Public pension crisis in OECD countries

The central aim of my bachelor's thesis is to demonstrate the unsustainability of public pension system in OECD countries in the longer run through the lens of a rigorous theoretical and empirical analysis.

The origins of contemporary public pension schemes date back to 19th century when Bismarckian Germany in 1881 first adopted a universal old-age public pension system based on pay-as-you-go (PAYG) funding principle. The principle itself captures full advantages of high (stationary) population growth rate. In the simplest form, PAYG pension scheme is based on the notion of generational solidarity upon which current generations pay mandatory social security contribution into the public scheme. Aggregate contributions are then paid out to current retirees. The cycle is then expanded through generations. However, PAYG funding scheme is sustainable as long as the population growth is high and above the marginal productivity of the capital. Back in 19th century, public pension schemes were adopted under unrealistic assumptions about future population prospects. In 19th century, advanced countries experienced high population growth rate, high fertility rate and an extremely low share of dependent old population that was receiving universal old-age support from PAYG pension schemes. These set of assumptions was crucial to the stability of government-provided old-age support embodied in the public pension schemes.

The sustainability of PAYG pension system requires the equivalence of population growth rate and real interest rate. In the early 20th century, the advanced world shifted towards aging population, declining fertility rates and lower labor market entry rate. In broad terms, a growing old-age dependency ratio led to the pure disequilbrium effects. In a theoretical framework, I re-examined the neoclassical framework of lifecycle hypotheses embodied in Samuelson and Cass-Yaari models of life-cycle utility maximization. The lifecycle hypothesis is based upon the assumption of the three-period model where individuals maximize the consumption in the course of a lifetime. In the first period, individuals do not discount the future consumption since, in this period, individuals acquire the human capital. In the second period individuals enter the working age and discount the future consumption. Hence, in the third period, individuals retire consume the output produced in the working-age period. Since future discounting is compounded, the lifetime consumption increases geometrically. In purely analytical terms, the individuals maximize the utility of consumption through time preference rate.

Considering the abovementioned equivalence between population growth rate and real interest rate, the stability of the equilibria requires the period discount rate to equal the population growth rate. If population growth rate decreases, the stability of the equilibria requires that individuals decrease the future discount rate by the same rate to keep the PAYG pension system within the theoretical limit. The rigorous theoretical formulation of the neoclassical model of lifetime consumption, which essentially captures the necessary conditions for equilibrium stability of public pension schemes, had been put forth by Paul A. Samuelson in his seminal contribution to the theoretical foundations of stationary "PAYG" public pension scheme .

In the course of the last decades, OECD countries have experienced a significant drop in fertility rates, population growth and, under the political climate of social democracy, a widespread adoption of early retirement schemes and generous social security benefits. In addition, labor market exit age dropped significantly, initiating a trend towards the unprecendent growth of generational indebtedness.

The OECD estimated that between 2000 and 2050, old-age dependency ratio is forecast to increase to the largest extent in Japan (193 percent), Spain (136 percent), Portugal and Greece (135 percent). The astonishing increase in the estimated old-age dependency ratio directly reflects the declining fertility rate in OECD countries from 1960s onwards. I estimated the ratio of fertility rate between 1960-1970 and 2000-2006 for OECD countries at around 2, which means that average fertility rate between 1960-1970 was twice the fertility rate between 2000-2006. The highest fertility ratios were found in Spain (2.23), Italy (1.96), Ireland (2.00) while the lowest ratios were found in Denmark (1.37), Netherlands (1.72) and the United States (1.46).

High and stable effective retirement age is the main assumption underlying the stationary stability of PAYG pension system. In the 20th and 21st century, OECD countries have experienced an unprecendent decline in effective retirement age. Blöndal and Scarpetta (2002) estimated the decline in labor market exit age for OECD countries between 1960 and 1995. The female labor market exit age had declined significantly in Ireland (10.7 years), Spain (9.1 years) and Norway (8.8 years). Male labor market exit age exerted persistent decline in all developed OECD countries except for Iceland. The exit age declined significantly in the Netherlands (7.3 years) and Spain (6.5 years).

In a large part, declining labor market exit age has confluenced the rapid growth of unemployment and disability benefits and early retirement incentives from the second half of the 20th century onwards. As the OECD correctly contemplated, in a number of countries, disability pensions and unemployment benefits can be used as de facto early retirement schemes. In a large part, widespread growth of early retirement schemes and implicit incentives for moral hazard in retiring too early via unemployment and disability schemes is held responsible by generous welfare states in the aftermath of the World War II.

When I examined various features affecting early retirement choices, I came across an interesting finding. I regressed labor market exit age and marginal tax rate in a cross section of 23 OECD countries in 2007. I estimated the relationship between exit age and marginal tax rate using a classical OLS linear regression model. The estimate suggests that, holding all other factors constant, if marginal tax rate increases by 1 percentage point, average labor market exit age decreases by 1.88 months. Surprisingly, 51.74 percent of sample variation is explained by marginal tax rate alone. The sample constant is statistically significant, suggesting that if the hypothetical marginal tax rate were zero, the average labor market exit age in randomly chosen country from OECD sample would be 69.65 years. The sample constant is consistent with a prior theoretical expectations since it concurs with the "substitution effect" hypothesis that higher marginal tax rate leads to lower labor supply and fewer working hours.

The cost of early retirement in OECD countries

Source: T.T. Herbertsson & J.M. Orszag, The Cost of Early Retirement in OECD, 2001. OECD, Pensions at Glance, 2009.

Fiscal imbalances arising from unsustainable PAYG public pension systems in OECD countries cannot be assessed without a sufficient estimate of economic costs of unfunded pension liabilities. I approximated the cost of early retirement using Auerbach-Kotlikoff-Gokhale (1999) methodology that directly estimates the size of generational imbalances created by public social security systems. Large and rapidly unsustainable net pension liabilities occured in late 1980s. Van den Noord and Herd (1993) estimated the size of net pension liabilities in seven major OECD countries. The results suggest that continental European countries have had the largest net pension liabilities in terms of GDP. The size of pension liabilities in France and Italy had been about 2.5 times the size of their respective GDPs and twice the stock of the public debt.

Gokhale (2008) directly estimated fiscal imbalances arising from unfunded pension liabilities to current and prospective generations. The size of generational fiscal imbalance, as a share of the GDP, is extremely large and rapidly unsustainable in all OECD countries. In fact, the size of the imbalance is the most severe in Greece (875 percent of the GDP), France, Finland and the Netherlands (500 percent of the GDP) while it is more than twice the size of the GDP in all OECD countries except for the United States, Canada, Australia and New Zealand.

Fiscal imbalance in OECD countries

Source: J. Gokhale, Measuring Unfunded Obligations of European Countries, 2009.

I built the econometric model of public pension expenditure for a cross section of 23 OECD countries in 2007 to assess which variables might explained the cross-country variation in public pension expenditures. I've been aware of the possible drawbacks of choosing a cross-section model since it might be vulnerable to specification errors and the unbiasedness of regression coefficients. To account for possible specification bias, I conducted Kolmogorov-Smirnov, Shapiro-Wilk and Jarque-Bera normality tests. By performing normality tests, I have examined whether the normality assumption of normally distributed error terms is valid in the studied sample of 23 OECD countries considering error terms as identically and independently distributed.

In the set of explanatory variables that might yield consistent and robust estimates of regression coefficients I chose 10 various demographic, economic and institutional independent variables. Apart from demographic and economic variables, institutional variables are dichotomous since the institutional features can be captured by binary modes of choice. The dependent variable is the size of public pension expenditures in the share of the GDP.

The results suggest that public pension expenditures are positively correlated with the share of population aged 65 and older (0.746**), difference in life expectancy after age 65 between 1960 and 2005 (0.477*) and dichotomous variable for continental European countries (0.697**) where * and ** indicate the statistical significant of the sample correlation coefficient at the 5% and 1% level. The estimates suggests that the probability of higher pension expenditures in the share of the GDP is likely to occur in a continental European country known for a relatively large share of older population and a high difference in life expectancy after age 65 between 1960 and the present. On the other hand, public pension expenditures are negatively correlated with average effective retirement age (-0.475**), private pension funds as a share of GDP (-0.658**), labor market exit age (-0.523**), dichotmous variable for Anglo-Saxon countries (-0.544**) and a dichotomous variable for private pension system (-0.672**), where ** denotes the statistical significant of the sample correlation coefficient at the 1% level. Again, the estimates suggest that the probability of lower pension expenditure is likely to occur if a randomly chosen country from the OECD sample is Anglo-Saxon and has a high effective retirement age, large private pension funds as a share of the GDP, high labor market exit age and a mandatory private pension system. The coefficients suggest that in repeated sampling, the estimated sample correlation coefficient will include the true or correct population value in 99 percent of cases.

