DON BOUDREAUX ON THE ECONOMICS OF PROSPERITY

Donald Boudreaux recently published an article where he discusses the emergence of prosperity (here)

ECONOMICS AND THE RULE OF LAW

Last week, The Economist posted an article (link) describing the relationship between economics and the rule of law. Until recently, the rule of law has been regarded as a matter of political and moral philosophy while neoclassical economists paid little or no attention to the rule of law in the course of economic analysis. Thanks to the contributors of Austrian school of economic thought and institutional economists, the rule of law was shown as an influential motherhood in economic development. Douglass C. North, a distinguished recipient of the Nobel prize in economics back in 1993, demonstrated the significance of the rule of law in his book "Institutions, Institutional Change and Economic Performance" where he wrote that the inability of societies to develop low-cost effective institutions being able to reduce transaction costs is the very reason of economic stagnation in both, historical and current perspective.

Seriously, is there a thing such as market failure?

In the course of economic thought, the rule of law emerged as an issue together with the collapse of the socialist economies of the Eastern block. After the fall of the Soviet empire, Eastern Europe had become a laboratory of testing economic macro and micro theories. Nevertheless, many curious conclusions were made. Among them, the rule of law and the ability of institutional flexibility were recognized as a driving vehicle in the process of economic growth and development. The essence of the rule of law could hardly be defined from a utilitarian perspective. In fact, former communist countries grew tremendously after the ideas of Karl Marx and Vladimir I. Lenin were put into practice. The industrial production and overall output grew several-fold but in the end, the economic growth in the socialist world failed because market incentives to work, save and invest were a deadlight line and the economies from the former socialistic empire were likely to be a balloon, virtually inflated by illusion waiting to explode.

Learning from Hayek and Locke

In economics, the idea of the rule of law was initiated by two distinguished economists. In his book, The Constitution of Liberty, Friedrich August von Hayek wrote that the aim of the rule of law is to set a basic framework of general rules perceived without coercive action. Simply, the more specific the law becomes, higher the magnitude of coercion. In 1690, enlightenment philosopher John Locke captured the essence of the rule in a brilliant sentence: "Wherever law ends, tyranny begins."

Current economic issues confirm that Hayek and Locke were right. When Asian crisis (1997-1998) deflated the expectations of the right policies, the essence of the rule of became obvious. Without a low-cost institutional setting of policymaking based on the rules rather than discretionary action, no macroeconomic reasoning (whether it is intuitive or analytical) may give desirable results.

Effort in the short run, 300 percent dividend in the long run

The first lesson I met when I opened my first economics textbook was that resources are scarce and therefore the optimal allocation of resources together with a given budget constraint is the precise mechanism that solves the basic economic problem displaying the limits of allocation for particular desires. However, it seems that modern postulates of political reasoning seem to neglect the first and very basic principle of economics. Thus, without a high-quality governance and the rule of law, the great divide between different countries is about to start. Economists Daniel Kaufmann and Aart Kray published a challenging working paper called "Growth without Governance" (link). What they showed is a 300 percent dividend, meaning that in the long run, country's income per head rises by about 300 percent, if its governance is improved by one standard deviation point.

Discretion returns discretion

The indices of the unruly law are the object of discretion settled deeply into the institutional framework. By itself, executing discretion among economic agents is more fatal than obviously perceived. In a more technical economic terminology, discretion leads to suboptimal allocation of scarce resources and into a more rigid institutional framework. Thus, discretion is the first step to the point where the law ends. There has been a lot of discussion about discretion (link) but honestly what discretion really means. Three economists, Vishny, Schleifer and Murphy (link) showed how rent-seeking negatively affects economic growth. The outcome of the institutional chaos when private agents seek anticipated benefits via public means. For example, using Nash Equilibrium, the outcome of the bargaining between two agents depends on the type of strategies. A dominant strategy undertaken by one agent is based on the setting of infinite utility given the information, status and unique preferences derived from the lack of the rule of law.

Rent-seeking and infinite demand for private wants by public means

In a rent-seeking model, the demand for public goods in mostly infinite while the supply is limited as shown by a fixed supply curve in a given space and time. The infinite demand is derived from incentives and preferences of the interest groups targeting the maximization of benefits at any price, given the monopoly status that enables the control and access to information needed to bargain a desirable slice. The comparative difference between market outcome and bargaining outcome is the rent, and the interest groups hindering the quality of the rule tend to change their behavioral responses to maximize the differential between market rate and bargaining outcome.

The long run consequences of the lack of the rule of law, meaning rigid and unchangeable institutions, are lower economic growth and structural defects such as corruption and rent-seeking incentives to abuse the rule of law and attain the outcome unavailable in the market with an unchanged productivity performance.

There is no such thing as growth without economic freedom

The question is why economic growth soared in places without changeable institutions and quality governance. The answer can partly be explained by the fundamental laws of macroeconomics such as the law of diminishing return or/and catch-up effects. A country Y with low per capita GDP attains higher growth rate than a country X with higher GDP per capita. In the long run, growth differential gradually disappears. The quality of governance and institutions cannot be neglected. The answer to the question why Ireland is richer than Mozambique is that institutional change and non-discretionary rule of law in Ireland enabled an economic performance that resulted in a decade of stunning growth and an unparalleled prosperity.

Paying the price of the status-quo

As the first former communist economy which recently adopted Euro as a single currency, Slovenia is often praised for its achievements. One side of the coin is certainly true but the other side of the coin shows a completely different picture. In 1990, the GDP per capita of Slovenia and Ireland was merely the same, measured in USD and adjusted for inflation. Today, Ireland's GDP per capita is 1,77 times (PPP) and 2,66 times (in current USD) higher than Slovenia's GDP per capita. Today, it would take between 50 and 60 years for Slovenia to "catch-up" Ireland's GDP per capita, adjusting it for inflation. Surely, Irish economy enjoyed the benefits of stable and non-discretionary institutions that helped sustained an incredible economic performance. On the other side, Slovenia's envious economic performance is mostly a continuous leap with little change in innovation and productivity performance. In fact, according to Eurostat, Slovenia is among those transition economies that have sustained a slow-motion productivity growth compared to Baltic tigers. Gimmick and backbone perspectives and shadows wavering over Slovenia's economy will sooner or later deliver a menu of price - a price of the absence of the rule of law and the price of the status quo. Period.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

ECONOMIC REFORMS AND THE POLITICAL CYCLE

Johnny Munkhammar (link) recently explained the willingness and to implement market-based reforms as a political incentive of re-election. He explains how economic policies based on product market deregulation, pro-growth tax cuts, market liberalization and the reduction in public spending can quickly bring re-election and thus offset the incentive to pursue further reforms and policy innovation The podcast can be launched here.

