WILL FISCAL ASYMMETRIES THREATEN THE EURO?

Earlier this day, I came across Moody's Misery Index (link) which estimated the size of macroeconomic difficulties in European countries. In particular, European countries within and outside the Eurozone are likely to face stagnant GDP growth rates, high unemployment rates, deflationary pressures and a depressing fiscal outlook.

Moody's Sovereign Misery Index

Source: FT Alphaville (link)

The most problematic European countries seem to be the peripheral edge of the Europen Union - Greece, Spain, Portugal, Slovenia and Italy. Greece, Portugal and Slovenia are small economies without very much effect on the European GDP dynamics. However, the size of Spain's and Italy's economy is large enough to be able to exacerbate significant effect on GDP dynamics within the European Union and the Eurozone.


Debt-to-GDP ratio in selected countries

Source: Market Oracle (link)

Spain topped the Moody's Misery Index due to the highest estimated unemployment rate for 2010 and a whopping fiscal deficit. Where's the trouble? As I wrote earlier (link), prior to the outbreak of financial crisis, Spain had a favorable fiscal outlook in 2006 and 2007 and an unfavorable current account balance . In 2007, Spain experienced a 10 percent of the GDP current account deficit largely due to net capital inflows from surplus countries such as Germany and Netherands. These net capital inflows further inflated asset prices, causing an outburst of asset bubble. In the mean time, asset price inflation escalated and real estate price index soared. Government's remaining choice was to push for a fiscal surplus to avoid the inflationary shocks. When the bubble turned into burst, the shortage of external demand (in spite of favorable domestic consumption rate) caused the economy's overcapacity and a deeply negative output gap. In 2008, Spain's economy overheated and the output gap increased to historic highs (3.06 percent of potential GDP). In 2010, the estimated output gap is -2.12 percent of potential GDP. Due to weak aggregate demand - especially weak investment and external demand - asset and consumer prices are decreasing. As firms are reluctant to hire new labor, the result is high rate of unemployment, deflationary pressure and non-existent GDP growth. The macroeconomic situation in Spain pretty much reflects the general macro outlook for the entire Eurozone.

If the ECB decided to raise interest rates significantly, it would further depress an already weak investment activity. If ECB's interest rates decreased further, there would be a serious danger of deflationary trap which dragged the Japanese economy into a decade long period of deflation rates, zero-bound interest rates and stagnant economic recovery. As European population is aging rapidly (as in Japan and other industrialized nations), the outlook for the European economic recovery is rather timid.

Rapidly rising fiscal deficit (link) and public debt is a permanent threat to the stability of the Euro. Of course, the best possible cure to decrease the debt-to-GDP ratio is higher economic growth and also higher rate of inflation which decreases the stock of public debt through higher price level. Europe's real macroeconomic disease is not just low productivity growth and high tax burden but also very asymmetric economic policies. While the ECB sets interest rates for the entire Eurozone, Euroarea countries set independent fiscal policies. In addition, the appreciation of the euro hinders currency swaps into high-yield currencies. That could enable covered interest parity and the reinvestment of foreign currency back into Euro when its appreciation trend would reverse.

Asymmetric fiscal policies are likely to cause significant public debt concern if fiscal policies are discretionary. Prior to the emergence of economic crisis, half of the European countries ran discretionary deficit-financed fiscal policies. If European countries ran prudent fiscal policy based on low government spending and balanced budget, the asymmetric fiscal shocks weren't a major problem at all. However, strong public sector, high government spending and the lack of rule-based fiscal policies pose a significant concern for the stability of the Euro.

What I propose, is not the harmonization of fiscal policy but a strong committment of European countries to limit the scope of discretion in fiscal policy. Each country should forge a prudent fiscal policy without high fiscal deficit. In addition, countries should set a medium-term perspective of public debt reduction. That would ease the problem of asymmetric shocks during economic downturns and enhance the prospects of European single currency. In addition, European countries should rigorously liberalize labor markets. The liberalization of the labor market would remove the unneccesary wage adjustment rigidities. When wages are rigid downward - especially during the recession - higher wages exacerbate a significant pressure on unemployment. And when unemployment rate is high, the demand for discretionary fiscal policy and deficit spending is very high as well.

Without the necessary liberalization of labor market and the pursuit of prudent fiscal policies, the future of Euro and the prospects of the Eurozone are not bright at all.

CURRENT ACCOUNT BALANCE IN THE EUROZONE

Source: IMF (2009)

THE EURO CRISIS

Paul Krugman has blogged an interesting analysis of the anatomy of the recent economic crisis in Europe (link).

Europe's difficult macroeconomic situation in the aftermath of the financial and economic crisis has exacerbated rising fiscal deficits and public debt alongside strong deflationary pressures. These pressures were triggered by the highly negative output gap - the difference between the economy's potential output and the real output. In fact, a brief observation of the output gap estimates (link) shows that the sick men of Europe (Portugal, Greece, Spain, Italy, Slovenia) are likely to face negative output gaps. In 2010, Spain is likely to reach -2.12 percent output gap. Slovenia, Italy and Greece will also face a negative output gap. The negative output gap triggered strong deflationary pressures since the nominal aggregate demand is insufficient, causing a decreasing price level.


Before the financial and economic crisis of 2008/2009 evolved, Europe's peripheral economies faced strong asset price bubble. As real estate prices were soaring, these economies attracted significant capital inflows which lead to inflationary pressures. Before the crisis, the inflationary dynamics in the peripheral countries of the Eurozone were strong. In Greece, Spain and Slovenia, consumer prices increased by more than 3 percent on the annual basis. The asset bubble was further spread by low interest rates. The asset price inflation in these countries was very high. In Slovenia, five-year asset prices increased by 500 percent (see: IMF, International Financial Statistics). As the increase in asset prices widened, Europe's sick men were faced with rising current account deficit.

In 2007, Spain's current account deficit amounted to more than 10 percent of the GDP. In such circumstances, a clever monetary policymaker would push up interest rates. As interest rates were at historic lows during the pre-crisis period, the real cure was on behalf of the fiscal policy. Before the crisis, Spain's fiscal picture was very well indeed. From 2004 to 2007, Spain was running a fiscal surplus which reached the level of 2 percent of the GDP in 2006 and 2007. However, massive capital inflows were not sterilized by raising interest rates which further inflated the real estate bubble and overheating of Spain's economy.

Independent fiscal policies and a common monetary policy - which is an economic model of the EMU - cause asymmetric shocks. During the years of high growth, these shocks are mostly neglected. However, during the crisis these shocks might cause a serious trouble in the macroeconomic adjustment. Greece, which recently declared a worrisome possibility of debt default, is a typical case of what happens when asymmetric shocks persist.

As Greece, Spain, Italy, Portugal and Slovenia now face high fiscal deficits and poor economic growth, these countries will likely face years of deflationary pressures and high unemployment. The fiscal policymakers already exhausted the ability of governments to boost spending. Further growth of government spending is impossible unless European countries want the Greek debt episode to evolve in a domino effect throughout the Eurozone. The ECB will sooner or later this year raise the baseline interest rates to avoid the inflationary swings in Germany, Austria, Netherlands and other countries with current account surplus.

