Economic Lessons from the Transition: The Basic Theory Re-Examined

Economic Lessons from the Transition The Basic Theory Re-Examined

Daniel R. Kazmer

and

Michele Konrad

M.E.Sharpe Armonk, New York London, England

Copyright © 2004 by M.E. Sharpe, Inc. All rights reserved. No part of this book may be reproduced in any form without written permission from the publisher, M.E. Sharpe, Inc., 80 Business Park Drive, Armonk, New York 10504. __________ Tables and graphs in this book are by Page Konrad __________ Library of Congress Cataloging-in-Publication Data

Kazmer, Daniel R. Economic lessons from the transition : the basic theory re-examined / Daniel R. Kazmer and Michele Konrad. p. cm. Includes bibliographical references and index. ISBN 0-7656-1298-4 (alk. paper) 1. Economics—Study and teaching. 2. Former Soviet republics—Economic conditions. 3. Europe, Eastern—Economic conditions—1989– 4. Post-communism—Economic aspects. I. Konrad, Michele, 1972– II. Title. HB74.5.K39 2004 330—dc22 2003057375

Printed in the United States of America The paper used in this publication meets the minimum requirements of American National Standard for Information Sciences Permanence of Paper for Printed Library Materials, ANSI Z 39.48-1984.

~

BM (c)

10

9

8

7

6

5

4

3

2

1

To my teachers, colleagues, and students, who taught me so much. Daniel R. Kazmer

To my parents, who set the excellent example of loving their work. Michele Konrad

Contents

List of Tables, Graphs, Boxes

vii

Introduction

xi

1 The Basic Market Mechanism

3

2 Firms and the Markets They Operate In

39

3 The Factors of Production

63

4 The Role of Government

90

5 Measuring Economic Activity: The Key to Understanding

112

6 Macroeconomics

124

7 Monetary Policy and Its Prerequisites

153

8 Foreign Exchange Rates and Exchange Rate Crises

168

9 Transition in the Context of the International Financial System

193

10 The Consequences for Open-Economy Macroeconomics

203

11 Benevolent and Malevolent Markets

218

12 Japan: The First Demographic Transition

227

Conclusion

237

Notes

239

Index

243

About the Authors

249 v

List of Tables, Graphs, Boxes

Tables 1.1. 1.2.

Schedule of Quantities Supplied and Demanded Decline in GDP During the Transition

4 14

Graphs 1.1.

Supply–Demand Graph

5

1.2.

Supply–Demand Graph with Producer Surplus

5

1.3.

Supply–Demand Graph with Consumer Surplus

7

1.4.

Supply–Demand Graph

8

1.5.

Supply–Demand Graph with Perfect Central Planning

9

1.6.

Supply–Demand Graph

11

1.7.

Supply–Demand Graph (Market Participants Only)

13

1.8.

Shifting Supply and Demand Curves

16

1.9.

Supply Curve Shifts Down Due to Technology

16

1.10.

Vertical Demand Curve

17

1.11.

Horizontal Demand Curve

18

1.12.

Vertical Supply Curve

20

1.13.

Kinked Supply and Demand Curves

21 vii

viii LIST OF TABLES, GRAPHS, BOXES

1.14. 1.15. 1.16. 1.17. 1.18. 1.19. 1.20. 1.21. 1.22. 1.23. 1.24. 1.25. 1.26. 1.27. 1.28. 1.29. 3.1. 3.2. 3.3. 3.4. 3.5. 3.6. 3.7. 3.8. 3.9. 4.1.

Effect of Rightward Shifts in Demand Effect of Rightward Shifts in Supply Supply and Demand Curves as Presented in Basic Economics Texts Perfectly Vertical Supply Curve Perfectly Horizontal Supply Curve 45-Degree Supply Curve Perfectly Vertical Supply Curve Combined Horizontal then Vertical Supply Curve Flattening the Supply Curve Perfectly Vertical Demand Curve Perfectly Horizontal Demand Curve Agricultural Supply and Demand Curves Effect of a Bumper Crop Effect of a Price Floor Effect of Policies to Flatten the Supply Curve Effect of Policies to Flatten Supply and Demand Curves Supply of Savings in an Economy Supply and Demand for Savings in an Economy Economies in Transition Supply–Demand Graph Supply–Demand Graph with World Price Supply–Demand Graph with Tariff Supply–Demand Graph with Opening to Imports Effect of World Price on the Domestic Market Imposing a Tariff on Imported Goods Lorenz Curves

21 22 24 25 25 27 27 28 28 30 30 33 33 35 35 37 67 67 71 84 84 86 86 87 87 105

5.1.

The Input-Output Table

113

6.1.

Aggregate Supply and Demand Curves

128

6.2.

Loose Monetary or Fiscal Policy

128

6.3.

Tight Monetary or Fiscal Policy

129

6.4.

Aggregate Supply Shifts Left in Transition Economies

129

6.5.

Price Stabilization Policies Shift Aggregate Demand Left

131

LIST OF TABLES, GRAPHS, BOXES ix

6.6. 6.7. 6.8. 7.1. 7.2. 7.3. 7.4. 9.1. 9.2. 9.3. 9.4. 9.5. 10.1. 10.2. 10.3. 10.4. 10.5. 10.6.

Increasing AD Results Mostly in GDP Increase Under Old Output Mix Since AS Curve Is Steeper, Increase in AD Results Mostly in Inflation Business Cycles May Appear If Shifts in AD and AS Curves Don’t Move Together Smoothly Tightening Monetary Policy Increases the Interest Rate So Long as Money Demand Is Stable or Increasing Tightening Monetary Policy Increases the Interest Rate with Stable Money Demand Tightening Monetary Policy Does Not Work If Money Demand Is Decreasing Effects of Tight Monetary Policy via Investment Short Run Supply and Demand Curves for Assets The Demand Curve for Assets Responds to Changing Expectations The Supply of Financial Assets, Given Time, Can Be Expanded to Meet an Increase in Demand Demand Curve Oscillating Steeper Demand Curve GDP Is Determined by the Intersection of the AD Line and the 45-Degree Line Aggregate Demand with Exports Aggregate Demand with Exports Minus Imports Aggregate Supply and Demand Effect of Exports on Aggregate Supply and Demand in Transition Increases the Price Level Shifting Aggregate Supply Curve Right Increases GDP

136 137 146 161 163 163 165 195 195 198 200 202 205 205 207 207 208 209

Boxes 2.1. 2.2.

The Cooperative Enterprise or Partnership Government Mandated Purchases of Agricultural Products

44 58

Introduction

Fools (and ideologues) rush in where angels fear to tread. In 1989, with the fall of the Berlin Wall, a period of transition began. The Council for Mutual Economic Assistance (CMEA) collapsed. Eastern Europe shifted away from the Soviet Union and looked toward the West. The Soviet Union broke up, creating fifteen newly independent states. Millions of people could finally turn from the communist path of development to build a free market system in their countries. Most academics, practitioners, and policymakers greeted these changes with hope and relief. They confidently expected that the former communist nations would discover the merits of the free market system, and become stable independent democracies. Western institutions, led by the International Monetary Fund, World Bank, and United States and European Union, plunged into the fray with a host of suggestions, programs, and prescriptions to help these countries make the leap from socialist, centrally planned economies to market-driven capitalist societies. What happened next is the subject of much debate. Experts do not agree on whether reforms went wrong, were derailed by fundamental and unforeseen complicating factors, or were not implemented fully. Whatever the reason, the results are clear. The former communist world in 2001 had a much lower gross domestic product (GDP) and standard of living than it had in 1989. With the exception of a few countries, such as Poland, Hungary, the Czech Republic, and the Baltic States, most of the countries that went through transition are burdened with a lower standard of living, severe xi

xii INTRODUCTION

economic hardship, autocracy, pervasive crime, and disillusionment with reforms and the “Western” model. The transition was expected to raise most people’s standard of living. Instead, it has worsened the lives of most people in the countries involved. As a leading economics text declares, “No period in history saw such sustained declines in output as the economies in transition (from central planning to markets) experienced after 1990.”1 These massive declines were not expected—in fact, they were hardly considered possible—when the transition began. Because Western governments and institutions were so active in promoting reforms in transition economies, many hold them partly responsible for the dismal result. Even where the policies implemented were not supported by Western advice at all, the stigma remains. With the disappointing results of the 1990s, scholars and economists have naturally tried to determine what went wrong. A new literature has emerged in which dozens of books and hundreds of journal articles contemplate why the transition was so difficult and what measures should have been taken. This literature is already extensive and continues to grow. This book is not intended to add to that literature. Rather, it will review the concepts and theories of economics as taught at the basic undergraduate level in the light of the transition experience. Economic knowledge goes through several stages of development. First, there are essays, in journals or in the popular press, which identify problems and point to their possible resolution. Next come the scholarly papers, which review the existing scholarly literature and then carefully extend it with mathematically precise models and thorough empirical quantitative testing. Finally, textbooks are written, containing the accepted knowledge on a subject. These textbooks are used to teach economics courses on the undergraduate level. They lay out the precepts of economics as it is known today—some of which go back to the time of Adam Smith. The basic precepts are rarely challenged—certainly not in the context of an undergraduate class. Upper-level economic classes may teach the latest theories, challenges, debates, and controversies, but undergraduate economics absorbs these changes only slowly. We feel strongly that economics, as taught at the undergraduate level, and as a mental backdrop for higher-level work, needs re-examining. This book was written because certain precepts of economics, as taught at the basic undergraduate level, need to be reviewed in light of the transition experience. It is not intended to review or summarize the vast (and important) scholarly literature on the transition using advanced theory.2 It is rather a series of essays intended to raise questions about the way main-

INTRODUCTION xiii

stream economics is taught (especially in the United States). We hope to spark critical reflection and debate about the basic economic assumptions that underlie much of economic policymaking. We focus on the Transition, as the most spectacular failure of basic economics applied to the real world since the Great Depression. This book will suggest answers to the following questions. How should basic economic theory, as taught in introductory economics courses, be revised in light of the failure of market-oriented economics to affect a successful transition in so many former communist economies? How can the theory be revised, and presented in a different manner? How can basic economic theory be used to help explain the past failures in understanding transition problems and to avoid future mistakes? The book is aimed at two interacting audiences: students of economics and the transition who want to think through alternative views of the basic theory; and noneconomists interested in the transition experience, who want to interact convincingly with mainstream economists and understand economic theory as it relates to transition issues. These audiences are critical. Economic policy is not always made by economists. Rather to the contrary, policymakers, business people, and other noneconomists often decide economic policy. International relations scholars have long understood the problem of making their knowledge available to, and understood by, the policymakers who make decisions in foreign policy. The same need exists in economics. A key effect of our review will be to integrate market theory with the role of government, that is, to more closely connect economics with political economy.3

Economic Lessons from the Transition

1 The Basic Market Mechanism

The heart of the market mechanism is the interaction, in fact, the intersection, of supply and demand. This is the first thing that all economics students learn in their first principles course, so we will not go over it in detail. However, it is interesting to see what this theory has to say about transition economies, and posit some changes to the theory to explain what happened there. The key to a functioning market is that both buyers and sellers are sensitive to price, but in opposite directions. As the price rises, sellers offer more units of the good for sale, while buyers are willing to buy fewer units. For example, assume a simple market in which only one kind of good is for sale. There are nine buyers and nine sellers: each of the buyers wants one unit, and each seller has one unit to sell. In this textbook example of supply and demand, each seller has a different price that she is willing to take for her good and each buyer has a different price that she is willing to pay. For example, at a price of 9 euro, nine sellers are willing to sell, but only one buyer is willing to buy. If the price falls to 8 euro, one high-cost producer drops out, so only eight units are offered for sale. However, at 8 euro, another customer is willing to buy a unit of the good, so quantity demanded rises to two units. Continue this process, and the result is the schedule of quantities supplied and demanded at each price given below (see Table 1.1). The same information is displayed in Graph 1.1, with price on the vertical axis, and quantities supplied and demanded on the horizontal axis. The quantity supplied equals the quantity demanded at only one price, 5 3

4 CHAPTER 1

Table 1.1 Schedule of Quantities Supplied and Demanded Price in Euros 9 8 7 6 5 4 3 2 1

Quantity Supplied

Quantity Demanded

9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8 9

euro. This is also the price at which the supply curve and the demand curve intersect, the equilibrium price for this market. The equilibrium quantity for this market is five units. The term “equilibrium” is also significant. Economics demonstrates that markets move toward the equilibrium point, due to the independent actions of market participants (see Graph 1.1). This intersection of supply and demand is absolutely the key principle of market economics. Equilibrium is found, not because of the actions of some third party (i.e., the government), but because the independent and rational actions of each market participant lead to this conclusion. Notice that not all of the goods are sold and not every buyer goes home with something in their basket. Only those willing to buy and sell at 5 euro make transactions on the market that day. Another key principle of economics is that surplus results from a wellfunctioning market. In the example above, most of the producers and consumers who make a transaction get a surplus. This is because each buys or sells at the 5-euro equilibrium price, not at their worst acceptable individual price. The lowest-cost supplier, willing to sell her unit for 1 euro, gets the 5-euro equilibrium price. The extra 4 euros that she gets is a bonus—what economists call a surplus. The next lowest-cost producer, willing to sell for 2, also sells for 5, and gets a producer surplus of 3. And so on. Thus, five active producers and sellers collect a total surplus of 10 euro. This is shown in Graph 1.2 by the triangle to the left of the equilibrium point bounded by the vertical axis between 0 and 5 euros, the horizontal line from the 5-euro point on the vertical axis to the equilibrium

THE BASIC MARKET MECHANISM 5

Graph 1.1 Supply–Demand Graph

9 8 7

Price

6 5 4

Supplied

Demanded

3 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

Graph 1.2 Supply–Demand Graph with Producer Surplus

9

Supplied 8 7

Price

6 5 4

Producer Surplus Demanded

3 2 1 0

1

2

3

4

5

Quantity

6

7

8

9

6 CHAPTER 1

intersection of the supply and demand curve, and the supply curve to the left of the equilibrium point. The “producer surplus” triangle shows that the producers who were willing to sell for less than 5, are still getting 5 euro for their product, thus receiving a surplus (see Graph 1.2). Consumers receive an analogous surplus. The buyer willing to pay 9 euros for her unit pays only the 5-euro equilibrium price and so gets a 4-euro surplus. The buyer willing to pay 8 receives a surplus (or bargain) of 3. And so on. The “consumer surplus” triangle shows that each buyer willing to pay more than 5 is actually paying less than she was willing to pay and thus receives a surplus. This surplus is shown in Graph 1.3 by the triangle bounded by the vertical axis above the 5-euro mark but below where the demand curve hits the vertical axis, the horizontal line at the 5-euro price level from the vertical axis to the intersection of the supply and demand curves, and the demand curve from the vertical axis to the intersection point (see Graph 1.3). Alert readers will be wondering: What happened to the people on the right side of the intersection point? What happened to all of those sellers who thought 5 was too low a price and all of those buyers who thought 5 was too expensive? That is the subject of our next section. A New Twist on the Basic Market Mechanism If you have followed this reasoning thus far, you are probably dreading the next several pages. We have analyzed what happens to the buyers willing to pay the market price or higher and the sellers willing to sell at the market price or lower: in other words, those people to the left of the intersection of the supply and demand curves, who are earning a surplus. Next, we should turn to the buyers and sellers to the right of the equilibrium point and carry through even more tedious analysis on their surpluses. Well, this book does not. So savor, for a moment, the combination of perplexity and relief felt by generations of basic economics students. Mainstream economics ignores the buyers and sellers who will not trade at the market price. Since they are not making a transaction in the market, they are not discussed. If all the world’s a stage, then in economics, only those to the left of the equilibrium price are players upon it. Those to the right of the equilibrium price are left waiting in the wings. When we start discussing factors that make the supply and demand curves shift, the equilibrium intersection point will shift with them. Producers and consumers will shift from the right to the left of the equilibrium point and back again, from onstage to offstage and back again, with no more question about why they are offstage than actors in a play.

THE BASIC MARKET MECHANISM 7

Graph 1.3 Supply–Demand Graph with Consumer Surplus

9

Supplied 8 7

Price

6

Consumer Surplus

5 4

Demanded 3 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

We suggest that the tendency of mainstream economics to ignore the producers and buyers to the right of the equilibrium point is a key reason that economists were so surprised when the transition economies experienced such huge declines in production. To see why, consider the following parable, which takes the model of supply and demand and adapts it to the real world. Nine peasant farmers each produce the same amount of food per year, but their costs of production vary due to soil conditions. Their production costs are respectively 1 coin, 2 coins, 3 coins, and so on up to 9 coins. In the neighboring town, there are nine families that buy their food from the local peasants, and each household needs the same amount of food per year that each farmer produces. The town dwellers’ incomes vary as well. The richest can afford to pay 9 coins, the next richest 8 coins, and so forth down to the poorest town dweller who can afford to pay only 1 coin for a year’s worth of food. The supply and demand schedules and curves will look like those in the euro example above except that we have coins instead of euros (see Graph 1.4). The nine peasant farmers and the nine town families, having no training in economics but great respect for the wisdom of the clergy, petition the

8 CHAPTER 1

Graph 1.4 Supply–Demand Graph

9

Supplied 8 7

Price

6 5 4

Demanded 3 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

abbot of the local monastery to set up a trading mechanism for them. The abbot interviews all of the town dwellers and all of the peasants. Each town dweller tells honestly how much he is willing and able to pay for a year’s food supply. Each peasant farmer tells honestly his cost of producing a year’s worth of food. When the abbot sits down to analyze the results, he is thrilled. Clearly, a divine hand is at work in his village. The producing costs of the peasant farmers exactly match the buying power of the town families. He matches up the highest cost peasant farmer to sell food to the richest town dweller for 9 coins. The next highest cost farmer is to sell to the next richest town dweller for 8 coins, and so forth all the way down to the lowest cost farmer, who sells to the poorest town dweller for only 1 coin. When we graph this outcome on a supply demand chart, we see a very different picture than in the market example (see Graph 1.5). Demand and supply are equal at all points. This is because the buyers and sellers are directed where and how to buy and sell, rather than choosing for themselves. The poorest consumer, able to pay only 1 coin, is now farthest to the left. The richest consumer, able to pay 9 coins, is now farthest to the right. The abbot is acting as a central planner, matching up

THE BASIC MARKET MECHANISM 9

Graph 1.5 Supply–Demand Graph with Perfect Central Planning

9 8 7

Price

6 5 4 3 2

Supplied

Demanded

1 0

1

2

3

4

5

6

7

8

9

Quantity

buyers and sellers. Note that the demand line has been shifted around to meet the supply line, rather than the other way around. Note also that our centrally planned economy has greater output than the market economy did. Total output is nine annual food supplies, while in the market example it was only five. This is possible because no producer or consumer gets any surplus. Each farmer just covers costs. Each town dweller pays the maximum he can afford. A nineteenth-century writer, who may be considered rather obscure in today’s Wall Street–dominated world, described this mechanism as “From each according to his ability (i.e., cost of production) and to each according to his need (i.e., willingness to pay).”1 Some readers interpreted this statement as a call for equality, rather than what it is: a plan for perfect price discrimination to maximize output and consumption. In economics terms, the central planning abbot has used both his authority, and his complete knowledge of both producers’ costs and consumers’ incomes, to impose perfect price discrimination on both consumers and producers. We will daringly call this a case of perfect central planning. We are not arguing that perfect central planning, as in the case of the abbot, actually existed in communist countries, or even in those still practicing communism today. But neither can the Western market economies

10 CHAPTER 1

boast of perfect market competition in their economies. What we are saying is that it is fair to compare perfect market competition with perfect central planning and use the same model to describe each. To use game theory terms, the authority acting as a perfectly price discriminating2 monopolist (a single seller from whom all must buy) and monopsonist (a single buyer to whom all must sell) provides an outcome superior to that of the competitive market since the quantity produced and consumed is higher. However, this system is “behaviorally unstable,” that is, it requires that buyers buy at different prices and sellers sell at different prices when some of them could be more successful by changing their behavior. The competitive market is “behaviorally stable,” that is, it provides a stable solution to the game if all buyers adopt the same behavior (each buyer tries to buy at the lowest price) and all sellers adopt the same behavior (each seller tries to sell at the highest price). To continue our story: The abbot’s central planning works well for several years. However, eventually the peasants start talking among themselves and find that they are paid different prices for the same food basket! Those peasants who have been clever (or lucky) enough to figure out a cheaper way to grow food think this is unfair. They decide to stop following the abbot’s orders, approach the rich families in town, and offer them a lower price. At the same time, the wealthy town families discover that they are paying more for the same amount of food than their poor cousins. They too think this is unfair, and begin secretly approaching peasants to see if they can get a lower price for food on their own than they could from the abbot. Two important events have taken place. First, the abbot’s authority is broken. He is no longer able to control the market because people’s natural desire to get a better deal causes them to break the original agreement and strike out on their own. Second, the regime of perfect price discrimination is over. Each farmer is going around trying to get the highest price possible for his crop, and each town family is seeking the lowest price possible. Within a short time, this bargaining will bring about the same equilibrium as in our competitive market example above. Production will be five annual food supplies produced by the five lowest-cost producers. Each annual food supply will be sold to one of the five richest town dwellers at a uniform price of 5 coins each (see Graph 1.6). Now that the market has taken over, the four highest-cost producers are out of luck. They cannot find anyone to sell their crop to, unless they sell it at below cost. They have been pushed to the right of the intersection of supply and demand. At the same time, the four poorest town dwellers can

THE BASIC MARKET MECHANISM 11

Graph 1.6 Supply–Demand Graph

9

Supplied 8 7

Price

6 5 4

Demanded 3 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

no longer afford food. They are also out of the market, to the right of the equilibrium point. What happens to these producers and consumers? Mainstream economics is silent on their plight. They are offstage. In real life, the four poorest town dwellers are unlikely to be content sitting offstage waiting for the market price to change. In fact, they are facing starvation. They will not be impressed by lectures on the Panglossian optimality of the market mechanism. More likely they will try to steal food, or even band together and threaten some of their richer cousins to get enough to eat. Meanwhile, the four high-cost peasant farmers can at least feed themselves, but they are certainly not content. They have three undesirable choices: go without selling anything at all, sell under cost, or resort to a barter economy. Both the poor townspeople and the disadvantaged peasants are wondering, “How did we get into this mess? For years, the abbot made sure there was a customer for my goods, and there was enough food for all to eat. Now we try this new market system, and half of us are out of work, and the rest can’t even feed ourselves!” There is a threat to the new economic order, precisely because the market has functioned as it was supposed to. Both town dwellers and peasant farmers are loudly questioning the utility of the new model.

12 CHAPTER 1

Their incipient revolt must be put down by some combination of force, free lunches, and sermons from the abbot. Of course, not everyone is worse off in this new system. The consumers and producers to the left of the equilibrium point are better off with the new market system. Just as in our market example above, they are now earning a surplus. The “winners” to the left of the equilibrium price can afford to pay to put down the “losers” to the right of the equilibrium price, by taxing part of their producer and consumer surpluses and paying for more police, welfare payments, or whatever it takes to pacify those who were left out in the transition. In market economies, “the poor are always with us.” The have-nots to the right of the equilibrium point do not go away, or seamlessly find other markets. However, standard market theory ignores this issue. Have you ever seen the graph below in an economics textbook? (see Graph 1.7). Of course, Graph 1.7 does not appear in economics textbooks, but most mainstream economics courses do focus on those in the market, those to the left of the equilibrium point. To repeat, mainstream economics ignores the buyers and sellers who will not trade at the market price. In real life, the people to the right of the equilibrium point do exist, and do affect both the market and society in important ways. This is where government enters the picture. A key role of government is to make sure that those who lose out in the market do not band together and create mischief, or even stop the market from functioning. In other words, politics is an integral part of the market mechanism. There is no economics without political economy. Mainstream economics has avoided this problem. The basic theory on the market is silent on this key role of government as “enforcer,” because it also ignores the potential market participants to the right of the equilibrium point. Before we continue, we would like to assure the reader that the above parable does not argue that the market mechanism is hopelessly flawed and needs to be replaced by perfect central planning. It does show, however, that the static equilibrium—that is, equilibrium where the supply and demand curves do not move—in a single market is not a good way to organize trade between producers and consumers. Static equilibrium does not maximize output. Further, it creates a class of have-nots, who are excluded from the market. The have-nots require a political solution not addressed in mainstream economics. In the following chapters, we will argue that the market mechanism is redeemed by market dynamics (“dynamics” means basically that the supply and demand curves move), that the have-nots to the right of the equilibrium point play a key role in these market dynamics, and that the real strength

THE BASIC MARKET MECHANISM 13

Graph 1.7 Supply–Demand Graph (Market Participants Only)

9 8 7

Demanded

Price

6 5 4

Supplied

3 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

of the market system is interconnected and well-functioning dynamic markets, not single static markets. One way to understand the poor economic performance of the transition from central planning to markets is that the economies in transition successfully replaced the price discrimination of central planning with poorly connected static markets. The first result of static markets, as we have shown, is a decline in output and creation of a class of “have-nots.” This first step has been achieved with great success in the economies in transition. The second step, creating dynamic connected markets, has proven more difficult. These dynamic well-functioning markets provide the true benefits of a market system. We close this section with a brief illustration of the catastrophic decline in outputs experienced by the economies in transition.3 They illustrate the terrible consequence for an economy’s output of transition to poorly connected static markets, and the corresponding fall in standard of living for people who live in those economies (see Table 1.2). The Market Mechanism in Transition Economies Now that we have provided a plausible explanation for the declines in output that accompanied transition from central planning to the market

14 CHAPTER 1

Table 1.2 Decline in GDP During the Transition

Country Albania Armenia Azerbaijan Belarus Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyzstan Latvia Lithuania Macedonia Moldova Poland Romania Russia Slovakia Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan

Percentage Decline in Real GDP from 1989 to Lowest Real GDP Year 39.9 65.1 63.1 36.9 36.9 37.6 15.4 36.5 76.6 18.1 40.2 50.5 52.8 40.8 45.6 69.2 13.7 26.6 46.5 24.7 20.4 74.0 49.6 64.5 14.4

Year of Lowest Real GDP 1992 1993 1995 1995 1997 1993 1992 1994 1994 1993 1998 1995 1993 1994 1995 1999 so far 1991 1992 1998 1993 1992 1996 1997 1999 so far 1995

The first column gives the name of the country; the second column, the cumulative percentage decline in real gross domestic product from 1989 to the year of lowest real gross domestic product; the third column, that year, the year of lowest real gross domestic product. (Gross domestic product is the measure of total output favored by economists. “Real” means that the effect of price changes has been removed. For example, assume that in 1989, a farm produced ten bushels of wheat at 10 euro per bushel for total value of output of 100 euro. In 1993, it produced eight bushels at 9 euro per bushel for total value of output of 72 euro. The decline in real output is (10 ⫺ 8)/10 ⫽ 2/10 ⫽ 20%. The change in price per bushel is not included.)