I conducted the econometric model which consisted of 8 regression specifications. I chose double-logarithmic model which yields direct elasticities as regression coefficients. However, I added two exceptions. In regression specifications 5 and 6, I chose a mixed specification mostly due to the inclusion of private pension funds (assets) variable in the regression specification. Unfortunately, but the share of private pension funds in Greece in 2007 equals 0 percent of the GDP which does not enable the researcher to apply double-logarithmic model as the basis of regression specification.

The estimates suggest that the share of population aged 65 and older is statistically singificantly positively related to the share of public pension expenditures in the GDP. Hence, the elasticity of public pension expenditures with respect to effective retirement age ranges from -1.465 to -4.935, suggesting that an increase in effective retirement age by an additional year leads to per unit increase in public pension expenditures by more than a unit increase in the share of the GDP. The coefficient of private pension funds is highly statistically significant. The elasticity of public pension expenditures with respect to private pension funds (as a share of the GDP) ranges from -0.34 to -0.38 and is statistically significant at the 1% level. The elasticity suggests that a 10 percentage point increase in the share of private pension funds reduces the share of public pension expenditures in the GDP, on impact, by 3.4-3.8 percent, holding all other factors constant. In addition, the estimates of coefficients for dichotomous variables suggest the following: the probability of higher public pension expenditures (as a share of GDP) is likely to occur in continental European countries with mandatory private pension system. Five estimates of dichotomous coefficients are statistically significant at the less than 10% level.

The significance of dichotomous (dummy) coefficients has been tested by beta coefficient analysis to rank the magnitudes of separate effects of explanatory variables on public pension expenditures as dependent variable. The results suggest that continental European countries are significantly more likely to face higher public pension spending in the share of GDP compared to Anglo-Saxon countries.

Earlier I mentioned the necessity of normality assumption in yielding robust, consistent and unbiased estimates of regression coefficients. The assumption has been questioned by conducting Kolmogorov-Smirnov test (K-S), Jarque-Bera test (J-B) and Shapiro-Wilk (S-W) normality test. The aim of the testing the normality assumption is to observe whether error terms distribute normally so that estimated test statistics, standard errors and confidence intervals are reliable. In setting test statistic, I set the normality assumption as null hypothesis. The results from K-S, J-B and S-W tests show that the null hypothesis cannot be rejected at 5% level, suggesting that the normality assumption is valid in the studied sample. Hence, test statistics, standard errors and confidence intervals are both valid and reliable.

The meaningful question to evaluate the prospects of the coming public pension crisis is how to reverse the growth of fiscal imbalances and reform public pension system as to avoid erratic generational indebtedness. Aging population and the growth of old-age dependency ratio trigger an enormous future burden on public finances in OECD countries. Lower fertility rate and population growth shall place an incurable burden on the stability of PAYG public pension systems. The estimates suggest that life-expectancy after the age of 65 is likely to increase by 2050 and gradually approach the age of 90 for both male and female. Assuming the effective retirement age is 65, the remaining life expectancy is 25 years or almost one-third of the average lifetime. As Alemayehu and Warner (2004) suggest: "Old-age health care costs thus will impose increasingly severe pressure on private finances and government coffers. Indeed, applying our age-specific estimates to the age distribution anticipated for the year 2030, we find that if nothing is done to alter current patterns of health care, per capita health care expenditures will rise by one-fifth due to population aging alone."

The long-term pension reform that aging societies of the West should undertake is a complementary measures of three key policy features of the reform.

First, the transition to fully-funded retirement savings accounts is the only viable and sound pension reform that can alleviate the damage generated by the growing fiscal imbalances. The theoretical foundation of the transition from public pension systems to fully-funded pension system has been laid down by Feldstein and Liebman (2001). The authors derived an algebraic solution which suggests that keeping a PAYG public pension system does not attenuate the persistence of a growing demographic pressure on the stability of public pension system. As I discussed earlier, PAYG system crucially depends on three key assumptions: high fertility rate, very low share of population older 65+ and high population growth. These assumptions are incompatible with actual demographic parameters and, hence, OECD countries should undertake a drastic transition towards fully-funded pension systems based on individual savings accounts. Otherwise, the growing demographic pressure will inevitably result in the exponential growth of generational debt, creating an enormous deadweight loss for current and prospective generations.

Fully-funded pension system is based on the premise of investing pension contributions into the capital market, earning a compound interest over time. The stock of individual's lifetime earnings is paid in the form of annuities upon individual's withdrawal from the labor market. In addition, there is a growing disparity between the implicit return of PAYG public pension system and real rate of return in the capital market. Under realistic assumptions, such as that the marginal product of capital (MPK) is below the welfare-maximizing level and the real rate of return exceeds the implicit return from PAYG system, fully-funded pension system would not create a deadweight consumption loss to the working-age population. In fact, Feldstein and Liebman (2001) derived an analytic solution for the transition to fully-funded pension system in which the transition induces a short-term consumption loss in the next period while, at the same time, it creates a geometrically-growing future consumption for both retired and working-age population.

The only remaining question is whether the real rate of return would compensate the consumption loss of working-age population and, hence, increase the stock of future consumption to all generations. According to Feldstein and Liebman (2001), assuming 6.5 percent inflation-adjusted rate of return, the payroll cost of fully-funded pension system would represent only 27 percent of the payroll cost incured under PAYG public pension system. Tax rate, required to bear the cost of current stock of pension liabilities is 12.4 percent respectively.

According to Congressional Budget Office, the average real rate of return for large-company stocks between 1926 and 2000 is 7.7 percent, 9.0 percent of small-company stocks and 2.2 percent for long-term Treasury bonds. Feldstein (1997) estimated that PAYG implicit rate of return is 2.6 percent.

Assume an individual wants to maximize the lifetime earnings in the capital market. An individual is offered 2.6 percent implicit return from PAYG system. The individual enters the labor market at certain age, say 25, and intends to retire upon the age of 65. Assume he invests $10.000 annually in the capital market to create retirement annuities upon labor market withdrawal. Assuming the implicit rate of return (2.6 percent), the stock of overall annuity would be 10 times the initial investment in 90 years. Assuming the average long-run real rate of return from large-company stocks (7.7 percent), the the overall annuity would be 10 times the initial stock of investment in 31 years. Therefore, the individual would reach the desired level of lifetime earnings at the age of 56 or 9 years before the targeted retirement age.

I assumed the distribution of lifetime investment portfolio is weighted average of availible asset types: large-company stocks (33 percent), small-company stocks (19 percent), long-term corporate bonds (20 percent), long-term Treasury bonds (20 percent) and 3-month Treasury bills (8 percent). According to the average annual real rates of return in the United States (1926-2000), I calculated the weighted average real rate of return (5.247 percent). Investing $10.000 annually at the age of 25 would buy $100.000 annuity at 5.247 real rate of return in 45 years (the age of 70) compared to 90 years (the age of 115) under the PAYG implicit rate of return (2.6 percent). Of course, the time to buy the annuity would shift alongside the changing composition of portfolio.

In addition, OECD countries should immediately increase the effective retirement age. I believe the solution suggested by Gary Becker is both meaningful but sustainable in reversing the growth of generational debt. Becker (2010) suggested "One simple and attractive rule would be to raise retirement age by an amount that makes the ratio of years spent in retirement to years spent working equal to the ratio that existed at the beginning of the social security system."

When President Roosevelt signed the notorious Social Security Act in 1935, the normal retirement age was 65. However, life expectancy after the age of 65 was significantly lower than is today. In 1940, average life expectancy after 65 in the U.S was 13.7 years. In 2006, it stood at 18.6 years, according to OECD. In 1935, the average life expectancy at birth in the United States was 61.7 years. We assume that individuals in 1935 worked for 35 years and spent 12 years in retirement. The ratio is thus 0.4 (12/ 35=0.34). Today, if individuals retire at the age of 65, they can expect further 18.6 years in retirement. To equalize the ratio to the 1935 level, (18.6/x=0.34), individuals should spend 54.7 years working. The estimate time is an equivalent measure of years required to spend working if PAYG public pension system is left intact. Assuming the individuals enter the labor market at the age of 25, then the expected effective retirement age is the age of 80.

