Our economics textbooks and the discussions in our media are peppered with simplistic economic arguments. Sometimes, these arguments form the basis for economic policy. Economic discourse about the Second World War often mentions that the war was " responsible for bringing America out of the Great Depression ". In the middle of the Great Recession, there is a possibility that similar arguments may be made in favor of war. Politicians that are lobbied by special interest groups in the military-industrial complex will find it convenient to vote in favor of increase in funding for war activities by using some of these arguments, which are often specious.
While it is true that an increase in war efforts can lead to higher employment, the nature of economic activity during wartime is very different from that during peacetime. The new jobs created by a war are geared towards the war or wars and are not associated with increase in normal consumption or investment. Therefore, simplistic statements to the effect that wars bring economies out of recessions are not accurate.
Also, the full employment or close-to-full employment brought about by war efforts are not sustainable once the war has ended. New and wasteful projects in the area of defense were probably responsible for the economy not reverting to pre-World War II-like conditions after the Second World War. The ability of the military-industrial-political complex to sell more wasteful military projects to the public is limited at the present time. Also, the current model of wars is to combine a low-tax, pro-corporate, laissez-faire economic model with heavy public borrowing to finance the extra expenditure needed for wars. Some of this public borrowing is from foreign entities. The possibility of such an economic system spinning out of control is always present. And the foreign indebtedness does not help.
Also, the extra expenditure associated with wars can lead to unsustainable debt situations. The current dismal debt scenario in the United States is in no small measure due to wasteful war efforts in the recent past. The current intransigence in the American political establishment about wars being waged by the United States abroad will likely lead to an exacerbation of the debt problem. Moreover, the international linkages of this debt can prove to be a serious problem for the geopolitical calculations of that part of the political establishment that pushes for larger American military presence abroad.
by C. Jayant Praharaj
The Global Analyst ( Commentary about economic, environmental, political and other topics )
Tuesday, June 21, 2011
Friday, June 3, 2011
The proposed African monetary union, economic independence and recessions
A monetary union has been proposed for Africa. However, there are several important questions involving national economic independence and economic efficiency that should be considered seriously by those contemplating such a union. That the political opinion and public opinion in so many European countries endorsed a monetary union despite the overwhelming loss of national independence, especially in the area of monetary policy, is striking in view of the obvious structural problems a monetary union engenders. Periods of economic weakness and periods of increasing unemployment usually impel the corresponding Central Bank to follow low interest rate policies and increased money supply ( significant exceptions occur when the IMF prescribes the opposite policies for certain countries in economic distress although countries like the United States tend to do monetary expansion during recessions ). The idea is to counteract slack in the economy ( a condition where actual output falls short of maximum possible output due to coordination failure between demand and potential supply ) by spurring demand ( as measured in the country’s currency ). The idea, a keystone of Keynesianism, has its detractors. For example, there are those who argue that money supply policy measures should be completely nullified by price adjustments in the economy. However, Central Banks do follow this kind policy, for example, in the United States. A weak economy is usually accompanied by deflation or very low inflation. So, there is not much to lose in terms of inflation by following these policies.
What could prove to be more important for a monetary union is the converse side of this policy. Namely, what happens if a Central Bank shrinks the money supply. Shrinking of money supply can sometimes lead to deflationary expectations and deflationary spirals, and can create slack in the economy and exacerbate unemployment. There is no guarantee that any particular monetary tightening measure by the European Central Bank, for example, is going to be right for all countries in the monetary union. Particular countries can get pushed into higher unemployment as a result of such steps.
Monetary tightening can lead to recessions in particular countries, put pressure on fiscal balances, drive up debt-to-GDP ratios and necessitate painful bailout conditions, when an independent central bank could have nipped the economic weakness in the bud by following low interest rate policies. The economies of individual countries will have to react to monetary changes by any central bank. The danger of deflationary spirals and irrational recessionary dynamics being set in motion because of a mismatch between central bank monetary policy and local economic realities is all too real.
The transaction costs due to currency exchange may be a constant kind of low-level inefficiency. However, the possible turmoil due to mismatch between central bank policy and local economic can have lasting impacts on a country’s economy. The actual inefficiency due to these can be way higher. It can impoverish entire sections of the country’s population. It can render entire sectors of the economy uncompetitive vis-à-vis global competition when an independent Central bank could have come to the rescue of these sectors.