AUSTRIA: ALPINE TAX HAVEN DEFENDS FINANCIAL PRIVACY LAW

Austria firmly rejected the initiative from the European Union to ease and possibly remove the legislation that aims at client data privacy and banking quality (link). The EU tries to impose sanctions on jurisdictions known for sound financial privacy, competitive tax policy and bank secrecy laws (link).

ECONOMIC FREEDOM IN 2008

In a mutual cooperation, Heritage Foundation and Wall Street Journal issued a new 2008 Index of Economic Freedom (link). The index measures the level of economic freedom in the world, emphasizing the degree of economic liberty in each country. Some countries, such as Montenegro, Serbia and Iraq, remained unranked subject to incomplete information about the areas reflecting the level of economic freedom. By a methodological definition (link), the economic freedom is a material autonomy in relation to the state and organized groups. An individual is free who can secure and protect his human resources, labor and private property. Economic freedom involves several sub-levels such as freedom to invest, freedom to start a business, freedom to choose, freedom to trade, freedom from corruption, freedom from government, fiscal freedom and the protection of private property rights nevertheless. Higher the value of each component, higher the level of economic freedom.

The Meaning of Economic Freedom

Innumerable empirical investigation has confirmed a positive correlation between economic freedom and sustainable economic performance. Gwartney, Lawson and Holcombe (1999) have explored the relationship between economic and economic growth (link). They concluded that an environment with a high degree of economic freedom is essential to sustainable growth performance. As an ingredient of general prosperity, high level of economic freedom is impossible without a firm role of institutions whose aim is to protect private property from expropriation and to enforce the rule of law. Institutions are defined as the rules of the game and interaction between individuals. Institutions are a set of formal and informal rules that define the scope and shape of behavioral limit in private contracts. Inevitably, the aim of institutions is to minimize the transaction cost through codified arrangements and the respect for individual liberty and a limited role of government. The pursuit of institutions to minimize the transaction cost is, of course, essential to sustainable economic performance. Douglass North, the father of new institutional economics once wrote:

"The inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the third world."

Source: Douglass North; Institutions, Institutional Change and Economic Performance, Cambridge University Press, 1990 (link)

The quality of the business environment regarding creativity, innovation, financial markets and free exchange, is a set of components that determine the rank of economic freedom in a particular country. By the logic of the common sense, economic freedom is a necessity for both human and political freedom. Economic control is not only the control of economic transactions. It is the control of the means for all individual ends. And whoever has the control over the means must also determine which values will rate higher and which ends shall be served. The following relationship has been succinctly explained by Friedrich August von Hayek who once wrote:

"Even striving for equality by means of a direct economy can result only in an officially enforced inequality - an authoritarian determination of the status of each individual in the new hierarchical order"
-- Friedrich August von Hayek

Top 10 - The Champions of Economic Liberty

In this year's index, economic freedom in only seven nations was distributed as free. The distribution of economic freedom is officially shaped in six different categories. Again, Hong Kong remained the freest economy in the world, scoring very high on each component of economic liberty. In the group of free economies there are also Singapore, Ireland, Australia, United States, New Zealand and Canada. Those countries scored very high in monetary freedom, business freedom, private property rights, labor freedom and financial freedom. Among top 10 there are three countries left: Chile, Switzerland and United Kingdom. Sound regulatory environment, efficient judicial system, deregulated product markets, liberalized financial sector and low exchange costs reflect the ranking of countries among top 10. Among them, only Chile is a middle-income country but economic reforms in the past decade such as the privatization of the pension system boosted growth performance of the Chilean economy and contributed to Chile's high score in economic freedom. In 2008, the overall economic freedom of the world has not increased, but some countries progressed dramatically well while some other countries diverged. For example, Mauritius and Denmark performed a continued improvement from previous ranking while Russia's ranking decreased substantially.

Economic freedom in Nordic countries

The proponents of the so-called Nordic model argue that it is possible to combine sound economic performance and an unlimited welfare state. At this stage, they cite the example of Nordic countries. It is somewhat of a paradox to speak of the Nordic countries as they notably differ in several aspects. Therefore, it is actually impossible to speak about the Nordic model in general. Nordic countries score very well in the area of the quality of the business environment, having created one of the freest business areas in the world. Nordic countries also score very well on freedom to trade internationally, open investment environment, non-existent corruption, flexible financial environment, and independent judiciary. But Nordic tigers score quite badly in the areas of fiscal burden and government size. However, each Nordic countries has its own features. Iceland has been very successful in tax reform, entrepreneurship and competitiveness, Denmark has reformed its labor market towards far greater flexibility, Finland is known for the highly rated elementary and secondary education system, Sweden pioneered voucher system and the privatization of health-care and pension funds. Norway, the least free Nordic country, is known for rich natural resources, enabling both generous welfare system and impeding structural environment.

Slovenia - Subalpine Jail

This year's rank of Slovenia in terms of economic freedom has not improved substantially. Officially, economic freedom in Slovenia improved by 0,4 percentage point reflecting a cautous approach to pro-growth economic reforms. However, Slovenia is ranked as 75th freest economy in the world. A growing number of former communist countries has overtaken Slovenia such as Albania, Macedonia, Romania, Bulgaria. Even Lebanon has surpassed Slovenia. The country scored well on trade freedom and monetary freedom. Poor quality of the business environment reflects the overburden and failure of the regulatory environment. Slovenia lacks the privatization of banking and insurance sector. Also, the judicial system lacks the independence from political influence and it is known for substantial court delays, inefficient staff and slow procedures. Halted privatization programs have been a wish of political aim to control particular sectors of the economy. In addition, minor tax reform slightly cut tax rates on productive behavior. However, tax rates remained steeply progressive and high. Public spending has not increased substantially but the level of public spending is still very high accounting for 47,2 percent of the GDP in recent year.