The macroeconomic outlook for the Eurozone is backlashed by the debt crisis in Mediterranean countries. An economic recovery may include indepedent monetary policies to adjust interest rates and prevent another asset bubble episode as well as to target current account balance. However, European countries will have to rethink the role of indepedent and discretionary fiscal policies pursued by the sick men of the Eurozone.

GDP GROWTH IN Q4 2009 IN EUROAREA

THE ORIGINS OF GREECE'S DEBT CRISIS

Paul De Grauwe published a very good article (link), discussing the macroeconomic origins of the current debt crisis in Greece.

"The period 1999-2009 has been organised in periods of booms and busts: the boom years were 1999-2001 and 2005-07; the bust years were 2002-04 and 2008-09.

One observes a number of remarkable patterns.

• First, private debt increases much more than public debt throughout the whole period (compare the left hand axis with the right hand axis).
• Second, during boom years private debt increases spectacularly.

The latest boom period of 2005-07 stands out with yearly additions to private debt amounting on average to 35 percentage points of GDP.

• During these boom periods, public debt growth drops to 1 to 2 percentage points of GDP. The opposite occurs during bust years. Private debt growth slows down and public debt growth accelerates."

EUROPE'S BLEAK MACROECONOMIC OUTLOOK

The Economist published a very lucid analysis (link) of the recent macroeconomic instability in the Euroarea, following the outbreak of Greek debt crisis (link) and disappointing quarterly data on GDP growth (link):

Barely had the ink dried on a statement by European leaders supporting Greece in its struggle to finance its debts when more bad news emerged from the euro zone. Figures released on Friday February 12th showed that GDP in the 16-country currency zone rose by just 0.1% in the three months to the end of December compared with the previous quarter. That there was any improvement at all was largely down to France, where a burst of consumer spending lifted the economy by 0.6%. In the region’s other big countries, GDP was either flat—as in Germany—or falling, as in Italy and Spain.

EUROPE VS. USA

In NY Times, Paul Krugman (link) wrote about the comparison of European and U.S economic model, concluding that in the last 10 years, the European model of social democracy led to higher standard of living and, compared to U.S in output per hour and standard of living, and relative convergence of European countries relative to the U.S respectively.

The real convergence is a complex mathematical and empirical issue, so I will rather outline the key patterns of GDP per capita gap between the U.S and Europe and the economic explanation of it. I downloaded the data from the IMF and composed a graph which shows the GDP per capita (PPP-adjusted) in European countries as a percentage of the U.S GDP per capita. Switzerland is the only European country whose level of GDP per capita is more than 90 percent of the U.S level. Ireland, where the output contracted by 7.5 percent in 2009 (link), was once the poorest country in the European Union. Today, its GDP per capita reached 85 percent of the U.S level. In spite of the notorious advantages of the Nordic model, the GDP per capita level of all Nordic countries (excluding Norway), is below 80 percent of the U.S level. The UK GDP per capita is also far below the U.S level (75 percent). The levels of GDP per capita of the less developed countries in European Union (Slovenia, Greece, Portugal, Czech Republic and Slovakia) are all below 62 percent of the U.S level.

Source: IMF, World Economic Outlook

The basic economic question is the length of the gap between the U.S and European countries. To answer the question, we have to set certain assumptions. So, let's assume that the U.S output will increase by 2 percent in the long run. The economic theory would predict faster growth of less developed countries, since countries with lower levels of standard of living (GDP per capita) tend to follow-up the countries with higher GDP per capita. In economic literature, that is the so-called "catch-up effect". So, what would happen if the UK economy increased by 3.5 percent in the long run. A quick estimate shows that the time gap between the UK and US is 19 years. So, what happens of the US economy increases by 2 percent in each of the next year while, at the same time, the UK GDP per capita is 75 percent of the U.S level? A fairly quick estimate shows that, if the UK GDP per capita will reach the U.S level in 10 years (although an unlikely scenario), the UK GDP per capita would have to increase by 4.9 percent each year to catch-up the U.S level of GDP per capita. If France's GDP per capita reached the U.S level in 10 years (assuming 2 percent growth in U.S GDP per capita), it would have to increase the economic growth to 5.3 percent in each of the next 10 years. If the convergence objective is set at 20 years, the French economy would still have to grow at the annual rate higher than 3 percent.

The main question is why the European countries are still behind the U.S level of GDP per capita? There are, of course, many plausible explanations. As far as the GDP per capita is concerned, the difference in the level and growth of productivity is the most important figure in setting conclusions. After all, in the long run, productivity determines the standard of living across countries.

First, the European disease is mostly the result of high tax burden. High tax rates diminished the incentives to work, since each additional hour of labor reduced worker's marginal productivity. Hence, as professor Mankiw explains, the rise of European leisure (link) is mostly the result of fewer working hours. In addition, early retirement is a common phenomena across Europe. By 2030, each worker will support one retired individual in Germany. The coming of Europe's pension crisis (link) is a consequence of generous PAYG pension systems. Lower employment-to-population ratio led to higher tax rates to finance the financial liabilities for the retired. In addition, high government spending and periodic budget deficits discouraged productivity growth.

Second, another key to the explanation of the anemic growth rates in Europe is rigidity of the labor market. In many European countries, labor costs are very high (link). If the cost of labor market entry is high, people prefer longer studying and working in the shadow economy. The shares of shadow economy are relatively high in all European countries (link). The highest rates of shadow economy are in the following countries:

1. Slovenia 27%
2. Greece 26%
3. Italy 24%
4. Spain 21%
5. Belgium 20%
6. Germany 15%
7. France 13%

Source: ATKearney (2009), Friedrich Schneider (2005)

Third, Europe's relative decline compared to the U.S, is not a consequence of the lack of R&D investment. High percentage of R&D investment in the GDP is not a cure for the real cause. In fact, European universities rank far below the top universities in the world. In the field of engineering and computer sciences, the first non-US university is in the 15th rank. Europe's brain-drain is a known phenomena since many bright European minds immigrate to places such as the U.S, Canada and Australia. The outcome is deteriorating international ranking of universities and low efficiency of R&D expenditure on misguided projects such as the intention of the European Commission to build a "European MIT" (link) to boost Europe's global technology leadership.

Without higher growth of GDP, productivity and market working hours, European countries will hardly sustain the convergence towards the U.S level of GDP per capita. To boost economic growth, bold structural reforms are required to cut the rates of shadow economy, reduce tax and social security burden, decrease government spending and deregulate the labor markets.

THE POLITICAL ECONOMY OF EUROPE AND THE U.S

In today's edition of NY Times, Paul Krugman opened a puzzling discussion on the economic performance of Europe relative to the United States (link), suggesting that the European model of social democracy is an envy for economic success compared to the U.S economy.

ECONOMICS OF WOMEN'S PROGRESS

Gary Becker (link) and Richard Posner (link) discuss the economic perspective in the empowerment of women and the weigh costs and benefits of public policy aimed at the empowerment of women.

MONTHLY U.S BUDGET REVIEW

CBO has released the monthly budget review of recent fiscal estimates for the U.S budget (link).

BEN BERNANKE AND THE GREAT RECESSION OF 2008/2009

Writing an op-ed for NY Times, Nouriel Roubini discusses the role of Ben Bernanke in this year's recession (link).

