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.

GERMAN ECONOMIC DISEASE

Hans Werner Sinn recently wrote a piece in WSJ discussing anemic growth prospects of the German economy (link). The German economy is expected to decline by about 6 percent annually, following a major decline in export sector. Foreign orders decreased by 43 percent in January and February. Many commentators emphasized the risk of Germany's exposure to foreign trade and its vulnerability to global economic shocks.

In spite of absorbing a rather strong shock from a decline in exports, the major backlash of the German economy is the rigid labor market and the lack of wage flexibility. In recent years, German policymakers launched the increase in minimum wages as an attempt to ward-off international low-wage competition from emerging market economies. What happened? In turn, workers in low-wage industries were protected againist labor-intensive producers from India, China and so forth.

In addition, as minimum wages grew, the labor cost of low-wage workers increased to such an extent that employers couldn't afford to hire them. Consequently, the creation of high-wage jobs was discouraged as "skills" were less abundant than low-wage jobs. High tax burden and extensive labor cost discouraged job formation and thus many young German minds voted with their feet and moved abroad to places such as neighboring Switzerland, Canada, United States and Australia.

It is simply not true that the expected output contraction will accelerate only because of the near collapse of export and manufacturing sector. Economists and policymakers often discuss the backbones to economic growth. The empirical studies showed that the rigidity of labor market comes at the cost of less job creation and productivity decline. This is exactly what happened in Germany.

When I was writing one of the forthcoming papers, I estimated the potential daily working time in OECD. While Korea hits the top with a stunning average of more than 9 hours of daily labor supply, Germany hits the bottom with no more than the average of 6 hours of daily labor supply. In microeconomics, this is a pure substitution effect - higher tax wedge discourage labor supply and induces individuals to consume more leisure. To stimulate labor supply, the policymakers should liberalize labor market and remove the disincentives to work. Second, the liberalization of the labor market goes hand in hand with the reform of the old-fashioned German welfare state. Keeping minimum wages above the wage rate in the private sector will not diminish the unemployment rate and stimulate job creation.

Also, providing the unemployed with generous entitlements and welfare benefits, will not cure the disease of low productivity. Third, in 2008, government spending reached equaled 45.7 percent of the GDP should be reduced. German economic performance lagged behind the EU. Between 1995 and 2009, the economies of EU15 grew by 27.1 percent on average. German economy expanded by 14.3 percent, only surpassing Italy, whose economy expanded by 11.9 percent during that period. A wise combination of deregulation of labor market, reform of the welfare state and reduction in government spending is the right path for German economic recovery.

THE IMPACT OF RECESSION: GERMANY vs. AMERICA

Douglas J. Elliott of the Brookings Institution compares the impact of this year's recession in the U.S and Germany (link):

"Equally importantly, Germany is justifiably proud of its prowess in exports, particularly industrial machinery and automobiles. Somewhere between 40% and 50% of Germany’s GDP comes from exports, depending on when and how you measure it. This is more than three times that of the U.S., although it is important to note that Germany is a considerably smaller country and is closely integrated with its European neighbors, who are the largest importers of German products. (If the U.S. counted sales from the Northeast to California as exports, our figure would be sharply higher than it is.) Germans view their trade surplus as a sign of virtue and the source of overseas investments that will carry the country through a future in which their aging population cuts back on output and necessarily lives more on the fruits of past labor."

CANADIAN AND THE U.S HEALTH CARE SYSTEMS COMPARED

A study by June O'Neill and Dave M. O'Neill (link) suggests that the U.S health care system provides more choice, efficiency, better delivery and capacity than the Canadian system:

"Does Canada's publicly funded, single payer health care system deliver better health outcomes and distribute health resources more equitably than the multi-payer heavily private U.S. system? We show that the efficacy of health care systems cannot be usefully evaluated by comparisons of infant mortality and life expectancy. We analyze several alternative measures of health status using JCUSH (The Joint Canada/U.S. Survey of Health) and other surveys. We find a somewhat higher incidence of chronic health conditions in the U.S. than in Canada but somewhat greater U.S. access to treatment for these conditions. Moreover, a significantly higher percentage of U.S. women and men are screened for major forms of cancer. Although health status, measured in various ways is similar in both countries, mortality/incidence ratios for various cancers tend to be higher in Canada. The need to ration resources in Canada, where care is delivered "free", ultimately leads to long waits. In the U.S., costs are more often a source of unmet needs. We also find that Canada has no more abolished the tendency for health status to improve with income than have other countries. Indeed, the health-income gradient is slightly steeper in Canada than it is in the U.S."

THE ORIGINS OF OBESITY

David Cutler, Ed Glaeser and Jesse Shapiro provide the evidence of high rates of obesity in the United States (link):

"Americans have become considerably more obese over the past 25 years. This increase is primarily the result of consuming more calories. The increase in food consumption is itself the result of technological innovations which made it possible for food to be mass prepared far from the point of consumption, and consumed with lower time costs of preparation and cleaning. Price changes are normally beneficial, but may not be if people have self-control problems. This applies to some population."

ECONOMIC SURVEYS

The OECD has recently published Economic surveys of Greece (link) and Mexico (link)

HAPPY BIRTHDAY, MILTON

Milton Friedman died on November 16th 2006. July 31st remarks his birthday and an opportunity to reflect his profound legacy of economic thinking and ideas promoting individual liberty.

I first came across Friedman's ideas through one of his first research papers, Income from Independent Professional Service (link), coauthored with Simon Kuznets, wherein Friedman and Kuznets showed how shortage of physicians emerges from restrained labor supply and upward wage pressures. Together with Kuznets, Friedman applied statistical models to the analysis of income from professional services. The empirical results indicated that the regulation of professional services raises general income level for existing practitioners while, at the same time, reduces incentives for market entrants by raising fixed entry costs and compliance cost.