THE BASIC MARKET MECHANISM 15

mechanism, let us turn to the market mechanism itself in the transition context. Mainstream economics provides excellent analysis of the market mechanism using supply and demand curves. Any external factor that affects the market—such as increased competition, higher taxes, change in income, or even natural disasters—can be described by changing the position of either the supply curve or the demand curve. (A change in price does not itself affect the curve. It is rather a movement along the curve.) Both supply and demand curves can move up and down, right or left, as external factors have an effect on buyers or suppliers (see Graph 1.8). Any introductory economics text provides examples of factors that shift supply and demand curves, so we will not go into detail here. Using this model, if the supply curve shifts down one unit due, for example, to a more efficient technology, the place at which it intersects with the demand curve becomes the new equilibrium. One more unit will be sold, and all units sell for a price 1 coin cheaper. The potential buyers who were left out in the old market (i.e., to the right of the equilibrium point) reappear, and purchase one additional unit of output (see Graph 1.9). The new equilibrium will be six units of output instead of five and a price of 4 coins instead of 5. (Peasant farmer incomes fall from 25 coins to 24 coins.) This outcome seems acceptable for all concerned. More units are sold, at a lower price, which is still (presumably) below the new, cheaper costs of production for our farmers. However, it assumes that our sixth-wealthiest city dweller somehow survived without food until the technological improvement reduced the cost of food baskets to 4 coins, which was all that she could afford. But what if, as we asserted above, all four city dwellers who could not pay 5 coins for their annual food supplies either had starved or moved away? This possibility plays havoc with the basic market model. It concedes that in real life, as opposed to in theory, actors do not move seamlessly “offstage” and back on, depending on the market price. Basic economics assumes with no explanation that both supply and demand curves are straight lines with no differences to the right or left of the equilibrium point. In real life, the curves are not straight. In our example above, the demand curve would have a vertical downward kink at 5 coins, because all of the town dwellers that did not immediately purchase food are gone, and will not be available in the market to purchase food if the price should change (see Graph 1.10). Given that any town dweller who did not immediately purchase food is no longer in the market, the effect of a shift in the supply curve is quite different. Instead of selling more food for a lower price, the amount of

16 CHAPTER 1

Graph 1.8 Shifting Supply and Demand Curves

Price

Demanded

Supplied

Quantity

Graph 1.9 Supply Curve Shifts Down Due to Technology

9

Demanded

8 7

Price

6 5 4 3

Supplied 2 1 0

1

2

3

4

5

Quantity

6

7

8

9

THE BASIC MARKET MECHANISM 17

Graph 1.10 Vertical Demand Curve

9

Demanded

8 7

Price

6 5 4 3

Supplied 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

food sold stays the same. The peasants now sell only five units of food at 4 coins each. Their total income drops from 25 coins to 20 coins. The point here is that the payoff of any downward shift of the supply curve depends on the shape of the demand curve to the right of the prior equilibrium point. If there is no further demand—if the demand curve drops off a vertical cliff—then the reduced cost in supply has no benefit to the farmers. The entire savings goes to the city dwellers, who each pay one coin less for their annual food supply, 4 coins instead of 5. The peasant farmers each get the same surplus as they did before.4 At the other extreme, imagine a situation in which the demand curve was horizontal to the right of the equilibrium. In this case, the downward shift of the supply curve results in sales of six units at 5 coins per unit. The peasant farmers would get the entire gain from the technological improvement (see Graph 1.11). To reiterate, the payoff to shifting the supply curve depends on the shape of the demand curve to the right of the equilibrium point. This is not news. It is called market analysis, and is an important component of any business plan. However, it is not emphasized in basic economics texts. Market analysis is particularly important for analyzing economies in transition since, as incomes fall (due to the replacement of

18 CHAPTER 1

Graph 1.11 Horizontal Demand Curve

9

Demanded

8 7

Price

6 5 4 3

Supplied 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

central planning with the market mechanism), demand curves in many markets shift left. Our example does not include this shift for the whole curve, but only for the part to the right of the equilibrium point. At the same time, potential demand to the right of the equilibrium point may drop off steeply, depending on what happens to the people left out when the market system replaced the centrally planned one. This is particularly true when the good in question is necessary for survival. For a moment, step into the shoes of a producer. What is the key incentive for struggling to increase capacity (shifting the supply curve right), or to lower costs, and be more efficient (shifting the supply curve downward)? Your key incentive is whether you can sell more of your product if you do so. Producers are very concerned with the shape of the demand curve to the right of the equilibrium point, that is, the propensity and ability of potential consumers to buy their product. From the point of view of the producer, the flatter the demand curve, the better. There is little incentive to produce more, or produce more cheaply if you cannot be sure that there are consumers able to buy your good. Income is the major component determining the demand curve, especially in markets for necessities. Thus, in economies in transition, income

THE BASIC MARKET MECHANISM 19

maintenance programs are important, not just for humanitarian reasons, but also so that individual markets provide incentives for increases in output. This is a standard Keynesian argument, but it is not often applied to economies in transition. For example, pension reform in Eastern Europe was approached from the point of view of minimizing the burden that pensioners place on the government budget. Our analysis suggests that pensioners and other welfare recipients who can afford to consume also provide a floor under demand in many individual markets. Many individual markets were hit hard by the disappearance of disposable income for pensioners and other welfare recipients in most transition economies. Markets for food, clothing, books, health care, education, and so on, were affected by the sudden drop in demand as pensioners had to cut back on all but the most essential purchases. We turn now to the parallel case of the supply curve. We have already noted two factors that would make the supply curve climb steeply to the right of the equilibrium point: one is that there is no incentive to maintain unused capacity that is out of the market; the other is that smart producers will be aware that potential consumers may not be able to buy their goods. (In this case, perceived lack of demand affects potential supply, a fact that is inconvenient to the model, and therefore frowned on in mainstream economics.) Other factors that affect supply include crime, corruption, confiscatory taxes, and the problem of uncertain ownership of property. These issues have plagued all of the transition economies to varying degrees. Add to these uncertain prices, input shortages, poor transport and communications, and poorly functioning markets, and starting a business in this environment begins to seem foolhardy. Even expanding capacity seems questionable at best. All of these factors tend to make the supply curve nearly vertical, especially to the right of the equilibrium point (see Graph 1.12). The result is that an upward or rightward shift in the demand curve is likely to result mostly in a price increase, with little increase in output. Eventually, a high price should lead to producers expanding capacity and a flattening of the supply curve. However, if this process is occurring in multiple markets, the multiple price increases will register as an increase in the overall price level, that is, inflation. During the transition, governments and central banks were encouraged to fight inflation by reducing demand with fiscal and monetary policies. We will discuss these “stabilization” policies later. Here we only note that such policies tend to shift the demand curves in individual markets left and

20 CHAPTER 1

Graph 1.12 Vertical Supply Curve

9

Demanded

8 7

Price

6 5 4 3

Supplied 2 1 0

1

2

3

4

5

6

7

8

9

Quantity

down to reduce the increase in the price. This shift in the demand curve holds down the level of output as well. If we now put the kinked supply and demand curves on the same graph, the specific problem of a market in a transition economy becomes apparent (see Graph 1.13). Rightward shifts in demand cause large price increases against very small output increases (see Graph 1.14). Rightward shifts in supply cause price declines but little increase in output (see Graph 1.15). In this market, stimulating demand has little output reward, because it impoverishes consumers; reducing costs has little reward, because it impoverishes producers. The key problem for markets in economies in transition is how to flatten both the supply and demand curves. We have only a partial answer to this problem. Placing a “floor” under the incomes of consumers—that is, providing some guaranteed minimum income—will help to flatten demand curves. However, flattening supply curves is much more complex and requires accepting inflation until enough capacity is added to satisfy the increase in demand. The problem is that flattening the supply curve is not merely a question

THE BASIC MARKET MECHANISM 21

Graph 1.13 Kinked Supply and Demand Curves

9 8

Supplied

7

Price

6 5 4 3 2

Demanded 1 0

1

2

3

5

4

6

7

8

9

8

9

Quantity

Graph 1.14 Effect of Rightward Shifts in Demand

9

Supplied

8 7

Price

6 5 4 3

Demanded 1 2

Demanded 2 1 0

1

2

3

4

5

Quantity

6

7

22 CHAPTER 1

Graph 1.15 Effect of Rightward Shifts in Supply

9 8

Supplied 1

Supplied 2

7

Price

6 5 4 3 2

Demanded 1 0

1

2

3

4

5

6

7

8

9

Quantity

of providing a market for goods, or even of subsidizing producers. The only real “fix” is long-term improvements in the business environment to encourage additions to supply capacity. Crime, corruption, and the other risk factors that make doing business so costly must be addressed. None of these risks are easy to tackle, even when well-meaning governments provide plenty of aid and advice. To make matters worse, each market depends on other markets. In order for a market to be efficient, it needs not only buyers and suppliers, but also well-functioning complementary markets on either side. Transition economies typically have serious problems with transport and communications, which are the key factors in linking markets to each other. It may take years, or even decades, before the infrastructure is in place to allow for free interaction between all of the markets that make up an economy. To recoin a phrase: no market is an island.5 To measure market integration, economists should measure price differentials for the same inputs and outputs across markets. We suspect they are extremely large in economies in transition.

THE BASIC MARKET MECHANISM 23

The Problem of Price Inelasticity Price elasticity is a clearly defined key concept in every basic economics text. Yet somehow it has been missed as a key source of conflict in market economies, including economies in transition. If you need to explain problems to economists on how a market works or fails to work, you must be fluent in the language of elasticities. This section is intended to help explain that language. Economists working on specific markets routinely estimate price elasticity, but do not recognize inelasticity as a market problem or market failure in need of intervention. Market participants and governments recognize elasticity as a problem because they are directly affected by it. The result of this basic difference is that policy makers learn to ignore economists or, if the economists prevail, disaster follows and the new policy makers learn to ignore the economists. We promise that working carefully through the following sections on elasticity will pay dividends when it comes to reasoning with economists and avoiding disaster. Elasticity in the Supply Curve Select any two points on a standard upward sloping supply curve with price on the vertical axis and quantity on the horizontal axis (see Graph 1.16). First, read off the horizontal axis the quantity supplied at the point you have chosen that is furthest to the right. Call this Qhigh. Then read off the quantity supplied at the left point you have chosen. Call this Qlow. Calculate the percentage change from Qlow to Qhigh as % Change in Q ((Qhigh ⫺ Qlow)/Qlow) ⫺ 1) ⫻ 100

If quantity supplied increases from 100 units to 110 units, then the percentage change in quantity supplied is +10 percent. Now for the same two points, calculate the percentage change in price from the lower point to the higher point. Let us say price rises from 10 euro at the low point to 12 euro at the high point. The percentage increase in price is then +20 percent. If the market price goes up from 10 to 12 euros, this will affect suppliers’ willingness to sell the product, so that there will be more goods sold on the market as a whole, 110 instead of 100. Elasticity is the percentage change in quantity divided by the percentage change in price, or 10/20 ⫽ 0.5. In our example, if nothing else changes

24 CHAPTER 1

Graph 1.16 Supply and Demand Curves as Presented in Basic Economics Texts

Price

Demanded

Supplied

1

2

3

4

5

6

7

8

9

Quantity

except that you offer the suppliers on this supply curve a price increase of 20 percent from the price point of 10 euros, they will offer a percentage quantity increase of half that or only 10 percent. Note that the steeper the supply curve, the lower the elasticity. A perfectly vertical supply curve has zero elasticity everywhere since the percentage change in quantity supplied is always zero (see Graph 1.17). Where might you see a perfectly vertical supply curve? Perhaps in the auction of a precious work of art, such as a newly discovered Monet. The price for the item is yet undetermined, but one thing is for sure: no matter how much people are willing to pay for it, there is only the one painting to be sold. A perfectly horizontal supply curve has infinite elasticity everywhere because if the price falls even a small amount, the quantity supplied falls to zero (see Graph 1.18). Where might you find a perfectly horizontal supply curve? Imagine a town full of cheese makers, who all produced identical units of cheese for the same cost. In this imaginary town, you could buy as many units of cheese as you wanted, at the market price. There would be no point in paying more, and no one would sell to you if you offered them less. A supply curve coming out of the origin at 45 degrees has unitary

THE BASIC MARKET MECHANISM 25

Graph 1.17 Perfectly Vertical Supply Curve

9 8 7

Price

6 5 4 3 2 1 0

1

2

3

4

5

6

7

8

9

6

7

8

9

Quantity

Graph 1.18 Perfectly Horizontal Supply Curve

9 8 7

Price

6 5 4 3 2 1 0

1

2

3

4

5

Quantity

26 CHAPTER 1

elasticity, that is, the elasticity is equal to 1 everywhere, because the percentage change in quantity supplied will always be equal to the percentage change in price for any two points (see Graph 1.19). We could continue to develop the concept of supply elasticity relative to price, but you have the basic idea: the more vertical the supply curve, the lower the supply elasticity and the lower the quantity response to any given change in price. Why do some supply curves have low elasticity? Basically because they do not have much unused productive capacity that could be put into operation. Even if demand were to increase and prices were to rise, the producer would not be able to produce much more than he already is. Agriculture markets often have low elasticity. Let us take an example to see how this works. Imagine that you are looking at the supply curve for raspberry farmers. Raspberries are harvested once a year. Once all the raspberries are harvested, an increase in price will not get more raspberries on the market, because there simply are no more until the next harvest. From the individual farmer’s point of view, his supply curve is perfectly vertical (see Graph 1.20). He has only a certain number of raspberries to sell, and must sell them at the market price, assuming he cannot store them for later sale. If you look at the entire raspberry market, you see the combined supply curves of all of the farmers (see Graph 1.21). The raspberry supply curve for the entire market is perfectly elastic or horizontal for all quantities up to the quantity harvested, then from that point it is perfectly inelastic or vertical because even an infinite increase in price will not provide one more raspberry—there simply are no more until the next harvest. One solution to this problem is to flatten the supply curve, that is, to increase supply elasticity. For raspberries, this may include buying raspberries at low prices and freezing them to be sold when prices rise (see Graph 1.22). Graph 1.22 shows the effect of storage or import of extra supply at increasing cost. Such storage might be performed by private speculators or by the government. Another solution would be to put in rail or port transport facilities, so that raspberries that are grown far away could be imported. Elasticity of the Demand Curve The definition of price elasticity for demand is analogous to that for supply elasticity. The price elasticity of demand is the percentage change in quan-

THE BASIC MARKET MECHANISM 27

Graph 1.19

Price

45-Degree Supply Curve

45˚ 0

2

1

3

4

5

6

7

8

9

Quantity

Graph 1.20 Perfectly Vertical Supply Curve

9 8 7

Price

6 5 4 3 2 1 0

1

2

3

4

5

Quantity

6

7

8

9

28 CHAPTER 1

Graph 1.21 Combined Horizontal then Vertical Supply Curve

9 8 7

Price

6 5 4 3 2 1 0

2

1

3

4

5

6

7

8

9

Quantity

Graph 1.22

Price

Flattening the Supply Curve

0 1

2

3

4

5

Quantity

6

7

8

9

THE BASIC MARKET MECHANISM 29

tity demanded divided by the percentage change in price that caused it. Thus if price doubles, that is, price increases by 100 percent and the quantity demanded falls by only 10 percent, then the price elasticity of demand is 10/100 ⫽ 0.1. Note that the convention is to drop the negative sign since everyone knows that the demand curve slopes downward to the right, that is, as price falls, quantity demanded increases; 0.1 is very inelastic. The steeper the demand curve, the lower the elasticity. A perfectly vertical demand curve has zero elasticity everywhere since the percentage change in quantity demanded is always zero (see Graph 1.23). Where might you see a perfectly vertical demand curve? Consider the market for pepper. If you like pepper on your food, you will probably not cut back on pepper if the price doubles. It is too small a share of your overall budget. Neither will you increase your pepper consumption dramatically if the price falls by half. Your demand for pepper is very inelastic, both because price changes have very small effects on your overall budget, and because you want a very specific portion of pepper on your food. More pepper would be too much; less pepper would be too little. A perfectly horizontal demand curve has infinite elasticity everywhere because if the price falls even a small amount, the quantity demanded falls to zero (see Graph 1.24). Where might you find a perfectly horizontal demand curve? Imagine you were shopping in a large market in which many vendors offered the same kinds of produce. If one vendor had apples for sale at a certain price, while his neighbor sold the same apples at a lower price, you would buy the cheaper apples. So would everyone else, which means that, in that market, for each apple seller, the demand line she faces for apples is perfectly elastic. Inelasticity and Necessities Inelasticity is of interest to more than just economists and marketing experts. Inelasticity of demand and supply can be critical to daily life. This happens when the good with inelastic supply is at once a necessity, and costs a large portion of the household budget. Both of these characteristics make demand highly inelastic. By necessity, we mean any good that people simply cannot do without, even when the price is higher than they can really afford. In economic terms, we mean a necessary good or service for which demand is highly price inelastic, that is, the demand curve is very steep. We focus here on those necessities that represent a sufficiently large share of consumers’ budgets to cause hardship. An essential good that was

30 CHAPTER 1

Graph 1.23 Perfectly Vertical Demand Curve

9 8 7

Price

6 5 4 3 2 1 0

1

2

3

4

5

6

7

8

9

6

7

8

9

Quantity

Graph 1.24 Perfectly Horizontal Demand Curve

9 8 7

Price

6 5 4 3 2 1 0

1

2

3

4

5

Quantity

THE BASIC MARKET MECHANISM 31

very inexpensive, such as a box of matches, which costs a tiny fraction of the household income, would not fall into this category, even if demand were quite inelastic. Examples of necessary goods with very inelastic demand are food, water, electric power, and insulin for diabetics. For all these, people need a basic amount for which they will pay most anything. However, people will not pay much for an amount that is more than they need. As another example of necessary goods with inelastic demand, take electricity. You will pay dearly for the electric power for basic heat and light. Nevertheless, at some point you will stop buying power even if it is almost free, if only because you have to buy more gadgets to use the power. Basic economic texts do not depict highly inelastic supply and demand curves in general. The usual picture is of straight lines of about 45 degrees intersecting at equilibrium. This picture is seen and used so often that it has become the unconscious assumed standard. Yet many important markets have very inelastic supply and demand curves. Throughout history, the supply of food has been very inelastic. This can cause problems. Historically, food shortages due to inelasticity of supply and demand led to famines and revolts. Electricity is a classic case of inelastic demand. The electric power generators can produce all the power you want at rising costs as the less efficient generators are turned on as the price rises. But once all the generators are running at full capacity, then no short-run increase in electric power supply is possible regardless of how much higher a price people are willing to pay. In modern times, the inelastic demand for electricity has also caused problems, albeit more peaceful ones. The crisis resulting from faulty electric power deregulation in California in 2000 is an example of this. As with raspberries in the previous section, the electric power supply curve becomes perfectly inelastic. Only now, because electric power is a necessity, the community has a real problem, much more serious than a shortage of raspberries! Our brief diagnosis is that more attention should have been given to flattening the electric power supply curve—that is, increasing the price elasticity of electric power supply. How could this be done? The inelastic electricity supply curve could be flattened by private speculators. The speculators could build extra generation capacity to bring online during peak periods of energy use. Naturally, the electricity produced during peak periods would sell for a premium, which is why speculators would be willing to risk building the extra plants. Alternately, the government could pay to maintain extra generators ready

32 CHAPTER 1

to meet a surge in demand, or could build long distance transmission lines so electric power could be imported from distant power generators. Throughout history, both solutions have been tried. And when the supply or demand for a necessary good was highly inelastic, governments have been especially willing to intervene in the market. Why is this? After all, modern economics does not consider price inelasticity of supply for a necessity a market failure for which such government interference is justified. So why do governments not allow private speculators to ameliorate the problem, which would be the “free market” solution? The danger with private speculators is that they might be tempted to hold capacity out of production, or not sell inventories they hold, in order to raise the price. This is fine when the good in question is not important to daily life. However, when the good in question is food, power, or some other critical good, a deficit means severe hardship. Thus, all modern governments (we can think of no exceptions) interfere in markets for necessities in which supply is inelastic. Economists expect that these markets will function according to theory, and are not surprised when they have high price volatility, since big swings in price are needed to get even small changes in quantities demanded or supplied. To the suppliers and demanders in those markets, however, those big price changes will lead to serious changes in their incomes, or even force them to go hungry or cold. To economists these may be expected results, but to governments, those suppliers and demanders are voters, citizens, or dangerous rabble. In any case, they must be appeased. Agriculture in Advanced Market Economies Weather is a key factor in agricultural markets. Because weather is so unpredictable, crop harvests are subject to great variability from year to year, which can move supply curves far to the right or the left. When a poor crop moves the supply curve left, very high prices result, which anger consumers (and consumers are everyone who eats!) (see Graph 1.25). When mild weather results in a bumper crop, the supply curve moves to the right, resulting in low food prices, which are good for consumers but reduce farm incomes even as they increase harvests (see Graph 1.26). Farm incomes drop because prices drop more than quantity sold increases. This occurs because demand for food is price inelastic. To the consternation of many economists, advanced market economies do not entrust their food supplies to the market mechanism. Both farmers and people who eat have chosen to reduce the volatility of agricultural

THE BASIC MARKET MECHANISM 33

Graph 1.25 Agricultural Supply and Demand Curves Demanded Supplied

P1

P2

Q1 Q2

Graph 1.26

Price

Effect of a Bumper Crop

P1 P2

Q1 Q2

Quantity

34 CHAPTER 1

prices through government policies, including price floors for agricultural products. Price floors essentially guarantee horizontal demand curves to the right of the equilibrium point with governments buying up and storing foodstuffs. The effect of a government price floor is shown below (see Graph 1.27). For example, the EU’s Common Agricultural Policy, a price floor, results in large inventories of basic foods and higher incomes for farmers. At the same time, many governments sponsor research and development (R&D) and provide free education and information (i.e., agricultural extension services) to spread best practices to individual farmers. Governments also pay farmers to maintain unused capacity and provide loans and grants to keep farmers in business even if they are losing money. These policies flatten the supply curve to the right of the equilibrium point (see Graph 1.28). To illustrate the consequences of vertical supply and demand curves, which are a historical characteristic of agricultural markets, it helps to take two widely known economic concepts, and apply them to agriculture. The first is the concept of the “dual economy.” The dual economy means that the rural agricultural economy can be treated as separate from the urban manufacturing economy, because peasant agriculture can withdraw from trade with the urban manufacturing sector and still survive. The second concept is the Marshall-Lerner condition, which we adapt here from foreign trade theory. Once we start thinking of the rural agricultural economy as a separate economy instead of just another sector, we can adapt concepts such as the Marshall-Lerner condition to help understand the problems presented by almost vertical, highly inelastic supply and demand curves. The original Marshall-Lerner condition dealt with exports and imports between countries with different currencies. Therefore, changes in the amount of exports and imports purchased depended on the exchange rate. For example, if the price of one euro in dollars is approximately $.95, then the price of a dollar in euros is approximately 1.05 euros. What happens if the euro-dollar exchange rates change so that the price of a euro in dollars is now $1? EU consumers can now buy a dollar for one euro instead of 1.05 euro. That makes imports from the United States cheaper, so European consumers will buy more goods made in the United States. Likewise, U.S. consumers find that euros are more expensive. Each euro now costs $1, instead of only $.95, and American consumers, to save money, will import less high-quality European food, eating U.S. hamburgers instead.

THE BASIC MARKET MECHANISM 35

Graph 1.27 Effect of a Price Floor

ply

Sup

Demand

1

ply

Sup

P1 P2

2

price floor

Q1

Q2 additions to inventories

Graph 1.28 Effect of Policies to Flatten the Supply Curve

Demanded

Price

Supplied

Quantity

36 CHAPTER 1

In our example, the agricultural peasant economy and the urban industrial economy use the same currency, so there is no exchange rate. But the theory still applies. The prices of agricultural products relative to industrial products, that is, the terms of trade between these two economies, play the same role as the exchange rate in the original explanation of the MarshallLerner condition. So what does the Marshall-Lerner condition say? The Marshall-Lerner condition, which we adapt here from foreign trade theory, states that changes in the exchange rate, in this case, the price of agricultural products relative to the price of manufactured products, will balance trade only if the sum of the elasticities of demand in the two economies relative to the terms of trade is greater than one. The reason for the break point being where the sum is equal to one is based on a complex mathematical proof, which we will not repeat here.6 Let us try a simple example instead. Assume you are a peasant farmer who sells his crop to the city and buys agricultural inputs, such as tools, fertilizer, fuel, and machine parts in exchange. The terms of trade are ten bushels of grain for ten units of agricultural input, that is, the terms of trade are one to one. Now you have an exceptionally good harvest. You are able to sell fifteen bushels of grain to the city. Unfortunately, so are all of your neighbors. The increased supply of grain gluts the market and causes the price to fall. However, the price of agricultural inputs has not changed. The Marshall-Lerner condition states that, if the elasticities of your demand for agricultural inputs and the city’s demand for grain sum to less than one, you will be able to buy fewer than ten, let us say only six units of agricultural input. This is because the price of your crop in bushels of grain dropped by a larger percentage than the 50 percent increase in bushels you were able to sell. Your increased output has made you poorer. Your natural response is to produce even more to increase your income. However, as you and your neighbors do this, the price falls more in percentage terms than the quantity sold rises. As you produce more, you push the price down by an even greater percentage, so your total revenue drops and you get poorer. Eventually, you cannot afford to import manufactured agricultural inputs from the city. You must revert to peasant agriculture that does not depend on manufactured inputs. You now have a dual economy. The country now has a backward agricultural sector that exists separately from the advanced urban sector. This situation has occurred throughout history, and governments have traditionally both meddled in markets and used political solutions to prevent this breakdown in trade between the rural agricultural and urban manufacturing sectors. The meddling in markets has included price floors for

THE BASIC MARKET MECHANISM 37

Graph 1.29 Effects of Policies to Flatten Supply and Demand Curves

Price

Demand

Supply

Quantity

agricultural products, government purchases to support farmers, and direct income supplements for farmers. The political solution has varied throughout history. Democracies have used a peaceful political solution, for example, by giving greater weight to rural agricultural populations than to urban populations in their legislatures. Dictatorships have used force, for example, collectivizing agriculture and using monopoly prices of supplies to agriculture by the state and monopsony purchases by the state to ensure low cost supplies of agricultural products for their urban proletariat. We believe that this analysis will help economists understand why governments have traditionally meddled in markets for agricultural products. The “visible hand” of government prevents the comparatively big price changes due to small quantity changes that are typical of very inelastic supply and demand, and that hurt either farmers or city dwellers and lead to an eventual breakdown of trade between the rural and urban sectors, and the impoverishment of either one or both. As deregulation and reliance on the market mechanism spreads to other necessary goods with low elasticities of supply and demand (where the sum of both is less than one), such as electric power, the prices of these goods will become more volatile. Until a system is found that controls the large price impacts of small fluctuations, there are bound to be some ad-

38 CHAPTER 1

verse effects on either producers or consumers. If a solution is not found, market reforms could lose credibility with the electorate and suffer a backlash, with public opinion leaning back toward government interference. This will likely surprise economists who assume that a well-functioning market mechanism is always superior to government regulation. Their mission should not be to preach the market’s superiority in all circumstances, but rather to explore innovative ways to reduce price volatility due to small changes in quantity, that is, ways to increase price elasticity for both supply and demand curves. Economists should also give the benefit of the doubt to government policies that increase supply and recognize without prejudice why some countries choose to have their governments interfere in certain markets. In our example, these policies are beneficial for both farmers and people who eat (see Graph 1.29). Now that you have worked through some problems in price inelasticity in agriculture, remember this argument to demonstrate to the next economist you meet why certain government policies can result in a better outcome than leaving things up to the free market. This definitely will be true if the Marshall-Lerner condition is not fulfilled, and may well also be true if the elasticities of supply and demand for a politically sensitive necessity are sufficiently low.

2 Firms and the Markets They Operate In

The Theory of the Firm Under Uncertainty Modern microeconomics has a very well-developed theory of the firm. Students can take courses on the subject, and there is a rich literature available, which we will not try to summarize here. We will, however, point out several characteristics of economies in transition that challenge the relevance of established theory. The theory usually assumes an already functioning firm in a smoothly working market economy. The main internal function of management is to produce its output at the lowest cost. Thus, if the last euro’s worth of machine use produced one unit of output, but the last euro’s worth of labor produced two units of output, then substituting labor for machine use will increase output without increasing cost. This substitution continues until management equalizes the marginal product of each input, that is, each additional euro’s worth of each input should yield the same addition to output. So, if one more euro’s worth of labor time added more to output than one more euro’s worth of machine use, then management should reduce machine use and use the euros saved to add labor until the last euro’s worth of labor time yielded the same addition to output as the last euro’s worth of machine time. In addition to this input mix adjustment, management must ensure that the last euro’s worth of each input must produce a euro’s worth of output. If the output produced by the last euro’s worth of input yields less revenue 39

40 CHAPTER 2

than a euro, then the firm must reduce output until the production cost for the last unit drops enough and/or the price of the units sold rises enough that price just covers the cost of the last unit. In economics terms, the firm produces at the level of output for which marginal revenue just covers marginal cost. The key elements in this theory are economically correct and readable relative price signals for all inputs and outputs for the firm. However, as discussed above, prices in economies in transition are both volatile (jumping up and down a lot) and misleading (not indicative of real economic scarcities). If price signals cannot be trusted, it is difficult, if not impossible, for a firm to know what it should produce and how much revenue it will earn. The basic theory starts with a firm in equilibrium facing stable and accurate prices for inputs and outputs, and shows clearly how management should respond to one price change at a time. It does not take into account the possibility of prices becoming so volatile that the management cannot cope with the uncertainty. Overwhelming volatility is in fact a common problem in economies in transition, which can baffle even skilled managers. In fact, price volatility may be so bad that firms cannot determine either their marginal revenue or their marginal cost, and therefore cannot determine whether or not they should produce goods. Imagine the chaos and hardship to a firm seeking to determine policy in an environment in which prices are misleading, demand is plummeting, suppliers and buyers are going bankrupt, and every move must take into account the likely reaction of competitors! As Nobel laureate and economist Herbert Simon points out in his theory of “bounded rationality,” if the cost in time and effort to find the optimal solution is too high, managers will rely on “rules of thumb” or “good enough” approximations to get by.1 However, the difficulty and novelty of operating a firm in the chaos of transition does not even allow for development of rules of thumb. Managers of existing firms find it easier to shut down the firm than to try to deal with the problems of running it. Others, observing their difficulty, chose not to start a firm at all. Given the chaotic and opaque nature of the markets in transition, the rational manager would exit, taking as much of the wealth of the firm with him as he could. In the midst of these acute problems, Western advisors focused on privatization as the cure for all ills, ignoring the difficulties of managing a privatized firm in this chaotic environment. Little attention was paid to helping new firms open, and less to the exit of formerly dominant players.

