Econ principles explained in layman's terms

It's Always Sunny in the U.S. Economy (by the cast of It's Always Sunny in Philidelphia)

Watch this hilarious video to learn the basic principles of Econ. You will be more econ savvy for watching it. My favourite parts were about risk arbitrage!

Oil Economies and Dutch Disease - Is Abu Dhabi Handling it Right?

Abu Dhabi runs on oil revenue. The Emirate owns 8 percent of the world’s oil reserves which are approx. 98 billion barrels - and at the current drilling rate of 2.7 mbd, the reserves will last over 90 years. The economy is worth USD. 270 billion (AED 1 trillion, almost!) where approximately 58 percent of this money comes from the oil and gas sector. Little has been achieved in terms of diversifying away from oil and gas and diversification has largely occurred in sectors closely related to oil and gas, such as petrochemicals. The second largest contributor to GDP is the construction sector, which accounted for 10 percent of GDP in 2011, followed by the finance and real estate sectors, which made up approximately 8.5 percent of the GDP. These numbers paint a bleak picture for a state that wants to transition into a knowledge economy, diversifying away from oil and gas, by 2030.

This dependence on oil exposes Abu Dhabi to Dutch Disease. Dutch Disease is what happens when huge amounts of foreign currency (from oil reserves) flow into the economy and cause the local currency to appreciate, making other non-oil sectors less price competitive on the export market. It also allows cheap imports to enter the local market which negatively impact the industrialization of non-oil sectors as production moves to lower cost locations. So in a nutshell, oil rich countries are cursed in that they can never really diversify away from oil and gas!

However, to mitigate Dutch Disease, countries use a nominal exchange rate peg. In UAE, the dirham is pegged to the dollar at a fixed exchange rate. This is the case across the small oil-exporting states of the GCC, except Kuwait that uses a basket of currencies. A peg is used in order to contain an overvaluation of the local currency when oil money floods into the economy. However, the dollar peg is not without its drawbacks. When the price of oil rises, this creates or increases inflation in the local economy as wages and property prices go up (because the adjustment to the real exchange rate comes through adjustments in prices). A fall in oil prices causes deflation in the oil producing economies. Furthermore, the peg causes macroeconomic policies to be highly procyclical as the government’s spending decisions are dictated by oil prices; i.e. when the price of oil rises, government revenue increases, spending increases, inflation increases and interest rates fall, and the opposite happens with oil price falls.

A better defense against Dutch disease is adopting a conservative fiscal policy instead of a peg to control currency overvaluations. This is what Norway does, as well as what Abu Dhabi is doing right. Norway spends part of its oil money to build production sectors and invests the rest of it abroad through its ‘Pension Fund’ – the largest sovereign wealth fund in the world. Abu Dhabi Investment Authority, the second largest sovereign wealth fund has also invested heavily in assets abroad.

Abu Dhabi has also done several other things right. They have taken concrete steps to build capital in non-oil sectors; increased investments in social and physical infrastructure – with a conscious effort to overhaul the education system and encourage research and development in new sectors. The standard of living is pretty high with GDP per capita being among the highest in the world at above USD. 100,000; the physical infrastructure is consistently rated among the best in the world.  

See: Peterson Institute for International Economics, “The Case for Flexible Exchange Rates in Oil Exporting Economies”; Booz & Co, “Economic Diversification: The Road to Sustainable Development”; Economic Research Forum’s Working Paper Series, “Has the UAE escaped the Oil Curse?”

Congo Now

Haha! Loved this poster of Rosie the Riveter - totally apt!

Congo – an economy of blood minerals

I just finished reading Radio Congo by Ben Rawlence which piqued my interest in the Democratic Republic of Congo.  You don’t hear much about the country unless you actively seek out news and information about it.  The mainstream media almost never reports on it, even though the country has been through the most violent wars and grotesque human rights violations of modern time. So sadly, while most of us probably remember the Rwandan genocide of 1994, we are largely oblivious of the wars it triggered in neighboring Congo in 1996; the Second Congo War of 1998, also known as the Great African War because of the large scale involvement of African countries; and the violent outbreaks of conflict that continue to plague the country to this day.