Trade Unions as Means of Coercion

The most significant obstacle to higher level of economic freedom is Slovenia's highly regulated and rigid labor market that hinders productivity growth and job opportunities. Without a radical deregulation of the labor market, productivity growth could slow substantially. Flexibility is a key feature of the labor market, brining generous effect on labor supply. In fact, the power of labor unions is the greatest obstacle to the strength of economic freedom in Slovenia.


Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

THE BENEFITS OF FREE TRADE

"No nation was ever ruined by trade."
- Benjamin Franklin

NEW DEAL AND JOB GROWTH

Amity Shlaes, economic history senior fellow at the Council on Foreign Relations and the author of The Forgotten Man: A New History of the Great Depression, wrote an article about the period of New Deal policies. Her contention correctly assumes that New deal policies lenghtened the Great Depression and that public job creation undermines the strenghts of private sector in providing jobs and creating overall prosperity.

Source: Amity Shlaes: The New Deal Job Myth, AEI, Wednesday, January 2, 2008 (link)

JOHNNY MUNKHAMMAR: GUIDE TO REFORM

In a thorough, understandable and comprehensively written book “Guide to Reform” Johnny Munkhammar addresses some fundamental issues and perspectives about the need to implement long-term economic and structural reforms. The content of the book is divided into several chapters. Each of them reflects key areas of economic reform and each of them highlights the essentials on the road to prosperity through today’s change towards tomorrow’s benefit. In this brief review, I shall highlight the main premises drawn upon the economic reform. As an economist, I will attempt to make essential conclusions regarding author’s groundbreaking book.

The first question is whether economic reform is good. The author of the book has concluded that the main purpose of the economic reform is to pursue economic freedom and guideline the course of public policy instituted upon the ideas that brought nations an unparalleled increase in prosperity. Such conclusion is relevant and supported by countless empirical evidence. The general parameters that reflect the quality of macroeconomic and business framework are crucial to essential conditions regarding growth performance and increases in standards of living. What distinguished sound business environment and macroeconomic picture from restrictive and risky type of macroeconomic framework is the extent of coercion and government involvement into business affairs and personal lives. There is a positive correlation between high real GDP per capita and high level of economic liberty. Nations that have pursued economic freedom and the principles of limited government have observed what could (in German) be described as “Wirtschaftswunder”, an economic miracle.

Let’s start with a methodological, theoretical and empirical grounds and arguments for structural change and major long-range reforms. The author of the book supported the arguments with a significant and incredible amount of economic and political literature. As for an economist, the quest for economic reforms is fairly simple. The economist is interested about the outcome of the reforms and how to design a theoretical framework after data collection, data analysis and after relevant and empirically-tested conclusion are finalized. Throughout the course of the book, the author used a series of graphs and charts to show the how economic activity and standards of living grow together with fundamental economic reforms regarding welfare state, labor market, business environment, health care system, education system and structural performance.

The author succinctly shows how reforms implemented in recent years and decade worked tremendously well in countries that have adopted them. From the theoretical point of view, it depends which side of the economy is taken into the analytical account. The experience such as stagflation has shown that Keynesian economic perception about the real economy was wrong. John Maynard Keynes believed that the economic performance can be restored by the acceleration of aggregate demand. Keynesians also believed that government intervention and a significant monetary expansion can boost the growth performance. However, if newly printed money is injected into the economy, the inevitable consequence is higher inflation which negatively affects the ability of the economy to operate at the optimal capacity regarding long-term sustainability of economic growth. The main consequence of high inflation is a deep negative shock on price behavior resulting from the overweight money funds chasing too few goods.

Thus, there is a paradox given the fact that money injection into the economy inevitably reduces consumer purchasing power. On the other side, the neoclassical growth theory supports the view that the essential condition for long-term growth is the quality of growth engines such as human capital, low tax burden, investment, and productive behavior in general. At the end of 1970s, stagflation, rising inflation and unemployment, indicated the collapse of the Keynesian politico-economic doctrine. From a theoretical perspective, productivity growth is the essential condition for the increase of living standards. Any kind of particular burden that hampers productivity growth also reduces the potentiality of higher living standards and general welfare.

Throughout the book, the author underpins the classical essence of economic success: good governance, limited government, low taxes, sound monetary and macroeconomic framework, low regulation, privatization of public services and competitive product markets, including labor market. In moving towards the solutions and proposals suggested by Johnny Munkhammar in the book deserves an analytical outline of the policy areas that impede economic growth and increase risk of low growth, weak economic performance and an overall decline.

The author suggests radical cuts in public expenditure. The proposal is relevant since reductions in public spending boost growth and productive behavior. In fact, low tax rates on labor supply, savings, investment and entrepreneurship positively correlate with economic growth. The evidence has shown that tax cuts do not reduce revenues following the Laffer curve statement, saying that tax revenue is higher when tax rates are low. The author makes a strong point for privatization and cutting-edge competition in policy innovation. He says that “different reasons may exist for selling publicly owned activities, for example increasing competition, improving management or increasing citizens’ ownership… Competition brings innovation, variety, improvements and lower costs. Increased competition is necessary in publicly provided services and this can be achieved by several methods”.

The author has put a significant amount of effort in the analysis and key policy solutions pertaining to the areas that hinder the evolutionary process of sustainable economic growth. Among the most vital reforms are labor market reforms, product market deregulation, tax cuts, the introduction of competition and private initiative in health-care and education system under sound capital and financial markets, solid infrastructure and the reform of the business environment. He also lists a growing list of nations that implemented productive reform solutions; Estonia’s competitive advantage of early tax reform in boosting investment, the introduction of vouchers in Sweden, the reform of the labor market in New Zealand and the remarkable economic transformation of Slovakia from a lingering performer into high-growing Tatra tiger. The author also outlined how Ireland went from the “poorest-of-the-rich” as how The Economist described Ireland in January 1988, to the Celtic tiger in nearly a decade. The arguments for economic reforms are put ahead in a very intuitive and interactive way nevertheless.

