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Name ____Rajesh Kandibanda________________________________ Score: ___/16
Macroeconomics Final Exam
Due Monday July 2 by 6:00 pm
Please type your answers to multiple choice questions in the following table. For the short-answer questions, please type the answers in the spaces provided below each question. Save the file with the
name "aaa bbb – Final. doc", where aaa is your first name and bbb is your last name.
Submit the file by emailing it to [email protected].
Please include “Final Exam” in the subject line of your email.
Late submissions will lose all points for the problem set.
Answer Form for Multiple Choice Questions
Question: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Answer: E C A A A E B D C C A B B D E
Part A. Multiple Choice Questions: Choose only one, most satisfactory answer for each question (0.75 point each).
1. In mid-1997, there was a financial crisis in Thailand which raised the risk premiums of all East Asian countries. Indonesians knew that this effect would prevent their banks from borrowing abroad and would force them to default on their debts unless the Central Bank bailed them out. At the same time, Indonesians understood that their central bank was under pressure to print money and bail out the banks. For about a year (mid-1997 to mid-1998) the central bank resisted the pressure but eventually gave in as expected and printed large sums of money and gave them to banks in exchange for their bad debts. What impact the people's expectation during mid-1997 to mid-1998 (before the actual money supply increase) must have had on GDP and inflation in Indonesia?
a) The expectation must have increased GDP and lowered the inflation rate.b) The expectation must have increased both GDP and the inflation rate.c) The expectation could not have affected GDP or the inflation rate.d) The expectation must have left GDP unchanged, but raised the inflation rate. e) The expectation must have lowered GDP and raised the inflation rate.
2. In many developing countries fiscal deficits tend to rise during election years because
a) Elections are typically scheduled during economic slowdowns when tax revenues decline.b) The public wants high deficits and incumbent politicians concede to the demand only when
they face the challenges of reelections.c) Politicians are tempted to spend more and prop up employment and incomes to reduce the
number of disgruntled voters. d) All of the above.e) None of the above.
3. The Taiwanese GDP fell below production capacity 2008 and 2009 as a result of the world financial crisis that started in mid-2008. Taiwan's financial system was quite sound and the impact of the world crisis on its economy was mainly through reduced foreign demand for the Taiwanese exports. Which
Macroeconomics, Exam 3 1
one of the following macroeconomic policies could have helped raise Taiwan's income level towards production in those years?
a) An increase in government expenditure.b) An increase in money supply.c) An increase in the real value of Taiwan's currency.d) Any combination of expansionary fiscal and monetary policies. e) None of the above.
4. Some discretion in monetary policy is socially desirable because
a) there is a need to adjust policy according to specific situations when the range of possible circumstances is complex.
b) the ability of policymakers to change policies at will is necessary to make the political system responsive to the voters’ demands.
c) investment would always be higher if the public expects the central bank to deviate from its announced policies.
d) fiscal policy is discretionary and must be counterbalanced by discretion in monetary policy.e) all of the above.
5. East Asian economies experienced major financial and economic crises during 1997-1999 and reduced their demands for oil and other raw materials sharply. This acted as a favorable supply shock for the US economy. The US macroeconomic policies remained unchanged during those years. The supply shock must have
a) increased GDP and lowered the inflation rate in the US. b) increased both GDP and the inflation rate in the US.c) lowered GDP and raised the inflation rate in the US. d) left GDP and the inflation rate in the US unchanged.e) left GDP unchanged, but raised the inflation rate in the US.
6. This questions is based on the article, “Investment: Prudence without a purpose”, published by The Economist on May 26, 2012. (It can be viewed through UIUC Library Online Resources. For your convenience, these articles are copied below.) The article, offers a number of reasons why China may not be over-investing domestically. Which one of the following is not one of those reasons?
a) China’s domestic investment is less than its savings.b) China’s financial investment opportunities in other countries have had low returns.c) China has been accused of not spending enough.d) China’s capital stock per person is still very low.e) China has invested in buildings that are yet to find occupants.
7. Some have argued that like Soviet Union, China’s investment-driven growth will come to a halt before long. The above-mentioned article, “Investment: Prudence without a purpose”, rejects this claim because
a) China is good at marshaling inputs of capital and labor, though not at generating growth in output per input.
Macroeconomics, Exam 3 2
b) China’s total factor productivity growth has been the fastest in the world over the past decade.
c) Rather than being investment-driven, China’s growth is export-driven, which ensures continued growth.
d) China can continue to grow by investing in useless projects, thus keeping more scope to invest later.
8. This questions is based on the article, “Consumers: Dipping into the kitty”, published by The Economist on May 26, 2012. (It can be viewed through UIUC Library Online Resources. For your convenience, these articles are copied below.) The article argues that the consumption-income ratio is likely to rise in China because
a) people try to smooth their consumptions, so when income surged in 2000s, they saved a large part of it and now as income growth slows down, their consumption will not slow down as much.
b) learning to consume rapidly rising incomes takes time, and the Chinese are just learning to do so.
c) social spending is likely to rise as the government tries to expand social security and the safety net, thus crowding in private consumption.
d) All of the above.
9. According to the two articles mentioned above, “Investment: Prudence without a purpose” and “Consumers: Dipping into the kitty”, the government of China follows a number of policies that tend to raise the country’s savings rate. Which one of the following is not among those policies?
a) Chinese government caps interest rates on bank deposits to extract income from household depositors.
b) Chinese government induces banks to transfer the rents extracted from household depositors to large firm that are big savers.
c) Chinese government confiscates quarts of barley from the people, making them available as seed-corn instead.
d) Chinese government under-provides social security to the majority of the population, inducing them to save for themselves.
e) China’s household registration system keeps migrants unsettled and therefore unwilling to spend.
10. This question is based on the article, "Lessons of the 1930s" published by The Economist on December 10, 2011. It can be viewed through UIUC Library Online Resources. For your convenience, the article is copied below.
The article mentions a number of reasons why Great Depression became a much bigger disaster that it would otherwise have been. Based on the article, which one of the following factors is widely viewed by the economist as a key cause of the deepening of the Great Depression?
a) In the early 1930s, labor costs rose due to government intervention.b) In the early 1930s, the government’s regulatory burden on businesses more than doubled.c) In the early 1930s, fiscal and monetary policies became severely contractionary. d) In the early 1930s, fiscal and monetary authorities slashed taxes and interests rates.
Macroeconomics, Exam 3 3
e) In the early 1930s, various countries colluded over their exchange rate and trade policies.
11. According to the above-mentioned article, which one of the following may have contributed to the recovery of the US economy between 1933 and 1936?
a) Increased government spending. b) Roosevelt’s determination to get the budget balanced.c) Congress’s spending cuts. d) Congress’s tax increases. e) Doubling of the reserve requirements by the Fed.
12. According to the above-mentioned article, the evidence behind the claim that austerity could be expansionary, particularly if focused on spending cuts,
a) is quite strong and well corroborated.b) is questionable because it is based on misidentified austerity episodes. c) is strong if one takes account of contemporaneous macroeconomic changes in other countries.d) is corroborated by Britain’s economic growth following its fiscal consolidation in 2010.e) is questionable because it ignores the impact of changes in expectations about future tax
burdens.