FIRMS AND THE MARKETS THEY OPERATE IN 41

This is in part because the standard theory does not examine what firms do when price signals are incorrect, erratic, or uncertain. The Theory of the Firm under Certainty We have discussed the effects of uncertainty on firm behavior. The welldeveloped theory of the firm under certainty also yields some useful insights for the firm in transition. One insight is the determination of the shutdown point: the point at which the firm ceases to operate and goes out of business. Most people would assume that a firm shuts down when it starts to lose money. This is not true. Actually, firms often continue running even after they begin losing money. The key to understanding this apparent paradox is to differentiate between fixed costs, those costs that persist if its production has shut down (output has fallen to zero), and variable costs, those costs that increase with each extra unit of output and are zero at zero output. A firm will shut down only if its losses during operation are greater than its fixed costs, its losses if it shuts down; that is, it loses more money by operating than it loses by shutting down. If it can cover all its fixed costs and at least some of its variable costs, then it will continue to produce even at a loss because the loss is less than the loss incurred by shutting down. Thus, the shutdown point is the point at which the firm covers only its variable cost and its loss is equal to its fixed cost. This occurs where the price it gets per unit of its product equals its average variable cost per unit output. As soon as the price of its output falls below average variable cost, the firm shuts down. This means that firms with high fixed costs—that is, high costs even at zero output—will continue to operate even with heavy losses. In well-functioning capitalist economies, these firms tend to be in sectors with high fixed capital (physical plant and equipment) that continues to cause high costs even at zero output, such as airlines, power plants, and mines. Note that these fixed costs are not just maintenance at zero output but the cost of holding a physical asset that produces nothing and therefore is worth nothing or almost nothing. Even if the owners manage to sell the firm, the new buyer has an asset worth little that will continue to operate as long as it can cover its variable costs, and some part of its fixed costs. This is important in economies in transition because the firms (also called enterprises) under communist central planning had huge fixed costs

42 CHAPTER 2

that continued into the transition. They did not just produce goods. They also provided health care, housing, recreational facilities, day care, pensions, and other services to their workers and, in some company towns, municipal services for the town as a whole. (If readers feel tempted to express disapproval of this practice, remember that firms in capitalist economies also traditionally provide health insurance and pensions for their employees and tax collection services by withholding wages for various levels of government.) Fixed costs for firms in transition are much higher and more pervasive than in well-functioning capitalist economies. Because of this, the basic theory of the firm operating under complete certainty in perfectly competitive markets would predict that for firms in transition, continuing to operate with heavy losses will be the norm rather than the exception. Somehow this key conclusion was missed by Western advisors. They supposed (logically enough) that firms that were loss-makers should shut down. The recommended remedy to loss-making firms’ refusal to shut down was strict enforcement of stiff bankruptcy laws. One of our favorite stories concerns a small-town dairy that was losing money. The director could not convince his advisor (who had studied traditional microeconomics) that there was no point in bankrupting the dairy. The children in the town would still need milk, and the cows, not understanding that they were bankrupt, would still need to be fed and milked. Unfortunately, the director did not know enough economic theory to put the matter into economic terms. If he had, he could have pointed out that the dairy, although losing money, was covering all its variable costs and at least part of its fixed costs, so that the losses from shutdown would be greater than the losses from continued operation. This is the case in many bankrupted enterprises in the economies in transition. Standard microeconomic theory also predicts another common behavior of firms in transition: firms can postpone having to shut down by cutting variable costs. Since wages and material inputs are the largest variable costs, firms will, if they can, delay paying wages and bills for inputs. We will discuss later the firms’ ability to delay payments. Here, we note only that firms have a strong incentive to do so according to standard microeconomic theory. The wage arrears and unpaid bills act as operating loans in the absence of well-developed capital markets. Since firms in transition economies were burdened by high fixed costs, they could not compete with imports from Western firms not burdened with the same fixed costs. In addition, economies in transition were advised to maintain fixed exchange rates as nominal anchors against inflation; that is, to use cheap imports to hold down domestic prices. It worked—domestic

FIRMS AND THE MARKETS THEY OPERATE IN 43

firms faced prices that could not cover their costs, so they reduced their variable costs and kept operating with losses. This is not a desirable situation, but it is consistent with basic theory (see Box 2.1). The Corrupt Firm Some Western economists who advised transition economies were familiar with, and enthusiastic about, the advantages of the modern corporation in well-developed capitalist economies. The modern corporation is efficient (able to accurately compute the marginal cost versus marginal revenue calculations crucial to optimal decision making), perpetual (a legal person who may never die), and able to make quick decisions (because the chief executive officer [CEO] is essentially a benign dictator). In addition, the corporate structure limits the liability and individual power of the owners (shareholders). All of these advantages promote a more efficient use of capital, which is a greater good both for the firm and for society as a whole. The problem is that the advantages of a corporation depend on strong corporate governance, effective law enforcement, and a code of accepted practices to check the natural self-interest of managers. In well-developed capitalist societies, there is a strong and transparent network of checks that ensures that the corporation fulfills legal and social obligations to owners, employees, customers, creditors, the community, and any other stakeholders. The economies in transition lacked both the legal and social foundations for strong corporate governance. The result was that CEOs and other top managers were able to loot the assets of enterprises under their control, ignoring both the interests of shareholders and the weakly enforced laws. Managers stripped assets from their firms, closed deals for their personal gain, blocked potentially profitable plans, and engaged in questionable practices, such as delaying wages and defaulting on payments to creditors and suppliers. From the point of view of the managers, these actions made perfect sense. A number of them became very wealthy, and were able to retire peacefully to a new home in a warm climate. Many others remain, reaping handsome profits from their exclusive access to the firm’s resources. This outcome surprised some observers. Corruption had long been a topic approached with caution by economists who dealt with lessdeveloped economies. It was potentially offensive to admit that corruption was endemic among political and business leaders in many less-developed economies. Some economists and observers theorized that corruption ac-

44 CHAPTER 2

Box 2.1 The Cooperative Enterprise or Partnership

There is a specialized type of firm that should be mentioned here, the cooperative or collective enterprise. The cooperative differs in certain important ways from the corporation, which is the model most often used for the theory of the firm. Collective enterprise theory is also well developed, but it is not often included in introductory economics texts, probably because it leads to perverse economic results for the economy as a whole. We include it here because the theory of collective enterprises may be important in some sectors of economies in transition, such as subsistence agriculture. Remember that the key feature of the capitalist firm is that it optimizes resource use at the margin: the last euro’s worth of each input adds the same amount of extra output, and inputs are added up to the point where the last euro’s worth of input yields a euro’s worth of output. Now assume a different kind of firm, a simple pure cooperative in which the only variable input is labor. Furthermore, only members can work in the cooperative and each member is paid an equal share of total revenue minus the fixed cost of the fixed inputs. To join, a new worker must be voted in by the current partners. This cooperative will not act like a capitalist firm. That is, it will not add worker-members until the value of the marginal product of the last worker-member added equals his marginal revenue as the capitalist firm does. The workers are not paid the value of their marginal product as in the capitalist firm. Each worker-member is paid an equal share of total revenue minus the fixed cost. This payment can be considered average net revenue. So, a new worker-member will not be voted in unless his marginal net revenue exceeds the average net revenue of the current members. A numerical example may be useful here. Assume a capitalist firm has 4 employees, each adding, 5, 4, 3, and 2 euros of net revenue. The net revenue added is less with each employee because of the law of diminishing returns.2 Each employee would be paid the same marginal net revenue, 2 euros. Total wages paid is 8 euros (i.e., 2 euros per employee). The total net revenue is 5 + 4 + 3 + 2 ⫽ 14 euros. Profit is 14 – 8 ⫽ 6 euros. If the marginal net revenue from a fifth worker is 1 euro and the firm can find 5 workers willing to work for 1 euro each, it will expand output. Total net revenue will be 15 euros. The wage bill will be (continued)

FIRMS AND THE MARKETS THEY OPERATE IN 45

Box 2.1 (continued)

5 euros. So, total profit will be 15 – 5 ⫽ 10 euros. The capitalist firm increases employment and output to take advantage of the cheap labor available. Now convert the capitalist firm to a simple pure cooperative. Start with the same four worker-members producing 14 euros of net revenue, each worker-member receiving 14/4 ⫽ 3.5 euros. Will these four workermembers vote in a fifth? Not unless the new worker-member will add at least 3.5 euros to net revenue. Otherwise, the original four members would have to accept a cut in their incomes. Thus, simple pure cooperatives will not optimize resource use because they stop adding workers and increasing output too soon. There are many more interesting results from the theory of the cooperative. We will mention only two here. First, the cooperative has a strong incentive to act like a capitalist firm, and hire workers for wages (rather than as a partner) as long as the net revenue product covers the wage of the last worker hired. If this is an acceptable alternative, it evolves into a shareholder-owned capitalist firm. Second, in pure cooperatives, such as law or medical practices, in which talent or ability determines each member’s net revenue product, a new worker-member will be voted in only if he or she will increase the income of the current members (that is the new member’s net revenue product must exceed the average net revenue product of the firm). Anyone who makes partner is expected to be more productive than half the current partners. Furthermore, the vote is likely to be near unanimous, since the less productive partners also will share in the increase in average revenue. We may as well add a third point. The partnership cooperative, in which net revenue product is a function of talent or ability, will improve in quality as new partners are added since each new addition is above average. Thus, long-established cooperative partnerships tend to be the best in their field, while long-established corporations may not be. This last point explains why partnerships survive and prosper in some fields, even given the tax and limited liability advantages of the modern corporation.

46 CHAPTER 2

tually helped the economy because it allowed entrepreneurs to circumvent bureaucratic barriers to growth. Furthermore, economists tend to equate private ownership with behavior that is “rational” (to Westerners), or following the models of development seen in well-functioning capitalist economies. Thus, when mass privatizations took place, most Westerners believed that the new owners would model their practices on those of firms in Western capitalist societies. What actually happened was quite different, as we have seen. The experience of widespread corruption in transition economies eventually led observers to focus on corporate governance as an important issue. Unfortunately, corporate governance is also a practical issue. It is not an exercise in altruism, and is almost impossible to enforce if the surrounding economy is corrupt. If it is in managers’ self-interest to practice good governance, they will. If the most profitable strategy for the managers is stripping assets and pursuing personal gain, then that will be the course that managers choose. Good corporate governance requires a civil society, transparent economy, and strict enforcement of the right behavior. In well-functioning capitalist economies, managers and employees certainly want to maximize profits, but they also want to live and retire securely as respected members of the mainstream community. However, in former communist countries, that community did not yet exist. The societies were in transition along their economies. Corporate governance and social norms for business behavior were as yet unformed, or were weakly enforced. Add real uncertainty for the future, and the economically rational conduct for managers was clearly to maximize their income in the short term, that is, to loot the firm of its assets.3 There is a rich and growing literature on corruption and illegal means that can be used to strip a firm for the benefit of its managers. We will not attempt to summarize it here; however, we will briefly discuss some common practices and relate them back to the theory of the firm. The Goal of the Firm The goal of the firm, in mainstream Western business theory (i.e., as taught in most business schools), is to maximize shareholder value. In other words, firms are designed to make money and give that money back to the “owners” of the firm, whether they are holders of stock, the firm’s partners, or in the case of a sole proprietorship, the firm’s individual owner. And “the firm,” by this theory, means all managers and employees of the firm. If there are any employees or managers who do not work for the best

FIRMS AND THE MARKETS THEY OPERATE IN 47

interests of the owners of the firm, they are treated as the exception, with little or no effect on the theory. In a transition economy, the faultlines in this theory become apparent. What possible incentives are there for managers and employees to work for the benefit of “owners” if they can work for themselves? As we have discussed, in economies in transition the rational, self-interested course of action for a manager—faced with nearly insoluble business problems and little penalty for corrupt actions—was to look out for himself first. This is not a new concept. It is called the “principal/agent” problem, and is addressed thoroughly in corruption literature. Briefly stated, the principal/agent problem is the difficulty you encounter, as a principal, in getting someone else, an agent, to work for your interests if you are not looking over his shoulder every minute of the day. In extreme examples, the principal/agent problem means that managers make decisions based on personal gain, with little or no regard for the benefit to the firm, the other employees, or the firm’s owners. Now assume a theory of the firm in which managers’ primary goal is not to maximize shareholder wealth, but rather to maximize their own benefit. The actions they take, based on individual self-interest, mirror the actions of managers defending corporate interest in certain ways. Like other managers, corrupt managers want to maximize the assets of the firm, attain the best financing mix, and structure the firm to maximize value. However, the details may differ from what is taught in business schools. Maximize the Firm’s Assets Maximizing the firm’s assets clearly benefits management, as it provides a larger pool from which to draw income. Management may use legal or semi-legal means to acquire other businesses or assets through the bankruptcy system, privatization, or even by making offers that “cannot be refused.” Cash assets can be built up by paying only those debts that must absolutely be serviced, while delaying and defaulting on everything else. Bank loans can be left unserviced, or even written off if the banks have no effective recourse to the courts. If outside groups have been foolhardy enough to purchase shares in the company (as was the case in Russia), these shareholders can often be ignored, particularly if they are foreign. This explains why wages were commonly as much as six months to a year late in many transition economies, while payments to suppliers might be settled in barter or not settled at all. In some cases, business transactions can benefit management. This depends on the relative bargaining power between the firm and the buyer or

48 CHAPTER 2

supplier with which it is bargaining. If the firm is a large and important buyer, then the smaller supplier with which it is dealing can be expected to pay a premium for closing a deal. This premium (otherwise known as a kickback) belongs to management. Similarly, if the firm is a critical supplier of some good, or a major contractor of services, the buyer or subcontractor will pay a premium. We do not know of any study on types of transactions most common in transition economies, but it is a fair bet that the majority of deals transacted during that period led to personal gain for the individuals involved. Obtain the Right Financing Mix All firms must seek financing of some sort to conduct their business. Finance can come from internally generated cash, from debt, or from selling equity in the firm. Insightful and rigorous analysis has been done on finding the ideal financing mix, and complex debt and equity instruments have been created to allow for incredible flexibility and precision. We will only briefly discuss the basic theory here, as it has been thoroughly explored in mainstream economic and business theory, and there is a wealth of literature available. To greatly simplify, there are two main issues when a firm considers financing: finding the cheapest capital available, and finding the best projects to invest in. When capital is obtained externally, the cost of the finance should not exceed the cost of the investment plus the investment’s expected rate of return. That is, the investment should not lose money. Even when capital is provided by cash generated internally, the rate of return for the new project must still pass a “hurdle” to be acceptable. In this case, the return can be measured against the rate of return that could be obtained by investing that cash in another part of the market, elsewhere in the economy, or even outside the country. Economists have come to the conclusion that firms follow a “pecking order” in determining where to go for capital.4 In purely competitive and transparent capital markets, a firm ought to be indifferent among methods of financing, simply choosing the lowest cost method.5 However, research shows that, all else being equal, managers prefer to finance from internally generated cash. If that is not available, they will turn to borrowing, and only then, if necessary, to issuing equity. There is a very good reason for this. Managers of the firm know more about their own operations than anyone else from whom they might obtain a loan or an investment. Since the managers have the best information, there is information asymmetry, which is a market imperfection. Outside

FIRMS AND THE MARKETS THEY OPERATE IN 49

lenders do not know as much about the investment as the managers do, and will demand a risk premium to make up for lack of knowledge. This makes debt less attractive than internally generated cash. Of course, in some countries there is a benefit to issuing debt because it reduces your taxes; this may make outside debt more attractive than internally generated cash, and may change the order of preference.6 Issuing new stock dilutes ownership and control of the firm, and could endanger the current management’s position. For this reason, issuing equity is even less attractive than issuing debt. There are exceptions to this rule as well, such as when a stock market boom makes stock prices soar and boosts the return of issuing stock. In general, however, firms follow the observed pecking order: internally generated cash is preferred, debt is next favored, and equity issue is the last resort. Thus far we are restating well-recognized business and economic theories on firms in well-functioning capitalist economies. But what about firms in transition economies? These firms must also finance their investments, and one can be sure that their analysis is no less rigorous. Let us explore for a moment a hypothetical firm in a transition economy, as opposed to a firm in a well-functioning capitalist economy. We will call this firm the “corrupt” firm, for reasons that will become clear below. Remember that we are dealing with a firm in which managers make decisions for self-interest, not to benefit shareholders or stakeholders. As discussed, the future of a manager in a transition economy depends to a great extent on his success in gathering a “nest egg,” far more than that of a manager in a civil society with a reasonable standard of living. And the most likely means of obtaining enough money to retire is to draw on the assets of the firm. What effect does this have on financing decisions? Interestingly, the pecking order of obtaining cash in corrupt firms is the precise opposite of that observed in standard business theory. And, as in standard business theory, the reasoning behind managers’ choices is also based on an asymmetry—in this case due to unequal bargaining power among participants. For a corrupt firm, internally generated cash is the least desirable choice for financing projects, making investments and acquisitions, and conducting operations. Outside sources are almost always preferred. After all, the goal is to get cash away from the control of others and use it to benefit managers and other privileged stakeholders. Internally generated cash is most readily available to managers, so it is closely guarded. It should be used only for the most pressing debts, those that cannot be satisfied with outside sources of capital and are important to the manager’s future. Borrowing from banks and the government is more desirable than using

50 CHAPTER 2

internal cash because the debt can then be written off or simply left unserviced. There are, of course, rare cases in which a defaulted debt will have immediate and painful consequences to the manager, but these are the exception.7 “Borrowing” can also go on within the firm, as where wages and supplier payments are defaulted on or delayed for a period of time. In either case, once the debt exists, the balance of power is with the debtor, not with the lender. The debtor can choose not to repay the debt if more profitable opportunities exist for “investing” those funds. Selling equity is even better than taking out debt, because in this case the power rests entirely with the manager. Shareholders outside of management do have a theoretical (i.e., legal) right to affect the management of the firm, but they have almost no chance of achieving this in practice (unless the shareholder is a powerful firm or “connected” individual). One favored method is to sell equity to minority shareholders, or to a friendly organization that will not try to affect management decisions. The best option is selling to foreign shareholders, who not only suffer from the same lack of power as domestic shareholders, but may also be unable to enforce their rights in domestic courts. Thus, while traditional firms prefer using internal cash first, then borrowing, then equity; corrupt firms issue equity first (to minority holders), then move to borrowing, and only use internal cash as a last resort. This reversed order of priorities will be seen again in comparing traditional and corrupt firms. In a well-functioning capitalist economy the asymmetry is information, and can be compensated by a “risk premium,” which increases the cost of capital. In a transition economy, the asymmetry is power. While a “risk premium” may still be paid (as with risky bonds in transition economies, such as Russian GKO bonds before August 1998), the market for these assets is neither transparent nor competitive. The investor has trouble correctly identifying risk and setting the right premium. The only truly safe investment for a lender or investor is not to invest at all, which is precisely why so much of the savings in transitions economies are still held “under the mattress.” We will discuss this in detail in later chapters. We have discussed sources of capital. What about uses of capital? Corrupt firms, like traditional firms, must weigh their potential investments against other opportunities on the market. Here their calculations look much like traditional firms, albeit with a broader base of investments under consideration. Should I pay my workers, or let them wait another month while I invest

FIRMS AND THE MARKETS THEY OPERATE IN 51

in treasury bonds at a 33 percent rate of return? Should I pay off this debt to suppliers, or can I get away with sending them some of our unsold inventory as barter payment? Should I spend money renovating the plant, or invest in the lucrative smuggling trade across the border? Here, as in traditional theories of the firm, rational self-interest is the driver behind management decisions, although it is often individual self-interest, rather than corporate self-interest. As in standard business and economic theory, players in the market are using hurdle rates and making risk assessments. However, these markets may be too opaque for even experienced “investors” to accurately value an investment. This is why arbitrage is still a profitable occupation in transition economies. Unlike in developed economies, arbitrage opportunities do not disappear with the touch of a key as soon as they appear on someone’s computer screen.8 Suitcase traders flourish in economies in transition, alleviating shortages and acting as a mechanism for arbitrage for consumer goods. By some estimates suitcase traders did $20 billion of business in 1996 in Russia alone.9 Smugglers provide the same mechanism in prohibited goods, and capital flight provides arbitrage in interest rates and the cost of capital. Having weighed opportunities, managers must decide which opportunities merit investment. Corrupt firms, like their traditional cousins, are very aware of risk and reward, and make rational choices about what to do with their earnings. Here again there is an order of priority. Traditional theory advises managers to distribute the firm’s earnings (net of short-term liabilities and new investment) in the following order: first, to stockholders and owners; second, to reduce debt or buy back equity; and only then in some form of savings or cash pool. Corrupt firms have, as before, a precisely opposite set of priorities. The best use for earnings is to place them in a cash pool somewhere safe, preferably out of reach of tax collectors (i.e., offshore). Second, certain privileged debt holders might be paid back, or control over the firm consolidated. Finally, and only reluctantly, would some of the earnings be shared with equity holders.10 Structure the Firm to Maximize Value In the traditional business model, the firm structures itself to maximize shareholder value. In the corrupt model, the firm is structured by managers to maximize their own gain. The most successful firm, by this theory, would be one in which 100 percent of retained earnings were stripped and

52 CHAPTER 2

placed in a safe, tax-sheltered place for managers’ use. There are many ways to achieve this goal. We will only touch briefly on some of the more important. The first principle is that prices in many transactions involving corrupt firms do not reflect market conditions, but rather the needs of the managers involved. Goods may be sold at above or below their market price for various reasons. For example, misleading estimates can be used to justify pricing decisions, or the government-dictated “price” from central planning days may become useful as a benchmark to justify unrealistic pricing.11 In any case, the end goal is to transfer funds from one organization to another. For example, a shell or front company could be set up to purchase goods from the firm. The shell would buy at a price dramatically lower than the market value, and then quickly resell the goods, earning a clear profit. This shell company is, of course, controlled by the firm’s managers. Alternatively, these assets could then be used by the new company to start a legitimate business with much lower initial cost than its competitors. In another tactic, the firm purchases goods from a shell company at an exorbitant price, with the profits going to the same managers who closed the deal. If the shell or front company is located offshore, then another important goal can be achieved: that of moving money out of reach of tax collectors and investigators. Patronage is another key element of corrupt businesses. If the goal is to benefit individual managers, managers’ families are also part of the equation. Nepotism is common in firms in transition economies, as is awarding of contracts to privileged firms controlled by managers, their families, or important friends and allies. Patronage also provides a handy way of paying for government influence without using scarce cash resources. If the firm needs a license, for example, for permission to trade overseas, one can provide the government official responsible with a lucrative job for himself or his relative. In this case, patronage begins to resemble the collective or cooperative partnership. As in most collectives, the new “partner” will not be brought in unless he or she will add more to the profits of the firm than the cost of employment. Observers were dismayed when firms in transition economies began to operate in ways that benefited managers rather than the corporation as a whole. To add insult to injury, the new market freedoms advocated by wellmeaning advisors were very useful in helping corrupt firms achieve their goals. If the theory of the firm taught at the basic level included issues of corruption, corporate governance, and the principal/agent problem, advisors might have been better prepared to predict and prevent some of the

FIRMS AND THE MARKETS THEY OPERATE IN 53

worst excesses, often facilitated by well-meaning Western aid, advice, and planning. Imperfect Competition in Transition Economies The best of all monopoly profits is the quiet life.12 Monopoly and Monopsony Monopoly theory, which is the problem of a single seller in a market, is fully explored in introductory economics texts. Briefly, a monopolist has market power—that is, she can affect the price for her good by reducing output, with no competition to undercut the price. As the monopolist reduces output one unit at a time, she loses the revenue from the sale of that last unit, but the price of all the other units sold will be higher. As she reduces output, the marginal cost—the cost of producing the last unit— will be lower. (Remember that marginal cost rises as output increases, so marginal cost falls as output decreases.) Monopoly theory states that monopolists will reduce output until the rising marginal revenue equals the falling marginal cost. This level of output is optimum from a profitability standpoint. The price for the good, although set by the monopolist, also depends on demand for the product at that level of output. The outcome is that a monopolist will sell less output at a higher price than producers in a competitive market. Economists have developed a rich literature explaining why monopolies occur, the effects of monopoly, and the proper remedy for each case. Developed market economies have applied monopoly theory to regulation of monopolies and antimonopoly laws with great success. Economies in transition were encouraged to copy these anti-monopoly laws and regulatory practices. This seemed a particularly urgent need since the legacy of central planning had left the economies in transition with a larger than usual number of monopoly producers. Central planners found it administratively convenient to concentrate production in a few large firms, which led naturally to the creation of monopolies in many markets. It seemed sensible to tackle these historical monopolies aggressively. Economists believed, naturally enough, that breaking up the monopolies would allow consumers to buy more goods at lower prices, thus benefiting society as a whole. While the problem of monopolies received a lot of attention both in developed economies and in the economies in transition, monopsony—the

54 CHAPTER 2

problem of a single buyer in a market—received almost none. Basic economic texts hardly mention monopsony, while the legal and institutional structures of developed economies do not recognize monopsony as a threat at all. Western market economies developed by expanding and integrating markets as transport and communications costs declined, so that local monopsonies were naturally wiped out as markets integrated. For this reason, the problem of monopsony has gone largely unrecognized by Western mainstream economists. One further reason monopsony is not treated in basic economics texts is that the damage from monopsony is not obvious. Unlike a monopolist, who harms consumers, a monopsonist extracts greater output from producers at a lower price than would occur in a competitive market. In a demand-driven (i.e., market) economy, this looks like a desirable outcome. Is monopsony then superior to the competitive market? No, because damage is done to all competitive suppliers who must sell to the monopsonist. Unless the monopsonist’s supplier is also a monopoly, it is clear that the bargaining power will be wholly on the buyer’s side. Competitive firms will be forced to sell at a loss or shut down entirely. Society as a whole also loses, since the competitive firms will produce too much, and their marginal cost will exceed their competitive marginal revenue. Western-trained economic advisors were not prepared to deal with monopsony as a key problem in economies in transition. They understood the threat posed by monopolies, but monopsonies were simply outside their experience. Even when monopsony buyers were recognized in the transition economies, the threat they posed was not understood because it was assumed that lower prices to the monopsonist would be passed on to consumers. This was seen as a good to society. The economies in transition inherited industrial structures prone to monopsony without the historical factors that broke down monopsonies in Western economies. Expansion and integration of markets did not typically occur in transition economies. Rather, breakdowns in transportation and declining demand (as people got poorer) tended to strengthen monopsonists by insulating the lone buyers within each region from competition with buyers outside the region. One-company towns dominated by a single employing firm were common under central planning. These monopsonist employers were also monopoly providers of health care, child care, housing, and other social services in the towns they dominated. Let us return to the explanation of the competitive firm in the beginning of this chapter. In particular, recall the determination of the shutdown point. The key insight was that firms do not shut down when they start losing

FIRMS AND THE MARKETS THEY OPERATE IN 55

money, but only at the point where revenue falls below variable costs. Rational firms will continue to operate at a loss until the loss from operations exceeds variable costs. Now put a number of competitive firms like this at the mercy of a monopsonist, a single buyer. What does the monopsonist do? It bargains with each competitive supplier individually to get the most units sold to it at the lowest price. If the supplier does not agree, the monopsonist threatens to buy nothing from it, that is, to shut it down. The supplier will accept any deal as long as it is better than its shutdown point, that is, as long as revenue covers its variable costs. A monopsonist who knows its suppliers’ shutdown point (as is common in regions with one dominant firm) will bargain the price down to precisely the point at which price equals average variable cost. This allows the monopsonist to continue milking its captive supplier without forcing it out of business. Eventually, of course, the supplier will go bankrupt unless the monopsony is broken by the appearance of other buyers. In economies with developed capital markets, the hapless supplier would borrow from banks or sell shares to investors to finance its operations through what it hopes is a temporary period of losses. However, in transition economies this kind of arrangement is rarely available. Instead, if the supplier also has some monopsony power of its own over its employees and suppliers, it will extract de facto loans by simply deferring or defaulting on its debts to them. The result is a chain of unpaid debts, with each firm supplying its monopsonist customer at the price that just covers average variable cost, suffering losses almost equal to its fixed costs, and surviving by impoverishing its own suppliers in turn. This is precisely what occurred in the economies in transition. Some economists and observers labeled this phenomenon “the virtual economy,” since each firm continues to produce and supply at a loss. Our point is that the “virtual economy” is consistent with microeconomic theory. Specifically, this outcome is consistent with a chain of linked monopsonists/oligopsonists, each exploiting its suppliers of labor and material inputs. This problem is solved eventually only by economic growth and regional integration, which brings more buyers to the market. Instead of growth and integration, the transition economies have suffered severe declines in demand and fragmentation of markets. The problem of monopsony and oligopsony has added to the difficulty of transition in unforeseen and significant ways. The one consolation is that once these economies start to grow and integrate their markets, there will be an extra boost to growth as monopsony and oligopsony buyers disappear.

56 CHAPTER 2

Combating Monopsony What happens if the suppliers try to combine, so that the monopsonist must bargain with a monopolist? Except in one historically important case (which we will discuss below), suppliers who band together are subject to antimonopoly laws! While no developed market economy has antimonopsony laws, almost all have active antimonopoly laws. Although the suppliers are being victimized by the monopsonist’s power to buy, they have no legal recourse, lacking antimonopsony regulation. There is one exception to this conundrum. Certain “suppliers” have found a way to successfully band together to defeat the power of a monopsonist without being branded a monopoly. We are referring, of course, to organized labor. The household, as a supplier of labor, has always been a target for monopsonistic exploitation. Households tend to be immobile and must “sell” labor in order to survive. Further, despite the rosy predictions of some market economists, most workers cannot easily retrain and enter new fields of employment. The monopsonist historically was the lord of the manor or the single employer in the one-company town. The only protection available to households confronted by monopsonistic employers was a shaky patchwork of social custom, religion, and the long-term interests of the exploiting monopsonists to keep households alive so that they could supply labor over the long term. However, as we know this protection was too flimsy to protect everyone. There are many historical instances of famine and hardship caused by exploitation of labor by unscrupulous employers. Eventually, with the rise of industrialization and increased need for labor, some governments yielded to threats of revolution from a proletariat with “nothing to lose but their chains,” and reluctantly allowed the formation of labor unions. However, most economies in transition lacked effective labor unions. The unions that were in place were wholly controlled by the government (another legacy of communism) and acted more like an avaricious middleman than a protector. Furthermore, the employers were themselves facing declining demand for their products, and perhaps facing monopsonists as well, so the chief weapon of the labor union, the strike, would not do much good. In fact, many firms were already working half-shifts or not at all, so that a strike would only lower variable costs for the employer by allowing him to forgo paying wages entirely, reducing variable costs. With no effective way for employees to organize or for small suppliers to band together, the economies in transition would have to wait for their

FIRMS AND THE MARKETS THEY OPERATE IN 57

monopsony problems to be solved by economic growth and the integration of markets. This problem is not limited to economies in transition. Monopsony, like monopoly, is a basic market failure to which many economies are susceptible at certain stages of development or due to government policies. Before ending this section, we would like to offer historical evidence of the monopoly and monopsony problems that existed in the United States in the nineteenth century and are probably recurring in one-company towns in the economies in transition in the late twentieth and early twenty-first centuries. It is the only microeconomic theory song we know. This song was sung by Appalachian coal miners and provided a hit song for Tennessee Ernie Ford. It is called “Sixteen Tons.” Notes for economists are below. You load sixteen tons* and what do you get? Another day older and deeper in debt.** Saint Peter, don’t you call me because I can’t go. I owe my soul to the company store.*** Oligopoly and Oligopsony By now, you are protesting that both monopoly and monopsony must be very rare. If buyers find another supplier, the monopoly is broken. All that sellers have to do is find a second customer and the monopsony is broken. This is true in theory, but there is a wide range of alternatives between monopoly or monopsony and perfect competition. If there are several sellers and they are able to collude to hold supplies down to raise the price, then you have oligopoly. If you have several buyers and they are able to collude to limit demand to lower prices and increase supplies, then you have oligopsony. Oligopoly, like monopoly, is thoroughly discussed in mainstream economics, and we will not explore it in depth here. However, oligopsony, like monopsony, is hardly mentioned in basic economics texts. Much of what is said about oligopoly is true of oligopsony, but until recently the problem of oligopsony has been little recognized. *Producing at maximum output. **Operating at a loss but above your shutdown point, which is to quit and starve. ***In this instance the company is both monopsony employer and monopoly seller of household necessities.