The main problem in implementing the economic reforms is not that politicians are unaware of the economic reforms but the fact that their political support is subject to special interests emerging from rent-seeking patterns of behavior placed in societies where the weakness of institutions enables interest groups to gain privileges from the state, codified into the law and made permanent. Powerful stakeholders in the corporativist model of society will thus resist change at any cost. Such case is the collective bargaining which distorts the competitive equilibrium in the labor market at the cost of lower productivity growth and slower structural adjustment to economic change and globalization. Special interest groups possessing a degree of coercion and political influence will inevitably refuse reform proposals and mobilize its force to do everything possible to prevent the implementation of economic reforms by the means of fear and propaganda.

The author suggests a strategic set of combinations of political decision-making, game theory and tactical methods that could reduce the opposition to economic reforms and structural advancement. As an important feature, the author also makes strong point on the continuum of economic reforms as the main policy asset that reformist politicians should embrace. True, there will always be those who oppose economic reforms everywhere but, as Harold Wilson said, “those who reject change are the architects of tomorrow’s decay.”

The book is not only a great source of inspiration but also a great educational material that provides important data, information and answers to some of the greatest tasks of tomorrow’s challenge.

Rok SPRUK is an economist

Copyright 2007 by Rok SPRUK

HIGH TAX JURISDICTIONS ARE AS BAD AS MONOPOLIES AND OIL CARTELS

JAPAN'S HYBRID INNOVATION: NEW ECONOMIC MODEL

The Economist published an article on Japan's business and economic performance. The article outlines the periodic evolution of the Japanese economy. After a prolonged cyclical crisis of low output rates and deflation, which hit the bottom in 1998, Japanese economic performance surged a modest recovery. Indeed, Japan's old industrial model formed the country's economic miracle, but under very different circumstances, such as pyramidal population structure and high growth under 'catch-up' conditions. The old model, known as a binding cross-sectional partnership named keiretsu, ran out of time and hindered both; entrepreneurship and innovation.

However, the time is changing and Japanese economy and business also:

"So policymakers rewrote corporate law to allow Japanese companies to adopt an American-style model of corporate governance, and some companies began to adopt Anglo-Saxon practices such as performance-based pay, share options, outside directors, promotion based on ability, pursuit of shareholder value and hiring new employees in mid-career. The banking system was recapitalised, cross-shareholdings were unwound and companies embarked on a programme of restructuring."

Source: The Economist, Going hybrid, November 29th 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.

MONTENEGRO'S ROAD TO FREE MARKET ECONOMY

The International Monetary Fund recently released the report on Montenegro's overall economic performance, emphasising basic fiscal and macroeconomic policy perspectives. In English the report is availible here while it can also be reached in Montenegrin (here).

Two years after gaining a formal independence from Serbia, Montenegro's economy operated at a full capacity, having seen robust output growth rates estimated to exceed 7 percent by the end of 2007. The growth, mainly driven by a significant amount of foreign direct investment, seems to remain robust in the medium-run despite particular tensions referring to the signs of overheating. Nearly 85 percent of capital value of companies was privatized. Banking sector, telecommunications, oil distribution and import services are 100 percent privately owned. Foreign direct investment is reaching record highs. In 2006, according to Montenegro's central bank, foreign direct investment reached $680 million USD, six times higher than in 2004. In the first half of 2007, foreign direct investment increased by 78 percent, while from January to July 2007, the amount of FDI was $650 million. Thus, Montenegro has one of the highest FDI per capita, $ 1,100 USD, one of the highest shares in Europe.

Montenegro's business environment is weak by international ranking, despite of significant improvement in since the independence year. Montenegro ranks 81st in the world according to the ease of doing business. The failure of public administration to provide the operating business environment at sound quality, long licensing procedures, severe difficulties faced when registering a property, bureaucratized trading environment, and a high level of difficulty in enforcing commercial contracts, reflect the disadvantages of Montenegro's business environment (link).

Affected by international financial turbulence, Montenegro's asset prices soared in the last two years, leading to a remarkably rapid growth of credit which further fueled the investment into real estate industry. However, rapid credit growth posed signs of an overheating economy which has been a particular backlash of Montenegro's domestic economic environment.

On the other side, Montenegro's growth is not drifted by inflationary pressures. Subject to concentrated market structure, retail inflation peaked slightly ahead of central bank's expectations, particularly in the electricity sector which has not yet been demonopolized by the infusion of competitive mechanisms and price liberalization. Electricity shortages occured despite tariff increases.

The economic reforms, such as the privatization of state-owned assets and the openness to foreign trade and investment, contributed to stable macroeconomic position. The budget remained anchored in surplus. Public debt does not currently evince any sign of quick consumption-inflated indebtedness. Total public debt peaked at 38 percent of the GDP while loans denominated into foreign currency presented 27 percent of the GDP by the end of 2006. As a matter of fact, overall public debt was reduced from 88,3 percent of the GDP where it stood in 2002 (link). Foreign indebtedness is expected to decrease in the years to come due to large amount of inflows from the investors' buy-outs of state-owned assets and enterprises.

As a transition economy, Montenegro has experienced typical short-term and medium-term problems due to the rapid convergence of GDP and robust economic growth as well. Transition process, by itself, poses a lot of risk and challenges, ensuring economy's vitality and growth sustainability. First, in Montenegro, real estate and equity prices skyrocketed due to signficant demand-induced pressures and country's valuable tourism potential, which folded residential and coastal property prices upward.

Second, according to IMF, credit growth accelerated at 170 percent by August 2007, pushing the the household indebtedness to record highs. Credit growth has surpasses the amount of inflows from foreign direct investment which Montenegro has received in this year. However, deteriorating current account deficit is not alarming, neither a sign of recession or downturn, whether it applied to established economy or an economy in transition. In case of Montenegro, widening current account is a result of accountable investment imports and capital inflows whose contribution to overall output growth is significant. In relation to credit growth, it is the question whether banking industry is strained by the lack of ability to assess loans in real estate.