THE MOST INFLUENTIAL GLOBAL THINKERS

Foreign Policy composed the rank of the most influential global thinkers (link).

INTERVIEW WITH JOSE PINERA

ECONOMIC RECOVERY AND THE FUTURE OF EUROZONE

Martin Feldstein offers some interesting thoughts on whether the eurozone will survive the economic recovery (link).

CHINA'S CURRENCY AND ECONOMIC GROWTH

Dani Rodrik wrote a nice article on the future prospects of China's currency and its industrial policy (link).

STOLPER-SAMUELSON THEOREM

Dani Rodrik offers a nice insight into one of the most remarkable theorems in international trade (link).

IN MEMORIAM: PAUL A. SAMUELSON

On Sunday, December 13th, Paul A. Samuelson has died at the age of 94 (link).


He was on the economic giants of the 20th century. His ideas reshaped the economic science and revolutionized the mode of economic thinking around the world. With the mathematical rigour and analytical mastermind, his groundbreaking approach to economic analysis transfored the economic science into a dynamic problem-solving tool. In this short essay, I will present my reflections on the life and contributions of Paul A. Samuelson to the economic science.

I first came across Paul Samuelson in the year before I entered the university. In the first year of the undergraduate class, Samuelson and Nordhaus's Economics was the assigned reading for the Introductory Macroeconomics. I read the textbook back and forth and I liked it; not because of its simplicity in introducing the analytical framework of economics but rather because of the clarity, intuition and incentives to undertake a rigorous pursuit of analytical economics at the theoretical and empirical level. In addition, Samuelson penetrated the application of linear programming to economic problem-solving.

Together with Milton Friedman, Paul A. Samuelson is the economic giant of the 20th century. Hardly any economist could take the same place in the scope of influence as an economic thinker. He conducted the Neoclassical synthesis. As an interested reader can verify in his Nobel prize lecture (link), Samuelson's synthesis combined a Keynesian macroeconomics with a rigorous Marshallian microeconomics. In microeconomics, Samuelson extended the Marshallian analysis of partial equilibrium with strong mathematical articulation of demand and supply curves, cost curves and deadweight loss. On the abstract level, together with Abram Bergson, he constructed social welfare functions based on three marginal conditions and extracted from earlier work of Kaldor-Hicks-Scitovsky analysis (link). In macroeconomics, Samuelson further affirmed the dominance of Keynesian macroeconomics with a strong emphasis on the role of fiscal policy in stimulating full-employment output. In addition, he invented the term multiplier and the acceleration, the former relating to the effect of change in exogenous macro variables on endogenous variable (notably, output) and the latter referring to the partial adjustment of aggregate investment to the capital stock. Samuelson-Hansen multiplier-accelerator principles spurred the theoretical foundations of Keynesian economic policy. He also popularized Overlapping Generations Model which later became the corner stone of innovations in the modeling of aging population. In macroeconomics, Samuelson also proposed the so-called "Samuelson-Mishi condition for the efficient provision of public goods. When the condition is satisfied, it implies that further substitution of private goods provision for public goods will result in a diminishing social utility.

Assuming Pareto efficiency, Samuelson-Mishi condition satisfied the criteria for Lindahl equlibrium. The equilibrium states that when individuals are willing to pay for the provision of public goods according to marginal benefits, it will be Pareto efficient. However, such condition is not compatible with the incentive mechanism since it requires the complete knowledge of individual demand functions for particular public good which could result in the asymmetric distribution of benefits in response to relevation-principled taxation.

As a student of international economics, I came across the influential theoretical work of Paul Samuelson. Modern international economics is a combination of mathematical economics, advanced microeconomics, game theory and international finance. One of the most interesting and penetrating areas of international economics are theorems in international trade. Under particular assumptions theorem postulate axiomatic explanations based on previous statements. Back in 1941, he proposed Stolper-Samuelson theorem together with Wolfgang Stolper. The theorem quickly became a source of academic debate. In its simplest form, the theorem states the following: assuming constant returns to scale and perfect competition, a rise in the relative price of good will lead to higher return on the factor which is used more intensively in the production of the good and to the fall in the return to the other factor. Stolper and Samuelson wrote:

"Second only in political appeal to the argument that tariffs increase employment is the popular notion that the standard of living of the American worker must be protected against the ruinous competition of cheap foreign labor… In other words, whatever will happen to wages in wage good (labor intensive) industry will happen to labor as a whole. And this answer is independent of whether the wage good will be exported or imported."

The theorem showed that the international trade between two countries could lead to the opposition of international trade since the relative price of labor-abundant good in the high-wage country will be higher than the world price of that good, reflecting the relative abundance of capital or human capital. The theorem quickly became the main theoretical weapon of opponents to free trade. Even today, Stolper-Samuelson is the best explanation of why labor unions in high-wage countries oppose free trade agreements and further economic integration with low-wage countries.

Another important contribution of professor Samuelson is the so called Ballasa-Samuelson effect which states that higher growth productivity growth rate in tradable goods relative to non-tradables will lead to the real exchange rate appreciation. Balassa-Samuelson effect also went through numerous time-series regression. The effect has been tested 60 times in 98 countries. Cross-section regression studies of Ballasa-Samuelson effect were analyzed in 142 countries. In a vast majority, the empirical evidence of Ballasa-Samuelson hypothesis was supported. The main empirical findings emphasize that productivity differential between tradeable and non-tradable sector is positively correlated with differences in relative prices. The empirical evidence also supported Samuelson's initial proposition that productivity differentials translate into higher purchasing power parity through real exchange rate appreciation.

In finance, Paul Samuelson penetrated the analytical aspects of lifetime portfolio selection. In 1972 he published The Mathematics of a Speculative Price which later became the ground of option pricing. Based on discoveries of Bachelier's pioneering work, he laid the foundations of stohastic price movements and random forecasting matches. His pioneering work in financial theory of speculation and random walk (stohastic) movements in stock prices became the underlying theoretical foundation in the emerging financial industry. In an article entitled Probability, Utility and the Independence Axiom (Econometrica, 1952), he discussed the role of probability models in measuring the overall utility. In this sense, he relied on Keynesian defence of subjective theory of probability and argued that thesubjective perception of probability does not inhibit the proper functioning of financial markets. In 1965, he published A Proof that Properly Anticipated Prices Fluctuate Randomly where he provided the foundation of the efficient market hypothesis that has been further developed by Eugene Fama and other scholars. For a detailed discussion of Paul Samuelson's contribution to financial economics, see Merton Miller's contribution in Britannica (link).

In addition to his theoretical and empirical work, he is the founding member of the Econometric Society and its president in 1951. In 1961, he was the president of American Economic Association. In the political sense, Paul A. Samuelson influenced the economic policy of the Kennedy Administration. In 1960, the U.S headed for the recession. President Kennedy, following Samuelson's advice, enacted tax cuts and a balanced budget. In 1964, when Kennedy tax cuts were enacted, top marginal tax rate was reduced from 91 percent to 70 percent. The economic reasoning behind tax reductions was firmly laid in the Keynesian multiplier (1/(1+c)(1+t)). Paul Samuelson and Walter Heller (Chairman of Council of Economic Advisers during Kennedy Administration) argued that lower tax rate would stimulate consumption spending and boosted output and employment. Throughout the 1960s, the U.S economy experienced one of the longest periods of stable economic growth, favorable employment outlook and balanced federal budget. Here is how JFK, following Samuelson's advice, supported the tax reduction (link). Also, David Greenberg's article on Kennedy tax reduction is a worthy source of further information on that topic (link).

