WHY EU FARM SUBSIDIES ARE DEADLY HARMFUL

EU Observer has recently quoted (link) the study conducted by a team of British scientists showing that, each year, farm subsidies on behalf of EU's common agricultural policy cause strong heart diseases and stroke-related deaths as a consequence of too high nutrition values per se, given the amount of fat that farm producers can use to produce food. This is an additional sign why EU's common agricultural policy is a roadmap in the wrong direction. Taking some basics of the microeconomic theory into account, we can see that EU farm subsidies lead to massive overproduction of milk and diary products simply because producers do not meet a sufficient amount of market information as a consequence of subsidy distortions. Again, subsidies can be attributed only if there is more negative neighborhood effects that the amount of positive ones while agricultural sector is a case study that would suffice the criteria for subsidy giving as there is a market-clearing price mechanism. World Health Organization revealed that EU's annual milk production subsidies amount 16 billion EUR, including a 500 million EUR butter consumption stimulus.

The EU Observer noted (link):

"Looking at the 15 EU states before the 2004 round of enlargement, the annual "mortality contribution attributable to CAP was approximately 9,800 additional CHD deaths and 3,000 additional stroke deaths within the EU," the study says, with France, Germany, Italy, Spain and the UK seeing the highest numbers of excess deaths."

Market liberalization and an immediate end of subsidizing agricultural production would certainly boost the shift towards consumer choice and demands. In turn, that would also bring positive neighborhood effects since producers' prices would be closer to marginal cost level which means that the severity of heart diseases and stroke-related deaths and consequences would disappear faster and easier. Frankly, it's about time to end the tyranny of EU's agricultural subsidies and CAP. The effect of farm subsidies revealed by British scientists are another strong argument and evidence of the mischief of subsidy-giving.