The paper was written in 1945 when orthodox Keynesian economic policies took a full-fledged march. Friedman's strong analytical rigour successfully challenged Keynesian economic establishment of that time. In Theory of the Consumption Function, Friedman showed how Keynesian theory of consumption fails to capture long-run behavior of households. In General Theory, Keynes postulated that household's consumption is determined by autonomous consumption and consumption induced by income. Since Keynes assumed that consumption is a linear function of income, higher income is ought to result in higher savings. Later on, Simon Kuznets showed that Keynesian consumption function suffers from empirical incosistencies. Even though it had been seemingly accurate in short-run cross-section data, it failed to predict household income pattern in time-series data over the long run. If Keynesian assumption was held true, the savings-to-income ratio would grow over time. On the contrary, the ratio remained constant over time in spite of relatively large income changes. Keynesian theory of consumption was further shook by new theories of consumption. Franco Modigliani, Nobel Laureate in Economics from 1985, challanged Keynesian consumption theory by introducing life-cycle hypothesis, showing how savings-to-income ratio changes over the entire lifetime, depending on household's life stage. Franco Modigliani and Richard Brumberg proposed the life-cycle income hypothesis with a more realistic assumption. He tested the following equation: C = aW + cY where a is marginal propensity to consume wealth (W), and c is marginal propensity to consume income (Y). The empirical results for the United States estimated the marginal propensity to consume from disposable income (c) at 0.7 and marginal prospensity to consume from wealth (a) at 0.06. The estimates were used to examine household consumption patterns. Thus, over the lifespan, as household's income went up by 1 percent, consumption expenditures wemt up by about 0.7 percent on average. Meanwhile, as household's wealth increased by 1 percent, the consumption expenditures grew by 0.6 percent on average.

The research by Modigliani and Brumberg in 1957 and Kuznets paved way for Friedman's Permanent Income Hypothesis. In a proposed hypothesis, Friedman argued againist Keynesian consumption theory. Its major inability is the weakness of prediction and the inconsistency in consumption patterns between short-run and long-run results. Contrary to Keynes, Friedman argued that disposable income arises from permanent and transitory income. Permanent income held by household was defined as household's preference for a stable consumption over the long run. Friedman showed that consumer's choices are made not by transitory income but by permanent income expectations. Thus, transitory changes in income have little effect on consumption behavior. The empirical assessment of permanent income hypothesis showed that households with lower income tend to have higher marginal propensity to consume. Friedman concluded that consumer's spending is not affected by static expectations but rather by real wealth such as physical assets and human capital assets. These determine consumer's earning ability and enable consumers to forecast their lifetime income.

When Friedman received a Nobel prize in economics back in 1976, the Nobel Commission entitled the award for "...his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of complexity of stabilization policies..." Back in 1963, Friedman and Schwarz wrote the Monetary History of the United States 1867-1960 where they examined the monetary trends in the United States since the end of the civil war.

Through an extensive empirical observation of money supply, monetary policy and business cycles they showed that monetary intervention by the Federal Reserve System, which was established in 1913, in an attempt to stabilize the short-term cyclical shock in the financial market resulted in the worst economic depression in world history. Fed's intervention reduced the broad money supply, destroying the depository base. The intervention led to the banking panic. Lending operations were disabled and the banking system suddenly went insolvent. When Federal Reserve cut the money supply by one-third in 1929, the ordinary recession turned into the depression in the light of deflationary shock. As the leading voice of the monetarist school, Friedman showed that inflation is a monetary phenomena resulting excessive growth of money supply relative to output growth.

Friedman's empirical research on monetary trends over time led to important conclusions. The most notable conclusions were that (1) short-run changes in money supply affect output while (2) long-run changes in money supply affect price level. Friedman's empirical work on monetary economics dropped the Keynesian myth of inflation caused by oil price increases or upward wage pressures. Friedman suggested that Fed should increase the quantity of money by a rate, ranging from 3 to 5 percent, determined in advanced. In a debate with Walter Heller, the chairman of Council of Economic Advisers to President Kennedy, Friedman argued that fiscal policy is an inefficient demand management tool in stabilizing economic fluctuations.

Milton Friedman was also a leading and indispensable libertarian voice throughout the world. Back in 1962, he published Capitalism and Freedom. The book spread the ideas of economic and individual liberty around the world. Friedman wrote that economic freedom is a neccesary condition for individual and political freedom. The ideas of ending all currency controls, removing barriers to trade, drastically cutting government spending, privatizing social security, introducing school vouchers and ending progressive income tax structure, spurred the creation of liberal freedom movements around the world.

As one of the rarest voices around the world, Friedman proposed the negative income tax as an alternative to progressive income taxes. As the wealthy take advantage of various loopholes, exemptions and tax breaks, progressive income tax does not achieve its purpose but, contrary to expectations, it further increases the income inequality. The basic idea behind the negative income tax is that general allowance would be raised to guarantee the minimum income level while the income above basic exemption would be taxed at the flat rate. The books written by Milton Friedman truly revolutionized the world. Free to Choose, coauthored with Rose Friedman, introduced free-market ideas to the general public by popularizing cases for limited government, the rule of law, and various way to end government monopolies.