There are political reasons, other than just a mere lack of interest, that this war is so underreported – the top being the illegal and unethical exploitation of Congo’s mineral resources, a business that is worth millions, if not billions, of dollars a day!   

Congo’s mineral wealth makes it the richest patch on earth.  It holds 80 percent of the world’s coltan reserves – which is used to produce high-end electronic goods and so will not run out of demand anytime soon; more than 60 percent of the world’s cobalt; and is the world’s largest supplier of high-grade copper. Other than that, gold, tin, zinc, diamonds are among the minerals mined there. Although war may have started because of ethnic antagonism, it has been perpetuated due to the mineral wealth of Congo, making the country a victim of the resource curse.

This is how the war economy is working.  The corrupt government headed by Kabila grants concessions to multinational firms to mine minerals in return for cuts and support against opposition groups in the country. Cuts make their way to the private coffers of the government. In areas where the government does not have a stronghold, these corporations are able to assert authority and exploit minerals by making alliances with rebel and militia groups, who use the small profits made in the partnership to buy weapons to threaten the local population and maintain their control.  The result of this is that around 80 percent of Congo’s mineral wealth is being smuggled out of the country to neighbouring countries, where it is then transported to Europe and the west.

So it is clear who the winners are in this conflict – and this is not to say that the Congolese government is without blame.  They have sold the future of their country very cheap. On the other hand, despite all the riches and resources their country holds, the people of Congo have not benefitted in the least. Per capita income is approximately 200 dollars, which is among the lowest in the world. Education and healthcare is almost non-existent. They only make cheap labour for the multinationals and warlords, often working for no wages, only the promise of food and shelter.

Backgroud

The modern conflict started with the end of the war in Rwanda when 1.2 million Hutu refugees and militia fled to Congo in fear of the newly instated Tutsi government. Mobuto, then president of Congo used the Hutus in his own ethnic war against the local Tutsi groups. Rwanda and Uganda, backed by the U.S., joined in to fight the aggression against Tutsis, arming guerilla and rebel groups against Mobuto.  Mobuto was overthrown and replaced by Laurent Kabila. Kabila didn’t want to continue serving the economic interests of Rwanda and Uganda and demanded the foreign forces to leave. Seeing their economic interests at risk, Rwanda and Uganda attacked the government in 1998 using local rebels and militia. Other African countries joined in to support Kabila, in what would become the Great War of Africa.  Although the war ended in 2002, it was impossible for the government and international organizations to disband the rebel groups that spread throughout eastern Congo. Just recently, fighting has broken out again between a local militia group M23, said to be backed by Rwanda and Uganda, and the Congolese army.  There is no telling how many more lives this renewed conflict will claim.

The Case for Big Government: 'Getting to Denmark'

Denmark’s economy is characterized by a high tax and spend regime, strong labor market policies, high income equality and close to equal wealth distribution. It makes a great case study for a successful social democracy where the state has actively intervened in the market to achieve low unemployment, high-income equality, and generous social services for all.

Denmark has long been a social democracy, both in terms of its government, and its social market economic model. The Social Democrats, vanguards of the welfare state, have ruled for the better part of the last half century, pointing to the fact that Danes do not want to part with their welfare state.

The argument against big government goes something like this – high taxes, large government transfer and services programs hurt the economy because they reduce the incentive to work hard, develop new skills, save or invest, or start a new business. Denmark’s overall tax-to GDP ratio was 47.7 percent in 2011, which is quite high compared to other wealthy countries (Eurostat news release April 2013), but GDP growth, per capita income and unemployment have all seen favourable growth over the past years. Currently, unemployment is 4.4 percent, much lower than many countries in Europe, and the U.S. The Danish model must have got something right.