Countries with independent Central banks also run into economic impasses where they need bailouts. However, anyone contemplating a monetary union in Africa needs to take into account the all-too-real possibility that a centralized monetary system can either lose touch with local economic realities or can find it impossible to accommodate local inhomogenities in its global monetary policies. Larger African countries may well dominate the agenda at the central bank and smaller African countries can be left to the whims of an insouciant central bank. Bailout packages will most probably be negotiated and extended in their own sweet time, well after economic activity has hemorrhaged in the country and well after fiscal balances have been thrown completely off-kilter due to recessions that a national central bank could have counteracted or mitigated much faster. The idea is not to let monetary problems become the source of growth, output and fiscal problems in the first place. And that is the danger from pushing for a monetary union of countries which are non-homogenous in their economic activities and whose output and employment dynamics are unlikely to be in sync with each other at all times.
A monetary union may have some advantages due to the larger scale when it comes to unscrupulous currency traders trying to manipulate currencies. However, appropriate policy measures can be devised to prevent excessive manipulation of a country’s currency. While currency speculation and currency attacks are real possibilities, fundamentals should prevail if deft enough handling of national economic policy is done. Also, there is no guarantee that currency manipulators cannot attack a common African currency. It is better to control the currency market and live with some low-level inefficiency on a constant basis than to be faced with large economic disruptions due to co-ordination failures between an African central bank policy and the needs of the national economies.
by C. Jayant Praharaj
What could prove to be more important for a monetary union is the converse side of this policy. Namely, what happens if a Central Bank shrinks the money supply. Shrinking of money supply can sometimes lead to deflationary expectations and deflationary spirals, and can create slack in the economy and exacerbate unemployment. There is no guarantee that any particular monetary tightening measure by the European Central Bank, for example, is going to be right for all countries in the monetary union. Particular countries can get pushed into higher unemployment as a result of such steps.
Monetary tightening can lead to recessions in particular countries, put pressure on fiscal balances, drive up debt-to-GDP ratios and necessitate painful bailout conditions, when an independent central bank could have nipped the economic weakness in the bud by following low interest rate policies. The economies of individual countries will have to react to monetary changes by any central bank. The danger of deflationary spirals and irrational recessionary dynamics being set in motion because of a mismatch between central bank monetary policy and local economic realities is all too real.
The transaction costs due to currency exchange may be a constant kind of low-level inefficiency. However, the possible turmoil due to mismatch between central bank policy and local economic can have lasting impacts on a country’s economy. The actual inefficiency due to these can be way higher. It can impoverish entire sections of the country’s population. It can render entire sectors of the economy uncompetitive vis-à-vis global competition when an independent Central bank could have come to the rescue of these sectors.
Countries with independent Central banks also run into economic impasses where they need bailouts. However, anyone contemplating a monetary union in Africa needs to take into account the all-too-real possibility that a centralized monetary system can either lose touch with local economic realities or can find it impossible to accommodate local inhomogenities in its global monetary policies. Larger African countries may well dominate the agenda at the central bank and smaller African countries can be left to the whims of an insouciant central bank. Bailout packages will most probably be negotiated and extended in their own sweet time, well after economic activity has hemorrhaged in the country and well after fiscal balances have been thrown completely off-kilter due to recessions that a national central bank could have counteracted or mitigated much faster. The idea is not to let monetary problems become the source of growth, output and fiscal problems in the first place. And that is the danger from pushing for a monetary union of countries which are non-homogenous in their economic activities and whose output and employment dynamics are unlikely to be in sync with each other at all times.
A monetary union may have some advantages due to the larger scale when it comes to unscrupulous currency traders trying to manipulate currencies. However, appropriate policy measures can be devised to prevent excessive manipulation of a country’s currency. While currency speculation and currency attacks are real possibilities, fundamentals should prevail if deft enough handling of national economic policy is done. Also, there is no guarantee that currency manipulators cannot attack a common African currency. It is better to control the currency market and live with some low-level inefficiency on a constant basis than to be faced with large economic disruptions due to co-ordination failures between an African central bank policy and the needs of the national economies.
by C. Jayant Praharaj
Wednesday, June 1, 2011
Credit Rating Agencies, Sovereign Debt and Self-fulfilling Prophecies
Credit rating agencies are busy downgrading sovereign bonds, from Greece through Spain to the United Kingdom and the United States and Japan. Of course, when there are crises, economic downturns, high debt-to-GDP ratios and political gridlock regarding how much taxes should be raised versus how much spending can be cut, a reappraisal of sovereign bonds becomes mandatory. What is troubling, however, is the fact that the bonds of countries like Greece are being downgraded to junk status. Junk status means that the budget fundamentals and the expected budget fundamentals of the country are so weak that buying the country’s bonds is an ultra-high-risk thing. How damaged can a country’s economy get, how damaged can its growth prospects get, how limited are its options for raising taxes on its successful economic entities and how limited are its options regarding spending cuts that the fiscal future of the country is basically in almost irretrievable trouble ?