Friedman's ideas reached the arena of public policy in many countries. Although heavily criticized by the left-wing intellectuals, Friedman visited Chile and delivered a lecture in Santiago on economic freedom. He advocated deregulation, privatization and the case for floating exchange rate. Due to the decision of Chilean Ministry of Finance, the exchange rate was fixed to the U.S dollar as a cure to heel rampant inflation. Since the Central Bank of Chile hadn't reduce the money supply, dollar-denominated foreign loans deteriorated Chilean trade balance. The decision to fix the exchange rate in the absence of accomodative monetary policy, imports were inflated. Because exchange rate was not floating, the elimination of fixed exchange rate and a disinflationary policy of the central bank unavoidably resulted in a two-year recession.

However, nothing could be further from the truth than then assertion that free-market reforms destabilized Chilean economy. Output contraction is a natural consequence of disinflationary policy, following the reduction of money supply. After exchange rate controls were eliminated, and after the launch of the privatization of state-owned companies and the social security, deregulation and free trade, starting in 1985, Chilean economy grew at the robust rate. Industrial production increased and the unemployment went down. In the long run, Chile's GDP per capita has been the highest in the region with a vibrant economy facing stable institutions and an enviable Friedman's ideas influenced many leaders around the world.

His ideas inspired Margaret Thatcher to undertake the course of free-market reforms. Prior to the launch of fiscal and monetary policy reforms, the British economy was recognized as the sick man of Western Europe, facing high annual rates of inflation and unsuccessful Keynesian economic policy attempt to cure the ailing economy by boosting aggregate demand through government deficits. After Lady Thatcher slashed marginal tax rates, introduced deregulation, liberalized labor market and proposed the privatization of state-owned industries, the British economy thrived with economic growth rates reaching historic highs.

Milton Friedman left a wealthy legacy of free-market thinking and efforts to promote individual liberty, free economy and political freedom. The financial crisis of 2008/2009 that spurred the economic recession intiated the beginning of heavy government intervention. The pursuit of ideas in favor of individual liberty and economic freedom is the best weapon againist the growth of government and the welfare state. With an iron will of the classical liberal, he successfully battled the failures of the welfare state and government intervention. He surely is one of the greatest economists and thinkers of the time.

LOWER CORPORATE TAX RATE IN ONTARIO

Chris Edwards, an economist at the Cato Institute, reports that Tim Horton's (Canada's "Starbucks") is moving its headquarters to Ontario, as the provincial policymakers are cutting the federal-provincial corporate tax rate down to 25 percent (link). That is 15 percentage points lower than the federal corporate tax rate in the U.S.

GLOBAL ENABLING TRADE REPORT 2009

World Economic Forum recently published its annual report on enabling trade around the world (link).

The report estimated broader openness to trade after taking all indicators, regulatory and administrative factors into account. Notably, among these are the ease of market access, customs administration, difficulty of export and import procedures, quality of transport infrastructure, the availibility of transport services and the use of ICT. The report found a positive and moderate correlation between the GDP per capita and enabling trade index. Thus, it implies that countries with higher GDP per capita, on average, tend to be more trade-friendly.

There are, of course, some other factors, aside from GDP per capita, that affect broader openness to trade. The research by the WEF found that the customs regulations, quality of regulatory and business environment and the quality of transport infrastructure and services significantly explain country's openness to trade flows fairly well.

Countries with the highest Enabling Trade Index (ETI) are Singapore, Hong Kong, Switzerland, Denmark and Sweden, followed by Canada, Norway, Finland, Austria and the Netherlands. In spite of robust growth of trade volume before the economic crisis, Russia ranks 109th out of 121 countries in the report, accompanied by countries such as Syria and Nepal. This suggests that Russia's growth of trade volume before the crisis can be assigned to its factor-driven economic growth. WEF's report reveals that Russia's score poorly in terms of border administration, market access and the business environment while performing modestly in terms of quality of transport infrastructure. Index of Economic Freedom noted that Russia's trade freedom is inhibited by the inefficient arbitrary customs administration. The latter restrains trade and is a popular protectionist policy measure. The least trade-friendly countries, according to the report, are: Chad, Cote d'Ivoire, Venezuela, Zimbabwe and Nigeria.

CALIFORNIA'S DISMAL FISCAL LEGACY

At Bloomberg, Kevin Hassett wrote an article (link), discussing the shortcomings of California's fiscal crisis. According to the official estimates, California's annual budget deficit is likely to hit $26 billion. Dan Mitchell recently debated California's spending disease on CNBC (link). In addition, high government spending has deteriorated California's economic growth prospects. California has become a textbook case of gradual economic stagnation. Back in 1960, California's GDP per capita stood 24.5 percent above the U.S average. In 2008, it stood 7.4 percent above the U.S average. In recent decade, California has pursued an economic policy based largely on government's meddling into economic affairs.

The data from California's Department of Finance (link) reveal the outcome of economic mismanagement. In California, minimum wage has been growing steadily with a fascinating rate. In 1957, the minimum wage rate stood at $1.0 per hour. In 2008, the minimum wage rate was $8.0 per hour. That is 800 percent increase. In 2008, the minimum wage rate in California was 10.35 percent above the U.S average. The economics of minimum wage is simple: as unions set the minimum wage above the non-union rate, the employment drops and union members enjoy a wage premium and more employment protection. Larry Summers, the chairman of National Economic Council, nicely summarized how minimum wages, welfare payments and unemployment insurance spur long-term unemployment (link).

The macroeconomic outlook of California is not favorable. Seasonally-adjusted unemployment rate in May 2009 stood at 11.5 percent compared to 9.4 percent of the U.S average. Second, California's record-breaking budget deficit is largely a result of high tax burden and high government spending. In 2009, California's government spending is projected to reach $417.3 billion or almost 25 percent of California's gross state product (GSP). The share of government spending in the GSP is likely to climb higher when the 2009 GDP data will be released. Time-series data on fiscal policy (link) show that California's gross public debt in 2009 is set to hit $367.7 billion or 21.63 percent of state's gross product. A study conducted by Arthur Laffer & Moore Econometrics (link) showed that California's 10.3 percent top personal income tax rate is the second highest in the U.S, just behind the state of New York.