In the long run, PAYG public pension system is unsustainable since demographic parameters do not suffice the assumptions under which the PAYG system is possible without distortions of labor supply incentives. The future of OECD countries will be marked by aging population, lower fertility rates and a growing demographic pressure on public finances. Without bold and decisive pension reform, OECD countries will experience increasing pension deficits and, hence, an explosive growth of generational indebtedness.

Parametric pension reforms are not a substitute for the postponement of paradigmatic pension reform. Thus, implementing the transition to fully-funded pension system essentially requires higher effective retirement age. A comprehensive pension reform cannot be made possible without these measures. At last, but not least, the major challenge in the systematic pension reform in OECD countries to address the burden of global aging, is whether political courage will withstand the pressure of interest groups to maintain the status quo of early retirement incentives. Nonetheless, eliminating early retirement incentives is the essential step towards creating retirement system without perverse incentives to retire too early. Unless political leaders encourage a transition to fully-funded pension system, OECD countries will be unable to withstand the deadly consequences of an enormous generational indebtedness.

Religion and economic growth

In the course of economic growth theory, the impact of religion on economic growth and GDP per capita has been largely neglected by the mainstream economic theory. Basically, there have been two major conceptual forces behind the demonstration of the effect of religiousness on economic growth. First, traditional theoretical approach to the analysis of economic growth embodied in the Solow approach emphasized the role of capital accumulation and technological progress in the growth of total factor productivity where the technological progress accounted for the unexplained and exogenous feature that drove the growth of total factor productivity.

Early analyses of economic growth and its main determinants heavily neglected the effect of institutional variables on economic growth. Second, the theoretical framework of economic growth usually follows the empirical evidence on the existence of postulated hypotheses related to the economic growth. Primarily, the effect of religion and other institutional features on economic growth has been displaced to the lack of empirical estimation techniques that could account and control for the effect of the institutional phenomena on the course of economic growth.

The best lucrative and empirically consistent analysis of economic growth and its determinants had been documented by Robert Barro and Xavier Sala-i-Martin. In 2004, Robert Barro published Economic Growth Across Countries. In the explanatory framework, the author included several institutional variables and examined its effect on 10-year economic growth interval in a cross section of 86 countries over 1965-1975, 1975-1985 and 1985-1995 time periods. For a given set of institutional control variables, the rule of law exerted a strong, positive and statistically significant effect on growth. The effect of democracy, the second institutional control variable, was estimated by a single coefficient and its squared term to account for a possible movement of the effect of the level of democracy.

The magnitude of both coefficients was statistically significant. The sign of the squared term was negative suggesting for a typical inverted-U effect of democracy on economic growth. In the meaning of the economic theory, the estimated coefficients suggested that the adoption of democratic institutions and policies in the initial stage of GDP per capita boosts economic growth, particularly by the institutions such as the rule of law, electoral representation, and multiparty political system as well as by the constitutional protection of civil liberties.

However, as countries depart from the initial level of GDP per capita, the political pressure from electoral representation tends to enforce egalitarian policies that negatively effect economic growth, particularly by the fiscal redistribution of income to mitigate income inequality. Consequently, the effect of democratic institutions tends to diminish and, as the curve bends, the predictive effect of constitutional democracy is negative, thereby exerting a negative effect on economic growth. However, the hypothetical relationship between democracy and economic growth is dubious, if not intriguing. In fact, neoclassical growth theories suggest that the rate of economic growth tends to diminish alongside the expansion of the capital stock and productive capacity of the national economy. The hypothesized theoretical assertion postulates that the non-linear, inverted-U effect of democratic institutions on economic growth is overestimated.

In 2003, Robert Barro and Rachel M. McCleary wrote a seminal contribution (link) to the theory and empirics of the relationship between religion and economic growth. Even though in The Protestant Ethics, Max Weber argued that the religious practices and beliefs have had important implications for economic development, the economists paid little or no attention to the role of religiousness as a cultural measure on economic growth. Arguably, the most difficult inferential problem in economic theory is to capture the direction of causality in non-experimental data which indistinguishably confuses the empirical inference from sample estimates. The theoretical relationship between the religion and economic growth is nonetheless a daunting task of the economic theory.

Across the world, there is a whole spectrum of religious diversity in the interplay between religion and economic development. Some countries, such as the United States have been largely influenced by the Enlightenment thought, penned in Thomas Jefferson’s 1779 The Virginia Act for Establishing Religious Freedom, on religious freedom as the principle of freedom from religious oppression. On the other hand, countries in Northern and some parts of the Continental Europe largely adopted Protestantism as the religious establishment while Southern and Central European countries experienced a strong and coercive influence of Roman Catholicism. Hence, the historical bond of nations in the Middle East and North Africa to the Islamic religion accounts for a significant share of the world population and a representative estimate of the effect of Islam on economic growth.

In addition, many political regimes, particularly in China, Soviet Union and Cuba, have attempted to suppress the religious freedom and, hence, establish a system that officially prohibited and punished the religious practice. Surprisingly, countries in Northern Europe such as Norway, Finland and Iceland have established an official religion that is effectively articled in the constitution. Given the vast difference in the distribution of GDP per capita across countries, the assessment of the relationship between the religion and economic growth is not a triviality per se.

Robert Barro and Rachel M. McCleary constructed a broad cross-country dataset which included national account variables and an array of other political, economic and institutional indicators in a cross section of over 100 countries since 1960. The predicted theoretical expectations postulate whether the religion fosters religious beliefs that influence individual cultural characteristics such as ethics, work and honesty. The authors estimated both the effect of different explanatory variables on religious outcomes such as monthly church attendance, the belief in heaven and the belief in hell.

The estimated coefficients suggest that monthly church attendance is strongly affected by urbanization rate and a set of dichotomous religious variables. In particular, a one percentage point increase in the urbanization rate decreases monthly church attendance rate by 1.49 percentage points, holding all other factors constant. In addition, a 1 percentage point increase in religious pluralism fosters the monthly church attendance rate by 1.35 percentage points, ceteris paribus, while the increase in the measure of the regulation of religion by 1 percentage point decreases the church attendance rate by 0.64 percentage point. Hence, the church attendance rate in countries with official state religion, on average, increases the religious participation by 0.87 percent more compared to countries with the absence of state religion, ceteris paribus. The belief in heaven and hell, on the other hand, is positively correlated with state religion and religious pluralism, Muslim religious faction and other religious factions. The belief in heaven and hell is significantly negatively correlated with urbanization rate, communist regimes, Orthodox religion, Hindu religion and Protestant religion. Barro and McCleary regressed growth rates of real GDP per capita on variables of monthly church attendance rate, belief in heaven, belief in hell and dichotomous (dummy) religious variables representing the share of religion in the countries observed. The table below reports dummy coefficients of each religion relative to the Roman Catholicism. The sign of the coefficient is negative suggesting the increase in the share of each religion (see table) decreases the growth rate of real GDP per capita by less than by the anticipated increase in the share of Roman Catholic religion.

The effect of religion on long-run economic growth
Source: R. Barro & R.M. McCleary: Religion and Economic Growth, 2003.

The p-value for religion shares in the regression specification is about 0.001, suggesting that the hypothetical zero simultaneous effect of the explanatory dummy variables of religious share is easily rejected at 0.1 percent level of statistical significance. The estimate suggests that religious shares influence the growth rate of real GDP per capita. Interestingly, sample estimates of regression coefficients suggest that monthly church attendance is significantly negatively related to the GDP growth rate. The estimated coefficient suggests that higher church attendance will, on average, lead to significantly lower growth rate of real GDP per capita and, hence, a lower growth of the standard of living. On the other hand, the sample estimates of growth regression coefficients suggest that the extent of belief in heaven and hell is positively related to economic growth. Thus, the empirical evidence from the panel of over 100 countries since 1960 suggests that the belief in heaven and hell encourage ethical behavior and honesty and thereby simultaneously increases the growth rate of real GDP per capita. The reported p-value for church attendance and beliefs is 0.000, suggesting the rejection of null hypothesis on a simultaneous zero effect of church attendance and beliefs in hell and heaven on the growth rate of real GDP per capita, and a strong influence of religious factors on the distribution of economic growth across countries since 1960.