58 CHAPTER 2

Box 2.2 Government Mandated Purchases of Agricultural Products

In the former Soviet Union and its Warsaw Pact allies, agriculture was treated as a matter of national security. This is easy to understand given the history of the USSR and Eastern Europe. All had experienced long and bitter periods of conflict, during which the nation’s food needs had to be met from within because the country was at war with its neighbors. Most had also experienced periods of famine. Besides the need for secure food supplies, Soviet exploitation of agriculture was justified by ideology and political necessity. Peasant agriculture is unique among economic sectors, since it is the only sector that can largely withdraw from the rest of the economy and survive. Leaders were all too aware that peasant agriculture, unlike any other sector, can withdraw entirely from the economy if it is too heavily exploited, and wanted to ensure political control over farmers. Trotsky alerted the Party to the threat in his “Scissors Crisis” of 1923. The “scissors” were two lines on a graph showing rapidly rising industrial prices diverging from less rapidly rising agricultural prices over time. The widening gap looked like an open scissors. If the gap got too wide, peasants would stop selling food to the cities and produce only for themselves (this was because, as discussed above, the Marshall-Lerner condition did not hold). This had to be prevented. Peasant agriculture needed to provide a surplus both to support the urban proletariat and to sell on world markets to finance industrialization, the key Soviet economic goal. Marxist doctrine supported putting the needs of the proletariat and party goals over those of the peasants. Stalin fulfilled these priorities with his agricultural policy. Historians have focused on Stalin’s ruthless and costly collectivization policy, which forced individual peasant farmers and their lands under state control and prevented them from withdrawing from the market and producing only for themselves. The other part of the policy was an agricultural input supply and procurement system, which used stateenforced monopoly and monopsony power to wring as much surplus as possible from the peasantry. Leaders were all too aware that peasant agriculture, unlike any other sector, can withdraw entirely from the economy if it is too heavily exploited, and wanted to ensure complete economic control over peasant farmers. For these reasons, the government watched the agricultural sector closely, and participated in many activities, which would be strictly commercial in market economies. For example, the government either pro(continued)

FIRMS AND THE MARKETS THEY OPERATE IN 59

Box 2.2 (continued)

vided fuel to farmers directly, or brokered deals for fuel provision, to be sure there would be enough fuel to sow and harvest. The government typically was involved in providing seed stock, determining which crops to grow, and how much should be raised. During communist days, the government was the monopsony buyer of all agricultural goods from large collectives (Produce from individual plots was sold in collective farm markets with prices determined by supply and demand.) and was also the producer of all processed foodstuffs. This ensured that the agricultural sector was integrated with, and dependent on, the rest of the economy. In socialist times, both the collective farms (kolkhoz) and the government-owned farms (sovkhoz) experienced many of the problems seen whenever small suppliers face a monopsonist buyer. The government bought their crops at the lowest possible price, whether or not that price covered costs, and made monopoly profits by reselling a portion on foreign markets. In one particularly egregious historical example, the Soviet Union made millions selling wheat on the world market during 1930–1932, a time of terrible famine in the Ukraine. The USSR sold so much wheat at this time that there was actually a glut on the market. All of this wheat had, of course, been confiscated from precisely those regions that were suffering from famine.13 In this case, the state used its monopsonist power both to punish dissent and to turn a profit. It is an accepted Marxist principle to exploit peasants in order to industrialize and take care of the urban proletariat. Since the collective farms were state-dominated enterprises, any shortfall in costs would be made up by the government in the form of budget increases. During socialist times this system worked—barely. Certainly it met the political goal of control over the farmers and the economic goal of a captive food supply. There was little incentive for the collective farmers to produce efficiently—in fact, it was common practice for workers to steal and misuse collective farm property to support cultivation of their own private plots. The system was set up to be unfair, so that people would need to break the law to survive and thus be vulnerable to the threat of prosecution. Less commonly discussed is the inevitable result when collective farms lost their state support but continued to face a monopsonist buyer in the form of the government. Gorbachev himself perfected the so-called “link system,” whereby agricultural teams, or “links” (usually farming households), bought their inputs from the state farm or collective farm (continued)

60 CHAPTER 2

Box 2.2 (continued)

at high monopoly prices and were forced to sell their outputs back to the state via the state farm or collective farm at low monopsony prices. The prices were set to wring the maximum surplus out of the “links” and transfer it to the state. Even after the transition, the former communist governments in Russia, Ukraine, and Belarus continued to have the “right” to buy the entire harvest from collective farmers if they chose—which is to say, to buy the harvest from 99 percent of farmers, since effective private ownership of agricultural land was still almost nonexistent. Meanwhile, the collective farms were urged to strike out on their own, use new seeds and techniques, buy new farm equipment, and take out loans. The government promised the farmers they would be able to sell their crops on the open market. The U.S. government and many other aid donors spent millions of dollars on grants, purchase incentives, and programs to help former collective farms become commercial farms. If you had taken a trip down into the sleepy farming districts of Ukraine and Russia at this time you would have seen some strange apparitions: shiny John Deere tractors in fancy new dealerships paid for by aid money; shiny Western trucks going from farm to farm; USAID and EU experts conducting research and passing out information. It was a serious effort, and some of the farmers took it seriously. They bought the new tractors, seed, and fertilizer, participated in the programs, and even signed contracts for their upcoming harvest. However, year after year the same result occurred. At the last minute, after agonized meetings and all-night sessions, the government would decide to exercise its option to purchase the harvest. All of the new crop would be bought at rock-bottom prices, and much of it resold on the world market to the same buyers that the farmers would have liked to sell to directly. Of course, few if any collective farms “failed” entirely. The government, as a monopsonist buyer with knowledge of its suppliers’ finances, made sure that they operated just above the shutdown point, thus extracting maximum surplus from them. This also prevented collective farmers from abandoning the farms entirely and moving to the cities, where they would present a political problem that the government was reluctant to solve. The incentive for the government to “confiscate” the harvest and extract maximum surplus is of course higher after foreign aid has increased the surplus to be extracted. There are many problems plaguing agriculture in the transition economies: uncertain ownership of land; the legacy of forced collectivization; environmental damage; corruption; and inefficient use of land. These are (continued)

FIRMS AND THE MARKETS THEY OPERATE IN 61

Box 2.2 (continued)

common to all, and yet agriculture in some countries, such as Poland, the Baltic States, and the Czech Republic, is recovering, while in others it is standing still. We would argue that the countries in which agriculture is recovering are precisely those in which the government has been induced to give up its monopsonist power. Either collectivization never occurred, as in Poland, or the government has broken with its predecessors to pursue a fairer agricultural policy. Curbing the monopsonist and monopolist power of the state over agriculture has been a key step in putting agriculture on an upward path.

Both oligopoly and oligopsony are theoretically messy and difficult to predict, because the outcome depends on the size of the market and the number of players. If there are few buyers and they are able to collude almost perfectly, then the market outcome will be very close to monopsony. As the number of buyers increases and their collusion becomes less perfect, oligopsony would fade into “monopsonistic competition,” if economics recognized this term. In monopsonistic competition, the price received by some sellers will be less than marginal cost, while some will receive a price closer to the market price. Oligopoly and oligopsony depend on collusion among buyers or sellers. Cheating weakens the outcome, and brings it closer to a market system. While collusion among oligopolists is usually illegal in market economies, collusion among oligopsonists is legal and encouraged. For example, in most market economies, purchasing cooperatives extract lower prices from suppliers and pass them on to members. As another example, large health care organizations in the United States are lauded for wringing price concessions out of suppliers, with the hope that they will pass these cost savings on to the members, the companies that are paying for their employees’ health insurance. Foreign trade is also a factor in determining the competitiveness of a market. All else being equal, increased foreign trade tends to dilute both monopolistic and monopsonistic outcomes. While competition from imports limits monopoly and oligopoly power, competition from export opportunities limits monopsony and oligopsony power. The greater the value of domestic currency relative to the currencies of the exporting countries, the less likely consumers are to buy the monopolistic producer’s goods, and thus the weaker their power. Similarly, the lower the value of the

62 CHAPTER 2

domestic currency relative to the currencies of the importing countries, the more likely domestic producers are to sell overseas and thus go around their monopsonistic buyers. Economies in transition were encouraged to defend the high value of their domestic currency to limit monopoly and oligopoly power. Monopsony and oligopsony were not even recognized as potential problems by most advisors. This policy directly increased the power of monopsonistic buyers, by limiting the options for suppliers to sell elsewhere. The economics literature on imperfect competition is rich, and has important conclusions that, although usually applied to monopoly and oligopoly, are also true of monopsony and oligopsony. The key feature of imperfect competition is that each firm bases its price and output decisions not only on the cost of producing, but on the likely reaction of other producers to its decision. Firms also must take into account the reactions of customers and suppliers. In imperfect competition, firms cannot simply sell at full capacity at the market price and concentrate on reducing costs. They must operate strategically, gaming their competitors, customers, and suppliers with threats, bluff, and random responses to their actions. As in poker, there is no stable equilibrium! We contend that the economies in transition have suffered severe problems of imperfect competition, in part because Western advisors did not recognize the serious cost of monopsony and oligopsony and the resulting impoverishment of suppliers. Summary Mainstream theory of the firm focuses on the problems of, and assumes the strengths of, well-functioning markets in growing market economies. But markets in transition economies were not well functioning. They were crippled by uncertainty, corruption, the principal/agent problem, poor corporate governance, and monopsony/oligopsony. Neither were these markets growing. Rather, the breakdown of transport and communication fragmented the markets and worsened an already contracting economy. Much of the contraction was due to replacement of monopolistic and monopsonistic price discrimination practiced by central planners, with static and poorly connected markets. Western advisors used traditional theory of the firm and of competitive markets to formulate their advice to former communist countries. In fact, many of the critical problems faced during the transition were not addressed by the theory. Our reassessment may help avoid these mistakes in future transitions.

3 The Factors of Production

How Incomes Are Determined Factors are the inputs into the production process. Traditionally, theory deals with three general categories. Land—including timber, fisheries, and other natural resources—earns rents. Labor earns wages. Capital—meaning here plant and equipment, not money—earns profits. These factors combine to make every product and service sold on the market. But how much are these factors worth, and who or what determines the income paid to the factor owners? Historically, this question has been answered both by political theory (capitalism, Marxism-Leninism, socialism) and by economic theory. We will first discuss economic theory, although the political theory relating to factor incomes is also interesting and important. Economic theory has developed an elegant and optimal determination of factor incomes, the theory of perfect competition. It applies the same marginal optimizing rules to factor markets that it applies to product markets. As in product markets, each factor will be paid the contribution of its marginal product to marginal revenue. Thus, if the last worker hired adds one-tenth of a widget per hour to total output and that last widget sold adds 10 euro to total revenue, then all workers will be paid the value of their marginal revenue product or 10 euro ⫻ 1/10 widgets ⫽ 1 euro/hour. Economic theory then proves that a competitive economy will make optimal use of its factors, from inputs to production, since each factor will 63

64 CHAPTER 3

move to the productive activity at which it is paid the most, that is, where the value of its marginal revenue product is highest. They will stop moving and be at equilibrium when the values of all their marginal revenue products are equal—when output can no longer be increased by moving inputs around. But what happens if the economy is plagued by high uncertainty and/ or volatility in product prices? The values of the marginal revenue products of factors, and therefore their incomes, will also be uncertain and/or volatile. Moreover, if monopoly and/or monopsony distort outputs and their prices, the incomes of the factors of production will also be distorted. Similarly, if oligopsony and/or oligopoly mean there is no stable equilibrium in product markets, then there is no stable equilibrium in factor markets or in incomes. Economic theory tells us that the market system is optimal when it works perfectly. It even tells us that the market system is less than optimal when it does not work perfectly (a prediction that the economies in transition could support with first-hand experience). However, to the best of our knowledge, theory does not yet tell us what the effects are for factor incomes when the market system breaks down, and when intervention is required to fix the cumulative effect of market “imperfections.” This difficult decision is left to the political system, which responds to the complaints of the factors whose incomes are uncertain, volatile, too low, or indeterminate. This is particularly important when it comes to labor income, since most voters depend on this income for their livelihood. In democracies, governments are likely to fix problems by adjusting labor incomes. We have already discussed labor unions, which are statesanctioned monopolies, designed to fix problems relating to labor incomes, even at the expense of optimal efficiency. Instituting a minimum wage is another popular method for governments to protect labor when the value of marginal product determination of wages is not sufficient to support workers’ families. If wages equal to the value of marginal product of labor are not sufficient for labor to reproduce itself, the labor force will decline through starvation or migration until the value of its marginal product rises sufficiently. Most political systems, including democracies, also bail out financial institutions when financial crises occur, in an effort to protect those dependent on income from capital. If these market imperfections occur even in developed market economies, and require government intervention in income distribution, then it is not surprising that economies in transition, for which the imperfections are worse, would also require at least as much

THE FACTORS OF PRODUCTION 65

government intervention as their developed neighbors. Government intervention in both cases will be determined by political power. The Classical Theory of Capital The concept of equilibrium, the point at which marginal cost just equals marginal return, extends also to the classical determination of the economy’s capital stock. Classical in this case means the microeconomics developed from Adam Smith on. Capital stock is produced means of production, including tools, machinery, factories, roads, or anything that is produced and then used in further production, rather than consumed. Let us return to the peasant farming families at the beginning of the book. They cannot produce very much from digging, planting, and harvesting with their bare hands. However, if they save up to buy farm tools, they can produce more in the future. What determines the supply of savings? Saving is forgone consumption, as the families forgo consumption now for greater consumption later. How much consumption they forgo depends on the degree of hardship now, versus the increase in later consumption that the hardship will “buy.” So, for any given range of hardship choices, the higher the future consumption that families can “buy” with that hardship, the more hardship they will be willing to endure. One can express this ratio between the future consumption required to be willing to give up current consumption as a percentage. If the peasant is willing to give up 1 unit of this year’s consumption in return for an additional 1.1 units of consumption next year, then he wants a 10 percent increase for delaying that first unit of consumption. Giving up a second unit will be harder, so the peasant may require a larger return for delaying a second unit of consumption, say 1.2 units or 20 percent more promised for next year. Forgoing consumption of a third unit for a year would be harder still, so the peasant would demand an even bigger reward for postponing consumption of the third unit, say 1.3 units promised for next year or 30 percent. You can see the pattern. Forgone consumption—the supply of savings— increases as the saver is offered a higher reward for postponing consumption. Then what happens with the saving, to the forgone consumption? The food units are sold and the proceeds used to buy capital, in this case, farm equipment. The smart peasant looks at his fixed supplies of land and labor, assesses the equipment he can afford to buy, and chooses for his first purchase the

66 CHAPTER 3

piece of equipment that will add the most to this year’s crop and therefore to next year’s consumption. Let’s assume the new equipment will add 30 percent of a unit of consumption. Since the peasant only requires a 10 percent return to forgo consuming that first unit of consumption, and he will get a 30 percent return on his investment, in this case he will definitely save and invest—that is, he will buy the first piece of capital. If the second piece of capital yields 20 percent, and as noted above he is willing to delay consuming the second unit of consumption one year for a 20 percent return, he will save for and buy the second piece of capital too. But the third piece of capital only adds 10 percent to consumption, and he is not willing to give up a third unit of consumption unless he gets at least a 30 percent return. Therefore, he will not save up for the third unit. At the end of the transactions, his farm will have two units of capital stock. The rate of return for the last unit of capital he was willing to invest in—a 20 percent return—is the equilibrium interest rate. That is, 20 percent is the lowest rate of return at which the peasant is willing to save. Now if you add up all the schedules of willingness to save at each interest rate of all the households in the economy, you get the supply of savings from the whole economy at each interest rate. If the supply of savings is on the horizontal axis and the interest rate is on the vertical axis, the savings supply rises with the interest rate. The savings supply curve rises to the right (see Graph 3.1). Similarly, the demand for savings to be invested in capital for all the households can be added up to get the demand for savings to be invested for the whole economy. Since land and labor are fixed, the capital equipment will be subject to diminishing returns. The capital equipment will be bought in descending order of rate of return. Each additional piece of capital reduces the amount of fixed land and labor that every unit of capital has to work with. Thus, as saving—and therefore, investing—increases, the capital stock also increases. The increase in the capital stock makes the marginal product of the capital stock fall. Therefore, the marginal rate of return on the capital stock, the return on the last capital unit bought, falls. That is, the savings demand curve falls to the right on our graph (see Graph 3.2). The two curves will intersect at the equilibrium investment in capital stock and the equilibrium interest rate. Thus, our perfectly competitive economy also optimizes the capital stock (in the same way that it optimizes the product markets), balancing on the one hand the willingness of savers to give up current consumption in exchange for future consumption, with, on the other hand, the ability of capital bought by sacrificing current con-

THE FACTORS OF PRODUCTION 67

Graph 3.1 Supply of Savings in an Economy

9 8

Interest Rate

7 6 5 4

Supply

3 2 1 0

1

2

3

5

4

6

8

7

9

Savings

Graph 3.2 Supply and Demand for Savings in an Economy

9 8

Interest Rate

7 6 5 4

Supply of savings

Demand for savings to invest

3 2 1 0

1

2

3

4

5

6

Savings and Investment

7

8

9

68 CHAPTER 3

sumption to deliver that increased future consumption. This is a beautiful system. But it is also a system with recognized vulnerabilities. We suggest that these vulnerabilities are much more serious in economies in transition, so serious that the system breaks down. Let us turn first to what happens if some peasant households have more savings than investment opportunities, while others have the reverse, more investment opportunities than savings. The solution is that the households with high savings should lend to the households with high returns on investment. This process, however, requires extensive expertise and institutional support. Somehow, peasants with excess savings (whose willingness to save exceeds their investment opportunities) must be able to find peasants they can trust who have the opposite problem (whose investment opportunities exceed their willingness to save). A stable and well-developed society will have a well-developed financial system and institutional structure, which transfers savings to the most productive investment opportunities. The institutional structure is the legal and social system that allows savers to give up current consumption power, with confidence that they will get it back later with interest. If the system is to optimize growth, it should also ensure that the savings go to the most productive investment opportunities, regardless of where they are in the economy. There are many ways to do this. The saver can deposit his or her savings in a bank and collect interest. The bank’s experts then loan the money out to borrowers, from whom the bank collects interest. The more expert the bank, the greater its profits, which are the difference between the interest collected from borrowers and the interest paid to depositors. Alternatively, the saver could buy shares in another peasant’s farm, or in his crops for a certain number of years or in perpetuity. The saver then becomes a capitalist rather than a depositor. This method, known as sharecropping, is common in many countries. Another alternative is for the state to tax the saver, and spend the money itself, or give it or lend it to other peasants, or even to other parts of the economy that offer higher returns, or so the state thinks. This last approach—the political solution—has been tried in most countries, not only in socialist and communist systems but in developed economies as well. In developed economies with established rule of law, farmers may themselves be willing to be taxed to pay for roads, grain elevators, irrigation projects, and other physical infrastructure that has higher returns than additional farm equipment. State investment in infrastructure can be

THE FACTORS OF PRODUCTION 69

a useful aid to the working of the market. Local government can also serve as a farmers’ cooperative. Taken to extremes however, this approach can lead to economic stagnation, protectionism, efficient investment opportunities being crowded out by those favored by the state, and even to the horrors of collectivization. In Russia in the 1930s, the country needed to achieve rapid industrialization without the economic freedom of a market economy, which would have allocated funds to the most profitable investments. The solution that Stalin found was to forcibly limit consumption and extract savings from the peasantry, so that the savings could be given to the industrial sector. As noted previously, peasant agriculture is a unique sector in an economy. It is the only sector that can largely withdraw from the rest of the economy and still survive, or even prosper. For this reason, Stalin had to use force to extract the peasants’ savings, lacking any other effective means to do so. In part because of the lessons learned from economic stagnation under state-controlled investments and central planning, the favored solution in the West is to allow the market to allocate investments with the help of a well-developed financial system. Thus, the economies in transition were urged to copy the financial systems prevalent in well-developed and stable capitalist economies, even though the economies in transition themselves were neither well developed nor stable. The opportunities for fraud and abuse, and the lack of effective social and legal constraints on complex kinds of theft, attracted the worst kind of unscrupulous operators to the financial sectors in these economies. Also, Western economists and business advisors tended to emphasize the competitive aspects of doing business rather than the important moral code and trust implicit in continuous day-to-day business dealings in well-developed capitalist economies. Economists do not like the idea of an economic system dependent on customary social norms, which are hard to quantify and are exogenous to— that is, outside of—their theory. Nonetheless, these social norms are important, and are no less real for being hard to quantify with numbers. One way to make economists more comfortable is to translate what is obvious to social scientists and historians into terms that economists can understand. It may help to view the economy as a transactions cooperative. One gains admittance to this cooperative by following the norms of fair trade and honesty that give the cooperative its advantage, which is much lower transactions costs. Another way to explain the phenomenon is to emphasize the value of a reputation for competence and fairness to any business.

70 CHAPTER 3

Accountants include this explicitly in the valuation of a firm as a recognized asset, which they call “goodwill.” A revealing exercise, which to the best of our knowledge has never been undertaken, would be the calculation of the share of “goodwill” versus the share of capital stock in the valuation of the firms in a developed Western economy. We suspect that the “goodwill” share would be highly significant. Both the physical capital stock and “goodwill” are valuable, because both contribute to the future stream of profits. But firms that operate in transition economies face a very different picture. The expected future stream of profits is risky and uncertain. The entire economy is in flux. Suppliers are unreliable. Customers have uncertain incomes. Theft and corruption are, unfortunately, much more certain. The rational behavior of anyone who has savings in such a business environment is to hold your savings in inventories of consumables—or in U.S. dollars under the mattress—certainly not to trust the unproven financial system. In graphical terms, the savings supply curve in a transition economy is shifted far to the left and is almost vertical. Smart savers in such a market will be tempted only by very high interest rates. Investors will naturally tend to invest only in sure-fire and very short-term investment opportunities. One of the safest activities is price arbitrage of physical goods. In Soviet times this was known as speculation, and provided goods that the state system did not. In transition economies the continued attractiveness of this type of investment is epitomized by the ubiquitous “suitcase traders.” In this kind of price arbitrage, since you are almost always holding physical goods, you are hedging against inflation, and you know your assets are safe because you can see them (not to mention you have probably paid off the local private “security” firm). Your goal is to leverage the physical goods that you have acquired, to accumulate assets that will not lose value, and get them to a safe place. The ultimate way to do this is to convert them to U.S. dollars and get the dollars out of the country under your control—in other words, capital flight. In graphical terms, the demand for funds to invest in the local economy is represented by a short vertical line cut off at the bottom and located in the upper left portion of the graph. The few domestic economy investment opportunities must have extremely high returns to be competitive with “tunneling” (embezzling assets from the firm), converting them to dollars, and engaging in capital flight. In other words, for an economy experiencing the risks and uncertainties connected with transition, classical capital theory predicts the following: a

THE FACTORS OF PRODUCTION 71

Graph 3.3 Economies in Transition

16

economies in transition

Supply

Interest Rate

14

Demand

12 10 8 6

normal supply and demand 4 2 0

Supply 1

2

Demand 3

4

5

6

7

8

9

Savings and Investment

breakdown or near-breakdown of the domestic capital market; high savings but little investment in the domestic economy; and capital flight! The savers and investors in economies in transition have shown remarkable energy and ingenuity in following the dictates of classic capital theory. But the results, rational as they seem in hindsight, were not predicted by observers because the actual shape and position of the curves—given the conditions brought about by the transition—were not even investigated for peculiarities, much less estimated. Once again, a well-functioning competitive microeconomy within a well-developed institutional and social framework was assumed by the advising economists (see Graph 3.3). Other factors, which are well recognized in classic capital theory, also had negative effects on investment in economies in transition. High and variable tax rates and constantly changing and complex tax laws lowered, and increased the volatility of, the present discounted values of investments. Governments soaked up savings by borrowing to finance current expenditures, crowding out investment with safer government bonds. The emphasis on price stability supported by international financial institutions and Western economists led to extensive use of tight monetary policy to fight inflation. This resulted in extremely high and varying interest rates as when interest rates soared overnight in Russia to fight off impending

72 CHAPTER 3

currency crises or to conform with the latest International Monetary Fund [IMF] requirements, also increasing uncertainty for investments. This in turn made the supposedly much safer government bonds even cheaper compared to the costs of risky investments in private-sector capital stock. Technology also played a role. Technological progress in modern economies is credited with increasing the rate of return on investment, at least partly canceling the effect of diminishing returns. In other words, technological progress increases the value of new capital stock. But technological progress also makes the capital stock currently in use obsolete. To the extent that investors anticipate and fear technological obsolescence, technological progress can discourage investment. The capital stock that the economies in transition inherited from central planning suffered massive obsolescence in a very short period. It was geared toward heavy industry and defense, so it produced the wrong products for a consumption-driven market economy. Much of it was also noncompetitive with global technological best practices; thus, even where enterprises produced the right things, they were hopelessly inefficient and could not compete with foreign-made goods in quality. For these reasons, investing in domestically produced capital stock in economies in transition was highly risky. Once again, capital flight became the most attractive use of savings. There is another issue of great historical significance, which classical capital theory does not directly address: the effect on the distribution of income and wealth. Once some households become wealthier than their neighbors—either due to luck or because they are more willing to reduce their current consumption and save money—they begin to save more and more, since the marginal consumption they forego hurts less and less as they get wealthier. As their incomes rise due to the interest they collect for lending out their growing wealth, these households save and invest more, and their wealth increases. There is no equilibrium mechanism to ensure an optimal distribution of wealth. In fact, there is not even an economic theory of the optimal distribution of wealth (although there are plenty of political theories). We have only the understanding that inequality is a bad outcome. There is no reason in the theory for this process of wealth accumulation to stop at all. The rich can go on getting richer almost indefinitely, as Russia’s oligarchs have done. In addition, wealth brings political power and influence, which can be used to reduce some of the risks of investing in domestic capital stock noted above, such as taxes and government regulation. But that political power and influence can also be used to facilitate capital flight.

THE FACTORS OF PRODUCTION 73

Basic texts in economics acknowledge that the cumulative effect of the saving and investment mechanism can lead to unlimited increase in the inequality of wealth and income. Governments face opposing imperatives: the need to alleviate economic inequality, and the need to harvest the economic efficiency given by classical capital theory in allocating savings to investments. Economics texts usually recommend that governments leave investment decisions to the market, and design a system of taxes and transfers that reallocates income to those who need it most while minimizing the damage done to efficient allocation of savings. How to achieve this, given the political power and influence that accompanies wealth, is a problem left to political economy. Once again, economic theory stops short of dealing with a key economic issue with important consequences for human society. So what is to be done in economies in transition, for which the lack of financial and legal structures will not allow this market-based solution? The typical debate places supporters of a market solution (inspired by classical capitalist market theory) against supporters of broad state intervention in markets (inspired by classical socialist political theory). Ironically, the answer is found in applying classic capital theory, not discarding it. We noted above that the supply and demand curves for savings in the economies in transition tend to be very steep and far to the left. That is, neither saving nor investment in domestic capital stock was very responsive to the interest rate or rate of return, respectively. Also, if the curves do intersect, they do so at very low levels of investment. How can the curves be made more normal, more like those in developed, stable economies? A domestic solution will only be found after years of institutional development in the financial sectors and development of normal investment opportunities. In other words, successful transition will solve the problem. But what can be done until that time? The answer is to open the economy to foreign financial institutions and make capital flight legal and inexpensive for all savers, not just the wealthy privileged who can circumvent capital controls without getting caught. If the domestic economy cannot offer lower risk and higher rate of return investment opportunities for domestic savings, then households with savings should be able to invest elsewhere. This is the opposite of the advice often given to developing economies or economies in transition. Great effort has been expended to restrict capital outflows, so the savings will be invested in the domestic economy. The result too often is that the savings are wasted or stolen.1 These losses fall disproportionately on hard-working and high-saving households that lack

74 CHAPTER 3

the wealth and political clout to get their savings out of the country illegally. Equalizing access to safe investment opportunities with a higher rate of return would go a long way toward correcting imbalances in wealth and income, while strengthening the efficient allocation of savings to the bestpaying investment opportunities, even if these are outside the country. This would at least partly solve the classic problem of the tradeoff between wealth distribution and economic efficiency. Furthermore, these gains from foreign investment could be taxed. What would the Russian economy be today, if Russian households had been able to convert their rubles to foreign currencies and invest in global stock markets, beginning in 1992? Not only would their money have earned them returns, but their foreign-earned wealth would have contributed to taxes, and the income coming back to households in Russia would have served an important role in the economy by providing a “floor” under domestic demand for goods and services. The domestic financial sector in Russia would have had to either compete with the foreign institutions or be replaced by them. Fewer savings would have been wasted on bad investments. The financial crises that have hit Russia since it began the transition would have been less damaging, if not avoided entirely. It is ironic that Western advice has not drawn on the conclusions to be found in classic capital theory, and has not supported this freer allocation of savings to the best investments available. The most successful transition economies did learn this lesson. Poland, from 1 January 1990, made it legal and convenient for its citizens to open U.S. dollar accounts in small amounts. Hard-working and high-saving households thus had a safe alternative to domestic investment options. Domestic financial institutions had to compete for domestic savings, prompting them to offer better safety to their depositors. The most successful transition economies also opened their banking systems to foreign competition after seeing the mess their domestic banks made of allocating savings to investments. In 1994, the share of bank assets controlled by foreign-owned banks in Poland was less than 5 percent. By 1999, the share had risen to over 50 percent. In Hungary, the share rose from 20 percent to over 50 percent. In the Czech Republic, the share rose from about 5 percent to 50 percent. Similar increases in the shares of total bank assets owned by foreign-controlled banks also occurred in Chile, Argentina, and Venezuela.2 Poland, Hungary, and the Czech Republic are the most successful examples of transition in Eastern Europe, while Chile and Venezuela are the most successful in South America. Like their less suc-

THE FACTORS OF PRODUCTION 75

cessful neighbors, they initially resisted giving foreigners control of their banking systems. They eventually realized, after bitter experience with wasted and lost savings, that the allocation of savings to investments is too important to be left to less competent and often corrupt domestic banks. Best-practice savings allocation is necessary for economic growth, even if it has to be imported. Some citizens are concerned with the idea that foreign banks might make excessive profits by using their hard-earned savings. We recommend that concerned citizens be allowed to buy shares in the foreign banks, so that they can participate in the excessive profits themselves. The Theory of Competitive General Equilibrium The theory of competitive general equilibrium is the crowning achievement of economic theory. Hook all those competitive markets together with complete information and no externalities (that is, all costs and benefits are included in the relevant prices), and the resulting outcomes in the entire economy are Pareto optimal. “Pareto optimal” means that no economic participant can be made better off without some other participant being made worse off. This is a powerful conclusion. Before discussing the theory further, it is worth reviewing how all the markets interact. The intersection of the supply curve and demand curve in each competitive market determines the equilibrium price in that market and the equilibrium quantity bought and sold in that market. The demand curve in each final product market is derived by summing the marginal utility curves of all the potential buyers in that market. The supply curve in each final product market is derived by summing the marginal cost curves of all the potential suppliers in that market. For intermediate goods markets and factor markets (factors are labor, capital, and natural resources), the demand curve is derived by adding up the marginal revenue products of all the potential buyers in these markets. These buyers are themselves producers who will use the intermediate good or factor in producing their own products for sale. The supply curve for each intermediate good or factor is derived by adding the marginal costs of the producers or owners. In the factor markets, the intersection of the demand and supply curves determine the rents paid for and the quantity of natural resources used; the wages paid and the quantity of labor employed; and the rate of return on capital and the quantity of capital used. These, in turn, determine the incomes earned by each factor. The incomes go to the owners of the factors

76 CHAPTER 3

once any taxes owed have been collected. These incomes are key to determining the marginal utility curves of the consumers of final products and thus come back to determine the demand curves for final products. The competitive general equilibrium circle is complete. Households, which are both owners of factors and consumers of final products, maximize their utilities by supplying factor inputs and buying final products according to the marginal rules. Producers maximize profits by demanding factors and intermediate goods and supplying the goods they produce by following the marginal rules. Competitive general equilibrium requires that all prices be flexible, and that prices move to the intersection of their supply and demand curves; that there are no increasing returns to scale; that no externalities, such as pollution, be excluded from the marginal cost and utility calculations; and that all buyers and sellers follow the marginal rules. The theory of competitive general equilibrium proves that, given these conditions, the result will be a Pareto optimal equilibrium, meaning there is no way to make any participant in the economy better off without making another worse off. Note that there are an infinite number of Pareto optimal equilibria, depending on the distribution of income. Note also that changing the distribution of income to move from one Pareto efficient equilibrium to another is not itself Pareto efficient because, although some economy participants will be made better off, at least one economy participant will be made worse off. In fact, depriving one rich citizen of an extra strawberry in his strawberries and cream to save a hundred other citizens from starvation is not Pareto optimal! This powerful theory leaves a key problem in any economy—the welfare tradeoffs among economy participants due to income redistribution— to the political arena. This is the problem of income inequality and its effect on society as a whole. The competitive general equilibrium model is the only one presented in basic economics texts. We therefore suggest that it is the one behind most economists’ prescriptions for transition from central planning to market economies. The implicit assumption was that privatization and marketization would approximate the competitive general equilibrium model or, at least, move toward it. To the best of our knowledge, there are no monopoly, monopsony, oligopoly, or oligopsony general equilibrium models to tell us how noncompetitive market economies function. There is, however, strong anecdotal evidence that noncompetitive markets are important, and may even dominate, in economies in transition. The evidence is only anecdotal because,