For example, if the GDP of a country contracts by, say, 1% in a year in a recession, how much does the central government revenue contract ? And how much extra government expenditure becomes necessary due to additional unemployment benefits payments and bailouts ? Let me take some numbers from Greece. The “ Budget 2011 Draft Law “ document from the Hellenic Ministry of Finance website has the following figures. The nominal growth rate of GDP in 2009 was -1.1%. Or a 1.1% contraction, to put it differently. The deficit went from 22.4 billion Euros in 2008 to 36.2 billion Euros in 2009. In 2010, the nominal growth rate was -1.3%, that is, a contraction of 1.3%. The deficit went from 36.2 billion Euros in 2009 to 21.9 billion Euros in 2010. If one considers 2008 to 2011 as the crisis period, the document shows that the government debt went from about 110% of GDP to about 145% of GDP. The document outlines a plan whereby, with a combination of tax increases and spending decreases, the debt to GDP ratio will stabilize at around 150% of GDP. But these kinds of numbers are increasingly becoming commonplace. Japan’s debt to GDP ratio is around 200%. Its low tax and high infrastructure spending policies have not yielded good results. When one includes the stakes that the United States government has taken up in beleaguered entities, its debt obligations add up to more than 100% of GDP, and are likely to increase to 150% of GDP or even more by 2025. So, what is it about Greece that makes its bonds junk while Japan and the United States receive a less severe or no downgrading ? Japan and the United States have their own structural problems too. For example, the United States has a long-term structural problem of capital flight to China and other countries. India has a sluggish agricultural sector that poses serious human welfare challenges for the country. As for reliance on foreign capital inflows, it has been a recurrent feature of the United States economy also.
Portugal had GDP growth of 0% in 2008 and -2.6% in 2009. The government debt, which was around a stable 65% of GDP till 2008, increased to 76% of GDP in 2009 and 82% of GDP in 2010. I have not come across stabilization plans regarding Portugal, but once again, given the kind of debt-to-GDP ratio that some of the bigger economies are running, it is difficult to understand why fears of default are being raised about Portugal so quickly.
For Spain, the debt-to-GDP ratio increased from 40% in 2008 to 53% in 2009 to 60% in 2010. It is projected to be around 75% by 2016. Once again, it is going to be above EMU stipulations of good fiscal conduct, but to talk about default at these levels of debt-to-GDP may just be gratuitous scaremongering. It can set its own self-fulfilling prophecies in motion. In other words, if credit rating agencies give a more negative rating to a country’s bonds compared to other countries with worse macro-sheets, the country will find it more difficult to raise debt and has to pay exorbitant interest rates. Too much of gratuitous scaremongering can even constrain the government’s ability to borrow so much that it may have to resort to EFSF and IMF loans with strict conditions. Therefore, this kind of scaremongering by credit rating agencies is likely to set in motion spirals that can lead a country’s finances to ruination when it could have been stabilized more easily with a bit of belt-tightening and a pragmatic approach to taxation and spending.
In many ways, a government bond is like a stock when it comes to the psychology of market valuation. If everybody is buying it, the value can remain high despite weak fundamentals. Vague considerations having nothing to do with fundamentals can result in one government’s bonds selling with lower interest rates, but another’s selling with junk rates. Non-uniform standards of credit rating for smaller and bigger economies can lead to an intensification of these irrational elements in the market’s pricing of government bonds.
Economies and countries, and especially economies and countries that follow pragmatic and practical economic policies as opposed to ideologically motivated and hidebound policies, are likely to be able to make the adjustments necessary to recover from recessions without inordinate delay. The United States is one case where intransigent lines of thinking make it difficult to reduce deficits without causing severe disruptions to the public’s welfare. The Greek plan, on the other hand, has displayed more flexibility and pragmatism and common-sense.