Regarding the true importance of religious freedom, not oppression, on the emergence of order alongside the abstract rules and the pursuit of individual liberty, Friedrich August von Hayek wrote in The Constitution of Liberty: “It should be remembered that, so far as men’s actions toward other persons are concerned, freedom can never mean more that they are restricted only by the general rules. Since there is no kind of action that may not interfere with another person’s protected sphere, neither speech, nor the press, nor the exercise of religion can be completely free. In all these fields … freedom does mean and can mean only that what we may do is not dependent on the approval of any person or authority and is limited only by the same abstract rules that apply equally to all.”

In the microeconomic perspective, religious market is highly oligopolistic, especially in Europe where government subsidies to large religious groups discourage the entry of competitive religions in the market. Therefore, in strongly Catholic countries, such as Italy and Spain, Roman Catholic church firmly resembles the behavioral pattern of a dominant firm, facing price inelastic demand and price elastic supply. Subsidies to churches do not quite differ from subsidies to corporations and enterprises - the net effect are lower marginal costs, increasing the total producer surplus of the church and increasing the deadweight loss to the consumers of religious services. A cautionary approach would require not only the precise modeling of the religious market upon the theoretical assumptions but also the contestable empirical evidence on the existence of the Catholic church as a dominant firm in highly oligopolistic religious market.

Incidentally, the empirical evidence suggests strongly negative effect of the share of Roman Catholic religion on the long-run growth rate of real GDP per capita. Nonetheless, religion is an important determinant of economic growth. However, the evidence from the second half of the last century suggests that the prosperity and wealth of nations is greater if people allocate fewer resources to the exercise of religious activities.

EARNINGS AND EDUCATION: A SURVEY

In 2009, the median weekly earnings of workers with bachelor's degrees were $1,137. This amount is 1.8 times the average amount earned by those with only a high school diploma, and 2.5 times the earnings of high school dropouts (link).

WHY DO THE POOR CHOOSE TO LIVE IN CITIES?

In the recent edition of Yale Economic Review (link), Ed Glaeser, Matthew Kahn and Jordan Rappaport ponder one of the most difficult and challenging puzzles of urban economics:

"The 2000 U.S. Census shows that the average poverty rate in American cities drops significantly, from about 20% to 7.5%, as you move from the CBD of a city to its suburbs. How can we tell that this connection between city residence and poverty comes from treatment – that is, cities make people poor – rather than from selection, where the poor disproportionately move to central cities? Here, the data support selection: although ghettos may exacerbate poverty, poor people move disproportionately to the center of the cit- ies, either when switching homes or moving to a new metropolitan area... Given the high proportion of the urban poor who are Black, one might think that inner-city poverty is really just another example of the segregation of minorities. However, [the authors] found that poor Whites have roughly the same central city - suburb poverty gap as Blacks, so it is unlikely that race plays an important role in the centralization of the poor."

POVERTY, INCOME INEQUALITY AND ECONOMIC DEVELOPMENT

Financial Times reports (link) on the new measure of poverty proposed by economists from Oxford University. The authors suggested the modification of current measure of poverty which, defined by the World Bank in annually published World Development Report, is currently set at the thresold of $1.25 per day or less. The new measure proposed by economic researchers from Oxford University sets the definition of poverty in a more sophisticated framework based on the household availibility of access to clean water, education, health care and other durable and non-durable goods. The new method, called Alkire-Foster approach, incorporates the qualitative elements into the measurement of poverty.

Using the new method, the authors examined poverty rates in four Indian provinces and evaluated the approach in comparison to the existing income method which had been used in economic and policy analysis by the World Bank and other institutions of economic development. The authors found a significant divergence of poverty rates when measured in both methods. For instance, under Alkire-Foster approach, the poverty rate in Indian state Jharkhand is 50 percent higher compared to the rate of poverty measured under the income method. On the other hand, the authors of the new poverty measure have shown that in some Indian provinces such as Uttaranchal (link), the official measure of poverty highly over-estimates the effective poverty measure as defined by Oxford's Poverty and Human Development Initiative. The multidimensional worldwide poverty index is also availible on the web (link).

The intuitive question arising from the data and empirical research on poverty is whether higher economic growth in less developed countries boosts the growth of income per capita and what is the role of institutional characteristics in economic development. The authors of the abovementioned measure of poverty have shown that despite abundant economic growth in past years and falling income poverty rates, the share of population without access to clean water, sanitation and minimum required nutrition remained unchanged. The percentage of malnourished children in India decreased from 47 percent in 1998-98 to 46 percent 2005-06.

The theoretical and empirical literature on economic growth suggests that there is an inverse U-relationship between inequality and income per capita known as Kuznets curve (link). The intuition behind the relationship is simple. At the very low levels of income per capita, income inequality is low. Alongside the course of growing income per capita, income inequality steeply increases and, after reaching a maximum, it decreases as countries achieve higher levels of income per capita. The rate of income inequality is closely related to the evolution of economic policies over time. Wagner's law, discussed in one of the previous posts, states that government spending over time increases due to long-run income elastic demand for public goods and capture of the democratic system by the particular interest groups that pose a permanent pressure on the growth of government spending and resist the reversals of government expenditures by trading votes.

There's a wide array of disagreement among economists on the effect of income inequality on economic growth. Back in 2001, Joseph Stiglitz re-examined the East Asian economic miracle and concluded that the evidence from the period of high economic growth in East Asian countries suggests that income redistribution has a positive effect on economic growth (link). Stiglitz's argument is based on the income distribution in East Asian countries during the economic miracle. East Asian countries have been known for relatively even distribution of income demonstrated by high Gini index and relatively high income tax rates.

On the other hand, the empirical investigation of the initial conditions in East Asian countries before the economic miracle shows that the political influence of interest groups had been relatively weak compared to Western Europe after the World War 2 when the productivity growth stalled from early 1970s onwards. The relative weakness of interest groups and a stable judicial system, inherited from English common law tradition, enabled high economic growth in the longer run given an enduring stability of property rights protection and the rule of law. In such conditions, income redistribution had relatively little effect on economic growth since the empirics of East Asian miracle suggests that the sizeable proportion of growth in East Asian countries (Malaysia, Singapore, Korea and Taiwan) had been driven by technological progress, investment and export orientation. Considering export orientation, Rodrik et. al (2005) provided the evidence (link) on the positive effect of high-quality export orientation on economic growth. The productivity growth in East Asian countries between 1975 and 1990 had been a pure example of economic miracle defined by the share of growth that could not be explained by the contribution of labor and capital input. In Taiwan and Hong Kong (link), total factor productivity accounted for about 60 percent of output per capita growth. Between 1975 and 1990, in Singapore, output per capita had increased by 8.0 percent. Consequently, the resulting outcome of almost two decades of robust productivity growth had been a significant decrease in national poverty rates (link). The lowest poverty rate, as defined by the measures of home authorities, is in Taiwan where 0.95 of the population live below the poverty thresold.

The basic set of policies that alleviate extreme poverty such as providing access to clean water, nutrition, medical protection against HIV/AIDS and basic sanitary standards have a positive effect on the economic growth and the standard of living. However, the major cause of persistent under-development in Subsaharan and Tropical Africa is mostly the lack of institutional enforcement of property rights, the rule of law and independent judiciary. In spite of billions of USD of direct foreign aid, countries such as Zambia, Sierra Leone, Mali and Rwanda endure in persistent poverty and under-development. Esther Duflo, this year's recepient of John Bates Clark Award, has shown in several studies how field experiments can enlighten the understanding of incentives in least developed countries (link). Understanding the significance of incentives in reducing poverty is crucial to further examination of the relationship betwen income inequality and economic growth.

THE EMPIRICAL EVIDENCE ON WAGNER'S LAW

Ever since the original proposition by a 19th century German economist Adolph Wagner, Wagner's law has undergone significant theoretical and empirical discussion on its long-run validity. In the most basic and rudimentary version, the law states that alongside the economic development of industrial societies, there is a persistent tendency of an increasing share of government spending in the GDP. Since the beginning of the 20th century course, the growth in government expenditures has escalated in all major industrial countries. The economic literature has centered the discussion on two elementary versions of Wagner's law. The first version of Wagner's law attributes the growing share of government spending to the ever expanding power of interest groups.