13. According to the above-mentioned article, reliance on the gold standard for exchange rate determination in the early 1930s,
a) helped stabilize European economies and financial systems.b) contributed to destabilization of European economies and financial systems. c) had no impact on the stability of European economies and financial systems. d) had no similarity with the use of the euro system in Europe these days. e) freed central banks to expand the money supply and reflate their economies.
14. The trade policies that the governments followed after the collapse of the gold standard in the early 1930s have lessons for the ways in which the current economic crises around the world should be addressed. One of these lessons for the United States is that
a) the US should sanction any country that devalues its currency against the US dollar.b) the US should sanction any country that revalues its currency against the US dollar.c) the US should impose trade restrictions on imports from countries like China that manipulate
their currencies’ exchange rates.d) the US should coordinate its macroeconomic policies with other countries to avoid
competitive devaluations. e) the US should devalue its currency to expand its net exports and speed up its recovery
process.
15. Which one of the following is not a reason given in the above-mentioned article for why it has been easier to avoid an economic depression in the 2000s compared to the situation in the 1930s?
a) Nowadays, unemployment benefits reduce the decline in expenditure and act as an automatic stabilizer.
b) Nowadays, governments are less reluctant to spend and run deficits during recessions.
Macroeconomics, Exam 3 4
c) Nowadays, governments play much more extensive roles in national economies. d) Nowadays, few large economies are linked together through fixed exchange rates. e) Nowadays, tax rates are much lower, making it easier for the private sector to respond. f) Nowadays, there is a global leader that may be able to coordinate disaster response.g) Nowadays, international institutions are much stronger, and democracy is more firmly
entrenched.
Part B. Short-Answer and Algebraic Questions: (The numbers in square brackets give the breakdown of the points for various parts of each question. To receive full credit, please explain your answers.)
16. Some economists have argued that the fixed deficit and debt limits, such as those stipulated by the Maastricht Treaty, must be replaced by flexible ones that are delegated to an independent "Public Debt Board" that can be put in charge of managing fiscal policy aggregates. [For a survey of the debates concerning such institutions, see Xavier Debrun, David Hauner, and Manmohan S. Kumar, “Independent Fiscal Agencies,” Journal of Economic Surveys, Feb 2009, Vol. 23 Issue 1, p44-81. This article is attached to this assignment for your convenience.] The Debt Board can be fashioned after the model of the European Central Bank, which oversees the Union's monetary policy. Compare this alternative arrangement with the Maastricht Treaty rules and discuss their pros and cons. [1.25]
Maastricht criterion has fixed rules on fiscal debt and monetary policy whereas alternative arrangements like “Independent public debt board” are more flexible and advisory with the structure of FC (Financial council). The authors clearly elucidate the fact that there is a great degree of enforcement with the setting up independent and impartial agencies like the Debt board rather than merely enforcing Maastricht treaty which has rules like keeping the debt to 3% of GDP. Table 3 on page 71 clearly shows effectiveness (Positive correlation) of the FC’s and implementing fiscal targets by the governments. Countries that already have very restrictive fiscal rules generally are less inclined to setting up FC’s like the Public Debt board. The countries that tend to have less budgetary transparency tend to favor more active non-partisan bodies like the “Public Debt Board”. The FC model is more flexible and individual countries have their own non-partisan financial councils monitoring and providing advice however, Mastricht treaty simply mandates the rules on all the EU member states. EU’s member nations have different polictical climates, economic situation and very varying macro economic variables, hence strictly enforcing Maastricht does not address the issue of fiscal indiscipline and procycliclaity. Maastricht treaty was very difficult to be ratified among the European nations due to the complexity of the fiscal and geopolitical climate among the ratifying countries. It is merely trying to enforce a number while shelving the practical difficulties and sidelining the future fiscal opportunities. The FC’s don’t have a clear mandate and do not have complete discretion as they are merely advisory to the discretion of policy makers and what the political climate dictates. If the checks and balances are not strong there is a good chance the that FC is more likely to be ignored in the political process. Accountability at the FC’s like public debt board comes with the autonomy provided and the fiscal decentralization and separation of powers is necessary for FC’s performance. Conclusively, with various pro’s and con’s of the FC’s over mandates like Maastricht treaty, it is wise to say that FC’s like “Independent public Debt Board” have greater advantages over Mandates when dealing with a very diverse geopolitical and fiscal climate such as EU.
Macroeconomics, Exam 3 5
17. In an article on March 4, 2010, “Dealing with budget deficits: Who pays the bill?” The Economist argued that as a period of loose credit gives way to an era of austerity, the social cohesion of many nations will be put to the test. An accompanying article, “The Icesave referendum,” examines the consequences of not paying part of the public debt. Please answer the following questions based on the arguments and points made on the article. (These articles are copied below for your convenience. The original articles can be viewed through the UIUC Library website.)
(a) Many countries have difficulty reducing their budget deficits even when such reductions are in the collective interest of the people living in the country. What are the main reasons? [1]
It’s difficult to reduce budget deficit due to several reasons. First of all, if the economy is not doing well than the government is willing to spend more i.e. willing to run a larger deficit in order to generate growth / prevent recession. Also, increasing taxes affects the long term growth prospects even if economy is doing well.
Secondly, deficit can be reduced by several ways- increasing taxes, cutting down the benefits to welfare recipients (state pensioners and/or public health system recipients), issuing government bonds, making foreign investors pay etc. Government is likely to face opposition by the people who pay for it like - union workers or tax payers.
(b) What are the immediate solutions to the deficit reduction problem? [1]
The government needs to be more accurate in its accounting figures for the total debt and making those figures public. That is likely to help with the public acceptance of measures that will be taken to reduce deficit.
Economic growth is another solution. If economy is growing that would automatically translate to increased tax revenue for the government and reduced welfare payments by the government in form of unemployment benefits etc. Hence government should pursue policies that will encourage long term growth of the economy such as lower tax rate, flexible labor market etc.
Macroeconomics, Exam 3 6
(c) Walking away from the public debt is one way to deal with large accumulated debts that are hard to repay. What are the ramifications of this solution? [0.5]
If the government walks away from public debt than its credit rating would be lowered, increasing the interest rate for future borrowing. Government will also find it very hard to borrow money for its expenditures. This would also mean that the public sector employees or welfare recipients may not get paid causing social unrest.
It would also discourage foreign investors from investing in the country which would affect future economic growth.
(d) Inflation is viewed as another solution. How can this be done? What would happen to the IS and LM curves under this solution? Would income remain below production capacity or rise above it, at least for while, if this solution is used? Why is this option tempting? What are the dangers of opting for this solution? [1]
Inflation is defined as rate of growth of money supply minus rate of growth of aggregate real output or capacity growth-
π = m y
Government can generate inflation by rapidly increasing money supply using monetary policies such that money supply growth rate is higher than capacity growth rate causing excess demand or capacity shortage. In the short run this would cause LM curve to rotate downwards. The income would temporarily rise above the production capacity.
But in the long run the inflation would rise and LM curve would rotate leftwards towards actual production capacity and income would reduce.
This is a tempting option because of the following reason-
Real interest rate- r = (1+i)/(1+) 1
Based on the above equation the higher inflation () would actually reduce real value of debt or could even reduce the value of the principal of a loan if inflation is high enough.
However, there are dangers of this solution. First of creditors may increase the borrowing cost due to higher inflation. Secondly, if money supply is increased too much the to raise the demand, the prices will rise too fast causing hyper inflation leading to major economic instability and crisis.