THE FACTORS OF PRODUCTION 77

to the best of our knowledge, no studies have ever been done to measure the degree to which the markets in either market economies or in economies in transition are competitive versus oligopolistic, monopolistic, oligopsonistic, or monopsonistic and what the consequences are for the economy as a whole. Instead of studies on whether the economies are competitive, we have been given measures on marketization (versus government-controlled prices and quantities) and privatization (versus government ownership). Thus, we further contend that a major reason for our poor understanding of the transition process is our failure to look beyond the competitive general equilibrium model for models of economies in which noncompetitive markets play significant roles. Mainstream theoretical economists acknowledge the limited empirical relevance of the competitive general equilibrium model. They defend it nonetheless as a powerful theory, with a role in economics analogous to the role of the theory of mass, energy, and motion in a frictionless vacuum in classical physics. The frictionless vacuum in classical physics does not exist in real life, argue the economists, and yet the theories of physics still stand. This is true, of course, which is the reason that physicists do not build bridges. In fact, the application of the principles of physics to real world problems is performed by engineers, not physicists. In most universities, physics and engineering are usually located in separate departments or even separate colleges. This distinction between pure theory and real world applications is not so well developed in economics, but academic economists will be familiar with an analogous phenomenon in their field: the tug-ofwar on whether the economics department should be located in the business school or the college of liberal arts. In most universities the economics department is located in the college of liberal arts, and the economists who teach at the business schools are rather isolated from their colleagues in the economics department—not only are their offices in another part of the campus, but their interests and research differ. In the United States, the largest organization of professional economists outside the academically dominated American Economic Association is the National Association for Business Economics, the association for economists who actually work in markets. Given these observations on the state of general equilibrium theory and the sociology of economics, what is to be done? The analogy with physics and engineering suggests some promising directions for research. The competitive general equilibrium model is based on nineteenth-century calculus (the marginal principle in economics is analogous to the first derivative in

78 CHAPTER 3

calculus). It is thus analogous to classical physics, also based on old mathematics. But when physicists were faced with problems not amenable to old mathematics, such as the problem of what goes on in the subatomic world, they developed a new mathematics, quantum mechanics, based on different mathematical principles. Similarly, the competitive general equilibrium model, based on marginal principles to determine points of equilibrium, cannot deal with oligopoly, oligopsony, or monopsony, for which there are no theoretically well-defined equilibrium points, only ranges of price and quantity outcomes. Much as in particle physics, where a subatomic particle has a given probability of being in a certain area, one can only say that the price–quantity combinations at which transactions take place in noncompetitive markets will occur in a certain two-dimensional price-quantity range with a certain probability. If the old method were replaced with a new one, the equilibrium point in the competitive market would be replaced by an area or range in two dimensions, price and quantity (three dimensions if we add time), within which transactions have a probability of occurring. A general equilibrium model based on such thinking and using twentieth-century mathematics, especially probability theory, might give us a noncompetitive general equilibrium model. Such a project is at least worth considering. Making another analogy with physics, the introduction of probability theory into a general equilibrium model would be analogous to Brownian motion in physics. The old competitive general equilibrium model based on nineteenth-century marginal calculus is the theory of the Brownian move. Old economics analyzes each change individually and mathematically proves an optimal response to each individual shock (a Brownian single move), but fails to say anything about the response to many random continual shocks. It implicitly assumes that optimal response to a single shock implies multiple optimal responses to multiple shocks. Thus, the old economic theory is a theory of a single Brownian move assumed relevant to a real economy subjected to Brownian multiple, continual, random shocks. The whole point of Brownian motion is that full understanding of the individual Brownian move is insufficient to understand Brownian motion. A second area of research would be attempting to measure the degree to which market-based economies are competitive versus noncompetitive, as opposed to marketized and/or privatized. Two approaches come to mind. First, a methodology and measurement system could be developed to examine all the markets in an economy and measure the effects of noncompetitive markets. Even a single oligopoly market in an otherwise purely competitive market economy will create distortions and uncertainty well

THE FACTORS OF PRODUCTION 79

beyond its own market. Second, a computable competitive general equilibrium model for an economy could be developed and estimated, and the actual performance of the economy could be measured against the performance simulated by the model. The performance differences provide a measure of the effects of the deviation of the real economy from the competitive model and thus a measure of the degree to which the real economy is noncompetitive. Development of economics along these lines would greatly improve economists’ abilities to understand and advise on transition. To return to our analogy with physics, the “bridge” from a centrally planned economy to a market economy would be designed by construction engineers, not by classical physicists who assumed the conditions of optimally frictionless surfaces in a vacuum. The Microeconomic Theory of Foreign Trade Back in the 1960s, when American undergraduate students took basic economics, foreign trade was barely discussed. Foreign trade was less than 10 percent of the U.S. economy, currency exchange rates were fixed, and financial flows between countries were controlled. The parties most interested in foreign trade were sectors that engaged in exports or competed with imports, and the people who worked in those sectors. If there was a chapter on foreign trade in the textbooks, the crux of that chapter was the conflict between the theory of comparative advantage and the desire for protective tariffs (taxes on imports) by domestic sectors that compete with the imports. This same theory is still the basis for foreign trade chapters in most introductory texts today. The major difference between then and now is that almost all texts today explicitly treat foreign trade theory in some detail. The theory of comparative advantage is easily understood by analogy. Assume you have a family with several children of different ages, strengths, and abilities. You also have a variety of household chores that need completing. You will apportion those chores among all the children, taking into account the relative abilities, or the comparative advantages, of the children. You will not make the oldest child do all the chores simply because he or she can do every chore better than the others. Nor will the youngest have no chores simply because he or she is worse at all the chores than any of the older children. The theory of comparative advantage proves that this is true also for competitive market economies engaged in free trade. Each country produces what it does best relative to the other countries.

80 CHAPTER 3

Even the country that is worst at everything relative to the other countries (analogous to the youngest child) will produce and export the product at which it is least bad compared to the others. Otherwise, the system would have unemployed productive resources and would not be achieving competitive market maximum output. This is the principle of comparative advantage. The current interpretation of comparative advantage most popular among Western economists and advisors is that all countries will be better off if they lower trade barriers and join the global market—even for the country that is the “youngest child.” In accordance with this theory, governments of economies in transition were strongly urged to reduce tariffs and other barriers to trade for several reasons: to exploit their comparative advantage in world markets; to use competition from exports to hold down prices and thus fight inflation; and to speed the adjustment of relative domestic prices toward relative world prices. Little attention was paid to the fact that the transition economies did not fulfill the assumptions required for comparative advantage to work: they did not possess efficient competitive domestic markets with no externalities. As we have already noted, the economies in transition were riddled with monopoly and oligopoly and with monopsony and oligopsony. Also, some prices, especially for necessities, were still set administratively. There was also massive unemployment and a high level of idle machinery and equipment, signs that the economies were not in competitive equilibrium. In competitive equilibrium, all resources are already fully employed producing maximum output. Despite the obvious failure of economies in transition to fulfill the assumptions underlying comparative advantage, their governments were urged to move toward free trade as quickly as possible. To the best of our knowledge, no discussion of comparative advantage in a basic economics text includes a discussion of what befalls a real world economy if the country suddenly opens itself to free international trade when the assumption of well-functioning competitive markets is not true. Most likely the textbooks do not describe this situation simply because the consequences are so dire. If the domestic relative price of a good is below its world relative price, the country will export it until its domestic relative price equals its world relative price. If for some reason, this relative price equalization does not occur, the country will export all of the good regardless of the domestic consequences. Consider a country that has been subsidizing the production of a necessity, such as food or fuel, and holding down the price to maintain political stability. Suddenly opening the markets

THE FACTORS OF PRODUCTION 81

to free trade will cause both serious hardship and civil unrest, as supplies of the necessity on domestic markets drop abruptly. So how does a real world government decision maker respond to the economist who insists that all prices must be freed and the economy immediately opened to free trade? Explaining the real world situation is unlikely to have much affect. The decision maker needs to understand enough of the theoretical structure of economics to use it against the policy recommendation. There are at least two arguments that can be made, and both are applicable to many situations. First, many economic policy recommendations are rigorously derived, but the derivation depends on the assumption of well-functioning perfectly competitive market systems with no externalities. If any of these assumptions are violated, then the theoretical conclusions are no longer proven, and the policy recommendations stemming from them no longer applicable. Furthermore, the theoretical conclusions have been rigorously proven only for perfectly competitive market economic systems. No theoretical conclusions have been derived rigorously for almost perfectly competitive market systems, much less for economic systems that are far from perfectly competitive. Nor has it been proven that there is a continuum along which, as market systems become more competitive, their equilibrium prices and quantities approximate more and more closely the perfectly competitive prices and quantities. The government decision maker should recommend to the economist that she accurately model the economy as it is, and then measure all the effects of the policy recommendation. Excuses that this is too difficult, costly, and time consuming are good measures of ignorance. The second argument for the real-world decision maker is to remind the economist of the principle of Pareto optimality in welfare theory. This principle receives much attention in the early chapters in basic texts but is then forgotten in later chapters that advocate policies, including free trade. To remind the reader, an economic change is Pareto optimal if it makes at least one economic participant better off and makes no one worse off. To open a closed perfectly competitive market system to free trade will result in both winners and losers, but free trade is strongly advocated on the grounds that total global output is increased. Once again, the honest economic approach is to accurately model the economic system as it is, then open the model to free trade and identify the gains and losses of the winners and losers. The economist can go even further by identifying the income transfers to tax the winners and compensate the losers so that the combination of opening to free trade and the

82 CHAPTER 3

income transfers is Pareto optimal. While this is theoretically and, we believe, practically feasible, we know of no real-world case in which it has been done. Pareto optimality is not used in policy recommendations, since it would require a complex combination of tax and income transfers to achieve Pareto optimality. In addition, even many economists who advocated flexible, marketdetermined domestic prices also advocated that one key price be fixed, the exchange rate. We will discuss exchange rates more fully later (Chapter 8). Here we will only note their effect on foreign trade. The economies in transition suffered massive declines in domestic production, partly due to the fact that domestic consumers preferred imports while domestic producers were unable to export. As imports flowed in, domestic money flowed out to pay for them. With a floating exchange rate, this trade deficit would depreciate the home currency and make imports more expensive and exports cheaper for foreign buyers, thus reducing imports, increasing exports, and reducing the trade deficit. With the exchange rate fixed, however, the central banks of economies in transition were committed to using their foreign money deposits to buy up the excess home currencies that foreign exporters were unwilling to hold. The results often were losses of foreign reserves and eventual currency crises when the reserves were exhausted or the central banks decided to let their currencies depreciate before they had lost all their reserves. In these cases, two economic errors combined to cost the economies in transition, and many other economies, dearly: failure to notice that the assumptions required for the principle of comparative advantage to apply were not met, and failure to notice the contradiction in advocating flexible, market-determined prices while holding one key price—the exchange rate—fixed. Economists were aware of the contradiction between advocating flexible prices and advocating a fixed exchange rate. There is even a euphemism that economists use when the fixed exchange rate differs from what the free market rate would be: the exchange rate is said to be “misaligned.” An exchange rate is misaligned if it corresponds not to the actual value that currency holders place on the currency, but rather to the value desired by the central bank. When domestic prices are fixed and are out of line with the real market demand, they are not said to be “misaligned.” They are said to be “wrong” because when prices are fixed they cannot respond to changing market conditions reflected in the movement of supply and demand curves. Economists’ commitment to fixed exchange rates has eroded substantially since the international financial crises of the 1990s. These crises

THE FACTORS OF PRODUCTION 83

resulted in tremendous losses to the countries involved, as well as to the International Monetary Fund when it loaned foreign exchange to central banks to defend their fixed exchange rates. At this point it is appropriate to recall that, as noted in the beginning of this book, each competitive market in each country has potential suppliers to the right of the equilibrium point, who are ignored since they are not active sellers. Their cost of producing a unit of output exceeds the competitive price in that country at that time. If country boundaries are now dropped and country markets for the same product are combined into a single global market, some suppliers will find that their production costs exceed the new global price, and will find themselves to the right of the equilibrium point and out of the global market. Members of this group of suppliers to the right of the global equilibrium point may or may not be able to switch to other products, which they can produce and sell in the amalgamated global market. They also may be concentrated in fewer countries than before the barriers were dropped. The point is that comparative advantage does not solve the problem posed at the beginning of this book: that of high-cost potential producers to the right of the equilibrium point in competitive markets. These producers, who in theory should be prepared to re-enter the market when the equilibrium prices rise, may not be there to re-enter. They may have been forced out of business altogether, or have sought better opportunities elsewhere in the economy. Comparative advantage does not eliminate the problem of welfare loss to the country when these producers become uncompetitive—in fact, it may result in these high-cost potential producers being concentrated in a smaller number of countries. We just do not know. Besides the principle of comparative advantage, the other major foreign trade theory included in most basic texts is a comparative static analysis of the gains from trade versus the costs of protectionism. The analysis starts with standard supply and demand curves intersecting to yield equilibrium price and quantity (see Graph 3.4). When the domestic market is opened to foreign trade, it is overwhelmed by the world market and the world price becomes the new domestic price. If the world price is lower, a gap opens between the supply and demand curves at the new lower price. The quantity demanded exceeds the quantity supplied at the lower price and the excess quantity demanded at the lower world price is satisfied by imports. Domestic producers sell less at a lower price. Domestic consumers buy more at that lower price (see Graph 3.5). Now the producers complain and get the government to impose a tariff; a tax on each unit imported. This raises the domestic price and reduces imports. The producers sell more units at a higher price equal to the world

84 CHAPTER 3

Graph 3.4 Supply–Demand Graph

9 8 7

Price

6 5 4

Supplied

Demanded

3 2 1 0

1

2

3

4

5

6

8

7

9

Quantity

Graph 3.5 Supply–Demand Graph with World Price

9 8

Supply 7

Price

6 5 4

world price 3 2

Demand 1 0

1

2

domestic production

3

4

5

6

imports

7

8

9

Quantity

THE FACTORS OF PRODUCTION 85

price plus the tariff. Buyers buy fewer units at the higher price, and the government gets tariff revenue equal to the tariff times the number of units imported (see Graph 3.6). Thus, there are both gains and losses from the tariff, but analysis shows that the losses exceed the gains. Once again, however, as the analysis progresses, suppliers and demanders shift from being active in the market (to the left of the effective price point), to being out of the market (to the right of the effective price point), and back again. The supply and demand curves themselves never change. This implies that both suppliers and demanders out of the market wait patiently offstage for a price change that might allow them to become active in the market. This important implicit assumption is never made explicit or dealt with. Entry and exit are assumed both instantaneous and costless. Nor are the consequences of its failure to hold worked through and included in the analysis. We will not work through tariff theory here except to note that if the supply curve bends upward to the right of the equilibrium point and the demand curve downward as argued earlier in this volume, then the effects of opening and closing to imports will be mostly large price effects, rather than quantity effects, in the short run (see Graph 3.7). The effect of the world price on the domestic market is to lower the price for goods without much change in total quantity demanded. Consumers benefit, but there are severe negative consequences for domestic producers. Every unit of imported good purchased means a loss of one unit of domestically produced good purchased (see Graph 3.8). Imposing a tariff on imported goods raises the price, and helps domestic producers. Consumers continue to buy the product at the higher price, but there is little change in total quantity demanded (see Graph 3.9). There are several other aspects of the way international trade theory is taught that can stand review and revision. First, international trade theory is taught from the individual country perspective, because it is the individual country government that makes most of the decisions, based on internal economic and political considerations. However, the effects outside the country are also important and become more important with globalization. For example, most texts present the theory of the optimal tariff, which maximizes domestic real income by maximizing the terms of trade. The terms of trade is the quotient derived by dividing export prices by import prices. In other words, economic theory has defined as optimal the tariff that maximizes the use of the country’s monopsony/oligopsony power as a buyer on world markets to reduce as much as possible the prices it pays for its imports and maximizes the use of its monopoly/oligopoly power as

86 CHAPTER 3

Graph 3.6 Supply–Demand Graph with Tariff 9 8

Supply

Demand 7

Price

6 5

world price plus tariff

4

tariff revenue

tariff

3

world price

2 1 0

1

2

3

4

domestic production

5

6

7

8

imports

9

Quantity

Graph 3.7 Supply–Demand Graph with Opening to Imports 25

20

Supplied

Price

15

10

Demanded Price at home

5

World price 0

1

2

3

4

5

6

imports replace domestic production but total consumption unchanged

7

8

9

Quantity

price drop

THE FACTORS OF PRODUCTION 87

Graph 3.8 Effect of World Price on the Domestic Market 25

20

Supplied

Price

15

10

Demanded 5

world price 0

2

1

4

3

5

6

8

7

9

Quantity

domestic production imports total demanded

Graph 3.9 Imposing a Tariff on Imported Goods

20

Supplied

Price

15

10

Demanded 5

tariff + world price world price

0

1

2

3

4

5

domestic supply replaces imports

total demanded unchanged

6

7

8

9

Quantity

88 CHAPTER 3

a seller on world markets to increase as much as possible the prices it gets for its exports. This is surprising. Although classic liberal economic theory preaches competitive markets as optimal, international trade theory is strongly influenced by what political economists term “neomercantilism.”3 In classic liberal economic theory, free trade is a win–win proposition in which all sides benefit from openness. Liberal economists believe that “a rising tide lifts all boats.” In neomercantilism, relative gains are important and the goal is to gain more than your neighbor does. Neomercantilists see trade as a zero-sum game. When this example is presented in the classroom, students often see the inconsistency between this concept of the “optimal tariff ” (where the goal is to maximize your own gain by selective use of tariffs) and prior assertions of the optimality of the competitive market system (where openness benefits everyone). If they feel the instructor is comfortable with questioning the basic theory, the students may raise this question. The solution we recommend is to recognize the contradiction and explain that when a country pursues the optimal trade policy from the individual country’s point of view, the effects on other countries in the market are similar to those experienced by the other actors in a market in which one firm is exercising monopsony/oligopsony power (in cases of import restrictions) and monopoly/oligopoly power (in cases of export restrictions). While monopoly/oligopoly and monopsony/oligopsony power are condemned in markets within a country as inefficient, according to current theory they are acceptable in international markets between trading countries. The optimal foreign trade policy for an individual country maximizes the terms of trade by minimizing the prices the country pays for its imports and maximizing the prices it receives for its exports. This, however, is at the expense of other countries and is certainly not optimal from a global perspective. Foreign trade policy in the world market thus is an extension of microeconomic market theory, specifically use of monopoly/oligopoly power, and monopsony/oligopsony, and price discrimination to separate domestic markets from the global markets. It will help students understand why economies in transition are urged to open their markets to imports, while the countries’ low-cost exports are rejected by developed countries on the grounds of “dumping.” A second useful extension to teaching foreign trade analysis is to pay greater attention to the role of traded goods and services in the domestic economy. Imports are almost always implicitly treated as substitutes for domestic competing goods. Greater emphasis must be placed on imports

THE FACTORS OF PRODUCTION 89

as complementary to economic growth and development. A good example is the import of financial services. We have argued elsewhere that the absence of an effective financial sector to collect savings and allocate them to the best investment opportunities, even if these are outside the country, has been a key factor in the poor performance of economies in transition. Importing financial services is an excellent fix to this problem, as it would limit untaxed capital flight while providing safer and diversified investment opportunities for all domestic savers. A third useful change in teaching foreign trade theory at the introductory level is to slice foreign trade data and perform analysis in ways other than just by country. The winners and losers from change, including changes in foreign trade policy, are those who draw incomes from various resources, technologies, labor force qualifications, and capital stock. From the analytical perspective, a country is simply the weighted sum of these inputs, and its gains and losses from its and other countries’ trade policies depend on the changing incomes of these components to its input endowment. If analysis is conducted on only a country basis, some important effects of trade policy are missed. In any change there are winners and losers. Are the winners the sellers of labor, capital services, or natural resources? For example, technological progress has been reducing the need for unskilled labor globally. The effect on an individual country will depend on the importance of unskilled labor in that country’s income-producing inputs. Thus, it is plausible that all countries gain as a whole from unskilled labor-saving technology, even though the unskilled labor in each country loses out. Effects such as this could be missed if comparisons are performed primarily by country. Another example is the role of Organization of Petroleum Exporting Countries (OPEC) in increasing the global price of oil by restricting exports. This has increased the incomes of poor countries that are high-cost oil producers, set off endogenous technological progress to increase energy efficiency, and decreased hydrocarbon emissions by reducing oil consumption (an environmental plus). In summary, if economics is to be useful in understanding the real world, it must spawn a practical science—just as physics has spawned engineering—that deals with the complexities of externalities, oligopsony and oligopoly, and endogenous technical change, as well as the effects of income distribution, political and social factors, and their interactions. This is a daunting agenda. But the payoff will be (to continue our metaphor) the economic equivalent of designing imperfect bridges—that can actually bear loads—for the real world, rather than designing optimal bridges for an imaginary world.

4 The Role of Government

An Overview of the Role of Government Government plays a crucial role in making a capitalist market system work. This fact is well recognized in mainstream economics, and will be familiar to most readers. The role of government is vital to understanding the problems of transition economies. Most businesses, like most individuals, pursue their own advantage with little regard to the consequence to the public or their fellows. While some enlightened individuals and firms may act for the collective good, they may also be penalized with lower incomes or profits. Government must be concerned with all actors—not only the best and most moral. Government must therefore take into account selfishness, either controlling it through law and regulation or harnessing it for the public good through incentives. It must reconcile competing goals among actors of varying strength and size. It must not only prevent the strong from crushing the weak, but also keep weakness from protecting inefficiency. It must at once allow factions to multiply, prevent one from winning over the others, induce great and small to work together, and resist the urge to itself become a faction and thus enter the market as a self-interested party. There is a saying attributed to revolutionary doctrine: “The people are a river and guerrillas are fish that swim in the river.” One might add, “and government is the riverbank.” Like a river, individual self-interest cannot be blocked. Faced with an insurmountable obstacle, the river will burst its banks and become dangerous and ungovernable. 90

THE ROLE OF GOVERNMENT 91

Good government is concerned with channeling, not blocking, the natural self-interest of all actors, both individual and corporate, while restraining its own self-interest. In doing so it balances the competing and equal ideals of liberty and the public good. Government plays several essential roles in a well-functioning market economy. For example, it is easy to see why an economy would crumble if no one dared to leave their store unguarded to go home at night. Government serves as the “night watchman” for the general public by maintaining the rule of law, enforcing contracts, and defining and protecting property rights. Government also serves as a regulator of a well-functioning economy, using antitrust and other policies to encourage competition in markets. If competition cannot be enforced, government will regulate an industry to force producers to act more like competitors than monopolists. Government also reduces the information costs and risks in key markets through standardization, regulation of sellers, and product quality control, such as safety standards for food and medicine. This dramatically reduces transaction costs. Imagine if you had to test all the food and medicine you bought yourself before you could consume them safely. In addition to the above roles, government concerns itself with externalities. In this role, the government forces market participants to adjust for costs or benefits imposed by market participants on innocent people outside the market. As a concrete example, consider the early years of transition, during which an East European publication ran an article for city dwellers who wanted to raise pigs in their apartments. The article was quite serious. Although we cannot confirm whether anyone took the advice literally, it provides an example of how the government is needed to regulate externalities in everyday life. Imagine that some enterprising apartment dweller had taken the article at face value and began to raise pigs at home. While the extra income and reliable source of meat might be considered a plus, there would be very definite minuses. Smell, for example. The pig raiser might consider the smell an acceptable trade-off for the added income, but his neighbors would probably disagree. After all, they would be faced with nearly the same smell and inconvenience as the pig owner, without getting any of the benefits. Government (in the form of the local council) would have a role to play in this scenario. The local government representatives could fix the problem and control the externality in several ways: by forbidding raising pigs in the apartment building; by requiring the pig owner to put in some special

92 CHAPTER 4

equipment to get rid of the smell; or by levying a “smell tax” on the owner and using the money to compensate his neighbors. By stepping in, government would prevent the neighbors from having to endure the external effects of the pig raiser’s entrepreneurship. The drive to marketize the economies in transition created many new externalities, but paid little attention to correcting them, or to compensating those who bore the costs. Beyond controlling externalities, government also regulates, or provides directly for, public goods. Public goods are goods that benefit everyone, that is, they cannot be denied to anyone, even those who refuse to pay. In economic terms, public goods are those for which the cost of provision to one more person is zero and/or the exclusion of non-payers is not feasible. National defense is an example of a public good for which government is primarily responsible. Another example is vaccination against disease. You are protected if all of the people around you have been vaccinated, even if you yourself are not. Government redistributes income from those who earn it to those who need it by means of pensions, unemployment insurance, welfare payments, and other transfers. In this role, the government also may tax income at progressively higher rates. Wealth, inheritance, and luxury purchases may also be taxed to redistribute income. The pervasive role that government plays in multiple individual markets means that government taxes and expenditures are sufficiently large to affect overall demand in the economy, not just individual markets. This power is explicitly treated as fiscal policy in macroeconomic theory. Fiscal policy is the role that government plays in determining the overall level of economic activity by adjusting the taxes it levies and the expenditures it makes. The sister policy to fiscal policy is monetary policy, which is the role that the central bank plays in determining the overall level of economic activity by controlling the money supply. We will return to the role of government in market economies repeatedly in this book. Two points are worth making here. First, government is not antithetical to the capitalist market system; it is essential. There is a popular conception of market capitalism as a sort of free-for-all, where the government does not interfere with market forces. Despite the wealth and power of the private economy in capitalist societies, almost the opposite is the case. If you think of well-functioning modern capitalist markets as a set of interconnected and fragile flowers, then government is both the greenhouse in which the whole set of flowers flourishes and the gardeners who patiently tend each plant. The nascent market systems in former centrally planned economies were tragically underprotected, lacking both

THE ROLE OF GOVERNMENT 93

“gardeners,” to tend individual markets, and “greenhouses,” to provide an ideal business climate. Second, there is a developed theory of the role of government as it relates to improving and regulating the functioning of individual markets and the market system as a whole, but, to the best of our knowledge, there is no theory of how market systems are created. Market systems seem to have grown spontaneously from the interaction of historical, political, and sociological forces, which is another way of saying that we don’t know exactly how they came about. When the newly capitalist countries began their transition from central planning to market systems, well-meaning economists and practitioners discovered that it is much more difficult to create these systems from scratch than it was to improve those that were already working at home. There has been only limited success in creating well-functioning market systems in former communist economies. In the transition from centrally planned systems to market economies, the spontaneous generation of market systems was slower than expected, and produced some unexpected mutations. In many cases, the new system that has emerged is not wellfunctioning market capitalism, but exploitative capitalism, which neither serves the needs of the populace nor reflects the values of civil society as a well-functioning market system should. Public Choice Theory Public choice theory analyzes the way decisions are made in government. Because decision makers within government serve their own interests, and the time horizons of elected officials stretch only as far as the next election, governments fail to improve their own efficiency and the efficiency of the economy, or to redistribute incomes “fairly.” Officials focus on reelection or on enriching themselves as much as possible before they leave office. This is where an understanding of sociology becomes important. In stable economic and social systems, government officials’ decisions are constrained by the likely effect of the decisions on their careers and on their total future incomes. Performance in government affects their future employment opportunities and their reputations in the community in which they and their families live. Amidst the social chaos and election uncertainty of a society in transition, these long-term considerations may be absent, or may run a distant second to more pressing goals. In this situation, a rapid transition to the heavy reliance on elected officials, which is the strength of well-established democratic systems that are expected to be permanent, naturally results in corruption.

94 CHAPTER 4

This conclusion was largely overlooked by experts who sought to advise the economies in transition. A careful reconsideration of the incentives for government officials in the economies in transition was needed. To understand the now well-known results, in economic theory terms, public choice theory needs to be linked to an expanded view of the permanent income hypothesis. The permanent income hypothesis has traditionally been focused on consumption patterns and states that consumers make consumption decisions based on their expectations of their long-term income flows rather than temporary fluctuations. Thus, unemployment would not cause a person to drastically change consumption patterns if the situation was considered temporary, while permanent unemployment or permanent employment at a lower wage would. There are two extensions that we would recommend to the permanent income hypothesis. First, work and earning decisions are also made on the basis of permanent income opportunities. People who undergo a long and expensive training period to qualify for a career must recoup this investment. The second extension to the theory concerns rational, self-serving decision making when the future is uncertain but the present offers opportunities to acquire wealth. When there is no likely permanent or long-term income path, Adam Smith’s “invisible hand” leads to theft, embezzlement, asset-stripping, and capital flight, just as surely as it leads to economic activity serving the needs of society when self-interest dictates that it be so—that is, when that economic activity has long-term consequences for the future income and quality of life in the community of the economic actor pursuing his/her long-term self-interest. Another extension should be added to public choice theory. Not only do officials make decisions based on their own self-interest, but there is also a strong self-selection mechanism at work. Just as opportunities to serve the community attract the altruistic, opportunities for theft attract thieves. Public Finance The second major specialty in economics focused on government is public finance: the study of taxes and government expenditures. Two major taxation principles are generally recognized: either tax those able to pay; or tax those who benefit, which requires that taxes and expenditures be linked. Note that these principles stem from alternative concepts of fairness, rather than from alternative versions of economic theory.