The concept of interest groups has been thoroughly developed by a rigorous theoretical analysis by Mancur Olson's The Logic of Collective Action. There is a remarkably positive correlation between the growth of government spending and the political power of interest groups. Back in 1954, Milton Friedman and Simon Kuznets have analyzed the income dynamics in independent professions (link). Although there has not been much discussion in the economic literature, the Friedman-Kuznets analysis is an important milestone in the explanation of the evolution of interest groups. Friedman and Kuznets examined five independent professions. Using a comprehensive statistical analysis, they showed how income growth in five profession has exerted an upward trend without significant gains in productivity. The five independent professions analyzed by Friedman and Kuznets emerged as pure interest groups. These groups have imposed a regulated labor market structure marred by occupational licencing and aimed at gaining an insider's earnings rent at the expense of entry restriction. Occupational licensing is one of the most powerful explanatory features of low coefficient of price and income elasticity of labor supply of physicians, dentists, legal consultants and medical practitioners. In most of the industrial countries, these groups have emerged as powerful interest groups and triggered an unbreakable increase on the growth of government spending. The evolution of interest groups in fields such as agriculture, social security and trade has resulted in the intensive pressure on the growth of government spending. The interest group perspective on Wagner's law emphasizes the state capture created by the democratic system and an irreversible pattern of increases in government spending centered on small and powerful interest groups. If interest group's representative utility function can be described as a relationship between the group's size and its price elasticity of labor supply: U(f,e)=f(1-|e|), then the effect of a unit change in price elasticity of labor supply dU/de=-f indicates that greater price elasticity of labor supply will reduce the size (f) of the interest group as a result of pure substitution effect at work. On the other hand, if price elasticity of labor supply of the particular interest group will decrease, causing more price inelastic labor supply, the size of the interest group will increase since most of the excess wage increases will spill into physician's pocket.

The second version of Wagner's law states that an increase in government spending in time is a result of a high income elasticity of demand for public goods. Rati Ram (1986) has tested this hypothesis on the sample of 115 countries between 1950 and 1980. His conclusions suggest that income elasticity of demand for public goods is very elastice (exceeding 1) in 60 percent of all countries in the sample. A comprehensive development of econometric methodology has enabled a more rigorous and empirical evaluation of Wagner's law on the basis of long-run simulation using time-series data. For example Sidelis (2006) has applied cointegration analysis and Granger casuality tests to determine whether long-run changes in income account for the growth of government spending in Greece between 1833 and 1938 (link). The author concludes that income elastic demand for public goods caused a growth in government expenditures. A recent study by Lamartina and Zaghini (2008) indicates (link) a negative relationship between government spending and economic growth in a sample of 23 OECD countries. The study further suggests that the correlation between income growth and government expenditure is stronger in countries with low initial levels of GDP per capita. Neck and Getzner (2007) collected data on government expenditure in Austria between 1870 and 2002 and examined whether the surge of government expenditure is attributed to either Wagner's law or Baumol's cost disease. The authors applied Phillipe-Perron and Augmented Dickey-Fuller stationarity tests, concluding that government spending time series more likely represents a stationary time series. In concluding remarks, the authors note that much of the increase in government expenditure is a problem of increasing prices in public sector, relating the growth in public expenditures to Baumol's cost disease where output reduction in public sector is a result of net decrease in productivity growth which yields a significant pressure from public sector interest groups on expenditure increases.

Wagner's law is an intriguing theoretical and empirical issue. In spite of the numerous empirical evaluation and theoretical design, the issue will probably remain an intensive course of the academic debate.

THE EMPIRICS OF CORRUPTION, INSTITUTIONS AND ECONOMIC DEVELOPMENT

Urska Zagar posted two very interesting empirical articles (here and here) about the connections between corruption, economic freedom and economic welfare. The first two indicators are qualitative while the third one is rather easily measurable. In a sample of 50 advanced, developing and least developed countries, she found a positive and robust correlation between corruption perception and GDP per capita, meaning that higher GDP per capita, on average, reduces the scope of corruption. The relationship between corruption and economic development is in fact even more intriguing than empirical figures suggest.

The impact of corruption on economic growth is an important theoretical and empirical theme in the economic literature. In this theoretical and empirical post, I will briefly review the main literature on corruption and development and discuss the empirical studies.

I would firstly refer to the article by Rodrik, Subramanian and Trebbi (2002) where the authors discuss the primacy of institutions for economic development over the exogenous factors such as geography (link). There has been an extensive amount of literature on the role of geography in economic development. The empirical strategy is quite simple. Usually, the basic equation includes the list of explanatory variables such as distance from equator, the percentage of land used for agricultural production and so forth. For example, the basic equation might take the following form:

log(GDP)=b1+b2(Dist)+b3(Land)+b4(Dummy_SubAfrica)+e

where GDP stands for GDP per capita, Dist for distance from equator, Land for the percentage of fertilized land and Dummy_SubAfrica is a dummy variable, taking the value of 1 if a country is located in the Subsaharan Africa and 0 if otherwise. In addition, e represents stohastic error unexplained by the selected predictors.

However, the basic problem with geographic approach to explaining economic development is that the approach does not, by itself, distinguish between the endogenous features of economic development. In regressing GDP per capita on the distance from equator, the empirical estimates usually result in a modestly negative correlation between the two variables. However, the distance from the equator cannot itself explain the nature of economic development and its significance over time mainly because of its low predictive power in explaining the evolution of institutions and governance.

An interesting approach has been incorporated by Acemoglu, Johnson and Robinson (2001). They incorporate a historical and institutional perspective in the empirical framework of the explanation of economic development. The authors used mortality rates of colonial settlers to explain the institutional quality. They further argue that where settlers encountered few health hazards compared to European settlement, they established solid institutions, strong enforcement of property rights and a robust system of law. In other areas where health hazards frequently occured, colonizers focused on the extraction of natural resources and showed little or no interest in building high-quality institutions. Rodrik, Subramanian and Trebbi (2002) further estimated the impact of geographic variables, institutions and openness on macroeconomic variables.

The main findings in their study were the following. First, each degree distance towards equator, on average, reduces the income per capita by 0.94 percent. The geographical location by the equator is also negatively related to capital per worker (-1.68), human capital per worker (-0.25) and total factor productivity (-0.32). Second, the quality of institutions is a very good measure of the economic welfare. In their panel, the authors found that each additional improvement in the rule of law, on average, leads to 2.22 percent increase in income per capita. The result is statistically significant at 1 percent. The improvement of institutional quality is both positively related and statistically significant when capital per worker, human capital per worker and total factor productivity are regressed on the institutional quality.

Back in 1997, Peterson Institute published an extensive study, searching the causes of corruption (link). The author estimated that the highest cost of corruption in regressing a series of macroeconomic variables on corruption index is lower education expenditure and a decrease in private investment. The estimate of the total macroeconomic cost of corruption is a difficult and daunting empirical task.

The main causes of corruption are mostly endogenous and related to the institutional evolution ranging from legal origins, colonial historical variables to the public sector efficiency variables. In search of the grain of truth, it should be noted that capturing the stylized effect of corruption of economic growth and development requires an interactive empirical approach. In other words, it would be impossible to establish "cause-and-effect" connection between corruption and development indicators without extracting a large amount of historical data and regressing it on the key endogenous variables.

Clearly, the role of geographical characteristics should not be neglected. However, the primacy of institutions in explaining the contemporary patterns of economic development is rather undisputable. Daron Acemoglu recently wrote an in-depth article on the distribution and explanatory factors regarding world poverty (link) where it clearly stressed the lack of institutions of human capital in the evolution of world poverty. When discovering the true causes of corruption, there should nonetheless be a clear and distinct rationale underlined by the evolution of institutional quality over time as the most significant measure in explaining the evolution, causes and effects of corruption on economic development.

ECONOMICS AND THE RETURN OF HISTORY?

In Friday's edition of NY Times, David Brooks wrote a very interesting column (link) discussing the state of economics. Although subtle and rigorous in its assertions I doubt that the field of economics needs a fundamental change in the philosophical origins of economic methodology. I agree with the author that economists often ignore the notion of moral philosophy and history in economic analysis but that doesn't mean that old textbooks on classical microeconomics need to be disposed. The author points out the role of economic forecasters who often appear on the TV, essentially trying to forecast economy's future path. Econometrics, which constitutes time-series forecasts on which most economic projections are based, is a real discipline to which numerous new scientific articles are devoted, published mostly in The Econometrics Journal and Econometrica. In his famous 1983 article (link) Let's take the con out of econometrics, Ed Leamer wrote how econometric modelling can be misused if a researchers ditch the true role and significance of assumptions. A prominent example is the study of death penalty on crime deterrence. As you can read in more detail in Leamer's article, one study found out that each capital punishment deters more than 9 murders while another one found out that each additional capital punishment causes more murders.