Macroeconomics, Exam 3 7
Special report: China's economy
Investment
Prudence without a purpose
Misinvestment is a bigger problem than overinvestment
May 26th 2012 | from the print edition
China’s answer to Dubai
GENGHIS KHAN SQUARE in Kangbashi, a new city in the northern province of Inner Mongolia,
is as big as Tiananmen Square in Beijing. But unlike Tiananmen Square, it has only one
woman to sweep it. It takes her six hours, she says, though longer after the sandstorms that
sweep in from the Gobi desert. Kangbashi, or “new Ordos”, as it is known, is easy to clean
because it is all but empty. China’s most famous “ghost city”, it has attracted a lot of
journalists eager to illustrate China’s overinvestment, but not many residents.
Ordos was one of the prime exhibits in an infamous presentation by Jim Chanos, a well-
known short-seller, at the London School of Economics in January 2010. Mr Chanos argued
that China’s growth was predicated on an unsustainable mobilisation of capital—investment
that provides only for further investment. China, he quipped, was “Dubai times 1,000”.
His tongue-in-cheek reference to the bling-swept, debt-drenched emirate caused a stir. But
not everywhere in China shrinks from the comparison. One property development that
actively courts it is Phoenix Island, off the coast of tropical Sanya, China’s southernmost city.
It is a largely man-made islet, much like Dubai’s Palm Jumeirah. Its centrepiece will be a
Macroeconomics, Exam 3 8
curvaceous seven-star hotel, rather like Dubai’s Burj Al Arab, only shaped like a wishbone
not a sail. The five pod-like buildings already up resemble the unopened buds of some
strange flower. Coated in light-emitting diodes, they erupt into a lightshow at night,
featuring adverts for Chanel and Louis Vuitton.
After a visit to Ordos or Sanya, it is tempting to agree with Mr Chanos that China has
overinvested from its northern steppe to its southern shores. But what exactly does it mean
for a country to “overinvest”? One clear sign would be investment that was running well
ahead of saving, requiring heavy foreign borrowing and buying. The result could be a
currency crisis, like the Asian financial crisis of 1997-98. Some veterans of that episode
worry about China’s reckless investment in tasteless property. But although China invests
more of its GDP than those crisis-struck economies ever did, it also saves far more. It is a net
exporter of capital, as its controversial current-account surplus attests. Indeed, for every
critic bashing China for reckless investment spending there is another accusing it of
depressing world demand through excessive thrift. China is in the odd position of being cast
as both miser and wanton.
Even an extravagance like Kangbashi is best understood as an attempt to soak up saving.
The Ordos prefecture, to which it belongs, is home to a sixth of China’s coal reserves and a
third of its natural gas (not to mention its rare earths and soft goat’s wool). According to
Ting Lu of Bank of America Merrill Lynch, Kangbashi is an attempt to prevent Ordos’s
commodity earnings from disappearing to other parts of the country.
China as a whole saved an extraordinary 51% of its GDP last year. Until China’s investment
rate exceeds that share, there is no cause for concern, says Qu Hongbin of HSBC. Anything
China fails to invest at home must be invested overseas. “The most wasteful investment
China now has is US Treasuries,” he adds.
When talking about thrift, economists sometimes draw on a parable of prudence written
three centuries ago by Daniel Defoe. In that novel the resourceful Robinson Crusoe,
shipwrecked on a remote island, saves and replants four quarts of barley. The reward for his
thrift is a harvest of 80 quarts, a return of 1,900%.
Castaway capital
Investment is made out of saving, which requires consumption to be deferred. The returns to
investment must be set against the disadvantage of having to wait. In Robinson Crusoe, the
saving and the investing are both done by the same Englishman, alone on his island. In a
more complicated economy, households must save so that entrepreneurs can invest. In
most economies their saving is voluntary, but China has found ways of imposing the
patience its high investment rate requires.
Michael Pettis of Guanghua School of Management at Peking University argues that the
Chinese government suppresses consumption in favour of producers, many of them state-
owned. It keeps the currency undervalued, which makes imports expensive and exports
cheap, thereby discouraging the consumption of foreign goods and encouraging production
for foreign customers. It caps interest rates on bank deposits, depriving households of
Macroeconomics, Exam 3 9
interest income and transferring it to corporate borrowers. And because some of China’s
markets remain largely sheltered from competition, a few incumbent firms can extract high
prices and reinvest the profits. The government has, in effect, confiscated quarts of barley
from the people who might want to eat them, making them available as seedcorn instead.
What has China got in return? Investment, unlike consumption, is cumulative; it leaves
behind a stock of machinery, buildings and infrastructure. If China’s capital stock were
already too big for its needs, further thrift would indeed be pointless. In fact, though, the
country’s overall capital stock is still small relative to its population and medium-sized
relative to its economy. In 2010, its capital stock per person was only 7% of America’s
(converted at market exchange rates), according to Andrew Batson and Janet Zhang of GK
Dragonomics, a consultancy in Beijing. Even measured at purchasing-power parity, China
has only about a fifth of America’s capital stock per person, depending on how its PPP rate is
calculated.
Boom, boom
China needs to “produce lots more of almost everything”, argues Scott Sumner of Bentley
University, even if it does not produce “everything in the right order”. Its furious
homebuilding, for example, has unnerved the government and cast a shadow over its banks,
which worry about defaults on property loans. But it still needs more places for people to
live. In 2010 it had 140m-150m urban homes, according to Rosealea Yao of GK
Dragonomics, 85m short of the number of urban households. About three-quarters of
China’s migrant workers are squeezed into rented housing or dormitories provided by their
employer.
Nor is China’s capital stock conspicuously large relative to the size of its economy. It
amounted to about 2.5 times China’s GDP in 2008, according to the APO. That was the same
Macroeconomics, Exam 3 10
as America’s figure and much lower than Japan’s. Thanks to China’s stimulus-driven
investment spree, the ratio increased to 2.9 in 2010, but that still does not look wildly out of
line.
Malinvestors of great wealth
In Defoe’s tale, Robinson Crusoe spends five months making a canoe for himself, felling a
cedar-tree, paring away its branches and chiselling out its innards. Only after this
“inexpressible labour” does he find that the canoe is too heavy to be pushed the 100 yards
to the shore. That is not an example of overinvestment (Crusoe did need a canoe), but
“malinvestment”. Crusoe devoted his energy to the wrong enterprise in the wrong place.
It is surprisingly hard to show that China has overinvested, but easier to show that it has
invested unwisely. Of China’s misguided canoe-builders, two are worth singling out: its local
governments (see article) and its state-owned enterprises (SOEs).
China’s SOEs endured a dramatic downsizing and restructuring in the 1990s. Thousands of
them were allowed to go bankrupt, yet those that survived this cull remain a prominent
feature of Chinese capitalism. Even in the retail, wholesale and restaurant businesses there
are over 20,000 of them, according to Zhang Wenkui of China’s Development Research
Centre.
SOEs are responsible for about 35% of the fixed-asset investments made by Chinese firms.
They can invest so much because they have become immensely profitable. The 120 or so
big enterprises owned by the central government last year earned net profits of 917 billion
yuan ($142 billion), according to their supervisor, the State-owned Assets Supervision and
Administration Commission (SASAC). It cites their profitability as evidence of their efficiency.