Third, external demand-supported pressure on wages poses a significant threat to overall competitiveness of Montenegro's booming economy. If productivity expectations are high, the spiral of wage-increases claims could have been eased by the fact of productivity outcome. But if the productivity expectations are low, the wage-increasing claims could have bursted the triggering of inflation-pressing spiral. In case of Montenegro, public sector has claimed wage increases several times. It is the question whether the sector whose contribution to growth is relatively low relative to the components of the private sector, could claim wage increases on a legitimate basis subject to distortionary effects of wage-increasing claims under conditions of low and possibly rachitic productivity performance. The rigidity of wage claims is mainly derived by the lack of labor market reforms, whereas outdated labor legislation returns uncompetitive effect respectively.

Montenegro's abundant potential of a flourishing tourist industry propelled by market optimism and Stabilization and Association Agreement with the EU, provides sound opportunities to address the abovementioned concerns. Years ago, Montenegro adopted euro as a common currency, thus eliminating the possibility of currency and exchange risk. Monetary policy's ability to tackle demand pressures is thus partly limited and that's why a prudent fiscal stance is needed in lines with transparency and restrictive expenditure agenda.

In a booming economy, such as Montenegro, fiscal policy is a powerful tool in managing the fluctuations and brisk economic progress. In the state of robust output growth rates and soaring private sector productivity, fiscal policy is ought to be countercyclical to prevent the possiblity of overheating where the expansionary fiscal policy could turn a non-inflationary economic performance into inflationary economic growth generated by fiscal expenditures on infrastructure and public or/and foreign indebtedness, while seeing the overheating of economy's overall capacity. Fiscal balance or possible surplus is favorable to the business cycle for two particular reasons: (1) it faces adverse shock with low risk and (2) it gives support when revenue growth cools the impact on public finance. Also, significant import growth, reflecting the current account deficit, presented 4-5 percent share of imports in the GDP.

The role of fiscal policy is ought not to be undermined. As a powerful tool in responding to cyclical fluctuations during a "catch-up effect" period, fiscal stability and low government spending are usually based on surplus mechanisms. By avoiding budget deficit, policy responses may prevent the demand shocks and low level of public spending is a sign of maturity that helps to detach the anticipation of inflationary pressures and its impact on macroeconomic stability.

Tax cuts implemented in previous years may be seen as a policy failure in generating greater revenue. As the Laffer curve succinctly explains, it is able to reach higher tax revenue from a broader tax base, by reducing the rates on corporate and individual income. Since the implementation of low flat taxation on major sources of productive behavior, revenues have increased rapidly. Currently, public spending stands at 45 percent of the GDP (link), and the share of capital investment is 3 percent in this respect.

As a negative aspect of fiscal and structural policy, Montenegro's policymakers approved a significant 30 percent wage increase in the public sector, which is far ahead of current productivity and output growth measures. Such expansionary effects should be wisely avoided to prevent the loss of incentives to boost the economic performance when the growth performance slows. Robert Barro, a professor of economics at Harvard University, has shown empirically that reducing the size of public sector by 10 percent, stimulates growth by 1,3-1,8 percent. As a sign of innovative policy, public sector employment and expansion might be frozen and possibly reduced to prevent further unanticipated shocks such as wage-increasing claims.

In recent years, Montenegro's economic policymakers implemented a rigorous tax reform. Flat tax was implemented on personal and corporate income and it is expected to be dropped slightly in the years to come. Tax cuts were imposed procyclically. However, complex taxation structure such as numerous exemptions, loopholes, breaks and deductions have counter-effects as they raise the cost of paying taxes, notified as a difficult tax compliance and administrative burden which costs firms and taxpayers millions. The aim of tax reform and system is to pursue the efficiency and minimal tax burden levied on firms and individual taxpayers. High tax burden, empirically and practically, constrains growth and does not meed the indicated measure of efficiency. Fiscal reform, such as braking-up the size of government spending, is expected to pursue the objectives of fiscal consolidation which contains easing pressures to anticipated as well as unanticipated external or domestic shocks. The goal of prudent fiscal sustainability in the medium-term is to meet the demands of macroeconomic and structural stability. In the medium run, demands to invest rapidly in infrastructure may be tackled. However, it would be wise to avoid infrastructure investment through the expansion of state-owned enterprises. By the means of risk-taking and efficiency of capital and technology investment, infrastructural investment is easily attainable through private sector. In case if externalities and signs of market failure appear, then public infrastructural investment may be justified, also to prevent the emergence of public or natural monopolies where one firm, in public or private ownership, could substantially abuse its market power, such as in case of railway and highway infrastructure.

In monetary area, Montenegro has stabilized low inflation rate and the monetary policy remains anti-inflationary (link). In 2006, inflation rate peaked at 2,5 percent. In the first half of 2007, inflation rate was 1,1 percent (link). S&P has given Montenegro BB+ credit rating. The abovementioned rapid growth of credit has tightened banks to raise capital adequacy ratios. This could hamper the ability of banks as well as equity funds in responding to the demand claims of investors in real estate and stock market industry (link)

At last, structural reforms demand both; challenge and perspectives. One of the greatest potential of structural reforms is to boost economy's potentials. According to the data, the government and state, still own shares in 65 companies. In 53,8 percent of those companies, government has more than 50 percent ownership share. The argument for an accelerated privatization is the fact that the allocation of labor, capital and technology resources is better utilized as well as distributed in the channel of productive use. In fact, as an owner, government has severely different interest than private investors. In addition, the data shows, that privatized companies sustain higher level of productivity than state-owned companies.

The area in which radical reforms should not be postponed, is the labor market. The aim of the labor law is to pursue flexible and dynamic environment, allowing firms to dismiss non-performing employees without high severance costs. As every economist can confirm, collective contracts and bargaining such as oligarhic bundling between monopoly structures such as federation of employers and trade unions, does not match the needs of modern market economy. Instead, flexibility and deregulated labor market are essential to maximize productivity growth and eliminate discretionary wage-increasing pressures and also fight unemployment. In this respect, Montenegro's business environment is free of unnecessary regulation which boosts the potential of private sector growth. In the long run, fiscal risks are inevitable and Montenegro's abundant potentials may be implemented not by government intervention but by low public spending and first-class investment environment that underpins the role of private sector, free of corruption, in the economic performance respectively.