On Sunday, the economic titan passed away. He not only revolutionized the field of economic science but also spurred the interest for economics and popularized it in a manner that turned dismal science into a problem-solving science based on theoretical foundations and empirical verification of theoretical postulates. His approach to economic analysis combined Marshallian microeconomics and Keynesian macroeconomics which he joined together after the WW2 in a Neoclassical synthesis. Compared to other economic thinkers, he knew how to formulate theoretical postulates in a manner that stimulates the research interest for further investigation.

He will be missed and remembered as the giant of the economic thought and a titan of economic theory.

MACROECONOMICS READING CLUB

For those of you who study macroeconomics and finance, here are some interesting articles on macroeconomic issues:

Menzie Chinn, The Employment Situation in the Graphs, Econobrowser, December 4, 2009 (link)

Menzie Chinn, Debt and Interest Rates; Some Empirical Evidence, November 23, 2009 (link)

Olivier Blanchard, Marianna Riggi, The Price of Oil and the Macroeconomy, Vox, December 7, 2009 (link)

Roel Beetsma, Massimo Guliodori, The Macroeconomic Costs and Benefits of the Economic and Monetary Union, Vox, November 27, 2009 (link)

THE CASE FOR CARBON TAX

Ted Gayer of the Brookings Institution testified before the U.S Senate, discussing the economic benefits of carbon tax over cap-and-trade (link)

ECONOMIC GEOGRAPHY AND THE RECESSION

New York Times published an interesting geographic map of the recession in the U.S (link)

AUSTRALIA'S INFLATION, RECOVERY AND INTEREST RATE

Reserve Bank of Australia decided to continue the increase in benchmark interest rates by 25 basis points to 3.75 percent in the light of short-term inflationary expectations (link). Here (link) is a brief macroeconomic outlook of Australia.

DEFLATION - JAPAN'S FIRST BIG "D"

The Economist discussed the return of deflation in Japan (link). Meanwhile, the Bank of Japan has published an interesting publication of macroeconomic overview of the Japanese economy (link).

LIBERALISM vs. SOCIALISM

Today's Hardtalk on BBC World News (link) discussed the political, economic and social aspects of communism versus liberal capitalism with Slavoj Zizek ,a philosopher and professor at European Graduate School.

Mr. Zizek discussed the role of liberal capitalism in the modern age. He condemned communism as a failure of the mankind and reaffirmed the liberal capitalism as the greatest invention of the mankind. The topic discussed was the future of liberal capitalism. In arguable words of Mr. Zizek, liberal capitalism, although dynamic and powerful in delivering ends of political and economic freedom, is doomed to fail and it thus requires new politico-economic alternative, divisible at the intersection of market and the state. Despite the interactive debate, I would like to add some points to the discussion which were, in my opinion, either mismatched or misinterpretated.

The evolution of liberal capitalism throughout the course of human history has been emphasized by the expansion of economic, political and human freedom. The greatest inventions in human history were not conducted under dictatorial political regimes. But they were conducted during the age of limited government and free innovation environment. Anytime the powerful wit of government was enforced, innovation and discoveries suffered. Although Mr. Zizek recognizes the failure of totalitarian regimes to stimulate intellectual creativity, his analysis of liberal capitalism inherently neglects its role.

The ability of individuals and firms to pursue their own goals in liberal capitalism is enabled not because of the design of desirable goals but because the free-market capitalism evolved as an undesigned system of ideas under strong rule of law. If liberal capitalism, as Mr. Zizek argues, would be doomed to fail, the individuals never witnessed an unparalleled increase in prosperity and in the 20th and 21st century.

What has distinguished communist political regimes from liberal democracies are the institutions of economic freedom. There is a clear and remarkably positive empirical relationship between economic freedom and standard of living. The experience has shown that political liberty is a neccesary but not sufficient condition for prosperity. Both, the neccesary and sufficient condition for the pursuit of prosperity is economic freedom. Without economic freedom, when governments replace the rule of law with the rule of man, and heavily interfere with free-enterprise activity, these countries are doomed to stagnate. Totalitarian political ideology, claiming to create heaven on earth, has always turned towards the hell on earth.

During the interview, Mr. Zizek argued several times that liberal capitalism can eat itself and fail in a similar vain as communism did. The Soviet Union and the communist block certainly hadn't failed because of the lack of technological investment, but because communist political ideology erased the system of incentives. Even today, when several politically totalitarian countries sustained high growth rates, the superiority of liberal capitalism is even more obvious. The motion behind the economic miracle of Gulf countries, such as UAE, Bahrain and Qatar, is the institutional arrangement that promotes solid economic performance under robust system of law, market economy and incentives that allocate scarce resources into the most appropriate uses. In the interview, Mr. Zizek described Dubai's miserable labor conditions as "labor concentration camps" where workers from other countries reside. Although this view sounds very compelling to Marxist philosophers and political thinkers, no government agency forced foreign workers to go to Dubai and work there.

In fact, the economy of United Arab Emirates went through a remarkable restructuring with the creation of the robust financial and service sectors. As productivity growth and capital investment soared in recent decade, wage rates in Dubai are much higher than in other Arab countries. Still in doubt? Ask foreign workers in Dubai how many of them would leave the place and returned to work in their home countries; and why they don't do that. In addition, in Mr. Zizek's home country, labor conditions for foreign physical workers mostly from ex-Yugoslavia are not the envy of the world despite the most regulated labor market in the world.

There is also a wide array of case studies from recent economic history that show how economic freedom crucially determines the wealth of nations. In 1955, Hong Kong was a miserable place flooded with refugees from the mainland China. In 1960, Hong Kong's average income per capita was 28 percent of that in Great Britain. In 1996, it rose to 137 percent of that in Britain. Neither the dictatorial political regimes led to the economic boom in Hong Kong, nor the desire to create heaven on earth. It was a set of strong rule of law of British origin, limited government spending and free markets that propelled Hong Kong to the climb up the ladder.

Mr Zizek arguably enforced the proposition that global financial crisis led to the crisis of liberal capitalism. Although the global financial crisis led to the recession, high unemployment and deflating prices, it certainly has not put the existence of liberal capitalism into doubts.

The origins of the last year's financial crisis go back to the New Deal and presidential time of Jimmy Carter and Bill Clinton whose administrations, as benevolent social engineers, enforced numerous acts to boost home ownership. Back in 1996, president Clinton signed Community Reinvestment Act which forced banks to allocate housing borrowings to low-income neighborhoods. In the aftermath, Fannie Mae and Freddie Mac securitized risky sub-prime mortgage loans to save banks from default. Meanwhile, they inflated debt-to-equity ratio to 60:1. It means that for deposit of USD, there were 60 USD behind in debt that nobody was willing to bear.