The contradicting evidence doesn't imply the falsification of the scientific method in economics. It merely reveals the hidden difference in how economists set assumptions regarding the behavior of individuals, firms and countries. David Brooks pointed out that economists failed to predict the recent financial crisis. However, many economists (myself included) pointed out the true dangers of an over-leveraged economy and monetary easing which led to subprime mortgage crisis and the consequential aftermath.

Many of us have had clear evidence, models and studies that showed how an over-leveraged financial sector can induce a significant economic downturn. However, many policymakers ignored the evidence of the behavior of the financial system which could be easily compared with chaos theory in mathematics. In my recent paper on Iceland's financial crisis I showed that the depository banks' overall leverage and indebtedness in the small country was growing exponentially, beyond the limit of capital adequacy.

As Paul Krugman recently noted, lessons from the Great Depression were not learned because people forgot it too quickly. Although mainstream economics, as every field within economic science, needs some major cures, I disagree with author's assertion that economics is not a real science but a moral philosophy. True, economics is not exact science because human behavior is not as experimental as particle analysis in physics but economics tries to resemble the scientific methodology through models, data, statistical inference and evidence. In fact, new interdisciplinary fields within economics are emerging such as behavioral economics, neuroeconomics and transport economics in which economic analysis is combined with other disciplines such as law, psychology, sociology and neuroscience.

The limits of mathematical recourse in economics were already discussed by economic thinkers such as John Maynard Keynes. And agreeably, mathematical reasoning is bounded by economic reasoning. However, from the real point of view, we need models to address human behavior mostly because, as F.A Hayek noted, it's too complex to capture its essence in a scientific entirety. If the neccesity of assumptions, models and evidence were not the case, hardly any lessons would be learned from the episodes of crises, booms, busts and periods of economic advancement in human history.

RUSSIA'S ROAD TO ECONOMIC RECOVERY

Russia's recessionary contraction has been marked with several distinct features. First, capital account deteriorated significantly. In Q3:2009 it posted a $23.7 billion deficit, reflecting net capital outflows as a result of recovery uncertainties, exchange rate and oil price volatility and the inability of the Russian banking sector of debt repayment. Thus, net capital flows to the private sector decreased by 31.5 percent in Q3:2009.

During the economic crisis of 2008/2009, Russian fiscal policymakers increased government spending when the output gap was positive. Thus, from the mid-2008 onward, Russia faced high inflation rate which peaked well over 10 percent level. Even the fiscal outlook remains sluggish. In 2009, the non-oil government deficit is expected to reach between 11.0 and 12.5 percent of the GDP. The dynamics government deficit remains deteriorating until 2012. In 2010, the non-oil balance is expected at -14.20 percent of the GDP. In 2012, the balance is likely to improve by 1.40 percentage points from 2011. The decline of oil demand has rapidly eroded Russia's reserve fund earnings which decreased from 10.3 percent of the GDP in 2008 to 4.1 percent in 2009. Before the financial crisis, Russia's economic growth model was based mainly on fiscal policy reforms, confluence of high oil prices and access to external financing at low benchmark interest rates. The World Bank estimated that Russia's real GDP will return to pre-crisis level in late 2012. In the long term, Russia's growth quality will be improved only by more dynamic diversification of the economic basis, bold structural, governance and institutional reforms, trade openness, higher productivity growth and liberalized financial sector.

Russia's Macroeconomic Outlook
Source: Central Bank of Russia, Ministry of Finance, Bloomber
*denotes preliminary estimates

Economic Growth in Russia, Central and Eastern Europe and Advanced Economies


Source: IMF, World Economic Outlook, October 2009

MINIMUM WAGE AND OBESITY

David O. Meltzer and Zhuo Chen explored the relationship between minimum wage rate in the U.S and body weight (link):

"Growing consumption of increasingly less expensive food, and especially “fast food”, has been cited as a potential cause of increasing rate of obesity in the United States over the past several decades. Because the real minimum wage in the United States has declined by as much as half over 1968-2007 and because minimum wage labor is a major contributor to the cost of food away from home we hypothesized that changes in the minimum wage would be associated with changes in bodyweight over this period. To examine this, we use data from the Behavioral Risk Factor Surveillance System from 1984-2006 to test whether variation in the real minimum wage was associated with changes in body mass index (BMI). We also examine whether this association varied by gender, education and income, and used quantile regression to test whether the association varied over the BMI distribution. We also estimate the fraction of the increase in BMI since 1970 attributable to minimum wage declines. We find that a $1 decrease in the real minimum wage was associated with a 0.06 increase in BMI. This relationship was significant across gender and income groups and largest among the highest percentiles of the BMI distribution. Real minimum wage decreases can explain 10% of the change in BMI since 1970. We conclude that the declining real minimum wage rates has contributed to the increasing rate of overweight and obesity in the United States. Studies to clarify the mechanism by which minimum wages may affect obesity might help determine appropriate policy responses."

IS SLOVENIA THE NEXT SICK MAN OF EUROPE?

Recently released data from OECD Economic Outlook (link) suggest that the recessionary period is likely ending as the output in world's major economies is reversing the trend of the past year. In 2009, the U.S economy is expected to contract by 2.8 percent annually. Germany, suffering from a significant decline in inventory orders and foreign demand, is set to contract by 6.1 percent and Japanese economy is likely to decline by 6.8 percent. The end of the global recession will be continued by a slow recovery as the economic growth in the OECD economies is most likely to reach 0.7 percent in 2010 after a 4.1 percent decline in 2009.

Besides Israel and Estonia, Slovenia is the next country to join the OECD. The macroeconomic outlook for Slovenia, unfortunately, remains sluggish. In Q2:2009, Slovenian economy contracted significantly. The output decreased by 9.3 percent. In Q1:2009, the economic activity decreased by 9.However, the data on GDP decline is too optimistic compared to the real sector. According to the latest availible data, the industrial production in April contracted by 28.26 percent, followed by double-digit consecutive declines each month. Investment, which in 2008 accounted for 28.9 percent of the GDP declined significantly. In Q1:09, the business investment contracted by 32.3 percent.

The pre-crisis boom in business investment was surged by quantitative easing and low interest rate which contributed to historic highs of credit stock. In addition to deteriorating macroeconomic outlook, the export of goods and services, which once used to be the core engine of Slovenia's economic growth, contracted by 21.1 percent in the Q1:2009. Thus, during 2008, the economic activity experienced unusually high rates of economic growth spurred by investment, foreign demand and historically high consumption spending. Throughout 2008, the economy was starting to exhibit strong signals of overheating.

By the beginning of the crisis, the economic policy pursued a radical debt-driven infusions of liquidity in the banking and bailouts to the real sector. Consequently, the state of public finance changed dramatically. For decades, Slovenia maintained on of the lowest public debt/GDP ratios in Europe. As a fiscal measure, low public debt had been of the merits that enabled the fulfillment of convergence criteria before entering the EMU.

As a result of government intervention, debt guarantees and surging public spending, the public debt is likely to soar from 21.5 percent of the GDP in 2008 to 32.6 percent of the GDP in 2009. The public debt is expected to rise further. If the current trend continues, the public debt is estimated to soar up to 53.7 percent by 2013 (link).

The black line and the left axis on the graph show general government balance while the left axis and yellow bar show public debt. Both categories are expressed in percent of the GDP.


Public debt and general government balance as a percent of the GDP (2004-2013)

Source: Ministry of Finance (link)

As we can see, the primary budget deficit will move from -0.27 percent of the GDP in 2008 to 6.58 percent of the GDP in 2009. By 2013, the deficit is estimated to move to -7.4 percent of the GDP. Compared to small and open economies, Slovenia's primary budget deficit is higher than in most small and open economies. It is, for instance, higher than in Denmark, Greece, Austria, Czech Republic, Finland, Luxembourg, Netherlands, New Zealand, Slovakia, Sweden, Switzerland and Norway. As far as I know, Norway is the only developed country without budget deficit in the near future (According to the OECD and Norges Bank, Norway will post 8.6 percent budget surplus in 2009, down from 18.8 percent in 2008. In 2010, the budget surplus will likely increased by 0.4 percentage point).