Rok SPRUK is an economist.

Copyright 2007 by Rok SPRUK

NOBEL PEACE PRIZE 2007

Nobel Peace Prize has usually been awarded to the individual contribution for making the world a more peaceful place. The list of prominently distinguished prize winners include Yasser Arafat, Shimon Peres, Aung San Suu Kyi, Mohamed El Baradei and other distinguished names as well.

In 2007, the prize was awarded to Albert Al Gore and Intergovernmental Panel on Climate Change. The committee explained the awarding decision to those two entitities in the following way:
"for their efforts to build up and disseminate greater knowledge about man-made climate change, and to lay the foundations for the measures that are needed to counteract such change"

IPCC has put together scientific knowledge in quite a comprehensive form while Al Gore has pushed policymakers to take action concerning global warming. Establishing scientific consensus on global warming is a difficulty. Regarding the definition of the consensus is that the latter is the agreement on particular issue or type of issue where everyone agrees with it, but in broader terms, nobody believes in. In 1992, professor Richard S. Lindzen wrote a fascinating article, a compelling truth about global warming where he wrote:

"The simple picture of the greenhouse mechanism is seriously oversimplified. Many of us were taught in elementary school that heat is transported by radiation, convection, and conduction. The above representation only refers to radiative transfer. As it turns out, if there were only radiative heat transfer, the greenhouse effect would warm the Earth to about seventy-seven degrees centigrade rather than to fifteen degrees centigrade. In fact, the greenhouse effect is only about 25 percent of what it would be in a pure radiative situation. The reason for this is the presence of convection (heat transport by air motions), which bypasses much of the radiative absorption."

Source: Richard S. Lindzen: Global Warming, The Origin and Nature of the Alledged Scientific Consensus (link)

In the course of global warming debate, there are several sceptics. On the issue of global warming, the understanding of science is crucial to the analytical predictions and estimates in the future about this particular issue. In addition, it is essential to separate science from non-science. Remember what Mr. Gore said in the interview on ABC when Mr. Stephanopoulos confronted him with the fact that the best estimates of rising sea levels are far less dire than he suggests in his movie:
"Scientists don't have any models that give them a high level of confidence."

Economist published a well-argued and notable article, judging whether Al Gore truly deserved to get a Nobel prize. In fact, the question is since when a movie which could hardly be identified as a documentary can serve as a tool for decision-making over such a distinguished award as a Nobel prize for peace. Clearly, the term "peace" includes effort that support the institution of peace in relation to preventing conflicts and suggesting solutions to solve particular complex problems. For instance, if there is a vast empirical evidence on the positive correlation between the decline of regional conflicts and free trade, then free international exchange is, in fact, the contributor to peace.

In Guardian, Bjorn Lomborg wrote a sizzling article on the Nobel prize for peace in this year. Have you read Mr. Lindzen's article Don't believe the hype? Here is a link to the article where professor Lindzen summarizes the fact that there is actually no consensus on global warming:

"So what, then, is one to make of this alleged debate? I would suggest at least three points.

First, nonscientists generally do not want to bother with understanding the science. Claims of consensus relieve policy types, environmental advocates and politicians of any need to do so. Such claims also serve to intimidate the public and even scientists--especially those outside the area of climate dynamics. Secondly, given that the question of human attribution largely cannot be resolved, its use in promoting visions of disaster constitutes nothing so much as a bait-and-switch scam. That is an inauspicious beginning to what Mr. Gore claims is not a political issue but a "moral" crusade.

Lastly, there is a clear attempt to establish truth not by scientific methods but by perpetual repetition. An earlier attempt at this was accompanied by tragedy. Perhaps Marx was right. This time around we may have farce--if we're lucky."

MARKETS AND CHOICE: THE CASE OF KOSOVO

Once again, Economist offers an excellent analysis about the future status of Kosovo, predicting the effects of choice between the model of full independence and the self-governing status of minimal dependence on Serbia.

Nevertheless, the issues deserves the piece of attention through the prism of economic analysis.

First, assume that Kosovo's long term objective is to seek the course of output growth and good structural environment that could, in turn, boost both: growth and development. As an empirical matter, the correlation between growth and democracy is weakly negative, meaning that the case of full democracy leads to the loss of growth momentum as well as to the widespread increase of bureaucratic and administrative means which deprive the dynamics of growth in a broader perspective.

Second, one of the main engines of prosperity and growth is the country's business and investment environment. Assuming the "catch-up"effects of a country with comparably low GDP per capita, the Kosovo's GDP would streamline the convergence quickly but in a larger sense, the quality of investment environment determines the intensity of investment, since a degree of firm's interest, looking forward to invest in particular segments of the region, would largely depend on the quality of the legal environment, such as the absence of barriers to saving and investment.

The ability to open the enterprise quickly, is also a part of the ability of how quickly job creation could go on. In fact, one of the broadest standpoints on which nearly all economists agree is that job creation is the best way to reduce structural unemployment of a typical post-communist economy in transition. In addition, high quality of the business environment is a thorough indicator of country's openness to trade and investment.

Third, the area in which most of post-communist countries lag is the labor market. In fact, labor is product that is traded in a voluntary agreement between the employee and employer at a certain price called the wage. In this respect, the general equilibrium of labor supply and demand for labor works as in usual cases.

If there is a scare labor supply in concrete area (say IT) compared to derived demand, then the price per unit of labor will go up and so will the employee's return to education and skills derived from labor's human capital. On the other side, if there is an extensive labor supply in concrete area (say sociology) and demand for labor is low, then the return to education will fall, raising the probability of unemployment and causing an incentive to accept the fact of lower return on education in case if labor demand is low in quantity terms.