Strong SME presence – Denmark’s economy is dominated by small and medium sized enterprises, albeit in low- and medium- tech industries such as food, textiles, and construction. However, Denmark is not without a stronghold in high-tech sectors such as renewable energy, engineering and pharmaceuticals. SME’s are known to drive growth and create jobs, which they successfully have in Denmark.

‘Flexicurity’ – The term refers to the flexibility in the Danish labour market brought about by major structural overhauls, which made labour mobile and employment protection minimal. But this is offset by the generous social security net.

A less harmful tax mix – High taxes have not hampered employment or growth in Denmark. This is because the main sources of tax revenue are consumption and income taxes, instead of social security taxes or corporate/ employer taxes. In 2007, consumption taxes totaled 16 percent of GDP in Denmark and 13 percent in Sweden, compared to just 5 percent in the U.S. In the same year, incomes taxes accounted for 14 percent of GDP in the U.S., versus 19 percent in Sweden and 29 percent in Denmark. Income tax rate is among the highest in the world in Denmark at 55.6 percent in 2013.

Supply-side versus demand-side economics – Denmark was able to introduce supply side structural reforms early on which improved the level and the quality of the production sector, particularly technology and human capital. It recognized that favourable industrial policies, labor market policies, education and training policies, and other structural policies are the key to sustainable progress. Denmark was among the first to deregulate its financial markets and liberalize capital movements, it introduced new technology polices and labour market overhauls and an array of industrial reforms – all accomplished by 1980s. What is remarkable about these reforms is that they did not weaken the welfare state model.

Aside

Although Denmark has not adopted the Euro, its exchange rate and monetary policy are linked to the EU. This gives Denmark little influence over the value of its currency – which is usually always stronger than the Euro and this in turn, makes Danish goods and services uncompetitive.

Stole this image from instagram (:s) to share my idea of the perfect wedding! Who needs all the ridiculous hullaballoo of a wedding when you are marrying the man you love - keep it simple and real.

Austerity versus Stimulus: The Right Question to Ask

The European Central Bank has announced its commitment to keeping interest rates low. This announcement comes following the criticism many European Union countries voiced against the European austerity measures and their failure to restore economic stability.

Europe adopted fiscal austerity as the path to recovery for its economy. The reason was that the debt-to-GDP ratios were too large in Europe, i.e. they were spending a lot more than their earnings, which is not sustainable. Therefore, in order to achieve lasting stability, budgets were to be balanced.  Also,  while stimulus would have made and kept Euro’s value low making its goods competitive, it would have also caused inflation which Germany feared.  Therefore, the European Union did not have many options but to adopt austerity. Europe set about raising taxes, where they were already back-breaking, but did not quite cut spending. 

On the other hand, despite a debt-to-GDP ratio of approximately 105 percent, the U.S. signed a huge stimulus bill and aggressively started pumping money into the economy (The stimulus of 2009-12 averaged over 6 percent of GDP annually – source: The Wall Street Journal). This unwavering commitment to an expansionary stance and aggressive quantitative easing policy even earned Ben Bernanke the nickname ‘Helicopter Ben’ for talking about using a ‘helicopter drop’ of money to fight a slowing economy.  However, just like EU did not go all the way with austerity, the U.S. also shied away from a full stimulus.  Deficit reduction efforts were taking place in parallel, although not as strongly as in Europe.

So, which has been a better response? Austerity measures have a contractionary effect on economies. Keynesian economists argue that during recessions, when the economy is already shrinking, stimulative polices such as increased government spending, tax cuts, lowering interest rates are a more appropriate response. The stimulus allowed the U.S. to experience faster growth than Europe, and keep unemployment levels well below Europe’s 12 percent (Youth unemployment is as high as 25 percent in Europe). Although the U.S.’s economy has fared better, both policy measures have had little success.

One argument I have come across, made by Charles Wolf Jr.,  is that the success of either policy depends on the response of the private sector. In both, the U.S. and Europe, the private sector did not respond positively to the policies and not much was done to mitigate the reasons for this response.  In the U.S., after 2009, private and household savings went up which offset the goal of the stimulus to increase aggregate demand. Private businesses were investing abroad instead of at home, which also did not help the stimulus.