But even now, returns on equity among SOEs are substantially lower than among private
firms. Nor do SOEs really “earn” their returns. The markets they occupy tend to be
uncompetitive, as the OECD has shown, and their inputs of land, energy and credit are
artificially cheap. Researchers at Unirule, a Beijing think-tank, have shown that the SOEs’
profits from 2001 to 2008 would have turned into big losses had they paid the market rate
for their loans and land.
Even if the SOEs deserved their large profits, they would not be able to reinvest them if they
paid proper dividends to their shareholders, principally the state. Since a 2007 reform,
dividends have increased to 5-15% of profits, depending on the industry. But in other
countries state enterprises typically pay out half, according to the World Bank. Moreover,
SOE dividends are not handed over to the finance ministry to spend as it sees fit but paid
into a special budget reserved for financing state enterprises. SOE dividends, in other words,
are divided among SOEs.
The wrong sort of investment
Loren Brandt and Zhu Xiaodong of the University of Toronto argue that China’s worst
imbalance is not between investment and consumption but between SOE investment and
private investment. According to their calculations, if state capitalists had not enjoyed
Macroeconomics, Exam 3 11
privileged access to capital, China could have achieved the same growth between 1978 and
2007 with an investment rate of only 21% of GDP, about half its actual rate. A similar
conclusion was reached by David Dollar, now at America’s Treasury, and Shang-Jin Wei of
Columbia Business School. They reckon that two-thirds of the capital employed by the SOEs
should have been invested by private firms instead. Karl Marx made his case for collective
ownership of the means of production in “Das Kapital”. Messrs Dollar and Wei called their
riposte “Das (Wasted) Kapital”.
Perhaps the best that can be said of China’s SOEs is that they give the country’s ruling party
a direct stake in the economy’s prosperity. Li-Wen Lin and Curtis Milhaupt of Columbia
University argue that the networks linking the party to the SOEs, and the SOEs to each
other, help to forge an “encompassing” coalition, a concept they draw from Mancur Olson, a
political scientist. The members of such a coalition “own so much of the society that they
have an important incentive to be actively concerned about how productive it is”. China’s
rulers not only own large swathes of industry, they have also installed their sons and
daughters in senior positions at the big firms.
The SOEs provide some reassurance that the government will remain committed to
economic growth, according to Mr Milhaupt and another co-author, Ronald Gilson. The party
officials embedded in them are like “hostages” to economic fortune, “the children of the
monarch placed in the hands of those who need to rely upon the monarch”. That gives
private entrepreneurs confidence, because the growth thus guaranteed will eventually
benefit them as well—although they will have to work harder for their rewards.
What are the implications of China’s malinvestment for its economic progress? At its worst,
China’s growth model adds insult to injury. It suppresses consumption and forces saving,
then misinvests the proceeds in speculative assets or excess capacity. It is as if Crusoe were
forced to scatter more than half his barley on the soil, then leave part of the harvest to rot.
The rot may not become apparent at once. Goods for which there is no demand at home can
be sold abroad. And surplus plant and machinery can be kept busy making capital goods for
another round of investment that will only add to the problem. But when the building dust
settles, a number of consequences become clear. First, consumption is lower than it could
be, because of the extra saving. GDP, properly measured, is also lower than it appears,
because so much of it is investment, and some of that investment is ultimately valueless. It
follows that the capital stock, properly measured, is also smaller than it seems, because a
lot of it is rotten. That would make for a very different kind of island parable, a tale of
needless austerity and squandered effort.
Fortunately there is another side to China’s story. It has not only accumulated physical
capital but also acquired more know-how, better technology and cleverer techniques. That is
why foreign multinationals in the country rely on local suppliers—and also why they fear
local rivals. A Chinese motorbike-maker studied by John Strauss of the University of
Southern California and his co-authors started out producing the metal casings for exhaust
pipes. Then it learnt how to make the whole pipe. Next it mastered the pistons. Eventually it
made the entire bike.
Macroeconomics, Exam 3 12
China “bears” like Mr Chanos sometimes neglect this side of the country’s progress. In his
2010 presentation he compared China to the Soviet Union, another empire in the east that
enjoyed a stretch of beguiling economic growth. Like the Soviet command economy, China
is good at marshalling inputs of capital and labour, he pointed out, but China has failed to
generate growth in output per input, just as the Soviet Union failed before it. Yet this
analogy with the Soviet Union is preposterous.
Economists refer to a rise in output per input of capital and labour as a gain in “total factor
productivity”. Such gains have many sources. One textile boss got 20% more out of his
seamstresses by playing background music in his factory, recalls Arnold Harberger of the
University of California at Los Angeles. The striking thing about the growth in China’s total
factor productivity is not its absence but its speed: the fastest in the world over the past
decade. Between 2000 and 2008 it contributed 43% of the country’s economic growth,
according to the APO. That is just as big a contribution as the brute accumulation of capital,
which accounted for 44% (excluding information technology). Thus even if some of China’s
recent investment has in fact been wasted, China’s progress cannot be written off.
And even if some of China’s past investment has been futile, adding nothing worthwhile to
the capital stock, there is a consolation: it will leave more scope to invest later, suggesting
that the country’s potential for growth is even larger than the optimists think. The right kind
of investment can still generate high returns. But what if the mistaken investments of the
past disrupt the financial system, preventing resources from being deployed more
effectively in the future?
Macroeconomics, Exam 3 13
Special report: China's economy
Consumers
Dipping into the kitty
Chinese consumption is about much more than shopping
May 26th 2012 | from the print edition
An
important source of demand
ZHANG GUIDONG GREW up on a farm in Anhui, a poor inland province, where China’s
economic reforms made a humble beginning. He left home for Beijing in 1995 with only a
few years’ schooling. First he sold belts and lighters in Tiananmen Square. When that was
banned, he joined some friends from back home in Beijing’s Silk Market, where he sold
vegetables and silk items to the staff of the embassies nearby.
The Silk Market is famous for selling brand-name goods at suspiciously low prices, often to
tourists who seem to enjoy the combination of rip-offs and knock-offs. Fined many times for
selling fakes, Mr Zhang eventually decided to change his strategy. He sought a licence to
sell genuine goods under the brand “Hello Kitty”. A white bobtailed cat that first appeared
on a purse in the 1970s, Kitty now counts as Asia’s answer to Mickey Mouse.
The brand’s guardians were initially worried by all the fakes on sale in the market, but in the
end they were persuaded that the place was trying to clean itself up. Mr Zhang’s business is
now doing well. In March he was set to move from his old ten-square-metre stall on the
Macroeconomics, Exam 3 14
ground floor to a 15-square-metre spot on the third floor, where the market is grouping its
more reputable outlets. Most of the other stallholders are also from the countryside, Mr
Zhang notes. “I never dreamt that I could one day have a life like this.”
Most people think of China as an industrial powerhouse, not a consumer’s paradise.
Household consumption as a percentage of GDP fell for ten years in a row from 2001. By the
end of that decade it amounted to only 34% of GDP, about 19 points below Japan’s lowest
post-war ratio and 15 points below South Korea’s. America’s consumption did not dip far
below 50% of GDP even during the second world war, as Mr Lardy of the Peterson Institute
for International Economics points out in his book, “Sustaining China’s Economic Growth”.
But this declining ratio is deceptive. Consumption in China has actually been growing faster
than in any other big country. It is just that China’s GDP has been growing even more
rapidly.