The price behavior in this exchange partly depends on the willingness of labor supply to embrace lower price than in comparable areas, since an employer is induced and given an opportunity to hire the labor supply at a lower cost than under conditions of high demand and scarce availibility of labor supply.

From labor market aspect, democracy entails a bulk of negative effects that hinder productivity growth and reduce the extent of flexibility of labor market through means of collective bargaining and monopoly power exercised by labor unions. By empirical and practical terms, productivity is the leading engine of growth of standard of living and thus, lower productivity growth correlates with a lower comparable standard of living.

Fourth, the comparison of benefits between multiple option of independence deserves a detailed study and empirical investigation. A macroeconomic quest for this particular choice, is the question of exchange rate risk but this also depends on the ability of the country to have its own independent central bank.

In fact, if the National Bank of Serbia suddenly started to manipulate with exchange rate such as subsidizing the export sector through inflationary policies, and if Kosovo had no central bank, then it could openly feel the negative effects of high inflation. On the other side, if National Bank of Serbia maintains tight anti-inflationary policies, then the absence of costs and risk could benefit Kosovo's economy. But of course, to analyze the effects of multiple options, there must be concrete data to start disseminating and analyzing the effects of political status regarding the future growth and prosperity.

And fifth, as an economist, I think that political mitigation of future status of Kosovo is overhaul. In fact, the systematic efficiency of political status includes the efficiency of institutions protecting the enforcement of private property rights and individual liberties. Nevertheless, individual rights emerge from the private property, i.e. from the ability to manage private property without external interference.

In fact, the question which country advances in economic and structural terms significantly and competitively, does not depend on whether country is fully democratic or not, but on which country is freer than others in terms of taxation, choice and deregulation, enabling faster and higher growth of output and productivity, and thus creating a comparative advantage.

Read also:
Steffen Ganghof, Phillip Genschel: Taxation and Democracy in the EU (link)
Amleto Cattarin: "Hands off my taxes!": a comparative analysis of direct democracy and taxation, NYU Law School (link)
Kosovo, Economic Profile, European Commission (link)
Capitalism & Freedom: Kosovo, European Hong Kong? (link)
The State of Kosovo's Economy; Perspectives and Development, CEEOL Südosteuropa Mitteilungen, Issue no.3/2005 (link)

DEMOCRACY: THE ENEMY OF ITSELF

One of the most strinking thins which can be observed around the world is the misguided connecting of liberty with democracy. Empirically, the effect of full democracy on economic growth is weakly negative.

In political terms, democracy means voting. It means the ability of the voters to elect representatives. There are many dubious side-effects of what is referred to as the "real democracy". In the state of democracy, there are few things that are contradictory to civil, human, political and economic freedom.

Coercion and constraints

1. Coercion. If political leaders are elected democratically through voting, it means that they have a full ability to pursue a particular political philosophy. As Friedrich August von Hayek wrote in The Constitution of Liberty, each extensive political philosophy supposes that the lives of individuals mismanaged by themselves, and thus they should be controlled through any means of coercion and constraint whether it be the taxation of individual income, information-sharing or the government force to agree and respect the disagreeable. Hence, the main determinator in the state of democracy is not the market where wants and goods are compensated by value exchange, but is the majority that casts the demands imposed on political bodies. Depending on the extent of majority rule, the demands will be suited only if they suit the political support over the term. The sum effect of majority rule is thus guided by the sources of political power which is close to the oligarchic rule. Thus, in many particular items, democracy is a self-contradiction governed by the seed of collectivism and by the tyranny of the majority rule as Alexis de Tocqueville wrote brilliantly in his work Democracy in America.

2. Interest groups: to gain support, the political rivals compete on getting votes from particular interest groups such as trade unions and agricultural lobbies to receive private interests on behalf of public good. In the free market, demand and supply are matched and taken as given. The ability to meet the market needs of individuals is determined by the freedom of choice, given the total utility impact. In political market, the ability to meet the needs of voters is determined by the concentration of power in the hands of most influential groups and formations in public whom the priority is given. This is another proof that democracy is perhaps the most notable hidden evidence of discrimination since "everyone-is-treated-equally" is rambled by "you-are-treated-equally-if-you-belong-to-majority".

3. Extensive government: Great Britain was free way before it became democratic. A country can be free and prosperous even without being dichotomously democratic. Singapore has a high degree of economic freedom and is treated as politically hybrid regime. Estonia is among the freest economies in Europe and the world, but its grade in democratic performance is likely marked by the label of flawed democracy. On the other hand, Sweden is known as "full democracy" but its 81,3 percent economically free relative to Hong Kong which is known as the economically freest place in the world.

Democracy - a self-contradiction

Democracy is treated as an untouchable dogma which is supposed to be in the interest of all. Failed and falsified as it is, democracy is neither close to liberty nor minimal state. Classical liberalism is based on the grounds of negative liberty of non-interference as well as on the absence of government coercion. Fundamentally, democracy mischiefs the extent of government coercion. Classical liberal/libertarian pursuit always predicts the individual and political action to reduce (or possibly eliminate) the extent of government coercion while the dogma of democracy takes no notice on the extent of government coercion, but only on the action which is governed by the rule of majority.

Democracy - the slavery of positive liberty

That is why government based on the principle of the minimal state, providing only the fundamental general framework of interaction (the-rule-of-law), functions efficiently and contributes a significant share to the future creation wealth in going for growth and prosperity. Minimal government is the best friend of individual initiative accompanied by the degree of being free to choose, live and create.

Read also:
Denis Bider: Robert J. Barro's Democracy and Growth (link),
Libertarec: Socializem ustvarja vojne (Socialism creates wars) (link)
Libertarec: Zgodba o dveh vased (A tale of two villages) (link)
Greg Mankiw: A question for democrats (link)
Robert Nozick: A tale of the slave (link)

KOSOVO: EUROPEAN HONG KONG?

At Blic Online, I came across the article which predicts the model of autonomous sovereignity of Kosovo based on the status which is similar to Hong Kong.