Not surprisingly, the overall employment grew only by 1.4 percent. In Texas, one of the most vibrant and highest-growing economies in the U.S, the overall employment grew by 2.9 percent. That is 107 percent difference. California's tax policy has also taxed dividends and capital gains by 10.3 percent tax rate, thus discouraging capital formation.

If California were an independent state, it would be the 8th largest economy in the world. However, tax and spending fine-tuning left a disastrous fiscal legacy of high public debt, deep budget deficits and stagnation of employment, productivity and income growth. To stabilize California's public finance and boost state's economic growth, the remedy of fiscal policy would include a drastic reduction of government spending, the ending of budget deficit and the creation of surplus. In addition, tax rates that penalize savings, work and investment should be slashed radically. It should not be neglected that entitlement spending is a hampering burden to the economy and is ought to be anchored by an official fiscal target. If California's public finances and fiscal policy continue the status quo, then, in a couple of years, California's economy will resemble France more closely than ever before.

4TH OF JULY 2009

"The ground of liberty is to be gained by inches, and we must be contented to secure what we can get from time to time and eternally press forward for what is yet to get. It takes time to persuade men to do even what is for their own good."

Thomas Jefferson

Happy Independence Day!

ECONOMIC GROWTH IN THE WORLD IN 2009

Source: Congressional Budget Office (link)

INTERVIEW WITH PAUL A. SAMUELSON

Conor Clarke has published a great interview with Paul A. Sameulson in two parts (here and here) discussing fiscal stimulus, Keynesian macroeconomics, behavioral economics and other issues as well.

LONG-TERM FEDERAL DEFICIT SPENDING

Source: CBO (link)

THE COST OF FREE TIME

This is what I chased in NYT (link):

IS ASIA THE NEW CENTER OF WORLD ECONOMY?

Gary Becker (link) and Richard Posner (link) discuss whether the gravity of world economy is moving from the US and the EU to emerging Asian economies.

Rapid economic growth and steady institutional transformation are the key drivers of Asia's economic rise in the global economy. While the United States and the EU will likely suffer from this year's recession and pursue a U-shaped recovery, India, China, Indonesia and Vietnam will continue to grow in 2009 with favorable midterm growth projections. Even minor short-run differences in economic growth can lead to a profound impact on long-run income per capita. For example, if China and India's long-run economic growth rate is about 5 percent, it would take 14 years to double its income per capita.

If the growth rate were 6 percent, which is more likely after taking the productivity shocks into account, it would take 12 years for income per capita to double. The medium-term forecasts by the IMF suggest that the U.S and Europe will grow between 2.5 and 3 percent. Similarly, that would take 29 years and 24 years to double the income per capita. The gap can be further estimated by the empirics of real convergence.

Rapid economic growth in Asian tigers will also induce their bargaining power in institutions such as WTO, IMF and World Bank. In particular, Asia's fast growing economies play a stronger role in world trade. Thus, the bargaining power of India and China in negotiating regional and multilateral trade agreements is growing. The central challenge, however, is whether Asian tigers will recognize that free trade promotes economic growth, welfare and peace. The rise of trade protectionism in the U.S (link) and Europe is a significant concern from a countervailing perspective. Even the area of climate change policy is a potential source of conflict between the US and the EU on one side and China and India on the other side.

Of course, I disagree with pessimistic arguments that the U.S will lose its leadership in innovation, technology and human capital. Indeed, top U.S universities will still remain world's top-notch sources of human capital and the U.S high-tech firms are unlikely to lose their world leadership. However, rapid economic growth in Asia will induce China, India, Indonesia and Vietnam to pursue free-market policies alongside economic, civil and political liberties to give up the authoritarian political climate. In fact, the transformation to free-market economy with independent economic and political institutions will, in the long run, determine the scope of Asia's economic rise in the world.

LABOR PROTECTIONISM IN THE U.S

Daniel Griswold, trade economist at CATO Institute, describes (link) how American labor unions oppose the free-trade agreement between the U.S and Columbia although the U.S International Trade Commission's estimates show that the free trade agreement between the two countries would boost U.S exports by about $1 billion annually. The AFL complains that Columbia is an unworthy of an agreement because of violence levied on union members (link). This may sound politically feasible, but the background is certainly much different from what AFL complains. In fact, Daniel Griswold showed that Columbian unions are as safe as American unions against political violence (link).

Recall the basics of international trade, H-O-S theorem (link) explains that international trade occurs because of the differences in relative factor abundance, i.e. differences between labor/capital ratio. Thus, a country with relative abundance in labor shall export labor-intensive products while the second country shall export capital-intensive products and services. Consequently, relative wages in labor-abundant country are lower compared to those in capital-abudant country. Why? Because in a more developed capital-abundant country, labor is scarce and, hence, relative wage is higher.

The complete liberalization of trade between the U.S and Columbia would reward the relatively abundant factor in the U.S (capital) and reduce the real reward to less abundant factor (labor). Thus, in the short run, relative wages may decline. Note that the Columbian level of productivity is less than half of the U.S level. In the long run, however, relative wages shall not decline given a staggering difference in productivity between the U.S and Columbia.

As a interest group, AFL is protecting labor againist the short-run decline in relative wages. The hindrance of free trade, in fact, harms everyone. The U.S exporters would suffer the loss of one the key Latin American markets while the Columbian exporters wouldn't absorb the benefits of free trade. On the other hand, the greatest victims of protectionist trade policy are consumers. The consumers in the U.S would be denied the freedom of choice of Columbian imports while Columbian consumers would lose the variety of choices from the U.S at a lower price, following the abolition of tariff protection.