Consumption always lags income, both on the way up and on the way down, argue Carl
Bonham of the University of Hawaii at Manoa and Calla Wiemer of the University of Southern
California. This is partly because people choose to “smooth” their consumption over time,
but also because people generally hesitate to abandon a lifestyle to which they have grown
accustomed. Although China’s output and income surged after 2000, its consumption habits
have yet to catch up.
Bootstrap businessmen from the boondocks do not always know what to do with their
newfound wealth, according to research by Jacqueline Elfick, a cultural anthropologist. One
couple, newly arrived in Shenzhen, lined their entire flat with bathroom tiles. Another
complained that their bathroom windows lacked the blue translucent glass found in rural
toilet blocks. A homebuyer who had never previously lived in anything bigger than a two-
room flat took a residence with six rooms, filling four of them with dining suites.
But consumer habits are evolving. In Shenzhen, notes Ms Elfick, the constant churn of the
population and relative absence of established hierarchies means “you are what you buy.”
The new rich announce themselves by spending profusely. They favour “heavy ornate
furniture in faux Baroque”. In Sanya, an advert for one luxury residence shows a painting of
Napoleon crossing the Alps hanging on the wall as a woman in a low-backed evening dress
lingers by the window.
But there is also a growing class of discerning customers who look down on ostentation.
They pride themselves on their appreciation of wine, tea and coffee. In Beijing the TV
screens that now pop up in taxis teach passengers how to judge a wine’s intensity and why
they should not overfill their glass. “Knowledge of how to consume has in itself become a
commodity,” Ms Elfick writes.
Just as consumption failed to grow as quickly as incomes over the past decade, it will fail to
slow as quickly over the decade to come. As China’s growth eases from 10% a year to
something closer to 7% during this decade, consumption will rise naturally as a share of
GDP.
Macroeconomics, Exam 3 15
Some economists think it has already begun to do so. Yiping Huang of Barclays Capital says
the official statistics fail to reflect a surge in consumer spending since 2008. They are
particularly bad at capturing extra spending on accommodation, such as rent payments by
tenants or the benefits enjoyed by owner-occupiers.
One proxy for consumer spending is retail sales, which have grown much faster than GDP in
recent years. Unfortunately, these statistics are no better at capturing expenditure on
accommodation. And in China they include many things other than household consumption,
such as government purchases and trade in industrial products like basic chemicals. But
even when those items are stripped out, Mr Huang shows, sales are rising fast.
He thinks that the level of expenditure as well as its growth may be understated. Despite
the conspicuous consumption, a lot of income and spending is hidden from the prying eyes
of taxmen and statisticians. The best effort to throw light on this shadow income is a study
by Wang Xialou of the National Economic Research Institute at the China Reform
Foundation. His team asked about 4,000 of their friends how much they earned and spent.
The answers they got were more candid, though also less representative, than official
surveys. After doing some statistical tricks to eliminate the bias, Mr Wang calculated that
the disposable income of China’s households was 9.3 trillion yuan ($1.4 trillion) higher than
the official 2008 figure of 14 trillion yuan. Drawing on this work, Mr Huang thinks that private
consumption may have accounted for 41% of GDP in 2010, about seven points higher than
the official figure (see chart 6).
Mr Huang’s calculations do not convince everybody, and even if they are right, they have
disturbing implications. Hidden income disproportionately benefits the better-off: the richest
10% of urban households take home over 60% of it. That might help explain why China is
now the world’s largest market for luxury goods, according to one estimate. If that hidden
income is counted, the top tenth of urban families are about 26 times better off than the
bottom tenth, not just nine times, as the official figures suggest. These figures make China’s
economic imbalances look better but its social inequities far worse.
Macroeconomics, Exam 3 16
However, there is another important source of final demand that is often neglected: the
government. Its consumption spending (on health care, education, subsidised rent and so
on) as a share of GDP has been growing since 2009, but it remains inadequate and uneven.
The patchwork state
China has greatly broadened its rural pension scheme, which collected contributions from
140m people in 2011, compared with under 80m a year before. But even now it reaches
only about 30% of the eligible population. The government has also expanded the coverage
of health insurance, bringing 95% of the population into the net, according to the OECD.
Patients now pay directly for only 35% of China’s total health spending, compared with well
over 60% ten years ago. But progress has not been uniform. China has one scheme for
urban workers, another for non-workers and a third for rural folk, each administered by
separate city or county governments. The contributions required and benefits provided differ
a lot between the three schemes. According to the OECD, the rural scheme pays out an
average of only $16 per person per year and covers only 41% of the cost of in-patient care.
In social as in economic policy, the government prefers local experimentation and piecemeal
expansion. That works well for economic reforms, but in social policy it fails to pool risk
efficiently. And the safety net is thin as well as patchy. This keeps down its cost to the
exchequer but leaves the population exposed to dangers such as debilitating illness or job
loss. Health benefits, for example, are capped, leaving patients uncovered for the worst
crises. And China’s hospital-centric health-care system provides only one general
practitioner for every 22,000 people.
Older Chinese grew up in a society where many of their consumption choices were dictated
by the state or by their workplace. They ate in state canteens and slept in state-provided
dormitories or flats. It was a grinding, tedious existence. But in discarding the “iron rice
bowl”, the Chinese state failed to provide alternatives, including health care and minimum
pensions. According to the World Bank, China spends only 5.7% of its GDP on these items
and other forms of social protection, such as payments to support the very poor. Other
countries in the same income category as China spend more than twice as much, an
average of 12.3%.
More social spending of the right kind would not crowd out private consumption. On the
contrary, it would encourage it. The patchiness of China’s safety net is one reason why
households save so much of their incomes. According to Emanuele Baldacci and other
economists at the IMF, a sustained rise in public spending by 1% of GDP, spread evenly
across health, education and pensions, would increase the ratio of household consumption
to GDP by 1.25 percentage points. The IMF’s Steven Barnett and Ray Brooks calculate that in
urban areas every extra yuan the government spends on health prompts an extra two yuan
of consumer spending.
Can China afford to spend so freely? In one sense, it cannot afford not to. If investment were
to falter and private consumption failed to compensate, China would be left with a big hole
in demand, jeopardising employment and growth. If the investment rate were to drop back
Macroeconomics, Exam 3 17
to its 2007 level, for example, the demand shortfall would run to over 6% of GDP. To make
up for that, the government would have to spend about 3.4 trillion yuan this year, or face
widespread joblessness. That is a substantial amount. With only a sixth of that sum, the
government could raise the incomes of all of China’s poor to the equivalent of $2 a day,
according to calculations by Dwight Perkins of Harvard. The point of such a thought
experiment is to demonstrate that China has enormous productive powers to mobilise, and
has to spend a lot to mobilise them fully.
There is another obvious measure, peculiar to China, that would lift consumer spending.
That is the earliest possible repeal of the country’s household registration system, or hukou,
which limits the access of rural migrants to public services in the cities where they work and
live. This keeps migrants unsettled and therefore unwilling to spend. Migrants without an
urban hukou spend 30% less than otherwise similar urban residents, according to research
by Binkai Chen of the Central University of Finance and Economics, Ming Lu of Fudan
University and Ninghua Zhong of Hong Kong University of Science and Technology.
Mr Zhang, the Silk Market trader, is a good example of the system’s iniquity. He arrived in
Beijing 17 years ago. He has a house, a son, a business and even a licence from Hello Kitty.
But he still does not have a Beijing hukou.