Under such proposal, Kosovo would be able to join the international organizations such as World Bank and International Monetary Fund. Politically, the status could induce the formation of institutions as well as an independent political decision-making among which there is an ability to form the rule-of-law and slash government intervention. As a partly independent region, Kosovo would probably be able to induce the foundations of economic, personal and political liberty to gain the competitive position in the world and pursue the policies in support of economic growth and capital formation.

Hong Kong, which is entitled as the freest economy in the world, generated significant economic growth and structural advancement among which there had been the enforcement of competitive law and the creation of growth-friendly business environment which attracted a significant inflows of foreign direct investment. As a result of pro-growth economic and structural policy, Hong Kong's income per capita skyrocketed over the past half of the century.

Regardless of the solutions, the creation of autonomous region or an independent state is an opportunity to gain territorialy tax sovereignity in the region with sound property rights, openness to trade and investment, and enviable structural environment which would, in turn, energize economic growth and the pursuit of prosperity through economic, individual and political liberty.

BATTLING WELFARE LEGACY IN SWEDEN

In Wall Street Journal there is a good article outlining the implementation of economic and structural reforms on the road to recovery from a typical generous experiment of the welfare state (link).

PROSPERITY, COMPETITION AND EUROPE

Here is the answer to the question how European economy and society prospered from competition and free exchange:

Johnny Munkhammar, What Competition Has Done for Europe, European Enterprise Institute, 2007 (link)

MALAYSIA'S MODEST CORPORATE TAX CUT

Malaysian Prime Minister Abdullah Ahmad Badawi announced another 1% cut in the rate of corporate tax in the Malaysian government budget. In addition, several other measures have been introduced to boost the investment, revenue and capital formation.

By 2009, the corporate tax cut proposal is expected to be reduced by an additional percentage point down to 25 percent. Despite a tax cutting "slow-motion" of slashing the corporate tax rate by 1 percent annually in the last two years, the aggregate corporate tax burden is estimated to reduce. The rate fell by 1 percent to 27 percent this year, and will bring about a further 1 percent cut next year.

Tax news reports that: "...announced a generous package of tax breaks for the investment industry in an attempt to consolidate and build upon Malaysia's position as one of the leading centers for Islamic finance. As a result of the budget measures, fund management companies will be given income tax exemption on all fees received for Islamic fund management activities until the 2016 year of assessment. Furthermore, the government's pension scheme, the Employment Provident Fund (EPF), will channel about 7 billion ringgit (US$2 billion) to be managed by Islamic fund management companies. Also, these companies will be permitted to be 100% foreign-owned, and will be able to invest all their assets overseas."

In addition to a mere modification of the tax system, Malaysian government further deregulation stock-broking licensing procedures by allowing the entry to the companies that can source the investment funds.

However, the new tax proposal seems to be discriminatory to international investors as government decided to slash the entry barriers only to investors from Arab countries and the Middle East. Among other measures, a a 50% stamp duty exemption on the purchase of a house worth less than 250,000 ringgit (US$72,000) has been launched.

Malaysia's currently ranks 48th internationally and 8th regionally in economic freedom, scoring significantly better than Slovenia.

FLAT TAX REVOLUTION IN POLAND?

In Central and Eastern Europe, the flat tax revolution took place in early and middle 1990s when simple flat-rated tax on individual and corporate income replaced previous progressive tax rates on productive behavior such as labor supply.

According to Eurostat, Eastern European economies generate high periodic growth rates and outstanding output performance despite some recent inflationary pressures which are, in turn, a natural consequence of high growth that normalizes when annual and period (quarterly) GDP growth rates resile the output gap (case study: Latvia):

Latvia - 11,9%
Estonia - 11,4%
Slovakia - 8,3%
Romania - 7,7%
Czech Republic - 6,5%
Bulgaria - 6,1%
Poland - 6,1%
Slovenia - 5,2%
Hungary - 3,9%

Source: Real GDP growth rate in 2006, Eurostat (link)
See also: Frederick Mishkin: Inflation Targeting in Transition Countries: Experience and Prospects, NBER Working Paper 9667 (link)

There is innumerable practical and empirical support for less aggregate tax burden. In effective terms, the reduction in marginal tax rates could significantly stimulate the propensity of productivity since each additional unit produced and hour spent in the market, would not be penalized by additional taxation. On supply-side, the fundamental rax reform applied to corporate entities, such as the elimination of double taxation of income that is saved and invested and the abolishment of capital gains and divdend taxes, could stimulate the economic performance as well as encourage the business competitiveness. The real evidence has shown that countries with lower aggregate tax burden and flat-rated taxes generate higher output growth rates respectively. In addition, high aggregate tax burden empirically leads to the tax evasion and the groundbreaking path towards hidden economy, since it is typically cost-beneficial to avoid paying the tax through complex set of deductions, exemptions and loopholes or to boost the economic performance away from government control.

The impact of progressive tax code is multi-layered. As first, punitive tax regime on labor income, produces a cost distortion as well as a negative impact on human capital creation which is essential to dynamic growth conditions. Hence, progressively-rated tax on labor supply results in a high wedge between gross cost of the employee beared by employer and the real wage. This particular variety of taxation negatively affects the productive ability of the employees to spend more hours on market since each additional earned income unit is deducted by a punitive tax rate. And second, labor supply is highly sensitive to tax rates. Higher tax rates on labor supply mean higher taxes on human capital. Thus, firms such as service sector are discouraged to hire employees that could generate high productivity and contribute its portion to firm's output. And third, in sum, high progressive tax rates on productive behavior alienate investors and contribute to the loss of net direct investment. Adding the aims for tax harmonization, the effect multiplies downward.

The latest indice of tax reform proposal has come from Poland. The effect of international tax competition between jurisdictions is that labor supply and capital easily shift from high-tax jurisdictions into locations with growth-friendly and less complex and costly tax system. Since investment and capital creation boost economic growth, Poland would suffer a loss in net direct investment in case of maintaining a progressive and complex tax code with rudimentary compliance burden, despite the advantages of Polish business environment such as low comparative cost of labor and outward/inward international flows. In fact, punitive tax regime with high effective tax rates on labor and capital and weak structural e-competitiveness, could backstage Poland's transformation to full-fledged free and competitive market economy.