In addition, the monetary policy of the Greenspan era kept low interest rates for too long which causeed an asset bubble and led to the decrease of mortgage values It led to the federal bailout of Bear Sternes and the failure of Lehman Brothers. It also triggered innumerable quests for federal bailout of financial institutions. Thus, it would be foolish to speak about the crisis of liberal capitalism after the financial meltdown. Is liberal capitalism to blame? Of course not. It is rather the greedy political apetite for destructive policies that compromised the stability of the world economy for the sake of short-term political goals.

Mr. Zizek wisely avoided the question of the post-communist politico-economic status of Slovenia after the collapse of Tito's Yugoslavia. True, Slovenia's superior economic performance in Yugoslavia was mainly due to its export orientation and higher growth compared to the rest of Yugoslavia. At the beginning of the independence in 1991, Slovenia was, by all measures, the most developed former communist country; far ahead of countries such as Czech Republic, Slovakia and Estonia. Today, Czech Republic virtually caught-up Slovenia's level of standard of living. In 2008, Czech Republic's GDP per capita was 94 percent of that in Slovenia. In 1991, it was merely of 60 percent of that in Slovenia. The politicians, of the same "market socialist" politico-economic beliefs as Mr. Zizek, designed the statist economic policy based on high tax rates, state-owned enterprises, weak rule of law and rigid market structures. Today, Slovenia's economic and political system more closely resembles Russia's mafia state than a liberal society based on economic freedom, rule of law and limited government. In a great part, thanks to the political ideology of "market socialism."

NEW EVIDENCE ON THE EFFECTS OF FISCAL POLICY

From Alberto Alesina and Silvia Ardagna (link):

"We examine the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007. Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions. We confirm these results with simple regression analysis"

FISCAL POLICY AND DEFICIT BOMB

Douglas Holtz-Eakin, former CBO director, discussed the negative effects of the new fiscal policy in the U.S (link).

CHINA'S CURRENCY POLICY AND YUAN REVALUATION

The Economist published a thorough discussion (link) of China's currency policy and reasons why yuan is unlikely to revaluate any soon.

JAPAN: THE LAND OF DEFLATION

The Economist updated the report on the Japanese economy which again suffered from monthly deflation (link). The forecasts for the end of the year forsee deflation as a structural problem of the Japanese economy and not as a short-term phenomena that would reflect temporary declines in domestic or foreign demand. True, the financial crisis and the recession depressed Japanese exports but the real cause of the deflationary persistence is to be found in the design of the monetary policy which pushed the Japanese economy in deflationary trap back in early 1990s.

The OECD's preliminary report on the Japanese economic outlook (link) suggested the Bank of Japan to keep interest rates low and immediately implement quantitative easing measures to boost the economic activity as long as the expected inflation remains firmly positive.

In 2009, the IMF's inflationary forecast is -1.1 percent. Recently, Deutsche Bank released an interesting report on the Japanese economy (link), emphasizing annual decrease in output by 7 percent country's record high public debt as well as its tearing debt scenario. Japan easily maintained high public debt because of low interest rates. In fact, most of the net value of the public debt has been denominated in yen which reduced government's interest payment risk and decreased the probability of government's debt default. Before the crisis, gross government debt stood at 172 percent of the GDP. The net debt, for instance, stood at 87.7 percent of the GDP mostly because public pension assets are counterbalanced by spending commitments.

The question is how to tackle Japan's disease of low output growth and persistent deflation that last well over the latest decade?

First, it is difficult to implement further quantitative easing for the Bank of Japan. If the Bank eventually decided to do so, the interest rate would go beyond zero ground, leading to higher future value of bond payments and, hence, higher indebtedness of the Japanese government. The Bank of Japan recently left the interest rate steady at 0.1 percent and decided to purchase government bonds to keep the monetary policy strongly accomodative.

Second, the Japanese experience with a long period of falling prices began when the Bank of Japan kept driving the expansionary monetary policy when temporary shocks in domestic and foreign demand led to lower capacity of the Japanese corporate sector. When output and prices started the recovery, excess reserves were compensated by further lowering of the central bank's policy rate. Low interest rates were not offset by the closing of the output gap so the measure to boost the aggregate private consumption, investment and exports hindered the goals of the economic policymakers. The result was a depressing decrease in the price level that couldn't be offset by quantitative easing and fiscal stimulus. The former would cause negative real interest rates while the latter would increase government spending, cause crowding-out effect and further increased the country's soaring public debt.

And third, Japan's unfavorable demographic trend pose a significant risk on the sustainability of government's pension system. As Japan's population is in decline, the overall private consumption decreases which leads the retail sector to cut prices to gain the market share. The rising aging population certainly endangers country's public finances, marred by budget deficits and the highest public debt in the OECD.

Japan's looming public debt and deflationary trap are the main inhibitors of country's long-term macroeconomic recovery. Pulling the economy out of deflation rate would require huge steps to reflate the prices such as charging banks for deposits at the central bank. That would raise the interest rate at the expense of decline in aggregate investment. However, the goal is not the mission impossible. What can save the Japanese economy from double D-trap is strong, persistent and high productivity growth. It would surely ease the burden of public debt, since the Japanese government's revenues would grow and thus, its borrowing abroad and raising the level of public debt were anchored. It would also allow for greater spending cuts. On the other hand, Bank of Japan could finally pursue the real credibility of the monetary policy and avoid the mismanaged quantitative easing.

POVERTY, INCENTIVES AND DEVELOPMENT

Daron Acemoglu wrote a marvelous article discussing the supportive role of incentives and institutions in global poverty reduction and economic development (link):

"If we know why nations are poor, the resulting question is what can we do to help them. Our ability to impose institutions from the outside is limited, as the recent U. S. experiences in Afghanistan and Iraq demonstrate. But we are not helpless, and in many instances, there is a lot to be done. Even the most repressed citizens of the world will stand up to tyrants when given the opportunity. We saw this recently in Iran and a few years ago in Ukraine during the Orange Revolution."

WHAT EASTERN EUROPEAN TIGERS CAN TEACH WESTERN EUROPE

In yesterday's edition of WSJ, Johnny Munkhammar and Nima Sanandaji wrote a well-argued dissussion (link) on how Eastern Europe's advantage in terms of competitive tax rates, low tax burden and sizeable reform efforts in emerging from the crisis offer a great lesson for economic recovery of the Western counterparts.

DANGERS OF U.S FISCAL DEFICIT

The Economist has published two great articles on the anomalies of U.S fiscal deficit (link) (link).

U.S DOLLAR AND RESERVE CURRENCIES

The Economist published an excellent analysis on the future of reserve currencies in the world (link).

ECONOMIC COST AND BENEFITS OF GERMAN UNIFICATION

Yesterday, it has been 20 years since the fall of the Berlin wall and the eventual collapse of communist political and economic system in Central and Eastern Europe. However, there is still discussion about economic costs and benefits of German reunification (Wiedervereinigung). I've been motivated to open this debate by professor Becker's analysis (link) on the size of countries and by the recent article in Financial Times by the contributing German economist (link).

Economists in Germany and the rest of the world have long warned against the consequences of the unification of East and West Germany. After the unification, German central bank set the exchange rate at 1:1. Because East German workers' relative productivity level lagged far behind the West German level, East German workers migrated to West Germany in search of higher wages. When wage rates between West and East Germany were equalized in the absence of productivity catch-up in East Germany, the excess labor supply in the East led to high unemployment and slow changes in the economic structure. As the exchange rate was equalized and wages prevented from the natural adjustment to productivity growth, the unemployment soared as East German manufacturing sector couldn't employ labor anymore. The unemployed received massive transfer payments which, even more than a decade after the reunification, still present about 4 percent of total German income.