Macroeconomics, Exam 3 18
Lessons of the 1930s
There could be trouble ahead
In 2008 the world dodged a second Depression by avoiding the mistakes that led
to the first. But there are further lessons to be learned for both Europe and
America
Dec 10th 2011 | from the print edition
“YOU’RE right, we did it,” Ben Bernanke told Milton Friedman in a speech celebrating the
Nobel laureate’s 90th birthday in 2002. He was referring to Mr Friedman’s conclusion that
central bankers were responsible for much of the suffering in the Depression. “But thanks to
you,” the future chairman of the Federal Reserve continued, “we won’t do it again.” Nine
years later Mr Bernanke’s peers are congratulating themselves for delivering on that
promise. “We prevented a Great Depression,” the Bank of England’s governor, Mervyn King,
told the Daily Telegraph in March this year.
The shock that hit the world economy in 2008 was on a par with that which launched the
Depression. In the 12 months following the economic peak in 2008, industrial production fell
by as much as it did in the first year of the Depression. Equity prices and global trade fell
more. Yet this time no depression followed. Although world industrial output dropped by
13% from peak to trough in what was definitely a deep recession, it fell by nearly 40% in the
1930s. American and European unemployment rates rose to barely more than 10% in the
Macroeconomics, Exam 3 19
recent crisis; they are estimated to have topped 25% in the 1930s. This remarkable
difference in outcomes owes a lot to lessons learned from the Depression.
Debate continues as to what made the Depression so long and deep. Some economists
emphasise structural factors such as labour costs. Amity Shlaes, an economic historian,
argues that “government intervention helped make the Depression Great.” She notes that
President Franklin Roosevelt criminalised farmers who sold chickens too cheaply and
“generated more paper than the entire legislative output of the federal government since
1789”. Her book, “The Forgotten Man”, is hugely influential among America’s Republicans.
Newt Gingrich loves it.
A more common view among economists, however, is that the simultaneous tightening of
fiscal and monetary policy turned a tough situation into an awful one. Governments made no
such mistake this time round. Where leaders slashed budgets and central banks raised rates
in the 1930s, policy was almost uniformly expansionary after the crash of 2008. Where
international co-operation fell apart during the Depression, leading to currency wars and
protectionism, leaders hung together in 2008 and 2009. Sir Mervyn has a point.
Look closer, however, and the picture is less comforting. For in two important—and related—
areas, the rich world could still make mistakes that were also made in the 1930s. It risks
repeating the fiscal tightening that produced America’s “recession within a depression” of
1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late
1920s and early 1930s, in which economies fell like dominoes under pressure from austerity,
tight money and the lack of a lender of last resort. There are, in short, further lessons to be
learned.
Riding for a fall
It was far easier to stimulate the economy in the 2000s than in the 1930s. Social safety nets
—introduced in the aftermath of the Depression—mean that today’s unemployed have
money to spend, providing a cushion against recession without any active intervention.
States are more relaxed about running deficits, and control much larger shares of national
economies. The package of public works, spending and tax cuts that President Herbert
Hoover introduced after the crash of 1929 amounted to less than 0.5% of GDP. President
Barack Obama’s stimulus plan, by contrast, was equivalent to 2-3% of GDP in both 2009 and
2010. Hoover’s entire budget covered only about 2.5% of GDP; Mr Obama’s takes 25% of
GDP and runs a deficit of 10%.
Roosevelt raised spending to 10.7% of output in 1934, by which point the American
economy was growing strongly. By 1936 inflation-adjusted GDP was back to 1929 levels. Just
how much the New Deal spending helped the recovery is still debated. Some economists,
such as John Cochrane of the University of Chicago and Robert Barro of Harvard, say not at
all. Fiscal measures never work, they say.
Those who think that fiscal measures do work nonetheless tend to believe that, in the 1930s,
spending was less important than monetary policy, which they see as the prime cause of
suffering. In a paper in 1989 Mr Bernanke and Martin Parkinson, now the top civil servant in
Macroeconomics, Exam 3 20
Australia’s finance ministry, wrote that rather than providing recovery itself “the New Deal is
better characterised as having ‘cleared the way’ for a natural recovery.” Others, such as
Paul Krugman, would ascribe a more positive role to stimulus spending.
Whatever relative importance is assigned to monetary and fiscal policy, though, there is
little doubt that their simultaneous tightening five years into the Depression led to a vicious
relapse. Spurred by his treasury secretary, Henry Morgenthau—who worried in 1935 that
“we cannot help but be riding for a fall unless we continue to decrease our deficit each year
and the budget is balanced”—Roosevelt urged fiscal restraint on Congress in 1937.
By that point the national debt had reached an unheard of 40% of GDP (huge by the
standards of the day, but half what Germany’s debt is now). Congress cut spending,
increased taxes and wiped out a deficit of 5.5% of GDP between 1936 and 1938. That was a
larger consolidation than Greece now faces over two years (see chart 1), but is much smaller
than what is planned for it in the longer term. At the same time the Federal Reserve doubled
reserve requirements between mid-1936 and mid-1937, encouraging banks to pull money
out of the economy. The Treasury began to restrict the money supply in step with the level
of gold imports. In 1937 and 1938, the recession within a depression brought a drop in real
GDP of 11% and an additional four percentage points of unemployment, which peaked at
13% or 19%, depending on how you count it.
The Snowdens of yesteryear
Today’s monetary policy hasn’t turned contractionary, as America’s did in the 1930s. As The
Economist went to press, the European Central Bank (ECB) was expected to announce a
further reduction in interest rates. But in many places fiscal policy is moving rapidly in that
direction. Mr Obama’s stimulus is winding down; state- and local-government cuts continue.
Republican candidates for the presidency echo the arguments of Mr Morgenthau, claiming
that deficit-financed stimulus spending has done little but add to the obligations of future
taxpayers. Mr Obama, like Roosevelt, has started to stress the need for budget-cutting. If
Macroeconomics, Exam 3 21
the current payroll-tax cut and emergency unemployment benefits were to lapse, growth
over the next year would be reduced by around one percentage point of GDP.
America is not alone. Under David Cameron, Britain’s hugely indebted government
introduced a harsh programme of fiscal consolidation in 2010 to avert a loss of confidence in
its creditworthiness. The rationale was similar to that for chancellor Philip Snowden’s
emergency austerity budget of 1931, with its tax rises and spending cuts. On that occasion
confidence was not restored, and Britain was forced to devalue the pound and abandon the
gold standard. On this occasion the measures have indeed boosted investor confidence, and
thus bond yields; that the country still faces a second recession is in large part due to the
euro zone’s woes. That said, the possibility of such shocks should always be a counsel for
caution when a government embarks on fiscal tightening.
Some say tightening need not hurt. In 2009 Alberto Alesina and Silvia Ardagna of Harvard
published a paper claiming that austerity could be expansionary, particularly if focused on
spending cuts, not tax increases. Budget cuts that reduce interest rates stimulate private
borrowing and investment, and by changing expectations about future tax burdens
governments can also boost growth. Others doubt it. An International Monetary Fund (IMF)
study in July this year found that Mr Alesina and Ms Ardagna misidentified episodes of
austerity and thus overstated the benefits of budget cuts, which typically bring contraction
not expansion.