APPLYING ARROW'S IMPOSSIBILITY THEOREM

"For centuries philosophers, mathematicians, political scientists and economists have searched for the best method of voting. Fifty-eight years ago the economist Kenneth Arrow (later a Nobel laureate) decided to see whether any voting rule could avoid the problems we've illustrated. Fix them all at once, he found, and you get--a dictatorship. One voter calls the shots every time. Arrow's "impossibility theorem" demonstrates that no system of voting always gives the "right" result."

Source: John Mark Hansen, Allen R. Sanderson, The Olympics of Voting, Forbes, June 3, 2009 (link)

RUSSIA'S ECONOMIC CRISIS

As seen by The Economist (here and here):

"...a recent study by McKinsey, a consultancy. It looked into five sectors of the Russian economy and found that, although productivity has improved over the past decade, it is still only 26% of American levels. Bureaucracy and corruption are stifling it. It takes six times as long to obtain construction permits in Russia as in Sweden and, despite cheaper labour and land, the cost of building a distribution centre is a third more expensive than in London, according to McKinsey. When profit margins were 25%, construction firms could afford to pay off bureaucrats. Now they cannot..."

THE COST OF FISCAL STIMULUS

The Economist observes that a growing public debt and exploding fiscal deficit is the foremost macroeconomic enemy of the U.S economy (link). Interestingly, Douglas W. Elmendorf, the head of CBO delivered a brilliant testimony (link) on the state of the economy, emphasizing the interest rate spread, the macroeconomic effects of financial crisis and the deflationary outlook for 2010. Below is a time series and the long-term projection of the U.S public debt in the percentage share of the GDP under three scenarios.

Source: Congressional Budget Office (link)

U.S TRADE DEFICIT AND CHINA

Today, Bloomberg reported (link) that April's trade deficit in the U.S increased by 2.2 percent. The recession in major trading partner sharply reduced external demand for U.S exports. As trade deficit has continued to grow, the U.S experienced significant investment inflows due to Fed's and external demand for Treasury bonds by which Chinese central bank accumulated massive foreign currency reserves. Consequently, the U.S dollar depreciated against the yuan, pushing up trade deficit. In the last three months, the yuan appreciated by 0.3 percent. In spite of the recession, the Chinese economy is set to expand by 7.5 percent annually in 2009. Thus, it is hard to understand why some U.S politicians repeatedly say that the yuan is overvalued.

THE 2009 RECESSION AND ECONOMIC RECOVERY IN SLOVENIA

Earlier this morning I was informed by Bloomberg (link) that Slovenia officially entered the recession for the first time in the last 16 years. The information has not been surprising since major economic forecasts predicted a significant downturn in the light of deteriorating exports and investment. The data pointed out to a significant economic decline. Gross capital formation shrank by an astonishing 32.3 percent. On the other hand, private household consumption grew slightly by 0.1 percent while government spending grew by 3.8 percent.

The outbreak of the financial crisis led economic policymakers to pursue a robust fiscal stimulus to compensate the decline of investment and consumption spending. Before entering the EMU, Slovenia had to comply with Maastricht criteria, including anchoring the budget deficit at the maximum level of 3 percent of the GDP. This year, the budget deficit soared over 6 percent of the GDP, suggesting a growing pressure on public debt. Earlier this month, John Taylor, a professor of economics at Stanford, wrote a great article in FT discussing the hidden dangers of a growing government debt (link). When credit rating agencies downgraded the sovereign debt outlook for the United Kingdom from "stable" to "negative", it should be obvious to economic policymakers that fiscal stimulus failed the cost-benefit analysis and hardly consolidated the midterm economic outlook and recovery.

Recently, Donald Kohn, the vice president of the Fed expressed concerns about fiscal deficit regarding inflationary outlook (link). The reaction of the fiscal policy included a typical fine-tuning infusion of government spending which produced little effect. Of course, it should be noted that a rather drastic expansion of public debt is not only a consequence of an expansionary fiscal policy but also of significant bailout loans from IMF. IMF's $2.4 billion bailout loan raised Latvia's public debt from 9 percent to 15.2 percent of the GDP in 2008 (link). By 2010, it is estimated to go up to 46 percent (link) of the GDP. The explosion of public debt is a particular concern and an obvious consequence of economy's overheating. The IMF recently reported that overall bank credit to private sector settled at 95 percent of the GDP. Complementary, external indebtedness rose to 130 percent of the GDP (link). Clearly, Bank of Latvia failed to act as a lender of the last resort with unbuilt foreign reserves basis and a balance sheet that couldn't sustain the bailout of the financial sector.

Iceland, definitely one of the biggest victims of the financial crisis has recently been downgraded on sovereign debt by Moody. The assets by the outward-oriented banking sector, fuelled by a stunning interest rate differential and carry trading against uncovered interest parity, skipped the size of the economy by 900 percent. The Moody predicted that Icelandic public debt will reach 145.3 percent in 2009 and shall decline slowly and gradually.

On the annual basis, Slovenia's small and open economy declined by 8.3 percent which is one of the most significant declines in the EU after Baltic tigers and Ireland. The European Commission predicts 3.4 percent decline in output by 2009. Exports are expected to decline by 11.8 percent. Small and open economies are vulnerable to economic crises and external shocks, particularly because its trade-to-GDP ratio stands at 60 percent of the GDP and beyond.