Today, the figures suggest that East German GDP per capita is roughly 70 percent of the Western German level and the unemployment rate exceeds 12 percent - more than twice the Western level. Low population density and high share of rural population are the main structural obstacle to higher productivity growth in the East. The majority of models in economic geography and urban economics suggests that agglomeration economies occur where population density is high. The latter yields significant advantages in terms of spillovers, search cost, factor mobility, know-how and economies of scale. Low population density is a major obstacle in attracting investment mostly because firms are not eager to locate at the periphery in the presence of high search costs and in the absence of high-skilled labor, agglomeration and linkages to economies of scale. In the U.S, for instance, Pittsburgh's industrial restructuring from resource-based steel industry into knowledge-intensive information technology, biotechnology and software development required agglomeration which combined high-skilled labor, human capital, access to regional and international markets as well as high population density.

In Germany, for example, Hamburg generated the highest GDP per capita (€51,000) among cities and Bavaria (Bayern) generated the highest GDP per capita (€36,000) among German states. Hamburg and Munich, as well as the linking cities located in their vacinity are among the most densely populated areas which enabled them to develop core industries, spillovers, know-how and dynamic knowledge externalities. There is an overwhelming evidence that differences in population density are a good source of growth difference between east and west Germany.

After the unification, German fiscal policymakers favored an expansive fiscal policy which directed federal expenditures into poorer regions of the East to boost the development of infrastructure. However, at an exchange rate 1:1, West German firms were reluctant to invest in East Germany mainly because of higher relative price of labor. As East German workers moved to the Western part of the country, west German firms hired eastern workers. As brain drain became widespread, the convergence of east German income per capita slowed.

East Germany were far better off, if the country remained independent. The reunification of Germany would yield singificant economic benefits, if the unification itself were based on close economic integration with the establishment of free trade area and free movement of capital, goods and labor. If East Germany remained independent and retained its own currency without the uncovered exchange rate realignment to to West German exchange rate parity, the relative price of East German labor wouldn't increase and thus the unemployment rate would be significantly lower than it has been ever since the reunification. Thus, West German firms would easily find attractive investments in East Germany. The process would dramatically reduce disparities in population density compared to the West. Under such scenario, East Germany's macroeconomic stabilization and institutional reforms would be a lot easier and the overall economic and political transition much less painful.

BUBBLES AND MACRO RISK

Frederic Mishkin says not all bubbles are a threat to the economy (link):

"Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy..."

EUROPEAN ANTITRUST POLICY

From The Economist (link):

"Nevertheless, it is unclear how a transatlantic row can be avoided along the lines of the spat in 2001, when a planned merger between General Electric and Honeywell caused a stink. The commission worries that a union between Oracle and Sun would reduce competition in the market for corporate databases. Oracle is the world’s biggest seller of proprietary software to run such databases, with a market share of nearly 50%. Sun is the owner of MySQL, the most widely used “open-source” database software, which already competes with Oracle’s products and could become more of a threat in the future. Neelie Kroes, Europe’s competition commissioner, spoke of her “serious concerns” that the deal would reduce choice and lead to higher prices."

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

U.S ECONOMIC RECOVERY AND MACROECONOMIC OUTLOOK IN 2009/2010

The latest macroeconomic data from major world economies suggested that the recessionary contraction is likely to be ended in the light of positive news on GDP growth and midterm macroeconomic outlook. However, the road of the economic recovery remains uncertain. The policymakers responded to the great contraction of 2008 by decreasing interest rates close to zero rate. Massive injections of monetary stimulus boosted liquidity and attempted to accelerate credit expansion. However, monetary stimulus such as TARP in the U.S encouraged excess reserves. Thus, the banking sector published significant quarterly results as the stimulus package covered the overall losses from the credit crunch and subprime mortgage crisis of the previous year. In this brief article, I outline the economic recovery in the U.S in the ongoing year.

In Q3, the U.S economy grew by 2.4 percent despite the negative unemployment figures. While the U.S productivity grew by 6.8 percent in Q2:09 and by 9.8 percent in Q3:09, the unemployment rate is expected to reach 10.5 percent in December. The $787 billion stimulus from Obama administration to the ailing industries did little to prevent the fallout of demand and the financial difficulties of many firms. In fact, most of the stimulus has not already been spent. In spite of enormous fiscal emergency aid, the Obama administration effectively nationalized the auto industry as Detroit's auto industry declared bankruptcy. The auto industry is likely to recover gradually. Eventually, the fall of Detroit's giants was more likely a consequence of auto industry's inability to cope with high labor cost and fringe health and pension benefits.

The underlying economic theory and evidence teach that massive government intervention in the economy is inefficient as if government bailout hadn't occured. In Q3:09, financial industry posted significant quarterly earnings. Monetary stimulus inflated another asset bubble which translated into highly prospective annual data and higher volatility. Morgan Stanley's annual stock return currently stands at 133.4 percent (link). On the other hand, stock markets rallied in the light of significant quarterly earnings of the banking and financial sector. In one year, Dow Jones Industrial Average grew by 18.27 percent (link), S&P 500 increased by 22.16 percent (link) while Nasdaq Composite's annual growth rate stands at 36.91 percent (link). Stock markets rallied in the light of favorable earnings projections and cost reductions.

On the macroeconomic level, the U.S economy is likely to face a long L-shaped recovery. The underlying conditions are extremely low interest rate, high unemployment rate and high quarterly productivity growth rate. Much of the confidence in fiscal stimulus and expansionary fiscal policy was based on the initial assumption that spending multipliers will exceed 1 and boost short-term output and investment to reduce the negative output gap. Nevertheless, fiscal policy outlook remains sluggish and the prevailing evidence suggests that spending multipliers are hardly positive, except for when the unemployment rate exceeds 12 percent, causing a major fallout of capacity utilization. Robert Barro and Charles Redlick recently estimated the cost of fiscal stimulus. The Obama administration has already expressed commitment to raising the marginal tax rates. Tax increases are the unfortunate midterm alternative because excessive borrowing and the estimated 9.9 percent of the GDP fiscal deficit in 2009 (link) has already downgraded sovereign U.S debt outlook. Redlick and Barro showed that one-period lagged increase in the average marginal tax rate reduces, GDP growth by 0.56 percentage point. The overall effect on consumption purchases is -0.29 and the overall effect on investment is -0.35, both statistically significant at 99 percent.

The U.S dollar further depreciated against the euro (link), increasing the U.S inflation rate above the expected target, partly as a result of the increase in short-term yield on Treasury bonds. Purchases of Treasury bonds effectively increased demand for U.S dollars and triggered short-term depreciation trend. An effective reduction of fiscal deficit in the coming years is a necessary condition for mitigating the negative effects of U.S current account deficit. As fiscal deficit raises demand for imports in the U.S, real depreciation of the real effective exchange rate raises relative prices in the tradable sector compared to non-tradable sector. The main highlights of U.S economy recovery will be focused on restrictive fiscal policy and policy interest rates. Zero interest ground is a real disadvantage in economic recovery, mainly because the negative output gap and the Fed is likely to face hard time trading-off between higher inflation if interest rates remains at historic lows while the real sector's credit demand could surge and potential output contraction in the coming quarterly periods if the Fed will raised targeted federal funds rates. In the latter scenario, the U.S economy could repeat the Japanese disease from the 1990s, being faced with long, sluggish and slow economic recovery that could last for several years.