Roberto Perotti of Bocconi University has studied examples of expansion at times of
austerity and showed that it is almost always attributable to rising exports associated with
currency depreciation. In the 1930s the contractionary impact of America’s fiscal cuts was
mitigated to some extent by an improvement in net exports; America’s trade balance swung
from a deficit of 0.2% of GDP to a surplus of 1.1% of GDP between 1936 and 1938. Now,
most of the world is cutting budgets and not every economy can reduce the pain by
boosting exports.
The importance of monetary policy in the 1930s might suggest that central banks could
offset the effects of fiscal cuts. In 2010 the IMF wrote that Britain’s expansionary monetary
policy should mitigate the contractionary impact of big budget cuts and “establish the basis
for sustainable recovery”. Yet Britain is now close to recession and unemployment is rising,
suggesting limits to what a central bank can do.
The move to austerity is most dramatic within the euro zone—which can least afford it.
Operating without floating currencies or a lender of last resort, its present predicament
carries painful echoes of the gold-standard world of the early 1930s.
In the mid-1920s, after an initially untenable schedule of war reparations payments was
revised, French and American creditors struck by the possibility of rapid growth in the
battered German economy began to pile in. The massive flow of capital helped fund
Germany’s sovereign obligations and led to soaring wages. Germany underwent a credit-
driven boom like those seen on the European periphery in the mid-2000s.
Macroeconomics, Exam 3 22
In 1928 and 1929 the party ended and the flow of capital reversed. First, investors sent their
money to America to bet on its soaring market. Then they yanked it out of Germany in
response to financial panic. To defend its gold reserves, Germany’s Reichsbank was forced
to raise interest rates. Suddenly deprived of foreign money, and unable to rely on exports
for growth as the earlier boom generated an unsustainable rise in wages, Germany turned to
austerity to meet its obligations, as Ireland, Portugal, Greece and Spain have done. A
country with a floating currency could expect a silver lining to capital outflows: the exchange
rate would fall, boosting exports. But Germany’s exchange rate was fixed by the gold
standard. Competitiveness could only be restored through a slow decline in wages, which
occurred even as unemployment rose.
As the screws tightened, banks came under pressure. The Austrian economy faced troubles
like those in Germany, and in 1931 the failure of Austria’s largest bank, Credit Anstalt,
triggered a loss of confidence in the banks that quickly spread. As pressure built in
Germany, the leaders of the largest economies repeatedly met to discuss the possibility of
assistance for the flailing economy. But the French, in particular, would brook no reduction
in Germany’s debt and reparations payments.
Recognising that the absence of a lender of last resort was fuelling panic, the governor of
the Bank of England, Montagu Norman, proposed the creation of an international lender. He
recommended a fund be set up and capitalised with $250m, to be leveraged up by an
additional $750m and empowered to lend to governments and banks in need of capital. The
plan, probably too modest, went nowhere because France and America, owners of the gold
needed for the leveraging, didn’t like it.
So the dominoes fell. Just two months after the Credit Anstalt bankruptcy a big German
bank, Danatbank, failed. The government was forced to introduce capital controls and
suspend gold payments, in effect unpegging its currency. Germany’s economy collapsed,
and the horrors of the 1930s began.
Macroeconomics, Exam 3 23
It is all dreadfully familiar (though no European country is about to elect another Hitler).
Membership in the euro zone, like adherence to the gold standard, means that
uncompetitive countries can’t devalue their currencies to reduce trade deficits. Austerity
brings with it a vicious circle of decline, squeezing domestic demand and raising
unemployment, thereby hurting revenues, sustaining big deficits and draining away
confidence in banks and sovereign debt. As residents of the periphery move their money to
safer banks in the core, the money supply declines, just as it did in the 1930s (see chart 2).
High-level meetings with creditor nations bring no surcease. There is no lender of last resort.
Though the European Financial Stability Facility (EFSF) has got further off the ground than
Norman’s scheme, which it chillingly resembles, euro-zone leaders have yet to find a way to
leverage its €440 billion up to €2 trillion.
Even if they succeed, that may be too little to end the panic. Investors driven by turmoil in
Italian markets are pre-emptively reducing their exposure to banks and sovereign bonds
elsewhere in the euro zone. Even countries with relatively robust economies such as France
and the Netherlands have not been spared. No matter how secure an economy’s fiscal
position, a short-term liquidity crunch driven by panic can drive it into insolvency.
History need not repeat itself. Norman’s Bank of England was created in the 17th century to
lend to the government when necessary; central banks have always been obliged to lend to
governments when others will not. The ECB could take on this role. It is prohibited by its
charter from buying debt directly from governments, but it can purchase debt securities on
the secondary market. It has been doing so piecemeal and could declare its intention to do
Macroeconomics, Exam 3 24
so systematically. Its power to create an unlimited amount of money would allow it credibly
to announce its willingness to buy any bonds markets want to sell, thus removing the main
cause of panic and contagion.
This week France and Germany proposed the adoption of legally binding budgetary “golden
rules” by euro-zone members, ahead of a summit of European leaders in Brussels on
December 8th-9th. Mario Draghi, the ECB’s new president, has hinted that were a fiscal pact
to be agreed, the ECB might buy bonds on a larger scale. What scale he has in mind,
though, is unclear. Jens Weidmann, president of Germany’s Bundesbank and an influential
member of the ECB’s governing council, has clearly stated that the ECB “must not be” the
euro zone’s lender of last resort.
Where this path leads
On the present course, conditions in developed economies look like getting worse before
they get better. Growth in America and Britain will probably be less than 2% in 2012 on
current policy, and in both recession is quite possible. A euro-zone recession is likely. The
ECB could improve the euro zone’s economic outlook by loosening its monetary policy, but
widespread austerity and uncertainty will be difficult to overcome. As in 1931 and 2008, a
grave financial crisis may cause a large drop in output. That, in turn, would place more
pressure on euro-zone economies struggling to avoid default.
As panic built in 1931, country after country faced capital flight. The effort to defend against
bank and currency runs prompted rounds of austerity and plummeting money supplies in
pressured economies, helping generate the collapse in output and employment that turned
a nasty downturn into a Depression. It took the end of the gold standard, which freed central
banks to expand the money supply and reflate their economies, to spark recovery. Today
the ECB has the tools needed to salvage the situation without breaking up the euro. But the
fact that the ECB and euro-zone governments have options does not mean that they will
take them.
Macroeconomics, Exam 3 25
Then and now
The collapse of the gold standard led to recovery, but caused terrible economic damage as
countries erected trade barriers to stem the flood of imports from those that had devalued
their currencies. Governments elected to fight unemployment experimented with wage and
price controls, cartelisation of industry and other interventions that often impeded the
recovery enabled by expansionary monetary and fiscal policies. In the worst-hit countries
long-suffering citizens turned to fascism in the false hope of relief.
The world today is better placed to cope with disaster than it was in the 1930s. Then, most
large economies were on the gold standard. Today, the euro zone represents less than 15%
of world output. In developed countries unemployment, scourge though it is, does not lead
to utter destitution as it did in the 1930s. Then, the world lacked a global leader; today,
America is probably still up to the job of co-ordinating disaster response in troubled times.
International institutions are much stronger, and democracy is more firmly entrenched.