This year's quite striking decline has much to do with Slovenia's main macroeconomic backbones. The inflation rate, which grew significantly during the 2007 economic expansion when GDP growth stood at 6.8 percent annually, has not increased. That is because Slovenia, as other EMU members, experiences the recessionary output gap and also because there were no inflationary shocks from the oil market. The third frontier of explanation for a deflating pressure on economic activity in Slovenia is that during the recession spillovers from the tradeable sector strongly affected domestic retail and service sector. In March 2009, the unemployment rate stood at 8.4 percent. The combination of a weak labor market and significant downturn of private consumption spending weakened the bargaining power of unions over wage determination, although wages in the public sector recently grew by double-digit rates (link). In May, the monthly rate of inflation reached 0.6 percent respectively (link). The industrial production, one of the keenest signals of economic activity, for instance, declined by 20 percent in March 2009 (link). The lack of productivity shocks such as restructuring and innovation further worsened the outlook of industrial production.

In a Keynesian spinning turn, Slovenian government pursued a dramatic fiscal expansion coupled with an easy money policy from the ECB's lowest baseline interest rate since early 2000s. In addition to horrible state of public finance, the government enforced a set of measures to protect the major banks from the failure. After the failure of Lehman brothers, it became obvious that the credit flow to state-owned companies for purposes of acquisitions and oligpolistic consolidation will inevitably decrease significantly as the banks' balance sheets were too soft and, of course, too small to secure loans to the real sector. Not surprisingly, the banks performed dismally at the stock market. SBI20, Slovenia's headline stock market index shrank by an astonishing 68 percent between 2008 and 2009 (link), suggesting that P/E ratios and earnings forecasts were mostly overvalued and distorted by the insider information and inadequate and unreliable signals.

The recent staff report by the IMF on Slovenia (link) suggested the immediate enforcement of structural reforms to boost economic recovery. The historical track record of macroeconomic and structural reforms is quite sluggish. During the financial and economic crisis of 2008/2009, the Slovenian government raised government spending and tax burden.

Additionally, it further regulated the labor market by preventing firings through wage guarantees to temporary unemployed whom employers are obligated to reemploy as the economic recovery goes further. Is this a reminder that a totalitarian political economy is still alive? Yes. It seems that economic policymakers ignored the overwhelming regulatory burden in the business environment (link), extremely regulated, inflexible and costly labor market (link), the lack of scale to develop sound capital and financial markets (link) (link), unfinished privatization, high tax wedge and the lack of judicial enforcement in defending the rule of law and the protection of property rights.

These structural and macroeconomic reforms would strengthen the midterm growth outlook and significantly boost the economic recovery. Nonetheless, these reforms would not inhibit the economic growth in the long-run. The IMF's World Economic Outlook predicts weak growth in 2010 and a consecutive recovery until 2014 when the economic activity is expected to increase by 3.5 percent. However, the economic growth in Eastern tigers is expected to go steadily beyond 4 percent by 2012. By 2012-2014, Estonia's economic growth is expected to set up between 4 and 4.5 percent. Nonetheless, Slovakia, which smoothly matured in macroeconomic stability by entering the EMU in 2008, is set to expand 5.2 percent in 2011 and experience moderate growth ranging between 4 and 4.5 percent until 2014. Even a minor difference in economic growth has a significant long-term effect.

If Estonia and Slovakia steadily experienced 4.5 percent economic growth rate, it would take 16 years to double its GDP per capita. On the other hand, if Slovenia steadily experienced 3.5 percent economic growth rate, its GDP per capita would double in about 21 years. In my workshop on real convergence, I estimated that Estonia and Slovakia shall catch-up with Slovenian level of the GDP in about 12 to 16 years. In 1991, the catch-up gap between Slovenia and Estonia was between 45 and 50 years respectively.

Thus, without bold and strong economic reforms, the future of Slovenia shall be nothing more than a story of a slowly-growing and gradually stagnating economy with close and unfortunate similarities to Italy and France rather than to Singapore or Australia.

RUSSIA'S MACROECONOMIC OUTLOOK

The WSJ reports that Russia's economy recorded nearly 10 percent output contraction in Q1:2009 (link). In spite of surging oil prices and strong increases in stock market index, the midterm macroeconomic outlook on Russia is not favorable in terms of economic growth, fiscal policy and macroeconomic recovery. While the local currency appreciated 0.3 percent against the U.S dollar (link), the slow recovery in the financial sector is likely to deteriorate the macroeconomic outlook. The main ailing problems of the financial sector remain high credit and liquidity risk as well as default risk. The central bank could possibly mitigate the shocks in the financial sector by building up foreign reserves to act as the lender of the last resort. However, Russia's persistent obstacle to macroeconomic stability is high inflation rate and dismal fiscal policy record. When the inflation rate is high, building foreign currency reserves may be risky, letting domestic currency overvalued. Reduction in public spending and tightening of the monetary policy to stabilize the inflation rate could essential pursue stable midterm outlook.

ECONOMIC CRISIS AND RECOVERY IN EASTERN EUROPE

The Economist has published an article about the economic slump and recovery in Eastern Europe (link).

INFLATION IN THE OECD

The WSJ reports (link):

"Consumer prices in the 30 members of the OECD rose 0.9% in the 12 months ended March 31, the lowest level since records began in 1971. The previous record low was the 1.3% rate of inflation recorded in January and February of this year. As recently as July 2008, the OECD inflation rate stood at an 11-year high of 4.8%. The OECD said energy prices in its 30 member countries dropped 11.8% in the 12 months to March, having fallen by 8.6% in the 12 months to the end of February. Food prices rose 4.5% in the same period, having risen 4.8% in the 12 months to the end of February."