THE ROLE OF GOVERNMENT 95

Public finance also tracks the effects of taxes through tax incidence (i.e., the actor who initially pays the tax may not be the bearer of the tax burden) and the impacts of the tax throughout the economy. Perhaps an example is in order. Years ago, the U.S. Congress tried to tax the rich by putting luxury taxes on some of their expensive toys. They put a large luxury tax on the sale of new yachts. The effect of the tax was not exactly what Congress had in mind. The tax turned out to enrich current yacht owners, since the price of used yachts rose relative to the price of new yachts. Further, the relative drop in price of new yachts reduced the incomes of yacht builders and their workers, many of whom were not rich. These lobbied hard to have the tax removed. The taxes that well-meaning advisors pushed onto governments of economies in transition were the same that are commonly used in Western developed economies, familiar to Western tax advisors. These were not recommended because of their relevance for economies in transition. Rather, they were recommended because they are the dominant taxes in important economies, and public finance has focused on them. For example, income and payroll taxes were introduced in the twentieth century to finance wars and provide social insurance. Since most of the population generated most of its income by working for companies, their wages could be recorded and companies could withhold the taxes, acting as tax collectors for the government. Another example: governments recently have been following the advice of economists in replacing sales taxes with value-added taxes (VAT). Economists recommend VAT taxes because they do not distort the vertical supply chain. For example: if a product is taxed each time it is sold, imagine the “tax life” of a simple product, say a loaf of bread. Wheat sold by the farmer to the mill is taxed. The flour from the mill is taxed when it is sold to the baker. The bread is taxed when the baker sells it to the grocery store. The bread is taxed again when the grocery store sells it to the customer. If one company now buys the farm, the mill, the baker, and the grocery store, then sales tax will be paid only when the customer buys the bread from the grocery store. In other words, the tax creates an incentive for owners to pursue vertical integration to lower the amount of taxes paid. VAT, which taxes only the value-added by the use of labor and capital at each stage of production, cannot be avoided by vertical integration. Under VAT, the tax on each loaf of bread is the same whether the farmer, miller, baker, and grocer are all independent of each other or all work for the same company. What is wrong with income, payroll, and value-added taxes? They are taxes on productive activity, on working, and on using capital stock in

96 CHAPTER 4

production. Any student of economics knows that one should tax behavior that one wants to discourage, and subsidize behavior one wants to encourage. By taxing productive activity, these taxes discourage working and using capital stock in production in favor of other ways of getting income and wealth. Note that we said “getting” income and wealth, not “generating” or “earning” income and wealth. One can get wealth without generating it, through speculation: buying or otherwise acquiring assets at low cost and selling them at a higher price. What was the result of bringing these taxes to the economies in transition? Working, employing labor, and productively using capital to produce goods and services were made much more expensive and risky by the imposition of income, payroll, and value-added taxes. However, speculative acquisition of assets by asset stripping, asset liquidation, and capital flight remained de facto untaxed, and these became the most effective means of getting income and wealth. The results are easy to see. Think of the amassing of wealth by Russia’s oligarchs; the unexpected consequences of voucher and other privatization schemes; theft, asset-stripping, and capital flight by the rich; and small-scale theft, trade, and barter by the poor. All are income and wealth “getting” activities that are de facto untaxed. Even if the activities are officially subject to taxes, in practice they go untaxed because they are so difficult to monitor. But how could these activities be taxed, when they are illegal and usually well hidden? Consider a tax that changes the incentives to reward desirable behavior and punish undesirable behavior. For example, replacing all taxes on useful economic activity with a simple wealth tax. Each taxpayer would lists all of his or her assets, with their estimated current values, and pay a fixed percentage of that total value. Failure to list an asset would be punished by forfeiture of ownership to the tax authority. The tax authority could offer a bounty for reporting unrecorded assets. These bounties would most likely be collected by potential buyers of the asset. This taxation system would put all undeclared wealth at risk. Think of the effect on Russia’s oligarchs, and on all owners of hidden amassed wealth. But what about difficult to appraise assets? This problem could be solved by building an appraisal into the taxation process itself under which the tax authority would have the right to buy any asset from its owner at the value specified by the owner. The tax authority would then have to auction the asset to the public. If the owner’s original price was too low, he or she could buy back the asset at the auction by making the highest bid. The difference between the auction price and the owner’s lower original valuation would then be the penalty paid for undervaluing the asset. If the government was wrong about the value of the asset, then the owner

THE ROLE OF GOVERNMENT 97

would receive a higher price when the asset is bought by the tax authority but would be able to buy it back at the auction at a lower price (because the auction price would be set by the market, not the tax authorities). This would be the tax authority’s penalty for overvaluing the asset. So much for the problem of appraising assets, and now for the key issue: what incentives would be created by imposing the new system? When considering the new tax system, what is the extra tax burden of taking the idle factory you already own and putting it to productive use, hiring people, and producing a product for sale? Nothing. What is the tax burden for taking a job in that factory and spending your wages for goods and services in the legal economy? Nothing. But what is the tax burden of acquiring assets and holding them idle? Paying the wealth tax. What is the tax burden of hiding assets? Full wealth tax and risk of forfeit if discovered. What if the owner does not know the best way to exploit an asset for income? The incentives would prompt him to either sell the asset to someone who does, or hire someone to manage its productive use. What is the tax burden of owning a beautiful house full of art and antiques? The wealth tax on the house, the art, and the antiques. What is the extra tax burden of opening the house to the public and charging admission? Nothing. A simple wealth tax is hard to evade and does not increase the cost of useful economic activity. But will it still pay to create and accumulate assets? Of course, as long as the assets are put to their most productive, highest-income–generating uses. The income generated from productive use of an asset is not taxed. There is an evaluation argument that says that a wealth tax on an asset is equivalent to a tax on the income generated from the asset. Assume a business generates 10,000 euros per year in net profit after all expenses have been paid. If the market interest rate is 10 percent, then the business is worth 10 times its annual net profit, or 100,000 euros. Now put a 10 percent tax on the profits. The business now nets only 9,000 euros per year, so at a 10 percent interest rate, the value of the business is still 10 times the net annual profit after taxes or now 90,000 euros. Now replace the 10 percent profits tax with an annual wealth tax equal to 1.111 percent, or 1/90 times, the value of the asset. The net profit from owning and operating the asset is now 9,000 euros and the value of the asset is 90,000 euros.1 Since there is always an income tax that will yield the same net profit and asset value as any given wealth tax and vice versa, then income and wealth taxes are equivalent. This reasoning makes at least three important assumptions. First, it assumes a well-functioning, purely competitive market economy that already

98 CHAPTER 4

allocates the asset to its most productive use regardless of ownership. Note that this includes well-functioning, purely competitive asset markets. Second, there is no difference in de facto tax payments between the wealth tax and the income or profits tax. Third, risk must be compensated by higher returns on the asset. A well-functioning market economy will optimize the risk accepted with the use of each asset, and the risk will be reflected in the market’s evaluation of each asset. Once again, the wellfunctioning, purely competitive market economy solves the asset pricing and allocation problem optimally. The first problem, of course, is that the economies in transition are nowhere near well-functioning, purely competitive market economies. So theory based on this assumption is misleading. The theory assumes that the value of an asset and, therefore, its sales price depends on the current discounted value of the expected income stream it will generate. This assumes not only a well-functioning, purely competitive market economy but a closed economy as well. The economies in transition are open to capital flight, so the value of an asset is determined by its most profitable use: converting it to a liquid asset that can be transferred out of the country to safer, less risky, and probably effectively tax-free use. Second, the reality of tax collection in transition economies is that any tax liability on assets, ownership, or sales depends on discovery, and discovery is much less likely if the asset is not used in productive activity. Furthermore, it is the productive use of assets that will trigger heavy profits, payroll, and income taxes. Thus, not only is there a second or shadow economy of untaxed activity but that activity is devoted mostly to acquiring and converting assets for capital flight, not producing real goods and services for the domestic economy. There is another important economic aspect of tax regimes treated only in passing in basic economics courses: the reward for risk taking. Going into business, hiring workers, and producing a product for sale is a risky economic activity. With income taxes, payroll taxes for social security, value-added taxes, and corporate profits taxes, the risk-taking inherent in productive economic activity is heavily taxed. Yet it survives this heavy multiple-tax burden in developed economies because it is so productive and therefore rewarding. However, as risk rises for starting and operating a business, the tax burden becomes more effective at discouraging business activity, especially starting new businesses. The risk of starting a new business in an economy in transition is many times that in a developed economy, so it should be expected that copying the developed economies’ taxes and high tax rates

THE ROLE OF GOVERNMENT 99

on income-generating risky activity would be fatal in the high-risk business environments of economies in transition. Given the advantages for economic growth of taxing wealth over taxing productive economic activity, why has the wealth tax not been adopted anywhere? After all, if the assertion of economic theory that wealth and income taxes are basically equivalent were true, then countries would be indifferent between the two alternatives, and random variation would lead to about half of countries adopting the wealth tax and half the income tax. We suggest that the reason is that a wealth tax would be strongly opposed by the most powerful class in every country: the wealthy. Let us not digress into a diatribe against the wealthy. Rather, we shall leave this issue with one final observation. When the economies in transition adopted a tax system that taxes income-generating economic activity rather than taxing holding wealth, they were encouraging the latter activity at the expense of the former. This helped to create a class of powerful wealth holders who owe their wealth not to invention, entrepreneurship, or ability to serve the needs of others but to grabbing and holding assets. The political and social consequences of this development will be with these countries for years. The penchant for taxing productive activity affects developed economies as well as economies in transition. We offer the following quotation from the Economist: Criminal and other unmeasured economic activity equaled 29 percent of Greece’s GDP in 1999, a bigger slice of national output than any other OECD country, according to new estimates by Friedrich Schneider of the University of Linz. The shadow economy ranges from illegal markets such as prostitution to the unreported income of self-employed workers. Switzerland has the smallest underground economy, equal to only 8% of GDP. Such activities are by nature hard to measure, so comparisons of the same country over time may be more telling. The shadow economy’s share of national output grew in every OECD country from 1989 to 1999. Rising tax and social security burdens, in addition to increased government regulation, seem to be crowding out the official economy.2

There is another problem with taxation in the economies in transition. Tax rates, regulations, and enforcement policies are subject to change and interpretation, leading to confusion and uncertainty about taxes. As a result, economic decision making becomes based on the fact that the tax system is constantly changing and uncertain, rather than on the incentives and disincentives of the current tax regime. This adds to the risk associated

100 CHAPTER 4

with committing assets to productive income and employment generating economic activity, discouraging that activity. Years ago, Professor Gertrude Schroeder coined the term “treadmill of reforms” to refer to the negative effects of the constant introduction and terminating of reforms in centrally planned economies. A “treadmill” effect in tax policy is still evident in the economies in transition. Indeed, a strong case can be made that there is a “treadmill of transition,” with changing and uncertain tax policy a major contributor to the problem. Government Regulation of Markets In our discussion so far we have commented on many aspects of government regulation of markets. To summarize our points, the basic theory of economics recognizes a legitimate government role in regulating markets to make them more efficient. • The first reason for government intervention is to contain monopoly/ oligopoly power. We suggest that there is a need to contain monopsony/oligopsony power as well. • We also note the important role that financial power—that is, wealth— plays in economies with imperfect capital markets, and the use of market and financial power to obtain political power. • The third reason for government intervention is to correct for externalities, which are costs and benefits not included in prices. • We have suggested a fourth reason for government intervention: that governments will in some cases regulate competitive markets, if the goods concerned are necessities, and the supply and demand curves are highly inelastic, so that small shifts in either the supply or demand curves will lead to large changes in prices with political repercussions. In addition to discussing the reasons for government intervention in markets, we have used public choice theory: the theory that government decision makers make decisions to serve their own interests, in combination with an expanded application of the permanent income hypothesis, to explain the short-term outlook and corruption that plagues governments facing the uncertainties of transition. This interpretation of public choice theory is not entirely ignored by the basic theory of economics. Basic theory does recognize one phenomenon related to our reasoning: that interest groups with the most to win or lose from government regulation will make every effort to influence that regulation. Too often, the interest group with the most at stake in regulation is

THE ROLE OF GOVERNMENT 101

the regulated, so they will try to “capture” the regulating agency and use it to further their own ends, most likely to increase prices and reduce competition. The Coase Theorem The Coase Theorem is a key development in economic theory, which explains how private negotiation can internalize externalities with minimum government interference. As such it is sometimes used by opponents of government intervention as a theoretical underpinning to their belief that private actors can, and should, deal with externalities without government action. Because of the theory’s central role in many discussions on the role of government, it is worth discussing here and considering how the Coase Theorem may or may not apply in economies in transition. The Coase Theorem is best explained with a simple example. Suppose that the runoff from a dairy farm is polluting a nearby stream, and imposing external costs on the brewery downstream, which uses the water to make beer. Can the problem be solved without resorting to government regulation? The Coase Theorem shows that it can, in at least three ways. If there is a strong sense in the public arena that the brewery has a right to clean water, it can appeal directly to that belief, and demand that the farm simply stop polluting the stream. In this case the farm bears the cost for ameliorating the externality. If the sense of entitlement is not sufficiently strong, the brewery can pay to filter the water or offer to pay the farm to control its pollution. In this case, the brewery bears the cost. Finally, either the farm could buy the brewery, or vice versa, or a third party could buy them both. The combined farm and brewery would be worth more than the two separate components, since the combined firm would internalize the external pollution cost and reduce it in the most costefficient way. In this case, the cost depends on the price or prices bargained. In all three cases, the externality is internalized and the market failure corrected without government regulation, no matter who bears the cost. However, for the negotiations to work two things are required: well defined property rights, and transactions costs that are low enough that the required transaction can take place. And creating these conditions are two key functions of government. In modern times, in fact, all property rights are fiat property rights. The right to property exists because the government says it does. What the government gives, the government can also take away, for instance, in seizure through eminent domain, restricting sales, nationalization, or taxation.

102 CHAPTER 4

Governments also create property rights when needed. Patents and copyrights are essentially the creation of a temporary monopoly on ownership of intellectual property. Airlines receive, without paying for them, landing slots at airports, which they buy and sell among themselves with government approval. Radio and television broadcasters are given the right to use certain bandwidths to transmit their programs. In some cases, bandwidths have been sold at auction by governments to telecommunication companies. Licenses to pollute are granted to polluters, who buy and sell them among themselves, while environmental groups who want to reduce pollution can buy the licenses and hold them without using them. Similarly, government plays a key role in reducing transactions costs by enforcing contracts and guaranteeing full information to all parties in a transaction. We have given several examples of this role in the discussion of government regulation above. Rather than minimize the importance of government in effective internalization of externalities, the Coase Theorem makes clear how important government is. Government creates and protects property rights and reduces transaction costs through contract enforcement. What does this mean for economies in transition? We propose a Coase Curse: if property rights are poorly defined and enforced by government and transactions costs are too high, then gross inefficiencies due to externalities may well increase. Furthermore, the benefits of internalizing externalities will go to the best financed, best armed, and most ruthless. This is precisely what we have seen in the economies in transition. Is There a Tradeoff Between Equality and Economic Efficiency? Government tax and transfer programs to reduce income inequality present a problem for champions of the market system. Free-market champions often focus on the costs associated with distorting the incentives by tax and transfer programs. There is indeed a distorting effect. If you think about it, the highly taxed rich and the poor on the dole have something in common: both work less due to government tax and transfer programs (the rich because raising their income will also raise their tax bracket; the poor because welfare allows them to work less and still survive). This is not the desired outcome, and yet no modern economy leaves its citizens to live on the value of their marginal products, as the theory of the competitive market would seem to expect. Why not? Why do all governments alike reject the conclusions of economic theory? Because this economic rationale is not the only driver of government decisions. Several

THE ROLE OF GOVERNMENT 103

noneconomic reasons come to mind. One is political and social stability. Tax and transfer programs help societies avoid class warfare. Another is altruism. In the face of all economic theory, citizens are disturbed by poverty among other citizens. There are also good economic effects from income redistribution. For example, a very common income transfer program is the universal insurance and pension program. Because of their monopoly hold on physical coercive force (in most cases at least), governments can impose universal participation in these programs and avoid the problem of adverse selection. These programs are a good not only to the individuals who benefit directly but also to society as a whole, because of their positive effect on stability and social welfare. Social safety nets also provide a floor under aggregate demand for the necessities made affordable by income transfers to the poor. The economies of scale prevalent in the industrial revolution and the network economies of the information technology revolution depend on mass markets for their successful growth. Income redistribution expands those mass markets. By this reasoning, it’s actually economically more efficient to subsidize the disadvantaged poor to buy modern appliances and Internet access. Interestingly, government tax and transfer programs may also make more bearable the disruptive effects of free entrepreneurship in the rough and tumble competition of dynamic capitalism. Consider Schumpeter’s much-vaunted “creative destruction” theory. Creative destruction creates much risk and volatility in incomes—both for the entrepreneurs who drive it and the workers and owners of capital whose incomes are affected by it. Income redistribution places a floor under the incomes of both risk-taking entrepreneurs and the members of society whose incomes are adversely affected by “creative destruction.” Dare we call this society’s internalization of the income externality of creative destruction? Income redistribution increases society’s tolerance for dynamic capitalism. When economists measure the economic effects of the blunting of incentives by income redistribution, they do not include the positive incentive to tolerate and even embrace change even if it costs wage income. Economic analysis of income and wealth distribution has the tools to investigate some important issues regarding income and wealth but, to the best of our knowledge, has failed to do so. Consider two powerful analytical tools: the Lorenz curve and Gini coefficient. They are excellent ways to measure the equality of distribution of anything across any population. Take wealth for example: line up the entire population along the horizontal axis of a graph in order of wealth with the poorest person on the left at 0 percent and the richest person on

104 CHAPTER 4

the right at 100 percent. On the vertical axis, list the percentage share of total wealth rising from 0 percent to 100 percent at the top. So, if the bottom 1 percent of the population has 0.3 percent of the wealth, then (1, 0.3) will be a point on the Lorenz curve. Perfect equality of wealth distribution will result in a Lorenz curve that is a 45-degree line from the (0, 0) point to the (100, 100) point (see Graph 4.1). The Gini coefficient is the area between this 45-degree line and the Lorenz curve divided by the total area under the 45-degree line. Thus, perfect equality has a Gini coefficient of 0. Perfect inequality means that the one person farthest to the right has 100 percent of the wealth, so the Lorenz curve is the horizontal axis all the way to 100, then a vertical line at 100 all the way up to (100, 100). That is, the Lorenz curve is the two legs of the right triangle. So, the area between the Lorenz curve and the 45-degree line is the whole triangle. So the Gini coefficient for perfect inequality is 1. Now derive the Gini coefficients for nonlabor income, that is, the income earned by capital, and for wealth. Remember that nonlabor income is the income generated by wealth. If the Gini coefficients for wealth and nonlabor income are the same, then wealth generates the same return whether it is owned by the rich or the poor, that is, the distribution of wealth does not affect society’s ability to use it efficiently. But if the Gini coefficient for wealth is higher, as we suspect it is, then wealth owned by the wealthy generates a lower rate of return than wealth owned by the poor. This could be due to Veblen’s “conspicuous consumption,” or it could simply imply risk aversion. We doubt that it is due to incompetence, since the wealthy can afford to hire the best advisors to maximize the return on their capital. These are the kinds of issues that need to be examined. The interactions between efficiency and equality go beyond the issue of incentive to work that has been the focus of recent welfare reform. Another issue regarding income distribution is the source of the funds earmarked for pensions. The insensitivity of the old in living longer than is convenient for the young has led to a movement toward privatization of pensions. The current pension system in most countries, the pay-as-yougo pension system, taxes the incomes of current workers and transfers it to pensioners. This intergenerational transfer becomes a greater burden on current workers as pensioners increase faster than workers. The advantage of this system is that it transfers current income, which was paid to generate current production of goods and services, to a different group of current consumers. The effect on the macroeconomic balance is minimal, and a pension system of defined benefits is not very risky. The reform to privatize pensions involves each pensioner doing his or

THE ROLE OF GOVERNMENT 105

Graph 4.1 Lorenz Curves 100%

80%

Wealth

Perfectly equal wealth distribution 60%

40%

Unequal wealth distribution 20%

0%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Population

her own intertemporal wealth transfer. Each pensioner saves and invests in capital with the hope that that capital will generate income later to finance the pension. The risk inherent in this attempt at mass intertemporal transfer is so obvious that almost all private pensions are “defined contribution plans.” That is, the pension benefit is not defined, but depends instead on the return on the investment bought with the savings. These pensions should be renamed “unknown benefit plans.” More attention needs to be paid to this risk. Ironically, the more dynamic the capitalist system, that is, the more Schumpeterian “creative destruction” in the economy, the greater the risk that private pension plans will make investments that will not pay off. The bursting of the U.S. technology stock market bubble in the second half of 2000 is evidence of the risks of depending on investments in a dynamic capitalist economy. Once again, should taxation for defined benefit pensions be regarded as society’s internalization of the income risk externality generated by a dynamic capitalist market economy? Another problem with income redistribution is the perverse work incentives created by benefits that are reduced or withdrawn entirely if the recipient begins earning more. For example, suppose a worker receives benefits equal to half her income, so long as her earnings stay below a

106 CHAPTER 4

certain cut-off point. However, earnings above that cut-off point impose a sudden loss of half her income. This situation would create a very strong incentive to earn just enough to stay below the cut-off point, but no more. While this example is extreme, all plans that reduce benefits as income is earned suffer from the same negative incentive, but to lesser degrees. This problem is easily solved. There is a long-established principle of tax theory, that lump-sum taxes are the least distorting to incentives, since the tax must be paid regardless of what the taxed person does. For the same reason, a lump-sum payment to each adult citizen would remove the distortion of the work incentive due to benefits declining as a person earned more. Furthermore, local governments could garnish this benefit for fines or jail costs, imposing another loss due to criminal behavior and helping to cover the costs of law enforcement. It’s at least worth considering. We close this discussion of income redistribution with what we hope will be an amusing example of the social ramifications of tax and transfer policies. We probably all suspect that people who are attractive have advantages in modern society, including higher incomes than the rest of us. So how about an attractiveness tax? And what would be your response to being audited and told that you had to pay more tax? Might you be pleased, and make sure that your tax became public knowledge? Would taxpayers bribe tax assessors to be assessed a higher tax? Would the taxpayers who did so be prosecuted for fraud, and be forced to suffer the public humiliation of a tax rebate? Would cosmetics companies develop special “get ugly” make-up for those wishing to reduce their tax bills? The point is that tax and transfer policies have social ramifications that should also be addressed. Besides attractiveness, we might also suggest taxes on the tall and athletic, since this would significantly improve the quality of life (create a positive externality) for the rest of us. From “Market versus Government” to Sovereign Governance The ideological and military confrontation between centrally planned communism and market democracy dominated the second half of the twentieth century. The end of the conflict, which thankfully took place with the collapse of centrally planned communism rather than with the opening of World War III, bolstered our commitment to both the market and democracy. But being good enough to outlast centrally planned communism does not imply that market democracy, as practiced in the industrialized West and preached to developing and transition countries, is either optimal or fully evolved. The disappointments of transition are ample evidence that

THE ROLE OF GOVERNMENT 107

instituting democracy and the market does not automatically lead to prosperity. Furthermore, the control of the economy by government central planning under communism has bolstered our antipathy to government interference in the market system. Economic theory strictly limits government’s role in the market system to correcting market imperfections, collecting taxes to supply public goods, and (if you interpret the Coase Theorem as pro-government) maintaining legal institutions to define property rights and reduce transactions costs. The result is a social dichotomy, with democratic government and the market economy operating separately from each other where possible, and in uneasy conflict where the two must coexist. We would like to make a case for “sovereign governance”: the design, construction, and use of markets by democratic governments to achieve important goals. We have chosen the term “sovereign governance” as an analogy to “corporate governance.” Corporate governance, still largely unmentioned in basic economics texts, became familiar to economists involved in transition when privatization and marketization failed to spontaneously generate the desired behavior by firms. It refers to the rules and norms both inside firms and in their external relations, that ensure the proper response to market incentives. To demonstrate how sovereign governance might work, we turn to one of the more intractable problems in modern economies, health care. Health care is fraught with economic problems. It is both age and income elastic— that is, as we get older and richer, we want more of it. (In the United States, the share of health care has risen from 7 percent of GDP in 1970 to 15 percent in 1999. This statistic is usually presented as a problem. We view it as the proper response to our aging and prosperity.) Health care benefits from rapid technological progress, mostly via patented drugs and devices. There is often a third-party payer for health care, either the government or employer, which reduces patients’ concerns about costs. The equality issue arises because health care is considered an entitlement, not a consumer good to be foregone if the patient cannot pay. Health care also involves many public goods, including communicable diseases, vaccinations, and basic science. (Basic science is a public good since it cannot be claimed as intellectual property. The distinction is arbitrary but useful.) Insuring health care is difficult because of moral hazard (overuse by patients who don’t have to pay and overcharging or overuse by health care providers to increase their incomes), adverse selection (the young and healthy don’t buy insurance), and asymmetric information (patients, doctors, and insurers may not share information with each other; information hidden by patients may even be protected by privacy laws).

108 CHAPTER 4

Lack of knowledge and the difficulties associated with being unwell often impair patients’ ability to exercise consumer sovereignty. This is why there are strict codes of professional ethics for health care providers. Of course, these same ethics codes pit health care providers—who want to provide the best care available—against their employers and third-party payers— who have to respond to economic incentives to keep costs down. One answer to the health care puzzle is the health maintenance organization (HMO), which reduces costs by limiting access to health care. There is a problem with HMOs, however, personified by the brand new MBA graduate, sitting in her limo on her cell phone, deciding whether you will get the expensive health care your doctor says you need. Patients are understandably concerned when economic incentives begin to affect the quality of care available to them. There are numerous cases in the courts trying to resolve instances of failure in this type of system. These, taken together, are a sure sign of systemic failure. Another sure sign of systemic failure is that the HMOs are now lobbying for special legislation to protect them from being sued. How would sovereign governance resolve these problems? To make up for the jibe at MBAs above, let us define sovereign governance for practical purposes as the way that a good MBA would organize the health care system starting from scratch. We choose a good MBA over an economist because the MBA will not limit herself to markets as they currently exist in designing a well-functioning system. The first task before our young MBA is to define the goal of the new health care system: to increase length of life and maintain the basic physical and mental capabilities to enjoy it. (The current system focuses on length of life, even if the quality of life is poor. Even the rights of patients to end their lives and the basic roles of health care providers are poorly defined and vary across jurisdictions.) The most direct way to achieve this goal—taking the liberty of unconventional thinking—would be to make healthy people valuable fiat property. If we did this, then organizations would maximize their income by maintaining them and their mental and physical abilities. Nikolai Gogol, a great Russian writer, first introduced us to this idea. In his unfinished novel, Dead Souls, Gogol describes how, in nineteenthcentury Russia, the state census counted serfs every ten years. Those serfs that died after the last census stayed on the tax rolls until the next census. A character in the story recognizes these “dead souls” as bogus fiat property that could be used to perpetrate fraud. He begins purchasing them from estate owners, who are glad to be rid of the tax liability, and then using them to populate empty estates. Gullible rich nobles then buy the

THE ROLE OF GOVERNMENT 109

estates sight unseen, trusting the paperwork, which shows they are being worked by officially registered serfs. (We are adapting from Gogol the concept of state-created fiat property, not the concept of fraud!) In Gogol’s honor, we’ll call our healthy old people “health souls.” Our system would work as follows: a health organization would be paid by the government for each health soul who has consented to draw his/her health care from that organization. The key feature of our system is that the payment would be tied to the age of the health soul and to his or her performance on basic mental and physical tests given by governmentregulated third-party testing organizations. The older and healthier the health soul, the greater the payment. Note the change in incentives. The health organizations would be paid for results, not just for procedures and treatment. The increased payments for age and performance would provide incentives for health care that maximized the length and quality of life, not just to avoid legal penalties for poor care, or to prolong length of life, regardless of quality. Preventive care, early diagnosis, and healthy lifestyle changes would become important elements of health care for the health organization. The conflict of interest between the doctor who wants to provide care and the health care organization maximizing profit would be reduced, if not eliminated. What about those with genetic or other chronic health vulnerabilities? In the current U.S. system, they may be denied insurance. In our new system, they would carry a higher payment for their health organizations. One way that a health organization could “hit the jackpot” would be to collect health souls with a specific disease that carries a large extra payment for each health soul. The organization could then discover a cure or treatment to ameliorate the effects of the disease, and collect the enhanced payments for the disease, as those suffering from the disease began to live longer, or at least to live better lives, with less mental or physical deterioration. This is very different from the current system in which the health “jackpot” depends on patenting a new drug or device that many sick people require and then charging a monopoly price for it from third-party payers. Fiat intellectual property rights, as currently defined, apply only to new things, namely to new drugs or medical devices, but not to new treatments or new uses for existing drugs or medical devices. Hence, pharmaceutical companies spend billions to search for new drugs, but not to find new uses for old drugs for which the patents have already expired. The health organization under our new system could capture profits from treatment, health regimens, early diagnosis, new uses for existing drugs, or by collecting health souls with a specific malady and then becoming spe-

110 CHAPTER 4

cialists in treating it. People with health care problems, rather than hiding them as sometimes happens now, would have a strong incentive to get them documented and become a higher-paying health soul, recruited by a health organization specializing in their malady. Researchers, doctors, and other health care personnel would also gravitate toward health organizations that specialize in maladies in which they had a particular interest or aptitude. For example, if a specialized physical therapy or mental training were found to be helpful in reducing the disability caused by some disease, specialist therapists and trainers will gravitate to, and be recruited by, health organizations focused on that disease. The organizations would also pay bonuses to therapists or trainers whose patients performed exceptionally well on their regularly scheduled mental and physical tests. Nursing homes would cease to be “warehouses” for those who were waiting to die. Instead, they would become “gold mines” for those who have the patience and ability to slow mental and physical deterioration among the aged. Since older souls would earn more for their health organization, they would get the attention of the best nutritionists, therapists, and trainers rather than being cared for by minimum wage, less-skilled caregivers. Furthermore, health organizations specializing in the elderly could even develop relationships with health organizations that specialize in the previous age group, much as major league sports teams support minor league feeder teams. While we cannot guess how the health care industry would organize itself in the long run, the incentive system would go a long way to ensure that its goal—and the individual goal of every organization related to health care—is to maximize the length of life and basic mental and physical fitness of the “health souls.” Our system would also pay for individuals who even suspect that they could qualify as a bonus health soul to get tested and certified. This would ease the work of the Centers for Disease Control and other emergency and public health organizations. Epidemics of communicable diseases would be discovered earlier, an important external benefit. One can even imagine a special kind of “bounty hunter” organization developing, which would test people for free for a whole range of “bonus” conditions and then supply their names to specialist health organizations for a fee. The large, growing standardized database generated by the regular testing of all the health souls would be an important external benefit for statistical research. But what about the politics of this new system? It would be worthwhile to identify and recruit people suffering from the same malady, who would then lobby for the highest possible bonus rents to be paid on these health

THE ROLE OF GOVERNMENT 111

souls. A group with the same malady could conceivably even relocate to be near the same specialist health organization, come to dominate neighborhoods, or even become a political force within a congressional district. Politicians would be serving their health constituencies, and would gauge their political power against that of other constituencies when deciding whose interests to vote for, lobby for, or trade favors for. The key difference is that the health organizations, their health workers, and all their suppliers and support organizations, would be united in maximizing the length of life and basic mental and physical fitness of their health souls, not only on the job, but also in their political activity as citizens. One can imagine that these would become formidable political pressure groups. What about the long-term economic and demographic effects? People would no doubt live longer and be healthier and able to work to older ages, especially part time. The whining of the young could change from having to support a large number of retirees with high payroll taxes to having to compete for jobs with still energetic and capable older folks. What about the health care “burden”? The share of GDP going to health care could conceivably rise above the current 15 percent in the United States. It certainly would, if the more efficient new health care system succeeded in lengthening life and improving quality of life. It would be up to the political system to make a decision on how much GDP to feed into this efficient health care system. The gains to society are obvious, and there would be indirect economic gains as well. Of course, we have not even mentioned gains from cross-national cooperation, or even globalization. A system based on clear goals to benefit society, consistent incentives for all participants in the system, and government creation of the proper fiat property rights is what we mean by sovereign governance. Our current system of cutting costs by rationing health care, the objective currently espoused by economists for most national health care systems, is a very shortsighted economic goal and a tragic welfare loss.

5 Measuring Economic Activity: The Key to Understanding

You are strongly tempted to skip this chapter. We understand. Even many economists’ eyes glaze over when the theory of economic statistics is mentioned. Standard introductory economics texts devote only two or three percent of their pages to measurement. But understanding what is measured, how, and more importantly, what is missed and how supposedly independent measures affect each other, is the key to understanding how economists perceive economies and their problems. The goals of this chapter are to give you an intuitive understanding of economic statistics as painlessly as possible, explain their shortcomings and how they can be improved, and equip you to win arguments with economists on statistical grounds. We will also refer back to these measures repeatedly as we explore problems of monetary and fiscal policy, financial crises, and growth and productivity. The Input-Output Table Input-output tables are unfamiliar to, or misunderstood by, many economists. They are not included in most basic or advanced texts; nevertheless, we will devote several pages to them and refer back to them throughout the remainder of this book. The input-output table provides an intuitive link between microeconomics, the theory of markets that traces back to Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations written in 1776, and macroeconomics, the theory of whole econ112

Capital inputs into domestic sectors Gross value of all inputs in each Domestic Sector (Sum of all rows 1 to 102 for each column 1 to 50)

Labor inputs into domestic sectors

Import Categories to match the Supplying Sectors

Domestic Supplying Sectors

3

4

5

6

7

8

9

48

49

50

0

0

0

0

0

0

0

0

0

0

0

Rows 51-100, Columns 51-100 2500 desks Imported Services used to process imports, assumed to be all zeroes

0

Rows 1-50, Columns 51-100 2500 desks All zeros except for domestic supplying sectors that help with imports: retail trade, transport, insurance, etc.