Even so, prolonged economic weakness is contributing to a broad rethinking of the value of
liberal capitalism. Countries scrapping for scarce demand are now intervening in currency
markets—the Swiss are fed up with their franc appreciating against the euro. America’s
Senate has sought to punish China for currency manipulation with tariffs. Within Europe the
turmoil of the euro crisis is encouraging ugly nationalists, some of them racist. Their
extremism is mild when compared with the continent-wrecking horrors of Nazism, but that
hardly makes it welcome.
The situation is not yet beyond repair. But the task of repairing it grows harder the longer it
is delayed. The lessons of the 1930s spared the world a lot of economic pain after the shock
Macroeconomics, Exam 3 26
of the 2008 financial crisis. It is not too late to recall other critical lessons of the Depression.
Ignore them, and history may well repeat itself.
Macroeconomics, Exam 3 27
Dealing with budget deficits
Who pays the bill?
Throughout the rich world battle lines are being drawn in the coming fight over
deficit reduction
Mar 4th 2010 | From The Economist print edition
WHEN friends go out to dinner, the convivial atmosphere can be shattered once the waiter
brings the bill. A pleasant evening can descend into a dispute about who had a starter and
who ordered the lobster. Running a public-sector deficit is similar: the arguments start when
the tab has to be paid.
The battles will be all the more fierce this time around because the deficits are so large and
likely in the short term to stay that way. With developed economies still weak, many
governments are (often rightly) keen to run large deficits for a while longer. But the bond
markets are getting impatient, especially with weaker European countries. Greece was
forced to announce a third austerity package this week, after its initial efforts failed to
reassure either the markets or its neighbours (see article). Although Britain has a lower
debt-to-GDP ratio than Greece and its debt has an average maturity of 14 years, sterling
also wobbled this week, with investors spooked by the prospect of a hung parliament. True,
the three biggest rich-world economies, the United States, Germany and Japan, are under
less pressure. But Japan has high debt levels and America has the government-bankrupting
cost of ageing baby-boomers.
If the world were run by economists, deficit reduction would be a very complicated balancing
act. For politicians one question may well dominate all others: who is going to pay? The
candidates differ from country to country, but the list usually includes taxpayers, public-
Macroeconomics, Exam 3 28
sector workers, entitlement recipients (such as state pensioners or public-health users),
foreign investors and future generations. Already battle lines are being drawn: witness the
strikes by Greece’s public-sector unions and the tea parties thrown by America’s tax
protesters.
Two immediate answers appear, which should be easier for politicians to embrace than all
those spending cuts and tax rises. The first is to be honest about the size of the problem.
Public-sector accounting is Enronesque. Creditors will punish governments with dodgy
numbers, as the Greeks have discovered. And voters can hardly make judgments about
what to scale back if they do not know what promises have been made. Talk in continental
Europe of an “Anglo-Saxon” conspiracy of greedy speculators is also dishonest. The
speculators did not invent the deficits. As one bank analyst has tartly remarked: “You can’t
blame the mirror for your ugly face.”
The second is to focus on economic growth. Higher growth reassures markets, increases tax
revenues and reduces spending on unemployment benefits and other welfare payments. So
politicians should eschew policies that reduce the long-term growth rate, such as
protectionism or higher taxes, and focus instead on measures that boost the growth
potential, such as more flexible labour markets and other productivity-enhancing reforms.
No matter what taxes it raises, Japan will not solve its fiscal woes without faster growth.
Many European governments are walking into the same trap.
Even assuming that most governments tell the truth a bit more and their economies grow a
bit faster, there will still be hard choices. The main fault-line is often intergenerational. Some
promises, particularly on public-sector pensions and health care, may impose too great a
burden on the next generation. Middle-aged Americans have written cheques on the
accounts of their children. Scaling back those promises, for example by raising the pension
age, is a prerequisite for getting public finances in order just about everywhere, even if it
will not do much to reduce the deficit in the short term.
The more immediate fight, which is already starting to break out in many European
countries, is between taxpayers and public-sector workers, and between raising taxes and
cutting public spending (see article). Politically, the contest is evenly matched, pitting
powerful unions against the biggest taxpayers—corporations and high-earners—who often
have the ear of politicians. In terms of economics, though, the bulk of the adjustment should
come in the form of spending cuts.
There is no alternative
The state had to step in during the credit crunch, given the scale of the banking crisis, but
this expansion of its scope should be temporary. This is not just ideological bias on our part;
economic studies suggest that fiscal adjustments that rely on spending cuts do better than
those based on tax rises. Yes, some tax rises may be necessary, if only out of the political
necessity of persuading the electorate that the burden is being shared. But tax rises, like
Japan’s in 1997, can kill a recovery.
Macroeconomics, Exam 3 29
In the past some governments have dealt with debts by walking away from them. Iceland is
voting on a milder form of that solution this weekend (see article). The graver threat this
time is that countries are tempted to diminish their debts through higher inflation. But that
would be a dangerous option to adopt and may not even be possible, given that markets can
see such policies coming and demand higher bond yields.
Whichever path governments choose will be hard. As a period of loose credit gives way to an
era of austerity, the social cohesion of many nations will be put to the test. Not all countries
will pass. Over the next few years the careers of many politicians will be made and broken in
the bond market.
Macroeconomics, Exam 3 30
The Icesave referendum
No, thanks
The ramifications of a likely no vote may not be pleasant
Mar 4th 2010 | REYKJAVIK | From The Economist print edition
ICELAND’S president is usually an apolitical and little-known figurehead. But Olafur Ragnar
Grimsson has become a national hero for his refusal to sign a law passed narrowly in late
December by the Althingi, Iceland’s parliament, to repay Britain and the Netherlands. The
British and Dutch governments had felt obliged to bail out their depositors in Icesave, a bust
internet operation owned by Landsbanki, a failed Icelandic bank, and they now expect
Iceland to reimburse them. But thanks to the president’s obduracy, the law is going to a
referendum on March 6th, and it seems certain to be rejected by a huge majority.
The voters and the president will doubtless rejoice, but the aftermath of a negative vote
may not be good for either the country or its government. Johanna Sigurdardottir, the prime
minister, leads a coalition that was shaky before the vote and could yet collapse altogether.
Even more worrying is the knock-on effect for Iceland’s $4.6 billion IMF programme. The
fund says that this should not depend on the Icesave dispute. But the Nordic countries that
are offering bilateral loans in support of the IMF’s rescue package are refusing to go ahead.
Without their backing, the IMF deal is frozen. The financial pressure is mounting. To satisfy
its creditors, Iceland must find some $2 billion in 2011 and $500m in 2012. Moody’s has
given warning that the dwindling chances of a deal over Icesave may lead it to join other
rating agencies in downgrading Iceland’s debt to junk.
The dispute is also clouding Ms Sigurdardottir’s aspirations to join the European Union. On
February 24th the European Commission recommended that EU membership talks should
begin, and hinted that Iceland could join quite soon. But largely because of Icesave, public
opinion in Iceland is shifting. Polls suggest that half the voters are now against joining the
EU, and only a third in favour.
The British and Dutch governments deny that they are impeding either Iceland’s IMF deal or
its EU accession. But there is no doubt that they have used these levers to extract stiff terms
over the Icesave repayment. In recent talks aimed at avoiding the referendum, the Icelandic
government secured a slightly better offer from the two governments. But it was never
going to be enough to satisfy the voters, who firmly believe that the nefarious duo are
profiteering from the woes of a small country caught up in a global financial crisis. That
belief will endure unless the British and Dutch suddenly get more generous.
Macroeconomics, Exam 3 31