Interestingly, Iceland and Ireland had the most extreme movements in consumer prices in recent year. Iceland, which has been severely hit by the crisis, experienced 15.2 percent inflation rate in recent year, partly as a result of rapid domestic currency depreciation after its banking sector collapsed. On the other hand, Ireland experienced a modest deflation (-2.6 percent) in recent year, mostly due to a significant reduction in investment demand. As the interest rate kept falling steadily (link), the risk of deflation emerged because lower interest rates on overnight loans failed to boost the investment activity and credit flows in the light of credit crunch, falling stock market indexes and grimmy data from the labor market. The OECD countries, indded, face the lowest inflation rate in the last 30 years and the deepest output contraction after the oil shocks shackled the world economy in 1970s and 1980s. Meanwhile, cutting interest rates further could bloat the liquidity trap, the consequences of which are well-known and painful in ther long-run perspective.

THE ECONOMIC CRISIS AND RECOVERY

Here's a speech delivered by CEA chair Christina Romerat Joint Economic Committee about the current economic situation and the outlook (link)

TWO INTERESTING READINGS

Earlier this morning, I came across the latest release of data on the distribution of federal taxes and household income, published by the CBO (link) and a fascinating lecture of Peter R. Orszag on the role of immigration in the U.S labor market (link).

THE NONSENSE OF DEATH TAX

Art Laffer discusses some negative implications of death tax in WSJ (link).

MACROECONOMIC OUTLOOK IN EUROZONE

European Commission has recently published the interim forecast for GDP, inflation, unemployment and balance of payments in the euroarea (link). The financial crisis and recessionary downturn induced by a negative demand shock have virtually stalled the European economy. The Commission predicted a -1,8 percent GDP decline and further forecasted a modest recovery starting in Q1 or Q2 in 2010.

In a comparative perspective, while the Japanese economy is facing an incredible -10 percent output gap (link) and prompting the government to infuse fiscal pumps, the US economy is set to decline by about 1.6 percent annually in 2009 as predicted by the IMF (link), but the US economy is expected to recover more responsively than the Eurozone. Eurozone's weakening domestic economy is a lingering worry for a long-term growth perspective. Germany, the main trading partner to European economies, is expecting -2,3 percent economic growth in 2009. France's GDP is set to plummet by 2,3 percent while Italian economy is expected to shrink by aout 2.0 percent annually. Basically, the eurozone is facing asymmetric shocks when different sets of fiscal policies throughout the continent impede the smooth functioning of optimum currency area and its monetary policy.

Following a dramatic fiscal expansion in all Eurozone countries (For instance, Slovenia's public debt is expected to soar from 23 percent in 2008 to 38 percent of the GDP in 2009), policymakers and interest groups have pledged a call for protectionism in labor market, public sector and trade. There is no doubt that tight and highly regulated labor market is causing European sclerosis - the inability of European economies to catch-up the U.S level of productivity and purchasing power parity.

An obscure size of European public sectors is the second sign of European sclerosis leading to higher-than-natural rate of unemployment, wage pressures and deadweight loss in the labor market when inelasticity of labor supply creates job-search disincentives resulting in a regulated labor market and a spiral of wages that is far behind the real level of productivity.

PENSION REFORM AND MACROECONOMIC STABILITY

The issue of pension reform is definitely the most challenging macroeconomic issue in the time to come. Faced with unfavorable demographic situation, economic policymakers in Western countries will need to reconsider the structure of the pension system to ensure the long-term sustainability of pension systems and overall macroeconomic stability as well. Negative demographic trends, namely a decreasing labor supply relative to increasing retirement rates as post-WW2 baby-boom generations retire and the burden of the welfare state is beared by the existing labor supply thru higher tax burden unless the reforms are launched.

Jose Pinera predicted (link) that Europe's aging population and the unsustainability of pension systems in the Euroarea could distort the functioning of optimum currency area and, consequently, launch a series of instability issue in the euroarea due to the inability of fiscal policies to cope with the exponentially growing net financial liabilities to the retirement system. Ageing population is, of course, more pronounce in the euroarea and Japan compared to the United States or Canada. In G7, assuming ceteris paribus, dependency ratio is expected to move from 40 percent to 70 percent by 2050.

The evidence from the OECD predicts that by 2050, Spain and Italy will face the highest dependency ratios. In Sweden, where private retirement accounts have been introduced (link) as a long-range supplementary to PAYG system back in 2000 (link), the trend of the ratio of population aged 65 and over is expected to reverse between 2030 and 2040. The United States is the only advanced country where the share of population aged 65 and over is not expected exceed 40 percent of the overall population (link).

Recently, Martin Neil Baily and Jacob Funk Kirkegaard of the Peterson Institute wrote a book entitled US Pension Reform: Lessons from Other Countries (link). The authors examined the prospects for the reform of the pension system in the United States considering the evidence from abroad. They showed that southern (Spain, Italy, Greece, Portugal) and continental (France, Germany, Belgium, Austria, Hungary, Slovenia) European countries are in the dead-end scenario of weak total assets of the pension system, unsound government finances. Although Austria, Spain and Belgium had a surplus structural fiscal balance in 2006, these countries are still unfamous for high corporate and personal income tax burden which has, by all empirical proportions, a negative overall effect on labor supply as working time is substituted for leisure activities, while as those of you who studied introductory micro and macro, productivity is the key to higher standards of living.

There is a three-step approach that European welfare states must face sooner or later if these countries want to avoid a continuous macroeconomic crisis whose effect is similar to oil supply shocks in 1970s. First, pension systems should be privatized by the introduction of private retirement accounts and PAYG net financial obligations should diminish gradually either in the framework of fiscal policy rule or in terms of partial lump-sum in the intragenerational transfer. Second, the transition to private retirement accounts must ensure the combination of risk-management approach to portfolio investment and returns managed by private pension funds. Sound and smart regulation should not be avoided such as the avoidance of investment into toxic assets backed by subprime mortgages where a decreasing interest rate has virtually inflated assets prices and propelled a the burst of the bubble that spurred the financial crisis in 2008/2009.