0

0

Import Categories to Match the Receiving Sectors 5 1 5 2 5 3 5 4 5 5 5 6 5 7 5 8 5 9 6 0 9 7 9 8 9 9 100

Total, Rows 1-100

Final Demand or End-Use Columns C I G Exports Gross value of deliveries 101 102 103 104 105

Row 101, Columns 101 to 104 - Row 102, Columns 51-100 = C + I + G + Exports - Imports

Gross Value of All Inputs = Gross Value of All Deliveries Row 103, Columns 1 to 100 = Row 101, Column 105

Rows 101 and 102, Columns 1 to 50, sum to equal supply-side GDP, that is, Labor value-added + Capital value-added = Supply side of GDP

Imports into the Domestic Economy

47

Imports into Domestic Economy and Use of Domestic Sectors to Import them

10

103

Rows 51-100, Columns 1-50 2500 desks Imports used by Domestic Receiving Sections

Rows 1-50, Columns 1-50 2500 desks Interindustry or Intersectoral Matrix

2

102

1 2 3 4 5 6 7 8 9 10 47 48 49 50 51 52 53 54 55 56 57 58 59 60 95 96 97 98 99 100 101

1

Domestic Receiving Sectors

The Input-Output Table (abridged and explained)

Graph 5.1

114 CHAPTER 5

omies that traces back to John Maynard Keynes’s The General Theory of Employment, Interest, and Money, written in 1936. To visualize the input-output table, imagine that you are looking down from a high catwalk at a sea of over 10,000 desks, arranged in neat rows and columns. Most of the desks have two graduate students at each one, one wearing a hat that says “price” on it and the other wearing a hat that says “quantity” on it (see Graph 5.1). This is the price and quantity from the intersection of demand and supply curves in a single segment of an individual market. Price multiplied by quantity gives you the value of goods bought and sold in that market segment over a certain period, usually during a single year. Walk along the catwalk so you can concentrate on the upper-left 2,500 desks. So, you are looking at the 50 ⫻ 50 square of desks in the upperleft corner of the big rectangle. Each of the 50 rows identifies one of the producing sectors that produce outputs in the economy. These sectors include names such as agriculture, non-fuel mining, forestry, fishing, machinery, electric power, coal mining, oil, gas, construction, transportation services, personal services, business services, government services, and a miscellaneous sector that includes other production not included elsewhere. The choice of 50 is purely arbitrary. You can designate the producing sectors in the economy in as much detail as you like. The only requirement is that all paid legal economic activity is included in some sector and in only one sector. Now repeat the sector names in the same order for each column in the 50 ⫻ 50 square. These are the receiving sectors for the outputs from the same producing sectors. Thus, if coal mining is the seventh sector and electric power is the sixth sector, then the desk in row seven and column six includes the price and quantity of coal sold to the electric power sector. Multiply the price and quantity together and get the money value of the coal delivered to electric power over the year of the table. Similarly, the desk in row six and column seven reports the money value of electric power delivered to the coal mining sector. The diagonal of desks from the upper left to the lower right reports the value of output that each sector delivers to itself. This 50 ⫻ 50 matrix of sectors delivering goods and services among themselves is called the interindustry or intersectoral matrix. At this point, we deviate from the usual construction of input-output tables by adding another 50 rows below the top 50 and another 50 columns to the right of the left 50. These new sending rows and receiving columns are for imports of the same goods and services in the same order as the producing and receiving domestic sectors. Our matrix is now 100 ⫻ 100.

MEASURING ECONOMIC ACTIVITY 115

The entry in the 57th row and sixth column is the delivery of imported coal to the domestic electric power sector. The entry in the 56th row and seventh column is the delivery of imported electric power to the domestic coal sector. Our matrix now has many zeros. The entries in rows 1 to 50 and in columns 51 to 100 (the upper-right quarter of the 100 ⫻ 100 square) are mostly zeros, but not all. Even imports use domestic transportation and domestic business services, including wholesale and retail trade, brokerage, and insurance services. Thus, for each sector category for which there are imports, there are nonzero entries in the import columns from these domestic sector rows. For rows 51 to 100 and columns 1 through 50 (the lower left quadrant of the 100 ⫻ 100 matrix), each entry shows imports delivered to each domestic receiving sector, that is, the dependence of each domestic sector on imported inputs. This is why we added the import rows and columns— to see clearly how dependent our country is on imported inputs. All the entries in rows 51 to 100 and columns 51 to 100 (the lower-right quadrant of the 100 ⫻ 100 matrix) are zeros unless imports are inputs into processing other imports. We will assume this quadrant is all zeros. We have so far a 100 ⫻ 100 matrix, which gives a complete detailed picture of how all the sources of goods and services, both domestically produced and imports, depend on each other. We will now add rows and columns around this matrix. We will start by adding three rows along the bottom. Look down any column 1 to 50. The column includes all the inputs received from all domestic sectors and imports to produce its output. What is missing? Each domestic sector also uses labor and capital services, where capital here is produced means of production, mostly structures, factories for example, and machinery. The use of labor and capital together is called value added. Each desk in the labor row, row 101, counts the quantity of labor used by the sector named at its column heading times the unit cost of the labor. We use unit labor cost because it is more inclusive. It includes wages, bonuses, payroll taxes, and cost of nonwage remuneration such as health insurance and pension contributions. Each desk in the capital row, row 102, includes the units of capital multiplied by the payment for use of each unit. This row is special because its totals (the returns to capital or profits) equal the total value of goods or services delivered from the sector minus the total input costs and total labor costs of producing and delivering those same goods or services. That is, total returns to capital or profits are derived as residuals after all other costs have been subtracted from revenues. Note that if a sector operates at a loss, returns to capital will be negative. Note

116 CHAPTER 5

also that this equation will be the cornerstone of the double-entry bookkeeping in the gross domestic product (GDP) accounts since it changes to make the two sides of the accounts balance. Now total every column in columns 1 to 50. Each column includes the value of all inputs received from other producing sectors, the value of all imports received by the sector, the value of labor used in the sector, and the return on capital used in the sector, which is derived as a residual. For columns 1 to 50, row 103 is the total value of all inputs used in the production of the output of the sector named at the top of the column. For columns 51 to 100, the columns for imports, there is no direct use of domestic labor and capital, so we leave the labor row, row 101, and the capital row, row 102, all zeros. For the entries in row 103, columns 51 to 100, we total each column and enter the total in its row 103. Note that row 103, columns 51 to 100, includes the value of total imports by type for each domestic receiving sector and the use of domestic transport and business services to move and deliver those imports. We can now total the supply side of the GDP accounting identity. The value added by labor in all producing sectors is the sum of row 101, columns 1 to 50. The value added by capital, residually derived profit, is the sum for row 102, columns 1 to 50. Total value added is the sum of these same 100 entries in rows 101 and 102, columns 1 to 50. Note that if the sum of rows 101 and 102 for any sector is negative, then that sector is a value subtractor rather than a value adder. This will occur if shutting down a sector is more expensive than operating at a loss. Row 103 of columns 1 to 50 gives the total value of all the inputs plus labor and capital services used in each domestic sector. In addition, row 103 of columns 51 to 100 sums the values of all the imports and the domestic services required to deliver them to each producing sector in the domestic economy. Imports are not part of GDP, because they are not produced in our economy, but they are an important input into domestic production of goods and services, so we want to keep track of them. We can now add some extra columns to the right side of our matrix. The purpose of all the supply side activity, namely producing and importing, is to deliver goods and services to final demanders or end users. These terms refer to the same economic actors. They are different from the producing sectors since they demand goods and services for their own final or end use, not to help them produce other goods and services to be sold during the year of our table. The first usual component of final demand is Consumption or Personal Consumption Expenditures, usually designated with a C. Households demand C. This is column 101. Next is Investment, I, which has two components. The first component,

MEASURING ECONOMIC ACTIVITY 117

Gross Fixed Investment (GFI), is the machinery, equipment, and structures demanded for use in future production by private businesses. The second component of I is Net Additions to Inventories, goods produced or partly produced that have not been sold. They are either stored in warehouses for future sale or are still only partly finished at midnight on December 31. Investment is not included in intermediate production because our inputoutput table covers only one year. I is part of Final Demand because it is assumed that I will be sold for consumption or used in production in following years, not in the current year. I is column 102. The third component of Final Demand is Government Expenditures for real goods and services or G. Sometimes G is divided into Current Government Expenditures and Government Investment. Note that G includes only purchases of real goods and services from a producing domestic sector and imports. Direct government purchase of labor services are made by a government producing sector. They are not in the G column but are in a government producing sector, say, row 50 and column 50 in our matrix. Since government services are not sold, there is no way to price them. Thus, the value of government services is the value of its inputs. Furthermore, since there is no total value of government output, there is no way to calculate the residual value of capital services used in the production of government services, so they are left out. Thus, the value added of government services is measured only as the cost of the labor input to government services. Thus, labor productivity, which is value added, divided by labor input is always equal to one, making labor productivity in government unable to grow because of the way it is calculated. Even if the military wins a war and saves the country, that victory enters GDP only as the labor costs of the soldiers involved. Also, if the military is defeated, that defeat registers in GDP only as the same labor costs of the soldiers involved. This is an extreme example. The point is to beware of all the talk of low productivity in government. The strange accounting procedures make it impossible for government to register productivity change. To summarize, government is treated strangely in most input-output tables and economic statistics due to neglect. Its productive activities are not integrated with the private productive sectors. Its value added as a productive sector, or row 103, column 50 in our 100 ⫻ 100 matrix consists only of the labor it hires and pays. There is no return to government capital. Its purchases of real goods and services are treated as deliveries to Final Demand or end-use G. Thus, as the economy grows, we are unable to calculate the need for government services to increase along with it. Let us return now to the G column, government as an end-user of real goods and services. G does not include government transfers: payments to

118 CHAPTER 5

people without receiving any good or service in return. Transfers include social security benefits, pensions, payments to the unemployed, subsidies to farmers, foreign aid, scholarships for students, or any other payment made by government for which no good or service is obtained. G is column 103. Note that the C, I, and G columns each receive goods and services both from domestic sectors (rows 1 to 50) and directly from imports (rows 51 to 100). The fourth component of Final Demand or end-use column is exports (X), deliveries of goods and services to customers outside the country. We can now add a total to the bottom of each Final Demand column and call it row 101 for columns 101 to 104. Note that imports can go directly to exports. Hong Kong, for example, imports from the rest of China and then re-exports those imports to the rest of the world. Hong Kong’s value added will be the labor and capital services it uses to provide the trade, transport, finance, and brokerage services it uses to import and reexport goods from mainland China. We can now show how our input-output table sums to the basic GDP accounting identity. Value added by labor (row 101, columns 1 to 50) + Value added by capital (row 102, columns 1 to 50) + Imports (M) (rows 51 to 100, columns 1 to 100) ⫽ C + I + G + X (row 1 to 100, columns 101 to 104)

Quite often, this is written as: sum of value added GDP ⫽ C + I +G + (X – M), where (X – M) is net exports. We do not do this here because we want to focus on where supply comes from (domestic labor and capital versus imports) and where it goes (its ultimate end uses: C + I + G + X). A country with X – M ⫽ 0 may not trade at all or have a large balanced trade. We can add one more column to the right side of our input-output table. It is usually called Gross Value of Output (GVO). Since we include imports as rows, we will call it Gross Value of Deliveries. For each row 1 through 100, sum across columns 1 through 104 and put the sum in column 105. Thus, each entry in column 105 is the sum of deliveries to intermediate users and to all four categories of Final Demand from one domestic sector or import sector. The basic identity of the input-output table is that the gross value of all inputs (row 103, columns 1 to 100) equals the gross value of all deliveries (rows 1 to 100, column 105). Both this identity and the GDP identity will always hold because the value added of capital, gross

MEASURING ECONOMIC ACTIVITY 119

profit, will be calculated as a residual to ensure the identities hold. Furthermore, if the data in the input-output table are correct, the same entries for gross profit will satisfy both identities. Visualizing an Adjustment to Equilibrium Let us assume our economy is in equilibrium. As you look down at the rows of desks below you, all the students with price or quantity on their hats are sitting in pairs at each desk and waiting for something to disturb the equilibrium. Now imagine your country’s soccer team is playing in the world championships. Many households watch the games on television, causing a surge in household demand for electric power. (We will ignore other effects, such as the increase in demand for beer.) The student with the quantity hat in row 6 (electric power) and column 101 (Personal Consumption Expenditures, C) stands up and signals an increase in quantity demanded for electric power to the Gross Value of Deliveries table in row 6, column 105. The student in charge of quantity at this table, GVD for domestic electric power, calculates a 2 percent increase in demand for electric power and runs over to the bottom of the electric power column, (row 103 and column 6) and tells them to increase all the inputs into electric power production by 2 percent. The quantity student for domestic electric power inputs at row 103, column 6 now stands up and flashes a 2 percent increase up the entire column 6. At each desk in column 6 in rows 1 to 102, the quantity student receives the signal for a 2 percent increase for each input into domestic electric power and immediately flashes the increase in quantity demanded to the Gross Value of Deliveries table for his respective row in column 105. Each of the students with a quantity hat in column 105 now calculates the percentage increase in total demand for his product and runs over to his corresponding table in row 103 to deliver the percentage increase in inputs needed for his sector to be able to meet the increased requirement for deliveries. Every sector that delivers to domestic electric power is now also flashing an increase in demand for all inputs in its column. Very soon, almost every desk in the matrix is getting increases in quantity demanded from the bottom of its column, row 103, and flashing them to its row desk in column 105. By now, the price student at each desk in column 105 has calculated the price increase, if any, that will accompany the increase in Gross Value of Deliveries. He does this by looking at the sector’s supply curve and moving up the curve to the right to read off the new higher price needed

120 CHAPTER 5

to deliver the increased output. Only if the sector supply curve is perfectly elastic, that is, flat, will there be no price increase. He then stands up and flashes the price increase to every desk in his row. Each desk in the row then flashes the price increase to every desk in its column, that is, to every intermediate user and end user that receives that sector’s output. As these price increases reach the price student at the desk of the bottom of each column, that student starts to compare the newly raised domestic price for each input with the price of the corresponding substitute import. He then orders substitution away from each domestic input in favor of imports. As these changes are received at each desk in his column, the quantity student in each domestic desk in his column stands up and now signals a decrease in quantity demanded to his corresponding desk in column 105. The import desks in that same column are signaling corresponding increases in quantity demanded to their total demand for import desks in column 105. Now all the quantity students in column 105 are off to deliver increases in demand for inputs to their corresponding desks in row 103. Now that imports are involved, the price students at the desks in column 105 are looking again at their total supply curves. The domestic sectors are reducing prices and signaling all the desks in their respective rows. The import sectors are looking at their supply curves from the rest of the world and calculating their price increases and flashing them across their rows. In addition to price changes in each foreign supplying country, the price flashed across each import row will also be affected by any changes in the exchange rates between the domestic money and the money used in each of its trading partners. By now, all the desks below are in turmoil, with changes in quantity demanded for outputs at each desk being flashed to the corresponding row desks in column 105 and from there run to the corresponding desks in row 103 and flashed up the respective columns. At the same time, the corresponding price changes are calculated at each desk in column 105 and flashed to all the desks in each row and from there to all the desks in that column. The effects of the price changes for all inputs are then calculated at each desk in row 103 and run to the corresponding desk in column 105 to be flashed across each row again. When does it all end? When will all the price and quantity students again be sitting quietly at their desks waiting for the next shock? The answer is surprising and troubling, except to mathematicians. The series of changes never ends. Each price and quantity will change an infinite number of times, but the changes should get progressively smaller. The reason this will not trouble mathematicians is that they know how

MEASURING ECONOMIC ACTIVITY 121

to sum infinite series. In fact, mathematician and economist Wasily Leontief received the Nobel Memorial Prize in economic science for his work with input-output tables. He found that, assuming no price changes— that is, assuming that all the supply curves are flat—one can calculate the total increase in each sector’s deliveries to everywhere in the table to support directly and indirectly any increase in final demand for any one sector’s output or combination of sector outputs. That is, instead of our infinite iterative process of students delivering progressively smaller price and quantity changes among all the tables, Leontief would run his prize-winning formula and deliver the final total deliveries required to each desk in the desk matrix. No students would have to run anywhere or signal any changes. It would all be done by Leontief’s formula. Remember, however, Leontief’s key assumption: no prices change since all the supply curves in all the sectors are flat. But what does our example mean for how market economies operate in the real world? In the real world, market economies are continually adjusting to changes in final demand for each sector’s output. In addition, technological changes are changing the price–quantity relationships at the desks throughout the matrix. Of particular relevance for economies in transition is the need that all price changes and changes in quantity demanded be transmitted quickly and accurately to all sectors supplying outputs affected directly or indirectly by the change. If communications are slow, garbled or supplying enterprises cannot respond due to high transport costs or for other reasons, then the interlocking markets across the economy will not respond to price changes and the system breaks down. In fact, once we see how the market system requires an infinite series of adjustments throughout the economy to respond to each small change in demand, the question is no longer why the market system failed in transition, but why it works so well in even, established, and stable market economies. Part of the answer is that each supplier of goods or services puts a great deal of effort into forecasting and affecting both changes in demand for its products and the prices of its inputs. Corporations in well-developed capitalist economies employ an army of well-paid, and high value-adding, specialists in business administration, marketing, and finance to analyze and forecast how demand for its outputs will change and how the prices of its inputs will change. These data drive corporate decisions on what to produce, what inputs to use, and to whom to market and how. Most basic economics texts do not recognize how difficult and uncertain this work is. The incentive system is typically presented as strong and optimal (in that it will maximize output in equilibrium). The ability to

122 CHAPTER 5

respond correctly to the incentives is assumed. Business schools (who train the small armies of analysts) are well aware of the arduous nature of this work, but they tend to take for granted that the right conditions will exist to carry it out. The Western experts advising international organizations and the governments of transition economies were more likely to be economists then businesspeople, or if they had business experience, it tended to be in well-functioning capitalist economies. They therefore recommended that the transition countries provide a market environment through rapid privatization and marketization, then stand back and watch the spontaneous generation of well-functioning market systems. Only the abysmal failure of transition, and also of many Western-educated businesspeople in transition economies, led to recognition of the differences between wellfunctioning capitalist economies and the economies in transition, and the need to train specialists in this field. Another part of the answer is that, despite the claims of dynamism and rapid change, the business environment in developed Western economies is actually quite stable. The rule of law and legal environment are fairly well established, as are the tax code and monetary and fiscal policies. When these do change, it is most often to improve the business environment. Western corporations and business associations constantly lobby their governments in an attempt to exert control over the business environment, and are thus involved in, or at least informed of, proposed changes in the environment. This means that corporations in well-developed capitalist economies are most often responding to small marginal changes in demands and prices, not to many large changes occurring simultaneously. This fits well with traditional microeconomic theory, which assumes optimal responses to clearly recognized, small marginal changes in demand and prices. However, to the extent that these assumptions are not true in transition, corporations in transition economies may not be able to respond optimally to autonomous or policy-driven changes in demand and prices. Not all observers were unaware of the differences in the business environments between Western developed economies and the economies in transition. Some businesspeople and economists had enough experience in less-developed economies—or understanding of the problems of transition—to be cautious about their ability to operate in this environment using Western business practices. We speak here of the multinational corporations—not only those based in the West, but all those who had adopted Western business practices as their standard. The low foreign direct investment by multinational corporations in the economies in transition shows that they had doubts about their ability to survive and prosper in the transition business environment.

MEASURING ECONOMIC ACTIVITY 123

The point of our earlier description of the input-output table as a room full of thousands of desks, with students racing from desk to desk carrying new price- and quantity-demanded information, is that a market economy’s responses to changes in demand are not simple, quick, or automatic. They require clear and correct price signals, as well as knowledgeable experts to manage businesses’ responses. The system can break down if overwhelmed. In economies in transition, the shocks are large, business expertise is in short supply, and price signals are often wrong or distorted. It should have been expected that the market mechanism would function poorly, given these conditions. This input-output section is meant to convey the complexity and vulnerability of the market system in adjusting to changes in technology, costs of inputs, and desired outputs as expressed in the mix of final demand components and the product/service composition of each final demand component. Also, the picture of the students running about with changing price and quantity supplied and demanded information is to show, in addition to complexity and vulnerability, that these changes take time both to transmit and to respond to. We define economic time as the time to do one pass through the entire table. For example, an increase in the quantity demanded for coal in electric power generation will eventually come all the way through the table to raise the price of coal and that price increase will partly reduce the increase in quantity demanded of coal in electric power generation, setting off a second pass through the whole table. There is an infinite series of passes through, and each takes finite calendar time. The key issue is how many passes through to get most of the changes required, and how much time per pass through. In advanced market economies, a complete pass through may take only days, because the smart MBAs at the desks anticipate the price and quantity signals before they actually get them. In the broken market systems of the economies in transition, the price and quantity signals may never arrive, and it may take a month or more to complete one partially broken or distorted pass through. The system responds only partly, and takes a long calendar time for even this partial response. This understanding is not conveyed in basic economics texts, which use aggregate demand and aggregate supply curves that do not show these key realities about real-world market systems. We hope this chapter has introduced the reader to these key realities—whether or not one wishes to master the intricacies of the input-output table!

6 Macroeconomics

Monetary and Fiscal Policy in the Input-Output Context Chapter 5, and the image of 10,000 students frantically passing price and quantity messages to each other, was intended to show how complex the market system is, and how vulnerable to breakdown. This chapter will focus on macroeconomics as taught in basic mainstream economics texts. The key levers in macroeconomics are monetary and fiscal policy. However, they work only if connected to the micro economy. So, before we turn to macroeconomics, we will explore that connection in the inputoutput context. Fiscal policy is concerned with taxes and expenditures by the government. Taxes take away income or spending power from one or more of the desks in the input-output table. That change then reverberates throughout the entire economy, just as in our above example where households watching the soccer game caused an increase in the demand for electric power. A tax on household incomes will reduce quantities demanded at many of the desks in the C column, and each of those reductions will reverberate through the table. There are two kinds of government expenditures: purchases of goods and services and income transfers. By purchasing specific goods and services, domestically produced or imported, or by increasing government services and hiring domestic labor, the government changes one or more elements in column G. Government can also give people money without receiving a good or service in return. These income transfers include pen124

MACROECONOMICS 125

sions, student scholarships, benefits paid to the unemployed, and many others. Note that only expenditures for goods and services and to hire labor in column G directly add into GDP on the demand side. Taxes and transfers affect GDP indirectly by changing the spending behavior in other columns. Taxing households reduces C. Taxing businesses reduces I. Taxing exports reduces X. Taxes on imports, called tariffs, reduce M, and so may increase GDP as domestic goods and services are substituted for imports. However, the overall efficiency of the economy is reduced. Reduced imports may even decrease GDP if the imports are key inputs in production. Note that most taxes and transfers operate by affecting the final demand columns. The value-added tax, favored in the European Union (EU), falls on columns 1 through 50, rows 101 and 102, that is, on the use of labor and capital services in domestic production. VAT also raises prices for all goods and services delivered to final demanders, much as a sales tax does. The key point here is that fiscal policy operates mostly by affecting aggregate demand (AD), not aggregate supply. Supply adjusts “automatically” since a well-functioning market system is assumed. It is assumed that all those graduate students dashing among the more than 10,000 desks in our input-output table are getting the supply response changes right. Monetary policy, usually conducted by the central bank, basically consists of the central bank buying and selling bonds (usually government bonds) in large enough quantities to affect the interest rate. Let us take three simple examples to see how monetary policy affects the real economy, measured as GDP, and including the production of all real goods and services. You are trying to decide whether you can afford to borrow money to send your child to college. This expenditure would appear under C, column 101 in the input-output table. You calculate that you can afford the tuition payments if the interest rate you must pay is 7 percent or less. At the same time, your village wants to put in sewer and water pipes, but has calculated that the village can afford to borrow the money and pay the taxes to service the loan only if the interest rate it pays is 9 percent or less. This expenditure appears under G, column 103 in the input-output table. At the same time you have researched the costs and cash flow from buying metalworking equipment so that you can make and sell tools to your neighbors in the village. This expenditure appears under I, column 102 in the input-output table. The investment will pay off only if the interest rate you pay is 11 percent or less. You and the village government go to the village bank, where all your neighbors deposit their savings. The bank can earn its customers 10 percent on their savings by buying government bonds. The bank lends only to you

126 CHAPTER 6

for your metalworking business since you will pay more than 10 percent interest. Your child does not go to college and the village does not get sewer and water pipes. Now the central bank buys government bonds. A government bond is a piece of paper that pays 100 euros per year from the government. When the interest rate was 10 percent, you could buy a government bond for 1,000 euros. In fact, the interest rate was 10 percent because you could buy a piece of government paper that paid 100 euros a year for 1,000 euros. 100/1,000 is 10 percent. When the central bank buys government bonds, it reduces the supply of government bonds available to the public. (It also increases the money supply since it pays for the bonds with money.) This increases the price of bonds since supply has been reduced but demand has not changed. Let us say the price of a government piece of paper that pays 100 euros per year now sells for 1,400 euros. What is the interest rate? It is 100/1,400 or 7.14 percent. The village banker can increase the return for his depositors by selling government bonds and lending the money to the village at 9 percent for water and sewer pipes. Unfortunately, your child still does not get to college. To send your child to college, the government bond interest rate would have to fall to 7 percent, that is, the price of a piece of government paper paying 100 euros per year would have to rise to 1,428.5714 euros. In this example, monetary policy affects the real economy. By buying bonds, the central bank raises the prices of bonds with a fixed payout. This lowers the interest rate and makes lower-return projects worth doing. Alternatively, by selling bonds, the central bank increases the supply of bonds, which decreases the money supply since the central bank collects money for the bonds it sells, raising the interest rate and reducing the number of projects that are worth lending for. Once again, monetary policy, like fiscal policy, operates by affecting the demand side of the GDP equation. Even more important, it affects projects with future payoffs, namely those that contribute to future economic growth. Keynes, in his classic book The General Theory of Employment, Interest, and Money, written in 1936, focused on fiscal and monetary policy because both tools were readily available to Western economies in the 1930s and because the chief problem during the Great Depression of the 1930s was that of raising aggregate demand. Aggregate supply was not a problem; the problem was unused capacity and unemployment. What happens when this view of the world is applied to economies in transition: economies where the problems are more microeconomic than macroeconomic; where markets do not work, the interconnections between markets do not exist, and supply bottlenecks and shortages abound? Prices,

MACROECONOMICS 127

once freed, will rise due to these microeconomic supply problems. Rising prices are, by definition, inflation. Western economies fight inflation by reducing demand, that is, by raising taxes and cutting government expenditures (tight fiscal policy) and raising interest rates (tight monetary policy). This was the advice given to, and the policy followed, by governments and central banks in the economies in transition. Aggregate demand was reduced by tight fiscal and monetary policy until it was close enough to the pitifully low supply capabilities of these economies that inflation was subdued. Aggregate supply was supposed to adjust “automatically” due to marketization and privatization. It did not. The result was declining GDP as inflation was brought under control. We can picture this problem by using aggregate supply and demand curves. These curves look very much like the supply and demand curves in Chapter 1 for individual products. However the axes are different. The vertical axis now shows the overall price level for the economy, that is, a weighted sum of the prices for all the goods and services the economy produces. The horizontal axis shows real GDP, that is, the total output of goods and services in the economy with all price changes removed (see Graph 6.1). Monetary and fiscal policy as described above shift the aggregate demand curve right or left. Loose monetary policy, lower interest rates, increases the demand for goods and services at each price level, shifting the aggregate demand curve to the right. Loose fiscal policy, increases in government expenditures and/or tax cuts, also increases the demand for goods and services at each price level and shifts the demand curve to the right (see Graph 6.2). Tight monetary policy, higher interest rates, and tight fiscal policy, reductions in government expenditures and/or tax increases, reduce the aggregate demand for goods and services at each price level and shift the aggregate demand curve to the left (see Graph 6.3). Now concentrate on the neighborhood in which the aggregate demand and aggregate supply curves intersect. In economies in transition, the aggregate supply is both very inelastic, very steep, and lurching rapidly to the left for all the reasons given in Chapters 1 and 2. Thus, GDP declines and the price level rises: inflation (see Graph 6.4). The economic policy advised by Western economists was first and foremost designed to “achieve stabilization,” which meant stabilizing the price level. There is good reason for this. Inflation has two pernicious effects. First, it transfers real purchasing power from creditors to debtors since loans are defined in nominal domestic currency and repaid in units of domestic currency that have dropped in purchasing power due to inflation.

128 CHAPTER 6

Graph 6.1

Price Index

Aggregate Supply and Demand Curves

Aggregate Supply

Aggregate Demand

Real GDP

Graph 6.2 Loose Monetary or Fiscal Policy

Price Index

AS

AD2 AD1

Real GDP

MACROECONOMICS 129

Graph 6.3 Tight Monetary or Fiscal Policy

Price Index

AS

AD1 AD2

Real GDP

Graph 6.4 Aggregate Supply Shifts Left in Transition Economies AS2

AS1

P2

Price Index

P1

AD1

GDP 2

GDP 1

Real GDP

130 CHAPTER 6

Second, if all prices are rising, then the important market signals of changing relative prices are lost in the inflationary noise. Professor Marie Lavigne, in her excellent book The Economics of Transition from Socialist Economy to Market Economy, lists the components of stabilization.1 They are: • price liberalization • balancing the government budget through increases in taxes • a tight monetary policy, so that the interest rate exceeds the inflation rate (a positive real interest rate) • an incomes policy to fight inflation by holding down wages All of these policies stabilize the price level by shifting the aggregate demand curve to the left; that is, the aggregate demand curve is made to chase the leftward lurching aggregate supply curve. This slows inflation but at the cost of severe reductions in GDP (see Graph 6.5). A better policy would have been to stabilize real GDP, maintaining the level of production and consumption of goods and services. Why was this not done? Because macroeconomic policy is all about using monetary and fiscal policy to adjust aggregate demand. Aggregate supply is supposed to respond automatically. This is not the first time that Western economists have made the mistake of assuming that aggregate supply will naturally and smoothly follow aggregate demand. In the 1970s, when oil price increases triggered by the Organization of Petroleum Exporting Countries (OPEC) raised the aggregate supply curves of developed Western economies, the Federal Reserve responded by using monetary policy to raise interest rates, to reduce aggregate demand and fight the resulting inflation rather than to maintain GDP. The result was severe recession and declining GDP. Western economic advisors did not expect the large and rapid leftward lurches of the aggregate supply curves that occurred in transition. The Great Depression was not an analogous situation, because during the 1920s the aggregate supply had been shifting to the right, not to the left. The Great Depression occurred because of a leftward shift of the aggregate demand curve due to inappropriately tight monetary and fiscal policies that resulted in price declines, or deflation, combined with plummeting GDP. The precedent most relative to transition—which, so far as we know, went unrecognized by most economic advisors—was the destruction of Europe in World War II, which shifted the aggregate supply (AS) curve sharply left. The U.S. response to this crisis was the Marshall Plan, which shifted the AS curve back to the right.