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."

OUTLOOK FOR THE NORWEGIAN ECONOMY

Norges Bank has recently published Monetary Policy Report 3/2009 (link) and a comprehensive list of figures and charts including major macroeconomic trends in Norway and abroad (link). Time series on unit labor cost, output gap and other macroeconomic indicators are interesting to observe, especially because Norges Bank has been the first central bank in Europe to announce a targeted increase in interest rate to mitigate midterm inflationary outlook. Here (link) is a closer look at NIBOR and monthly interest rate dynamics in Norway (link).

ECONOMIC THEORY AND THE FINANCIAL CRISIS

Eric Maskin offers a comprehensive insight into financial crisis from the perspective of the economic theory (link)

NOBEL PRIZE IN ECONOMICS 2009

This year's Nobel prize in economics goes to Elinor Ostrom and Oliver E. Williamson (link). Elinor Ostrom received the prize for her analysis of economic governance, especially the commons while Oliver E. Williamson received the prize for his contributions to the economic governance, emphasizing the boundaries of the firm and its role in conflict resolution and case bargaining.

Michael Spence, the 2001 Nobel prize winner, briefly summarized (link) the main contributions of Elinor Ostrom and Oliver E. Williamson to the economic theory.

THE MACROECONOMIC EFFECTS OF STIMULUS SPENDING

Robert Barro and Charles Redlick wrote an op-ed in WSJ (link) on their original paper (link) where they discuss the macroeconomic effects of fiscal stimulus and construct long-term time-series on U.S macroeconomic data to examine whether real GDP increases follows the spending multipliers and whether reductions in marginal tax rates, rather than spending increases, tend to exert a stronger effect on GDP growth.

"Our research also shows that greater weakness in the economy raises the estimated multiplier: It increases by around 0.1 for each two percentage points by which the unemployment rate exceeds its long-run median of 5.6%. Thus the estimated multiplier reaches 1.0 when the unemployment rate gets to about 12% ... For data that start in 1950, we estimate that a one-percentage-point cut in the average marginal tax rate raises the following year's GDP growth rate by around 0.6% per year. However, this effect is harder to pin down over longer periods that include the world wars and the Great Depression."

THE ECONOMICS OF UNIONS

Gary Becker (link) and Richard Posner (link) opened a discussion on how unions influence policymaking decision. Recently, president Obama imposed punitive 35 percent tariff rate on imported Chinese tire (link) risking the coming trade war. Indeed, China may file a case against the U.S at the WTO, and the WTO may rule against the U.S for imposing illegal and discriminatory trade practices.

Many believe that president Obama enforced trade protection to win the support of the unions in health care reform. In fact, the bailout of GM and Chrysler was one of the major efforts to help unions, particularly the United Auto Workers, in paying the health-care and pension benefits that GM and Chrysler couldn't actually afford to pay.

Recently, the Congress has been split up on Employee Free Choice Act which suggests giving mandate to unions representing employee in arbitrating union-management contracts. I believe the Congresional Budget Office will yield a meaningful research on the economic effects of the act.

The empirical evidence on union activity is, in fact, quite clear. In OECD comparison panel (link), there is a strong, negative and significant relationship between the density of union membership and labor market rigidity. Sweden, for example, hasn't enforced a general level of minimum wages. Yet in 2007, over 7o percent of the working population was unionized. High union density further contributed to inflexible labor market structure which led to low employment growth, low productivity growth and exerted a strong upward pressure on real labor cost.

Yet, there is a distinctive character of trade unions within Europe. Traditionally, unions in Europe possessed a stronger influence on political decision in areas such as taxation, income redistribution and government size. However, there are significant disparities in union activity throughout Europe. In 1990s, Denmark enforced a series of reforms that deregulated labor market structure towards greater flexibility. Today, Denmark's labor market is cited as the most competitive in the world (link). From 1990 to 2007, union density decreased from 75.3 percent to 69.1 percent. On the other side, labor market structures in Continental and Mediterranean Europe are known for inflexible features, regulation and rigidity. Meanwhile, Anglo-Saxon countries, Britain and Ireland, are known for flexible labor markets and few barriers impeding labor market performance. Dismissing and employee costs 10 weekly salaries in Ireland compared to 56 weekly salaries in Spain.

Although variation in trade union density over time explains a relatively large part of variation in productivity, union activity and influence in political decision-making could be the decisive factor in explaining cross-country variation in labor market outcome. That would requiring the design of principal indicator that could measure union influence on the quantitive basis. The influence of trade unions has, in my opinion, a strong common connection to cultural patterns and informal institutions.

For instance, countries with weak rule of law, persistent corruption, high tax burden and barriers to trade and investment, tend to have larger underground economies. Empirical estimates on the size of underground economies suggest that, in Europe (link), Mediterranean countries (Italy, Spain, Greece, Portugal) have the largest share of shadow economies. There is a significant cross-country variation. The estimates of shadow economies for 28 transition countries is 40.1 percent and 16.3 percent for the OECD. So, could union activity affect the size of shadow economies

If unions, as an interest group, exert a strong influence in politics, their political philosophy will probably lean left. Thus, if unions influence decisions on taxation issues, welfare benefits, pension schemes and government size, the outcome will probably induce more complexity, more regulation and more barriers to trade, entrepreneurship and investment. The combination of those factors can strongly influence labor and business incentives and, hence, also determine and productivity growth.

HOW FISCAL AND MONETARY POLICY LED TO THE GREAT DEPRESSION

In the recent edition of WSJ, Arthur Laffer highlighted (link) how mismanaged fiscal policy during Hoover and Roosevelt administration led and prolonged the Great depression, and how contractionary monetary policy let it happen.

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.

DOING BUSINESS 2010

The World Bank has recently released the latest Doing Business 2010 report, measuring the level of business and economic regulation around the world. In spite of the financial crisis and the global recession, Singapore, New Zealand, Hong Kong and the United States retained the leadership as the most friendly locations for doing business. Notably, some countries have achieved high ranks. For example, Saudi Arabia moved to 13th placed and Georgia, once the bastion of Soviet-style state capitalism, now ranks as 11th most friendly place for doing business with open investment environment and low regulatory barriers to trade, entrepreneurship and investment. Countries such as Georgia, Thailand and Saudi Arabia have surpassed countries such as Sweden, Finland and Iceland although there is a notable difference in international comparison of those countries when it comes to the issues of the rule of law, property rights and institutionaly quality.

Douglass North, the 1993 Nobel-winning economist once famously wrote the essence of institutionaly quality for economic development. He said that the inability of societies to develop effective low-cost institutions is the major reason of today's contemporary underdevelopment of the third world. In terms of the ease of contract enforcement, 3 out of top 10 countries are Iceland, Finland and Norway where institutional quality and the rule of law are on the high level by all international indices and comparison.