However, lessons from financial crisis and financial innovation will probably peer the question whether pension funds shall benefit from investing in asset-backed securities. Traditionally, pension funds diverse the portfolio structure by hedging or diversification into a stable and predictable rates of return with low beta coefficient on most of securities as pension fund managers aim to reduce the variability of return rates as risk fluctuates except for in optional accounts. And third, European countries should immediately deregulate its rigid and inflexible labor markets and also strongly decrease marginal and average tax rate on personal and corporate income and should nevertheless immediately raise the retirement age in the effort to stimulate labor supply and avoid early retirement. The combination of high tax burden, early retirement age and inflexible labor markets is a vicious circle where stagnation, ageing time bomb and macroeconomic crisis are the main consequence of delaying pension reforms into the future while such reforms never really happen.

FRANCE'S ENORMOUS TAX BURDEN

WSJ reports that French president is under pressure of labor unions to raise taxes on the wealthy as an act of solidarity (link). Meanwhile, France's economy deteriorated significantly in the light of recession and turmoil of the financial crisis. The economy is expected to decline by 1,9 percent in 2009 on the annual basis. The forecasting prospect for French economy in 2010 is also a little grimmy. The IMF expects 0.7 percent economic growth in 2010 (link). The stagnation of France has been diagnosed as a consequence of high tax burden, inefficient and oversized public sector and rigid labor markets which hinder productivity growth and further deteriorate the already unsustainable social security and pay-as-you-go pension system when net financial liabilities increase exponentially in the share of the GDP. The OECD has shown an interesting comparison (link) of tax burden on labor supply in OECD countires. France, Belgium, Hungary and Germany are in the top ladder of tax burden on labor supply, where tax burden on average workers is very close or above 50 percent of labor cost while the OECD average is slightly below 40 percent.

WILL BOND PURCHASE SPUR GROWTH?

The Fed declared that it would buy as much as $300 billion of long-term treasury securities and even more in mortgage-backed securities. While the Fed has already targeted federal funds rate to 0,25 percent, the prices on US Treasury debt have soared, pushing the yield on 10-year notes from 3 percent to 2.53 percent. The WSJ reports:

The Fed will buy as much as $300 billion in long-term Treasurys in the next six months. It will increase the ceiling on purchases of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac to $1.25 trillion, up from $500 billion. The Fed also is doubling potential purchases of their debt, to $200 billion (link).

Zero-ground interest rate is a serious concern regarding the long-term conduct of the monetary policy. While the major central banks have already plummeted into a liquidity trap, it is surprising that stock markets and macro data on employment and output are not responding to the proposed policy measures. If the Fed is likely to buy more long-term Treasury securities in the following months, an unparalleled increase in government debt may occur which could deteriorate the state of macroeconomic stability which is unlikely to be mitigated by neither fiscal nor monetary policy. If the Fed really aims to tackle the economic recovery, then it should set time-consistent policy rule, declaring a stop to further policy rates with a clear and indisputable statement in mind.

NEW BLOG ON GLOBAL ECONOMY

Antonio Fatas and Ilian Mihov of INSEAD have launched an interesting blog on global economic issues (link).

SLOVENIAN ECONOMY: 2009 FORECAST

UMAR has issued the latest edition of Slovenian Economic Mirror (link).

LESSONS FROM THE GREAT DEPRESSION

Here is a link to Christina Romer's speech about the lessons from the Great Depression and the economic recovery of 2009, presented yesterday at the Brookings Institution.

FISCAL POLICY IN ECONOMIC CRISIS

A new study by IMF (link) suggests a framework for fiscal policy during recessionary periods. IMF admits that discretionary fiscal policy could further deteriorate economic recovery, increasing budget deficits and public debt which already reached new heights in G20 countries (link). It also suggets that vulnerabilities from financial markets should be addressed in preventing economic downturns. Agreeably, IMF does not suggest an introduction of large-scale entitlement programs which are politically almost impossible to reverse as well as an increase in public sector bill that could downsize productivity performance and exert a growing pressure on cost inflation. The study also concludes that industry-specific subsidies are harmful and could escalate protectionism. The study, however, does not recommend lower corporate tax rate, saying that tax reduction is likely to be ineffective leading to tax fraud. Numerous empirical studies have shown that high corporate tax rate is the primary reason for tax evasion, pushing private sector to move to jurisdictions with lower tax rates. And second, it would be suspicious to claim that corporate tax cut is ineffective because business profits are low. It is true that corporate tax reductions lead to higher tax multiplier and exert strong upward pressure during expansionary period, but that does not mean that corporate tax cut is ineffective during recessions. In fact, cutting taxes during recession eases the economic downturn as well as the pace of the recovery.

WHY INTELLECTUALS LOVE SOCIALISM

Back in 2005, Vaclav Klaus delivered a great speech (link) on why there is a huge and remarkable inclination of intellectuals towards the ideas of socialism.

"As we see both in Europe and in America, the intellectuals love such a system. It gives them money and an easy life. It gives them an opportunity to be influential and to be heard. The Western world is still affluent enough to be able to support and finance many of their unpractical and directly unpurposeful activities. It can afford the luxury of employing herds of intellectuals to use “poetry” for praising the existing system, for selling the concept of positive rights, for advocating constructivist human designs (instead of spontaneous human action), for promoting other values than freedom and liberty."