Another argument is that neither policy was adopted fully and completely. Although on paper and in the media, Europe was on the path to austerity, government spending was actually rising (see chart below for government spending before and after the crisis). In the U.S. as well, many government spending programs were cut to control the deficit.  

 

(Source: Constantine Gourdiev’s research)

Latvia has been hailed as the poster child for adopting complete austerity – even though it is not a triumphant success. Being the hardest hit economy in EU in 2008/2009, during the two years that followed Latvia's government sacked 30 percent of public sector staff and cut salaries by 40 percent. New taxes were introduced and existing ones were raised. As a result, the economy registered positive growth as GDP grew by 5.5 percent and 4.5 percent in 2011 and 2012 respectively. This is all good, but only in relative terms. Latvia has not bounced back to pre-crisis growth levels, and unemployment is still quite high at 15 percent (source: cnbc.com).

In light of all this, a more poignant question to ask would be which sectors of the economy are being affected by stimulus and austerity measures. Both measures have merit, so long as intelligent cuts and spending decisions are made; i.e. cutting spending on over-sized and non-competitive sectors, such as defense and public administration, while increasing spending on education and infrastructure which can have a significant impact on recovery.

The beautiful Canadian countryside

The Nordic Economies - for Big Government

Since the recent financial crisis, the Nordic economies have been hailed as the panacea for the failure of capitalism in many circles of policy makers and economists. The Economist’s February issue featured the success of the Nordic economies, calling them the “The Next Supermodel”; WEF’s “The Nordic Way – Shared Norms for the New Reality” pointed to the strengths of their economic models – and it goes on.  They have been impervious to the financial crisis, enjoy high credit ratings from rating agencies and are considered havens in financial markets.

These economies include Sweden, Norway, Denmark and Finland. Despite a few differences in their economic models, they are characterized by heavy tax and spend, and high living standards. They have made phrases like “Getting to Denmark” and “Flexicurity” popular because of the reforms that modernized their welfare system, but nonetheless, kept their egalitarian principles intact.

Nordic states have high levels of public spending. In 2007, the average tax-to-GDP ratio was upward of 55 percent, with Norway’s as high as 59 percent, Denmark’s 56 percent, and Sweden’s 55 percent - a lot higher than the OECD average of 38.5 percent. Although this decreased slightly in 2011 according to OECD statistics to just below 50 percent, it was still a lot higher than U.S’s 25 percent and 33.8 percent in OECD.

The public sector is one of the largest employers in these states, accounting for 30 percent of the total employed, compared to the OECD average of 15 percent. Despite this, Nordic labour force is more competitive and productive than the average OECD worker as their labour productivity (measured as GDP per hour worked) is higher than the OECD average of $45.5 (Norway $83, Sweden $51.7, Denmark $53.5, and Finland $48.1).  Furthermore, the Nordic states surpass rest of Europe and OECD in economic activity rates. In 2011, 78.2 percent of Norway’s working age population was active; in Denmark, Finland, and Sweden, the rates were 79.46, 74 and 79.5 percent respectively – all higher than the OECD average of 70.6 percent and Europe’s average of 69.4 percent (source: OECD). This really drives the point home - despite having a welfare system that looks after the unemployed, the Nordics not only work more on the average compared to other OECD workers, but are also more productive!

Other indicators of economic performance such as annual consumption and GDP growth rates have also been better than the average performance of OECD countries (For details, read “Economic Lessons from Scandinavia” by Graeme Leach, Legatum Institute).

So how have the Nordic states defied economic theory which states that heavy taxation will retard growth and serve as a disincentive for people to work, save and invest. One answer is to look at the nature of their tax structure. Despite a high tax-to-GDP ratio, corporate taxes are relatively low compared to the U.S., Germany and some European economies.  Furthermore, the Nordic states are open economies that promote free trade, have little product market regulation and low levels of industry protection. They also have control over their own monetary policy which gives them freedom to respond to market failures, apart from Finland because it is part of EZ.  The private sector also plays a strong role and in many cases has stepped in to provide public sector services.