In recent decade, embracing free-market ideas has had a significantly positive impact on the institutional quality, regulatory barriers and the overall quality of business environment - all of which affect the size of transaction cost and, by empirical evidence, the standard of living and the wealth of nations. Global economic integration further induced institutional competition in terms of tax structure, regulatory environment, administrative barriers and labor market structures. Thus, when countries such as Georgia, FYR Macedonia, Moldova, Liberia and United Arab Emirates, enacted the liberalization of the business environment, the results were significant ever after. The World Bank also published the list of top 10 reforms in 2010 among which are Rwanda, Kyrgyz Republic, FYR Macedonia, Egypt, Moldova, Belarus, Columbia, United Arab Emirates, Tajikistan and Liberia (link).

The efforts to deregulate and liberalize business environment worldwide, will have a strong impact on high-income countries to remove the existing barriers to trade and investment such as high tax burden, rigid labor market structure and government size relative to private sector. 2008/2009 financial crisis and the growing role of government in the economy will probably deteriorate the country ranking in the next year. However, the leadership in the quality of business and regulatory environment will depend on further liberalization of the business environment, particulary the labor market, which is a major backbone of high-income countries where union density and regulated labor markets are widespread.

If countries such as Italy, France, Germany and the rest of the developed world will hesitate in reforming the remaining barriers to trade, more direct investment flows will move to high-growing emerging markets where macroeconomic stabilization is proceeding and where policymakers impose reforms faster then their peers in the developed world.

If such trend continues, emerging markets will soon reap the benefits and could become the leaders in reforming the business environment, attracting direct investment and, by and large, in economic growth and catch-up with the rest of the world.

THE END OF RECESSION

Words of wisdom from Gary Becker (link) on the prospects of recovery, unemployment figures and productivity outlook.

THE ECONOMIC SURVEY OF ICELAND 2009

The OECD has released The Economic Survey of Iceland 2009 (link), discussing the origins of the banking crisis that eventually led to the collapse of the country's oversized banking sector relative to its GDP and the prospects of fiscal and monetary policy in the aftermath of the financial crisis and the recession.

EFFECTIVE TAX RATES AROUND THE WORLD

Here's a short brief (link) by The Economist on effective tax rates around the world. At a stunning 55 percent effective tax rate on annual gross earning of $100,000, Slovenia is the most heavily taxed country on earth followed by India, Italy, Sweden and Argentina.


Source: The Economist (link)

SWISS BANKS AND FINANCIAL PRIVACY

Pierre Bessard of the Liberales Institut in Switzerland, makes the case in NY Times (link) why financial privacy shouldn't be infringed and why Dept. of Justice and the European Union should not exert pressures on Swiss banks regarding financial privacy and client information disclosure to foreign governments:

"Switzerland, which is home to an impressive number of global corporations, has also come under fire from the European Union for offering too-favorable tax rules, including exemptions for income earned abroad. But what critics forget is that these practices also benefit other countries. Swiss firms alone employ hundreds of thousands of people in the United States and Germany, for example. Subsidiaries of multinational corporations usually pay income taxes where they operate, so having their headquarters in Switzerland can help companies avoid multiple taxation in high-tax countries, thereby safeguarding productive capital for investment."

ANTITRUST, MARKETS AND COMPETITION

Earlier today, I read Steve Forbes's discussion (link) of recent antitrust reaction to the announced Yahoo-Microsoft search-engine global partnership deal (here and here) by the Department of Justice. The merger of Yahoo and Microsoft is ought to create a new competitor to tackle Google's supposed 75 percent market share in search advertising. Back in 2008, Department of Justice swatted the aligned Google-Yahoo search-advertising partnership, saying that "it would have furthered Google's monopoly"(link). Google is currently also under investigation by Department of Justice which accusses Google of copyright infringement in company's book-scanning project (link). In addition, Christine Varney, Obama's antitrust appointee at the Department of Justice, targeted Google's dominance in search-ad market by blaming the company for "starting to colonize the emerging cloud-computing industry and amassing enormous market power" which customers would hardly escape.

The antitrust policy enhanced by Sherman Act, Clayton Act and Robinson-Patman Act prohibits the so-called "predatory behavior" that could restrain trade, induce monopolization efforts or impose unfair trade practices such as price discrimination. The antitrust targeting of Google has been inspired by the antitrust case from 1964 United States vs. Aluminium Company of America in which the court, headed by Judge Learned Hand, laid down a landmark decision that "under certain circumstances, a company may come to dominate its field through superior skill, foresight and industry." (here, here and here).

Donald Marron, former CEA economist, recently wrote a nice piece on how Google may defend itself against Department's potential antitrust investigation (link). First, Dept. of Justice will face a difficult task in defining Google's relevant market. Antitrust commentators often point out that Google possesses more than 70 percent of revenues in search-advertising market. However, Google's top antitrust attorney say that such definition of the relevant market is too narrow, arguing that the company actually receives less than 2 percent of revenues from search-ad market. The merger of Yahoo and Microsoft's internet search-engines could deteriorate Google's market share.

The enforcement of antitrust policy in preserving competitive market structures has resulted in complete failures several times. Recently, the European Commission imposed € 1.06 billion fine on Intel Corporation for exercising illegal practices such as giving loyalty discounts and implicit rebates to computer manufacturers and major retailer under the condition that Intel's chips are integrated into CPUs. The Commission argued that such "illegal practices" prevented customers from choosing alternative products (link) and thus, Intel supposedly abused the dominant position. That is against the provisions of EC Treaty.

The enactment of antitrust policy relies on the idea of competitive market structures. Microeconomic theory teaches that a monopoly leads to a deadweight loss and, thus, its relative efficiency is inferior to competitive market structure which operate under zero-profit assumption. However, the classic microeconomic theory neglects economies of scale in industries with significant fixed costs and entry costs such as high tech, health-care and airline.

However, antitrust policy embodied in Clayton Act, Sherman Act and other legislative acts, often leads to protectionist pressures from interest groups since the enforcement of antitrust is driven by the political process. Thomas DiLorenzo, famous Austrian economist, showed how interest group use lobbying pressures to exercise antitrust policy in favor of protecting competitors rather than competition (link).

In recent years Google acquired several smaller companies. The Federal Trade Commission and Dept. of Justice, for instance, put the acquisition of DoubleClick in 2008 under investigation. However, acquisitions in tech industry could produce significant efficiencies in distribution and consumer prices (link).

The notion of Sherman Act is that practices that restrain trade are illegal and doomed to be prosecuted. However, antitrust enforcers should recognized that high fixed costs and entry costs are not the result of market action or conspiracy but natural obstacle. Thus, industrial organization in technology, retail, health care and airline industries, enables significant economies of scale through lower average costs of production. This requires high levels of innovation including merging resources and joint cooperation. By the token of perfect competition for instance, Wal-Mart should be broken (link). If federal antitrust enforces forced Wal-Mart to split into more parts, gains in distribution which enable low prices and various discounts, would diminish considerably.

Thus, the real aim of antitrust enforcement should not be to prosecute successful firms and deprive them of productive gains, but to prevent alledged conspiracy that inhibits market entry and harms the consumers. In a free market, natural monopolies are short-lived and challenged by either new entrants or international competition.