The government intervention in the real sector further regulated the labor market by introducing subsidies to employers to retain the employees and discourage layoffs to prevent the rise in unemployment. However, recent data suggested that public sector employment grew significantly while private sector employment declined respectively. In Q2:09, private sector employment decreased by 9.3 percent. Public sector employment, on the other hand, increased by 1.4 percent on the annual basis.

For at least two decades of transition, Slovenia's gradualist economic policy favored rigid and inflexible labor market embodied in collective bargaining, high tax rates on labor supply and barriers to entry. The economic policymakers created discriminatory labor market structure which still discourages young graduates from entering the labor market after graduation. Consequently, unit labor costs are among the highest in the EU. Recently, The Economist snapped a nice chart, showing that tax burden on labor supply in Slovenia is the highest in the world (link). In combination with ageing population and of the youngest retirement generations in the world, the abovementioned labor market dualism further encouraged policymakers to raise health and social security contribution rates. It lead to one of the lowest growth rates of private sector employment in the EU. It further lead to the highest tax wedge in the EU and the unusually high growth of unit labor cost relative to productivity growth. In addition, strongly regulated labor market is the major cause of Slovenia's low productivity convergence relative to the EU15. The majority of central European and Baltic countries have been lowering the productivity gap behind the Euroarea much faster than Slovenia.

In 2009, Slovenia reach 90 percent level of EU27's GDP per capita. Compared to the Euroarea, Slovenia reached 83 percent level of the GDP per capita. Compared to EU15, which is a reasonable measure of comparison, Slovenia reached 81.7 percent level of GDP per capita. Compared to Switzerland, Slovenia sustains only 64 percent level of Swiss GDP per capita (link). Interestingly, if Slovenia were a part of the U.S, its GDP per capita would be at the 54 percent of the U.S level, even lower than in Mississippi and West Virginia - the least developed states in the U.S.

Although Slovenia is often cheered as being the "Switzerland of the East" and the most developed former communist country, its economy will likely resemble slow growth in Italy, Germany and France rather than dynamic growth in Singapore, Hong Kong, Australia and Switzerland. Current economic policies are the recipe for eurosclerosis, experienced by pre-Thatcher Britain. If such pattern of economic policy will continue, the Slovenian economy will, sooner or later, exhibit economic stagnation with low economic growth, onerous tax burden, high structural unemployment and rapidly ageing population.

OIL SHOCKS AND RECESSION 2008

Those of you who enjoy grasping the macroeconomic reality with both hands and attend advanced macro classes will probably enjoy reading professor Hamilton's posts on the contribution of energy price spike to consumption spending and this year's recession (here and here)

COMPETITION, MARKETS AND DISCRIMINATION

Professors' Gary S. Becker and Richard Posner articles on the economics of discrimination (here and here) gave me an interesting motivation to discuss some economic aspects of discrimination which is a popular question into the economic analysis.

The Framework of Labor Market

Discrimination is a relatively young and still fresh theme in economic analysis. It has been pioneered by professor Becker's The Economics of Discrimination (link). The analytical foundations of the economic analysis of discrimination can be found in the attempt to measure discrimination in the labor market and elsewhere by the empirical analysis. In a simple, two-variable model of labor market determined by wage and quantity of labor, there is not a unique equilibrium of demand and supply in the labor market. The demand for labor is downward sloping, reflecting the fact that lower wage (the price of labor) tends to induce the demand for labor. For example, if the wage for software engineer drops from 8 EUR per hour to 6,5 EUR per hour, then Google, for example, will certainly not feel reluctant to hire more skilled software engineers. It should be noted that the slope of labor demand curve is much flatter than demand curves in partial equlibrium models usually behave. The reason is that firms hire labor supply in order to maximize profits and firm's utility function. However, there is no simple marginal rate of substitution between labor and other means of production and that labor suppliers' knowledge, skills and profession determine the result of firm's production function. Also, there is not a unique picture of labor supply, since workers possess different preferences regarding the allocation of time between leisure and consumption. For example, productivity gains by Google engineers may induce them either to increase the amount of leisure time they consume or to allocate even more time to research and product development. In economics, to sketch a brief picture of labor market, we use regression analysis to depict labor demand and supply curve where the wage as an endogenous variable is determined by the inclination of demand curve and the quantity of labor as an exogenous variable. Since a decreasing wage rate induces the demand for labor, demand curve is, expectedly, downward sloping. On the other hand, labor supply is upward-sloping since employees are not reluctant to supply more free time when the rate of real wages is increasing. Even though labor market is a partial equilibrium model of employer-employee preferences, discrimination has often resulted in a two-sector labor market where skills and knowledge are traded in separate markets as shown by the picture.

How Discrimination is Motivated?

There are two types of discrimination in the labor market. First, employers discriminate when they hire labor supply with higher wage rate, even though other labor supplier are cheaper relative to their productivity than labor suppliers hired by the employer. In this case, discrimination is motivated by employer preference of future employees by race, religion, sex or other human charateristics. An employer who discriminates has a comparative disadvantage compared to employers who do not discriminate since first employer's profits are lower due to the fact that first employer's competitor scores better on productivity performance and profit while his relative market-clearing price of labor is lower. Employer discrimination can be enforced with strong cultural and institutional background. In former socialist economies, such as Slovenia, regulated and rigid labor market protected the premium of insiders while it, at the same time, increased entry and career barriers to future employees. Thus, with the lack of productivity convergence and high tax burden, employers in Slovenia are reluctant to hire high-skilled labor supply because of (1) high bargaining power of trade unions and because (2) age-determined income distribution favors older workers compared to younger workers even though older workers in infant industries do not posses high human capital skills as college graduates do. Consequently, human capital premium has been replaced by age premium. In job advertisment, employers often put experience ahead of knowledge and ideas, thus restricting job and career prospects to labor market entrants. On the other hand, employee discrimination occurs when employees, for example, refuse to work with minority workers, demanding real compensation. Regulated labor market structure is, most notably, a cause of employee discrimination since workers possessing more bargaining power tend to discriminate workers with weaker concentration of bargaining power, thus requesting higher premium enabled by the formal (trade union) or informal (intra-market nets) monopoly of existing labor supply. Nonetheless, the attempt to exterminate labor market discrimination by the exercising regulation results in information asymmetry, giving privilege to inside workers' privileges such as seniority and their bargaining power over the medium term (see: Lindbeck, Snower 2002).

Competitive Markets, Economic Freedom and Flexibility

For example, in the old American south, African Americans were often discriminated by local employers (link). Thus, the old South was put in a comparative disadvantage in comparison with Northern and Western states which faced higher productivity growth rates and profits. The situation led to a gap between northern-western and southern states; the latter having lower living standards because of the productivity lag as a partial result of labor market discrimination. The deregulation of labor market is essential to less discrimination since economic freedom such as freedom of trade, enterprise and labor, leads employers to relatively less beneficial discriminatory hiring preferences unless employers prefer lower profit. In Europe, where labor markets are more regulated than in countries such as the United States, Singapore, Denmark and Australia, regulated labor markets lead to lower productivity performance, except that age and experience-based discrimination substituted racial or sexual discrimation at the workplace. Consequently, the standard of living in European welfare states is significantly lower than in the United States. For example, cost decreases in child care, as a result of competition, put more mothers into the labor market in the United States and Canada (link) while the percentage of mothers in the labor market, while having child-care liabilities, is significantly lower in Europe, reflecting regulated and rigid labor market designed by the intervention of trade unions. In freer labor markets where employers have fewer discrimination preferences, firms score higher on productivity, human capital and profits, advantaging employers with non-discriminatory hiring practices while putting employers with discriminatory hiring (related to race, skin color, religion, sex or any other characteristic) in a serious relative disadvantage.

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."

THE 2008 YOUNG ECONOMIST AWARD

The 2008 Young Economist Award goes to Raj Chetty of Berkeley. Raj Chetty has done extensive research on taxation, unemployment, social insurance and risk preferences. His notable spectrum of research includes "Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut". The work has been published in Quarterly Journal of Economics together with Emmanuel Saez. Raj Chetty is also a faculty member at the National Bureau of Economic Research.

Source: The American (link)

THE ECONOMIC PERFORMANCE OF ICELAND IN 2008

The IMF estimated that Iceland's economy could slid into a mild recession in 2008. Meanwhile the rate of inflation is estimated to reach 3,3 percent (link).