The information about the economy and the finances are public information. Each institutional investor and each individual investor that is interested in buying Greek or Portuguese or Irish government bonds can do its own research about the sustainability of the government’s public finances and the likely course of its taxation and spending trajectory and about the risk of default. How much importance should one attach to the ratings done by credit rating agencies ? Should institutional investors factor in these sovereign credit ratings while deciding whether or not to buy the bonds of a particular government ? It seems there is a lack of uniformity in the ratings being given by rating agencies like Fitch or S&P or Moody. Unnecessary scaremongering and unnecessary downward spirals set in motion in a country like Spain, for example, can easily lead to contagion effects for Europe, and thereafter for the world.
by C. Jayant Praharaj
For example, if the GDP of a country contracts by, say, 1% in a year in a recession, how much does the central government revenue contract ? And how much extra government expenditure becomes necessary due to additional unemployment benefits payments and bailouts ? Let me take some numbers from Greece. The “ Budget 2011 Draft Law “ document from the Hellenic Ministry of Finance website has the following figures. The nominal growth rate of GDP in 2009 was -1.1%. Or a 1.1% contraction, to put it differently. The deficit went from 22.4 billion Euros in 2008 to 36.2 billion Euros in 2009. In 2010, the nominal growth rate was -1.3%, that is, a contraction of 1.3%. The deficit went from 36.2 billion Euros in 2009 to 21.9 billion Euros in 2010. If one considers 2008 to 2011 as the crisis period, the document shows that the government debt went from about 110% of GDP to about 145% of GDP. The document outlines a plan whereby, with a combination of tax increases and spending decreases, the debt to GDP ratio will stabilize at around 150% of GDP. But these kinds of numbers are increasingly becoming commonplace. Japan’s debt to GDP ratio is around 200%. Its low tax and high infrastructure spending policies have not yielded good results. When one includes the stakes that the United States government has taken up in beleaguered entities, its debt obligations add up to more than 100% of GDP, and are likely to increase to 150% of GDP or even more by 2025. So, what is it about Greece that makes its bonds junk while Japan and the United States receive a less severe or no downgrading ? Japan and the United States have their own structural problems too. For example, the United States has a long-term structural problem of capital flight to China and other countries. India has a sluggish agricultural sector that poses serious human welfare challenges for the country. As for reliance on foreign capital inflows, it has been a recurrent feature of the United States economy also.
Portugal had GDP growth of 0% in 2008 and -2.6% in 2009. The government debt, which was around a stable 65% of GDP till 2008, increased to 76% of GDP in 2009 and 82% of GDP in 2010. I have not come across stabilization plans regarding Portugal, but once again, given the kind of debt-to-GDP ratio that some of the bigger economies are running, it is difficult to understand why fears of default are being raised about Portugal so quickly.
For Spain, the debt-to-GDP ratio increased from 40% in 2008 to 53% in 2009 to 60% in 2010. It is projected to be around 75% by 2016. Once again, it is going to be above EMU stipulations of good fiscal conduct, but to talk about default at these levels of debt-to-GDP may just be gratuitous scaremongering. It can set its own self-fulfilling prophecies in motion. In other words, if credit rating agencies give a more negative rating to a country’s bonds compared to other countries with worse macro-sheets, the country will find it more difficult to raise debt and has to pay exorbitant interest rates. Too much of gratuitous scaremongering can even constrain the government’s ability to borrow so much that it may have to resort to EFSF and IMF loans with strict conditions. Therefore, this kind of scaremongering by credit rating agencies is likely to set in motion spirals that can lead a country’s finances to ruination when it could have been stabilized more easily with a bit of belt-tightening and a pragmatic approach to taxation and spending.
In many ways, a government bond is like a stock when it comes to the psychology of market valuation. If everybody is buying it, the value can remain high despite weak fundamentals. Vague considerations having nothing to do with fundamentals can result in one government’s bonds selling with lower interest rates, but another’s selling with junk rates. Non-uniform standards of credit rating for smaller and bigger economies can lead to an intensification of these irrational elements in the market’s pricing of government bonds.
Economies and countries, and especially economies and countries that follow pragmatic and practical economic policies as opposed to ideologically motivated and hidebound policies, are likely to be able to make the adjustments necessary to recover from recessions without inordinate delay. The United States is one case where intransigent lines of thinking make it difficult to reduce deficits without causing severe disruptions to the public’s welfare. The Greek plan, on the other hand, has displayed more flexibility and pragmatism and common-sense.
The information about the economy and the finances are public information. Each institutional investor and each individual investor that is interested in buying Greek or Portuguese or Irish government bonds can do its own research about the sustainability of the government’s public finances and the likely course of its taxation and spending trajectory and about the risk of default. How much importance should one attach to the ratings done by credit rating agencies ? Should institutional investors factor in these sovereign credit ratings while deciding whether or not to buy the bonds of a particular government ? It seems there is a lack of uniformity in the ratings being given by rating agencies like Fitch or S&P or Moody. Unnecessary scaremongering and unnecessary downward spirals set in motion in a country like Spain, for example, can easily lead to contagion effects for Europe, and thereafter for the world.
by C. Jayant Praharaj
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