Another reason for their success is that the Nordic economies went through their financial crisis in the 1990’s and so knew better not to nose dive into another one! The crisis led them to introduce fiscal policy reforms and financial market regulations which resulted in the nationalization of banks, and the return to flexible exchange rates in 1992, as well as a host of other reforms. 

So if there was one reason for their success, it would have to be the balance that they have managed to achieve between the public and the private sectors by extending the market into the state rather than the state into the market.

Prelude to the 'Big Government' series

I have been wanting to write about the role of government in economic development, especially the question of if big government hampers or helps economic growth for quite some time now. Because I studied economics at school and have an interest in these topics, and given that the current state of economic conditions around the world has given rise to a lively discourse on the public economy, this question has never been more relevant.

I want to take a stab at addressing this in the blog series which I am calling ‘Big Government’. I intend to give examples of countries where big government has been extremely successful in increasing prosperity and growth, and then some where it has inhibited growth. For the former, the Nordic states, as well as Austria, and The Netherlands come to mind. While big government in Japan a few decades ago created a lot of inefficiencies and hampered growth.  

Although there is a lot of literature out there arguing that big government stunts economic growth – including a recent World Bank report (2012), and another study conducted by the European Central Bank called ‘Economic Performance and Government Size’ that made the same conclusion – I still believe in its virtues. But I am open to how my ‘Big Government’ series may change my opinion.

As an introduction to the series, I want to talk a bit about the economic role governments are expected to play in democratic countries in the private sector. Their role is to correct for “externalities” – i.e. rewarding the private sector for positive externalities in the form of tax cuts, or subsidies; and conversely, punishing the private sector for negative externalities in the form of taxes.  The revenue collected from taxes is then spent to increase the welfare of citizens.

 

For the purpose of this series, having a big government, therefore, primarily means having a welfare state; i.e. you allocate a substantial share of GDP to transfer programs that spend on safety nets and human investment. A big government does not mean a protectionist, freedom inhibiting, and welfare reducing government. You can have a state that spends a sizeable share of its GDP (according to some sources, this share is 15% or more) on social programs and still be an open and a growing economy - but just a more equitable economy. Over the last decade for instance, U.S. public social spending increased from less than 15% of GDP to almost 19.5% of GDP in 2012 (Source: OECD). The Nordic states have had the highest social spending rates in the world for decades without negatively impacting their growth or prosperity. This said, it is worth looking at some key socio-economic indicators to compare across welfare and ‘non-welfare’ states and see where the differences start to matter for policy planners and decision makers.

My first case study will be on the Nordic economies. Hurrah!

 

Leaving Places

Leaving places sucks, especially when you think of all the exciting things that might have happened if you had stayed just a bit longer, or explored more places, or taken advantage of the  opportunities that came along or spent more time with that special someone. It’s like going through a long list of “what might have been” – and that doesn’t get you anywhere!

Realizing that the window is now - potentially permanently - closed on these opportunities is a disheartening thought. But then you hope for another door to open for a slew of more exciting ones until you have to pack up again, likely at the most inopportune time, and move to your next pit stop.

Not knowing for how long this new place will be your home, or where your impulse or fate will take you next is a fear most people given to a nomadic lifestyle may have overcome. But for the rest of us, who build meaningful relationships, and create memories, and try to put down roots, all to start from scratch somewhere else, leaving places is actually quite hard and scary!

I have left places quite a lot – and I am doing that right now in a few hours as I write this blog, and will be leaving a very special place that I have called home for three years now in the very near future, and in all honesty, I am terrified as hell!  But the one thing leaving places affords you, is the chance to start afresh and do it better and wiser. If you can do that, leaving places and moving on is worth it!   

Muscat, Oman.