The empirical data has shown that Iceland experienced one of the highest coefficients of fiscal revenue elasticity, whether it is measured in terms or relative changes in private consumption or in terms of effective real exchange rate. On the other hand, rigorous tax reform in previous decade returned a soaring growth of fiscal revenue which reflects the broad range of revenue elasticity as well as the effects of tax cuts on supply side of the economy and fiscal parameters.

Read also:
Anthony Arnett: Toward a Robust Fiscal Framework for Iceland; Motivation and Practical Suggestion, IMF Working Paper 07235, International Monetary Fund, 2007 (link)

SLOVENIA GOING SLOW ON PRIVATIZATION

Here is a note from Economist on Slovenia:

Slovenia was already economically advanced by regional standards when it gained independence, so that it has experienced slow growth rates relative to other central European economies, and has adopted a more complacent attitude towards privatisation and economic reform... The main economic policy issues include the privatisation process and attempts to improve the business environment. Progress on both is made difficult by the consensus-based nature of policymaking.

Source: Economist, Country Briefings: Slovenia (link)

The empirical argument in favor of privatization is that the allocation of scarce resources is more efficient in private economy than in public sector regardless of the economy's sector. The only argument that could speak against privatization is the establishment of natural monopolies in case if competitive code is not fully enforced. In this case, control over natural monopolies is needed to prevent price speculations that could occur at the expense of consumer welfare.

The quality of Slovenia's business environment is restrained by administrative burden, restrictive labor regulation and high tax burden which disables the creation of productive behavior. The total number of reforms in Slovenia regarding the ease of doing business is zero (link).

The product quality of the country's business environment is, by competitive analysis, as any other market product. Higher the quality supplied (the number of implemented reforms to improve business environment), higher the demand for the product (the number of investors going for business in Slovenia and the growth of start-ups, spin-offs, and wanna-be's) and higher the reputation of the country as an investment location.

NOBEL PRIZE IN ECONOMICS 2007

This year's Nobel prize in economics jointly goes to Leonid Hurwicz of the University of Minnesota, Eric S. Maskin of the Princeton's Institute for Advanced Study and Roger B. Myerson of the University of Chicago, for having laid the foundations of mechanism design theory, as released by the Royal Swedish Academy of Sciences (link).

Adam Smith's invisible hand refers to how market mechanism ensure an efficient allocation of resources under ample conditions. In pratice, those conditions are distanced from the ideal. Competition is not completely free as there exist oligopolistic, imperfect and monopolistic type of competition.

Among four basic definitive principles of perfect competition, there is an assumption that consumers initialize perfect information about the anticipation of the market. Consumption and production may generate externalities, a positive influence on by-standers. However, many transaction do not actually occur in the open market but in the depth of the microeconomic transactions between firms or in particular exchange agreements between individuals, interest groups (link).

In addition, transactions also occur as an institutional phenomena. The question is not if such transactions are equitable but whether such allocation mechanisms function optimally. The subsequent question is also what is actually the optimal mechanism in going for a certain goal whether it be a goal related to welfare or/and profit maximization. In fact, contemporary economic theory is based on extremal theory of utility and profit maximization.

As in the upgrading of the circular-flow of the economic cycle, there is also the role of government regulation and the question, under which conditions, government regulation is supportive to achieving concrete goals and objectives. From the basic point of view, governments can sometimes improve the economic well-being and welfare nevertheless. For example, government anti-trust and anti-monopoly policies can benefit the overall economic well-being through the enforcement of competitive law as a way towards making welfare deliverable.

However, it is an absurd idea that government should own enterprises due to the fact that the scale of externalities is rare and hardly attainable on the locus of benefits and advantages of the private sector as markets are usually a good way of organizing the economic activity. The issues regarding the efficiency of allocation mechanisms are difficult to tackle mostly due to asymmetric information among market actors.

The fact, that information about individual preferences of particular choice and availible inputs (such as technology) may be dispersed and the fact that information about the individual interest is delivered asymmetrically and through random variables, is probably the core of the theory of allocation mechanism.

This year's Nobel winning economists succinctly initiated and further developed a theory of mechanism design. Enhanced by the laws of complexitiy, optimal allocation mechanism cannot be stated on the typical view from government's perspective, assuming that market failures occur frequently and, further, thus government distortion of market and exchange is non-peculiar.

Contrary to popular assertions, mechanism design theory distinguishes situations in which markets work well and in which they don't, judging the validity of allocation resource mechanism regarding the private information and individual incentives to fluctuations in the market accountably.

In practice, mechanism design theory is a great tool of assistance in experimenting various different mechanisms of trade and multiple exchange, schemes of sound regulation and deregulation. The theory is also applicable in the field of political science as it may upgrade voting procedures to perform efficiently with the supportive role of the economic theory in the process respectively.

SLOVENIA, SOCIALIST REPUBLIC INC.

Janez Jansa, Slovenia's socialist prime minister, once again demonstrated that he's not keen on macroeconomics and the explanation of inflation. In today's radio speech he mistakenly explained the causes of currently higher inflation in Slovenia than in other countries in the EMU, in the fashion of an old Soviet rethorics which could be read from Lenin's textbooks. Perhaps Slovenia's prime minister should read today's column written by Mićo Mrkaić published in business daily Finance, to learn the fundamentals of inflation.

In addition, Slovenia's prime minister, stated that Slovenia is emulating an Irish model since Ireland faced a significant GDP growth throughout 1990s and periodically higher inflation, so according to the words of Slovenia's prime minister, Slovenia is now generating a strong and stable long-term GDP growth. If Slovenia's prime minister had some basic economics in his mind, then he'd know that the time difference between two countries crucially depends on basic macroeconomic parameters such as price-adjusted income per capita and the rate of GDP growth.

Let's take two countries; Ireland and Slovenia. The question what is the developmental distance between Ireland and Slovenia. The equation is written in the following form:

(1) Yslo(0)(1 + Rslo)^t = Yire(0)(1 + Rire)^t

where Y is the income per capita, and R is the rate of output growth. To obtain the result expressed in time period, the upper equation needs to be logged:

(2) t = ln(Yire/Yslo)/ln((1 + Rslo)/(1 + Rire))

which is approximately similar to

(3) t = ln(Yire/Yslo)/Rslo - Rire

According to World Bank, in 2006 Ireland's GDP per capita in terms of purchasing power parity was $35 540 USD and Slovenia had $23 960 USD of GDP per capita (PPP). Assume that Slovenia's estimated GDP growth rate is 4 percent annually while Ireland's long-term growth estimate is 3 percent. If so, then using (3), it would take 40 years for Slovenia to catch-up Ireland's GDP per capita in terms of purchasing power parity.

The issue can be launched differently. Assume that numbers of macroeconomic aggregates discussed above are the same and that we want to know what should be the growth rate if Slovenia is set to catch-up Ireland's GDP per capita in 20 years. The equation is then the following:

(4) Rslo = (Yire/Yslo)^(1/t) (1+Rire) - 1

where R is the required "catch-up" growth rate, t is the time (length) of the catch-up period and Y is the GDP per capita (PPP). Thus, if Slovenia wanted to catch-up Ireland's GDP per capita in terms of purchasing power parity in 20 years, the growth rate would have to equal 7,4 percent annually. If desired "catch-up" time period is reduced to 15 years, then Slovenia's output would have to grow by 8,4 percent annually. Given the negative side-effects of ageing population, labor supply reduction, and of the external pressure on tax-funded generational acccounts, growth estimates for Slovenia show that in the long-run, the growth rate is ought to reduce to the range between 2,5 percent and 3 percent accountably.

As shown above, Slovenia does not emulate an Irish model of economic miracle as Slovenia's prime minister is saying. Given the scope of current growth dynamics, Slovenia emulates a typical Keynesian debt-financed economic growth based on chain effects of stimulus to construction sector. In the short run, the growth rate is temporarily high but in the long-run, when the dynamics of generating output growth is exhausted and fiscal and debt indicators burdensome, the rate is comparatively low and hampered by an upward pressuring inflation rate and consumption-inflated indebtedness of household and fiscal sector.

In addition, in this year's Fraser Institute's Economic Freedom of the World, Slovenia is ranked 91st in the world regarding the scale of economic freedom. Slovenia was surpassed by nearly all post-communist countries in most areas. Ranked on the same place as Mozambique, Ghana and Papua New Guinea, realistically explains the state of economic freedom in Slovenia. High tax burden, weak protection of property rights, extensively sized government sector and highly restrictive labor market definitely explain the low score of economic freedom in Slovenia, the most socialist EU republic.