MACROECONOMICS 131

Graph 6.5 Price Stabilization Policies Shift Aggregate Demand Left AS2

AS1

P2 P2

P3

Price Index

P1

AD2

GDP 3

GDP 2

AD1

GDP 1

Real GDP

In transition, the AS curves were expected to shift rightward as marketization and privatization freed Adam Smith’s “invisible hand.” When this did not occur, tight monetary and fiscal policy to fight inflation made sure that aggregate demand moved left to match receding aggregate supply. China provides an interesting counterpoint. The Chinese government decided on a policy that first freed up agriculture to increase food supplies, then progressively freed up other sectors. The AS curve and its most important components received more attention than aggregate demand. The immediate foremost policy goal was robust growth of real output of goods and services, not price stability. However, the rightward shifting of the AS curve also helped to reduce inflation. Prices in Transition Prices, or rather the level of price indexes, are of central concern in macroeconomic theory and policy. The major task of central banks is maintaining a stable price level. The price level is measured by a price index, which is a weighted sum of the prices of the goods and services included in the index. For example, assume food has a weight of 20 percent in a consumer price index; shelter has a weight of 50 percent, and clothing 30 percent.

132 CHAPTER 6

Further, assume the price of food rises 5 percent, the price of shelter stays constant and the price of clothing falls 2 percent. The price level before any price changes is (.2 ⫻ 100) + (.5 ⫻ 100) + (.3 ⫻ 100) ⫽ 100. The base index number from which changes are calculated is set equal to 100 by convention. After the price rises, the price index will equal (.2 ⫻ 105) + (.5 ⫻ 100) + (.3 ⫻ 98) ⫽ 100.4. Thus, the price level increase, or inflation rate, is 0.4 percent. A fall in the price level is called deflation. A production index is a weighted sum of outputs of various products and services with each product or service assigned a weight. The only restriction on the weights is that they sum to 1 or 100 percent. Also, there are two basic types of weighting schemes. With the fixed weighting system, the weights do not change as you add up disparate components. With the chain weighting system, the indexes change their weights for each calculation. For example, a fixed weight price index would use the shares of your budget spent on each product in a particular year as the weights. A chain-weighted index would have those weights change each year to reflect changing shares in your budget. This is only a very basic description of index number theory, a welldeveloped, though often neglected, specialty within economics. But even this basic understanding is enough to show that an index number is basically a weighted mean or average. In basic statistic texts, the section on means or averages is almost always followed by a section showing the calculation of the variance and standard deviation. We strongly recommend an expansion of economic indexes, beyond the calculation of weighted averages. Weighted averages by themselves are not enough—the weighted variance and standard deviation should also be calculated. The variance is a measure of the degree to which each component in the average differs from the average. The differences are then squared and summed to equal the variance. In our above example, the weighted variance before the price changes is 0.2 ⫻ (100 – 100)**2 + 0.5 ⫻ (100 – 100)**2 + 0.3 ⫻ (100 – 100)**2 ⫽ 0. The **2 means square the number in parentheses, that is, multiply it by itself. But after the price changes, the weighted variance is 0.2 ⫻ (105 – 100.4)**2 + 0.5 ⫻ (100 – 100.4)**2 + 0.3 (98 – 100.4)**2 ⫽ 6.04. The weighted standard deviation is then the square root of 6.04 or 2.4576411. The changes in variance and standard deviation give important information in addition to that from the change in the mean. While the price level rose only 0.4 percent, relative prices changed very significantly. The increase in food prices signals the economy to produce and/or import more food or consumers to reduce their food consumption. In contrast, the economy should also produce and/or import less clothing or consumers should

MACROECONOMICS 133

buy more clothing. The production and consumption of shelter also will change. Even though its price remained constant, its price relative to other prices changed. We contend that changes in price variance and standard deviation are excellent indicators of the extent to which an economy should be changing its output mix. Changes in the average price level do not show the degree to which relative prices are changing. In our example above, if all three prices had risen 0.4 percent, the overall price index would also have risen 0.4 percent, but the output mix would not have changed at all since the relative prices had not changed, and the variance and standard deviation would still be zero. Thus, the change in prices does not signal any change in relative outputs. In addition to calculating the variance or standard deviation of prices over time, it is useful to calculate them across markets to measure the geographic variability of prices. For example, if markets are fully integrated and the market system is working efficiently, the price of food in Moscow should not differ from the price of food in Vladivostok by more than the cost of shipping food from one to the other. If the prices do differ by more than transport costs, a profit can be made by buying your food in the low-price city and shipping it to the high-price city to sell. Of course, as we have discussed, the price of food in Russian cities varies widely, and there is a large and profitable trade in price arbitrage of physical goods. This indicates that the markets are not fully integrated and not working efficiently in Russia, even ten years after the start of the transition. So, what should be happening to price variance in economies in successful transition? The variance of prices over time should be increasing during transition, as changing relative prices signal the needed changes in product mix and then input mix throughout the economy. As these changes in product mix and input mix are achieved, the variance in prices over time should decline again. This is true for any market economy changing from one output and input mix to another for any reason, not only for changes in the economic system. For example, in advanced market economies, technological change is a major driver of relative price changes. We have discussed above the problem of fragmenting geographical markets in the contraction of output under transition. This problem should register as an explosion in price variance across a country in transition. Similarly, market integration should register as a decline in geographical price variance. There is also a long-standing controversy in economics about the degree to which inflation hampers economic growth. One answer is that inflation hampers economic growth to the extent that it increases the risk of lending

134 CHAPTER 6

to finance investment, since lenders are repaid in currency that has lost purchasing power. Another is that inflation obscures the changing relative price signals necessary to reallocate productive resources efficiently. However, to the extent that inflation is a byproduct of relative price changes, it promotes rather than hampers growth. We can even go so far as to say, that if there are customary or institutional barriers to reducing prices, then inflation is a necessary byproduct of changing relative prices since relative prices can change only if some prices rise faster than others. Then tight monetary and fiscal policy to fight inflation may hamper the changes in relative prices necessary to signal the efficient reallocation of economic inputs, that is, tight monetary and fiscal policies hamper the transition. So what do the changes in price variance over time tell us about the economies in transition? We do not know. To the best of our knowledge, economic statistics on prices stop with the calculation of changing mean or average levels. Price variance or standard deviation is not calculated for products in general or for products across different geographic markets. We contend that calculating price variance along with price means would be useful in determining when inflation should be tolerated on grounds of market efficiency. Further Extension on the Theme of Calculating Variance Once we calculate price variances, a natural extension is to calculate output variances. Output indexes are calculated analogously to price indexes, so we do not need to provide numerical examples. Output indexes are weighted sums of outputs where the weights may be prices, labor, and capital services used in producing each unit of output (GDP or value-added weights), energy used in producing each unit of output, pollution generated in producing each unit of output, imports used in producing each unit of output, or any other useful weights. Output indexes are thus weighted averages of the outputs for an entire range of products, just as prices indexes are weighted averages of prices for an entire range of products. Analogous to price variance, output variance measures the degree to which the composition of output is changing separately from whether average or mean output is rising or falling. For example, GDP is the sum of producing sector outputs weighted by value added per unit output. An economy with zero GDP growth (on average) may be undergoing massive structural change if the composition of GDP is changing, that is, some sectors are increasing output while others are reducing output. Even stag-

MACROECONOMICS 135

nant or contracting economies in transition may be making progress if their GDP-weighted variance of sector outputs is rising. Unfortunately, even though the raw data is available (if you have the data to measure change in mean, then you have the data to measure change in variance), economists do not measure variance in output either. Now what happens if we measure variance in prices along with variance in output using identical weights, such as base-year gross value of output weights, that is, price multiplied by quantity for each product and service produced in the base year? In effect, we are calculating the degree to which whatever changes are affecting our economy are resulting in price changes or output quantity changes across all the markets for goods and services summed using the gross value of output weights. We are measuring the degree to which all our markets are responding to whatever changes or shocks are being administered by changing output mix or changing relative prices or both. This reasoning points to the flaw in assuming stable aggregate demand and supply curves that relate average price changes to average output changes. Consider Russia’s economy at the beginning of transition. We start at the point at which aggregate demand and aggregate supply intersect and increase aggregate, or average, demand. Will the result be mostly price increase or output increase? If we maintain the old output mix, weighted mostly toward heavy industry and military goods, that is, zero variance of output, Russia had plenty of extra capacity and could have increased output with little or no price increases. In other words, the aggregate supply curve in the neighborhood of the intersection point was fairly flat. Increasing AD results mostly in GDP increase if the economy has excess capacity in sectors where the increase occurs (see Graph 6.6). But this is not what happened. The increase in aggregate demand was overwhelmingly in favor of consumer goods and services while the demand for heavy industrial and military goods plummeted. In other words, the variance in output demanded exploded while output actually contracted. But there was little or no extra capacity to produce consumer goods and services, causing the aggregate supply curve to shift left and become more vertical with the change in the composition of demand, so that even unchanged aggregate demand would result mostly in price increases, that is, inflation. Using the standard macroeconomic tools of monetary and fiscal policy to fight inflation, aggregate demand is shifted left until the price level is stabilized with a big decrease in output. This is what occurred in the years of transition. So, if economists use aggregate demand and supply curves,

136 CHAPTER 6

Graph 6.6

Price Index

Increasing AD Results Mostly in GDP Increase Under Old Output Mix

AS after transition if emphasis is still on heavy industry and defense

P2 P1 AD2

AD1

Real GDP

Q1

Q2

calculation of the variance in prices and output mixes are useful to warn of shifts and changing shapes of those curves. They may help reveal the surprisingly high cost in output of pursuing stable prices by reducing aggregate demand (see Graph 6.7). GDP, Wealth, and Asset Prices The relationship, or rather the lack of relationship, between GDP and wealth is at the root of much misunderstanding of the health of economies. GDP is a flow over a period of time, usually a year or a quarter of a year. Think of it as the flow between two buckets connected by a pipe. The pipe is our trusty input-output table in which physical transformation occurs. Labor and capital services flow through a meter into the producing sectors of our input-output table. The meter assigns prices to each type of labor and capital used in all the sectors and adds them up. This is our first measure of GDP, sometimes called the sector-of-origin measure. Imagine you are sitting in a barber’s chair. In GDP terms, the barber/hairdressing sector is producing a service, which is valued at whatever you pay the barber when he is finished with you. You are paying not only for the labor, but for the capital services: sitting in the chair, use of clippers and combs, and other types of capital.

MACROECONOMICS 137

Graph 6.7

Price Index

Since AS Curve Is Steeper, Increase in AD Results Mostly in Inflation AS2

AS2 after transition with emphasis on consumer goods and services AS1 after transition if emphasis is still on heavy industry and defense

P3

AS1

P2 P1

AD2

AD1

Real GDP

Q1 Q3

Q2

Electricity for heat and light originates in the electric power sector, so the contribution of labor and capital services in the electric power industry to your haircut is counted there, just as we described in the input-output table at the beginning of Chapter 5. As the labor and capital services flow from the first bucket into the input-output pipe, the sector-of-origin meter gives us our first measure of GDP. At the other end of the input-output pipe, out flow deliveries of goods and services to end-uses or categories of final demand: consumption, investment, government, and net exports, that is, exports minus imports. GDP is metered again at this point. This is called the final demand or end-use GDP. If both measures have been priced and added up correctly, the sector-of-origin measure and the end-use measures of GDP should be identical. This is the principle of double-entry bookkeeping. In our haircut example, the consumption sector receives one haircut priced at what you paid for it. Note once again that we are measuring flows within a period from one bucket to another. The outflow from the first bucket of labor and capital services is a measure of level of effort. The inflow into the end-use bucket is a measure of the fruits of that effort, and the bookkeeping is set up so that the two measures are always equal, meaning that in theory you can measure GDP as either an outflow of capital and labor services or an inflow of goods and services into the end-uses of GDP.

138 CHAPTER 6

Wealth, on the other hand, is a stock that exists at a point in time. Think of it as the contents of the second bucket. Once you consume your haircut or food, it no longer exists in the second bucket. However, not all goods are used up immediately. They may stay in the second bucket for a while. These are investment goods, good produced for later use. There are two kinds of investment goods: goods that will be used to produce future capital services (such as fixed investment in structures and machinery), and inventories (goods to be consumed later). Each of these goods has a price determined by the value of the flow of capital services it will produce or of the price it will command when taken out of inventory for consumption. Multiply each good in the second bucket by its current price and sum the results of all these prices multiplied by quantity calculations and you have the total real wealth of the economy. (For this example, we are not including other real wealth, such as the health and education of workers [human capital], natural resources, and the environment.) The key problem is that the price of each good is no longer related to its cost of production as it was in the GDP accounts. But the production costs have already been paid to all the labor and capital used in production of the good. The first owner of the good is the one who paid the production cost. He or she is betting that the prices of the good will rise above its production cost, or at least not fall below it. As you can see, the value of the goods in the second bucket, wealth, goes up and down with the prices of those goods, and these prices are no longer tied to production costs. In fact, it is decline in the prices of assets in the second bucket that are at the root of financial crises. However, these price changes do not affect past GDP, which is a flow metered both when it leaves the first bucket and enters the second. At both meters, current domestic prices are used: at the first meter, for labor and capital services; at the second meter, for goods and services delivered to end users. We belabor this point because GDP has been too often mistaken as a measure of wealth or vice versa and then extended to other capabilities. For example, in the early 1990s, the sudden decline in wealth, in the prices of the assets in the second bucket, for the former USSR, was taken as evidence that measures of GDP under communism must have been much too high. This fallacious reasoning was then combined with the equally erroneous assumption that per capita GDP is a good measure of military capability to conclude that the USSR must not have been a significant military threat to NATO. Such erroneous uses of GDP measures seem to be peculiar to specialists on the former Soviet Union. We have seen no analogous efforts to increase

MACROECONOMICS 139

historical estimates of the GDP of Vietnam given that country’s ability to defeat both the French and the Americans militarily. Nor have we seen efforts to reduce the GDPs of the U.S. and Asian economies for the 1990s after the Asian crisis of 1997 and the bursting of the information technology bubble in 2000. There are many other peculiarities of GDP as a measure of production. Remember that GDP only measures the paid use of labor and capital stock services, nothing more. Thus, if a home owner takes unpaid leave to work on her house, GDP declines by the amount of wages foregone but increases only by the amount of labor and capital services used to produce any building materials she buys. Her unpaid labor on her house is not included. However, the wealth in the second basket increases with the value of the house. Technological progress often reduces GDP. A cure for cancer adds to GDP only by the labor and capital used to produce the pills, but reduces GDP by reducing the demand for hospital and outpatient care. Cutting down a forest adds to GDP by its use of labor and capital equipment. No deduction is made for the destruction of the natural resources of the forest or any environmental damage, although the wealth in the second bucket declines. Cleaning up after oil tanker spills adds to GDP because of the labor and capital used in the cleanup. GDP is not reduced because of the environmental damage of the oil spill. The point is that GDP is useful as a measure of economic effort. It is analogous to the treadmill test in your doctor’s office. But rapid GDP growth is insufficient to diagnose an economy as healthy, just as your good performance on the treadmill test is insufficient for your doctor to assess your overall health. The Keynesian Model Again The heart of the Keynesian model of the modern macroeconomy is the balance between aggregate demand and aggregate supply. Aggregate supply is determined in the long run by labor force, capital stock, and technological progress; all of which are hard to control. Thus, the short-term problem becomes regulating aggregate demand using monetary and fiscal policy. The largest component of final demand is consumption, C in the GDP identity: GDP ⫽ C + I + G + EX – IM. Economists have devoted much effort to understanding consumption. The irony is that some of the unexpected problems of transition might have been foreseen by carefully checking the assumptions underlying standard consumption theory. Introductory economics texts build a strong intuitive and empirical case

140 CHAPTER 6

that current consumption is mostly determined by current disposable income. Disposable income is GDP – depreciation – direct and indirect taxes – net business saving + any transfer payments from government. Disposable income is the money consumers have at their disposal, to spend or save as they see fit. Remember that for a transaction to register in the GDP accounts, money must change hands for a real good or service. Furthermore, to count in an end use or final demand category of GDP, the sale must be made from a producing sector to that end use. If a consumer buys a can of food from a business, which must be included in a row in the input-output table, that consumption purchase shows up in the C column of final demand in our input-output table. If the consumer gives or receives a can of food through charity or buys it from or sells it to another consumer, that is a transfer or transaction within the C column and does not count. If the consumer does not buy anything with some of her disposable income, that is saving in the GDP sense. Saving (to an economist) is failure to consume or spend on a real good or service. If the consumer donates money to charity, it is not saved but spent by the charity on consumption for those helped by the charity. If the consumer buys stock on the stock market, the paper asset appears on her personal balance sheet as saving, but will not register as saving in the GDP accounts! Why? Because the person the consumer bought the stock from may spend the proceeds on consumption. In the aggregate GDP accounts, aggregate saving by consumers is failure of consumers in the aggregate to consume all their disposable income. The financial assets in which they hold their savings are irrelevant. The essence of saving in the GDP sense is failure to spend on real goods and services, that is, failure to contribute to aggregate demand. The Keynesian system assumes that this aggregate saving in the GDP sense is allocated via well-functioning capital markets to investment, from column C to column I in the input-output table. As noted previously, however, economies in transition usually lack well-functioning capital markets. So what happens to the saving? The non-consuming consumer has two ways to add to his/her personal saving balance sheet: hold inventories of real goods, which will be counted as consumption anyway since the goods were bought by the consumer from some supply row in the input-output table; or hold domestic or foreign cash. By holding domestic or foreign cash, the consumer does not transfer the purchasing power of his/her saving to the business sector to be invested in productive real assets: a factory, machinery, a retail store, or other productive real good. Nevertheless, the saving will register under I, as additions

MACROECONOMICS 141

to unwanted inventories of unsold goods. This is what happened in transition. Instead of contributing to growth by freeing resources for investment in additions to the productive capital stock, saving added to the drag of unwanted inventory, much of which eventually was written off as worthless. Unwanted inventory is not the only item that can become worthless. Intentional investment can also become worthless. Factories may become obsolete because they are technologically inferior or produce products no longer in demand. This happened to much of the capital stock in the economies in transition as they opened their markets to imports from all over the world and as demand for heavy industrial products and defense goods was replaced by demand for high-quality consumer goods. Note that when goods in column I are later found to be worthless or worth less than originally thought, there is no provision for going back to the GDP accounts and reducing the value of GDP. Wasted effort, capital, and labor services is still effort and effort is what GDP measures. This is why GDP growth may be followed by financial crises. The essence of a financial crisis is that asset prices drop. Now we return to the consumption function. While Keynesian economics still recognizes current disposable income as the key determinant of consumption, there have been two major additions to the theory, each of which merited the Nobel Prize. Milton Friedman established the permanent income hypothesis that consumers adjust their consumption to the long-term trend level of income, that is, income after removing temporary or transient influences. But consumers in transition economies had no idea what their permanent income would be. The unpredictable temporary or transient influences were so overwhelming that they obliterated the trend income from which to remove temporary or transient income. Does this mean that the permanent income hypothesis should be ignored? No, because the key point about consumer behavior depending on permanent income is still valid. One reasonable extension of the permanent income hypothesis is that if permanent income is highly uncertain, then consumers will save as much as possible against their uncertain future, reducing their purchase of consumer goods except to amass storable inventories for the future. Under this special case of the permanent income hypothesis, monetary and fiscal policy is ineffective in regulating consumption, either up or down. This is because consumers, after consuming some minimal level for survival, will save 100 percent of any additional income against their uncertain futures. To the best of our knowledge, the hypothesis was never considered, much less tested, under the extreme uncertainty of transition.

142 CHAPTER 6

The other Nobel Prize–winning addition to consumption theory is Franco Modigliani’s life-cycle model of consumption, which assumes that people save or borrow to smooth their consumption over their lifetimes, with adequate retirement income being a key objective. Once again, the uncertain incomes under transition mean that life-cycle incomes are unknown and could include extended periods of zero income. The security that workers previously felt, namely the assurance of always having a job, disappeared with the transition. Also, expected retirement benefits became uncertain and/or near zero. The most certain aspects of life-cycle incomes for many people suffering through transition is that they will not be able to borrow to smooth their consumption over their life cycles because of inadequate capital markets and that they will have inadequate incomes in retirement. Might the life-cycle model be extended to include the hypothesis that many will shorten their life-cycles, or make little effort to lengthen them, if adequate income will not be available in their later years? Numerous studies have shown that the average lifespan in Russia, which in the 1980s was equivalent to the United States and Western Europe, has fallen to close to that of sub-Saharan Africa. The shortened life spans that people are facing in many economies in transition are consistent with this extension of the life-cycle hypothesis. Monetary and fiscal policy is of little use in regulating consumption in the face of such despair. A third major factor affecting consumption behavior is the wealth effect. The wealthier people feel, the more they will consume (even to the point of having negative savings; that is, their consumption exceed their disposable income). In the economies in transition, there was little private wealth held by consumers but significant wealth in terms of having a place to live, health and child care, a job, and a secure retirement. All these rights disappeared with transition. The wealth effect was very negative for most of the population. However, for the new elites who understood the arts of fraud, theft, asset-stripping, tax evasion, and capital flight, the wealth effect on their consumption, especially of luxury imports, was considerable. By now, the sociologists and psychologists among you are saying that extending consumption theory is a poor way to deal with issues such as insecurity about the future, despair, and the effect on public morale and morality of conspicuous consumption by criminals. Such issues are treated much more thoroughly in sociology and psychology. We agree. Our point is that many economists tend to dismiss knowledge outside their field as “soft” (that is, not rigorously established by their theory or quantitative

MACROECONOMICS 143

testing) or irrelevant to the functioning of the economy or the effectiveness of economic policy. But even the most skeptical economist can neither ignore nor dismiss extensions of accepted economic theory, especially theory that wins Nobel Prizes. Stress and despair among the population may not be an economic issue, but if they impair the effectiveness of monetary and fiscal policy in regulating consumption and saving, their importance becomes evident. Investment, the I column in the input-output table, is mostly determined according to macroeconomic theory (we say “mostly” because some I is unwanted inventory increase). The calculation includes the costs of each investment, the likely profit stream it will produce in the future, and other competing investment opportunities, including putting the funds in the bank to be loaned to other businesses, or buying government bonds. This means that investment is extremely sensitive to the interest rate. And monetary policy, in particular, operates by changing the interest rate. That is, a tight monetary policy to fight price inflation reduces aggregate demand by reducing investment, a major determinant of the economy’s ability to produce output in the future. Stabilizing the current price level comes at a terrible cost in future output. Yet, to the best of our knowledge, no estimates were made of the lost output capacity due to the reduced investment caused by tight monetary policy. The reason, we believe, is the assumption of a well-functioning micro economy underlying the macro economy. A well-functioning micro economy guarantees that all factors of production will be optimally utilized by following correct relative price signals, so no potential current output can be lost. But even if this assumption were true, monetary policy by switching production from I to C or G still reduces future production potential. The fact that the assumption of a well-functioning micro economy fails to some extent in all real-life economies is not recognized as a problem by macroeconomists. We contend that in economies in transition, the costs in future output of often tight monetary policy for long periods were exceptionally high and should not have been ignored. This assertion can then be extended to other economies in which the underlying micro economy is not well-functioning. But even in an optimally functioning micro economy, tight monetary policy reduces future output by reducing the share of I in GDP. Monetary policy may be administratively convenient because of the independence of central banks, but sacrificing future output capacity seems an expensive way to stabilize the current price level.

144 CHAPTER 6

Yet with all their concern with efficiency, maximization, and optimality, why do economists fail to estimate the costs as well as the benefits of the use of monetary policy? We leave this question to psychologists and sociologists as it does not fall within the purview of economic science. Please excuse our attempt at irony. The Transition as Business Cycle Business fluctuations or cycles are economy-wide changes in GDP, income, and employment, which usually last for as little as two years but can last for as long as a decade. They involve widespread expansion or contraction in most sectors of the economy. By this definition, the transition is a business cycle. To borrow a phrase from Saddam Hussein, transition is “the mother of all business cycles.” Labeling the transition a business cycle is useful, because economists can neither ignore business cycles nor completely explain them. They occur often and irregularly, are usually not predicted, run their course, and then end, often unpredictably, as the economy returns to its so-called normal or trend growth path. Individual business cycles may be attributed to outside forces (exogenous factors in the language of economics), such as wars, revolutions, oil-price shocks, gold discoveries, migrations, new resources, new technologies, or even the weather. Business cycles may also be attributed to internal economic mechanisms such as the accelerator theory of aggregate demand. Briefly, demand for investment, I, depends on the growth of consumption, C, not on its level. Assume the capital output ratio for the economy is 3 to 1. (For almost all economies, it is very close to this.) Thus, if C is growing by 1 unit in year 1, then 2 units in year 2, and 3 units in year 3, then I must be 3 units in year 1, 6 units in year 2, and 9 units in year 3. If C stops growing in year 4, then no more capital stock is needed, and I falls to zero. The greater the capital/output ratio and the variation in the growth rate of C, the more extreme the boom and bust cycle. Economists usually can display the initial impact of a shock to the economy by shifting either the aggregate demand or the aggregate supply curve and reading off the effects on GDP and the price level. The difficulty with this approach is that the cycle often peters out or corrects itself over time: both inflation and the GDP growth rate return to their trends. Somehow, the aggregate supply and aggregate demand curves start moving together in such a way that the path of their equilibrium intersections trace out a steady path moving northeast on the graph: north because the price

MACROECONOMICS 145

level is rising steadily; east because GDP is also rising steadily. The disturbances are easy to depict and explain using aggregate supply and demand curves; the return to apparently coordinated movement to the northeast less so. In this view the business cycle is tracing out a series of AS-AD equilibrium intersections as these two curves move over time (see Graph 6.8). We submit that a better way to understand business cycles is to return to the input-output table as we described in Chapter 5, with thousands of desks, each staffed by a pair of graduate students constantly receiving quantity requirements from customers, doing calculations for their own sector’s or end-use component’s price and transmitting it to their customers, and then recalculating their own new demands and frantically passing the new demands to their suppliers. Remember that return to a steady state after even a small disturbance requires an infinite series of price and quantity changes throughout the entire table. The market pricing system, once disturbed, re-achieves an optimal allocation of resources only after an infinite number of price and quantity adjustment passes throughout the entire economy. Furthermore, all the desks must be staffed and performing their price and quantity calculations correctly and passing on the results of these calculations to customers and suppliers quickly. This image of the input-output table makes clear the fragility and difficulty of achieving the optimal equilibrium state. The system is optimal, but the optimal result cannot be achieved during a finite time period or if any component (desk) within the overall mechanism fails. That is to say, business cycles are periods between equilibria. This is very different from the usual mathematical depiction of a market system: a large number of linked equations that re-achieve equilibrium immediately with one instantaneous calculation yielding the new equilibrium solution. In reality, computers also approach the new equilibrium solution iteratively with multiple passes through the entire system of equations much like our input-output model with all the desks sending price and quantity information to each other repeatedly. This saves on computer power, and the computer performs the iterations (the multiple passes through of changing price and quantity information) so quickly that it seems instantaneous. But the fact that even computers do not solve one huge simultaneous equation in a single pass is a warning that real-world economies do not function with single passes either, but rather each real-world economy pass takes time, perhaps as long as several months. We contend that the focus on the new equilibrium after a disturbance makes understanding business cycles more difficult and less intuitive. In

146 CHAPTER 6

Graph 6.8 Business Cycles May Appear If Shifts in AD and AS Curves Don’t Move Together Smoothly

AS1

Price Index

AS1 2

AS1

3 1

5

4

AD3 AD2 AD1

Real GDP

the real world, market economies are never in equilibrium. They are always in the process of moving toward equilibrium, but the equilibrium target also moves with each disturbance. The input-output image is closer to the way real-world economies function. This raises very important issues, the same issues raised by business cycles. Adjustments to reach a new equilibrium for the whole economy take time. A computer solving for the new equilibrium can count the iterations as the price signals run through the entire input-output table time after time. But how long does each iteration last in calendar time in a real-world economy? This is an empirical question. An economy with good transport and communications links, no impediments to price changes either up or down, and with each desk staffed by sharp MBA students so expert in their sectors that they can anticipate the price signals of future passes will adjust to shocks quickly and correctly. Its business cycles will be short and shallow. On the other hand, an economy with poor transport and communications links, restrictions on price flexibility, and changing use of inputs—restrictions on laying off workers and reducing wages are common, and firms run by managers who do not respond to price signals for various reasons will take much longer to complete each iteration. Furthermore, if the eco-

MACROECONOMICS 147

nomic system is in sufficiently poor shape (for example, if input-output desks are unmanned and price signals are not transmitted) and the shocks are sufficiently numerous or large, the economy may not even move toward the new equilibrium. In other words, real-world market economies can break down temporarily, or perhaps even permanently. The perfectly functioning market economy of economic theory may be optimal, but its real-world counterpart is vulnerable and may even fail. The Depression experienced by most developed economies in the 1930s is an example of an internally generated shock with policies that prevented the economic mechanism, as represented by our input-output based system, from correcting itself. The shocks suffered by the economies in transition were much larger and their economic mechanisms (their input-output based systems) were in very poor shape. Using our input-output based model, the poor performance of the economies in transition and the long period of poor performance is understandable. An input-output iteration that might take a month or two in a well-functioning economy might take years in an economy in transition. It is also expected that some economies might be overwhelmed by the transition shocks. Successful adjustment to shock is not inevitable for every market economy. For each economy and each set of shocks, successful adjustment is an empirical question and an important policy issue. This is as true for the future as it has been for the past. Basic Keynesian Macroeconomics and Soviet Central Planning In this section, we will review basic Keynesian macroeconomics as it might be presented in a current mainstream introductory textbook. At each step, we will compare and contrast each element in the Keynesian theory with what might be called classic Soviet central planning. We do this for two reasons. The first reason is historical. Keynes published his General Theory of Employment, Interest, and Money in 1936, when the industrial world was in the Great Depression. His aim was to explain the Depression and how to get out of it. At the time Keynes was writing about the Depression, the Soviet economy was growing spectacularly under central planning. An observer as astute as Keynes must have noticed the difference in economic performance and examined the reasons for it. He was, however, politically astute enough not to include a chapter on “Economic Lessons from the Bolsheviks” in his book. The requirement for ideological purity, already strong in the 1930s, grew only stronger with the Cold War. Now

148 CHAPTER 6

that the Soviet threat has passed, a more objective analysis of the common elements between these two ways of organizing human effort on a macroeconomic scale may be both acceptable and useful. The second reason for our examination of Keynesian macroeconomics is that his theories, carefully applied in the economies in transition, might have made better use of the remnants of the central planning system. The central planning system had to be smashed both for ideological reasons (it was contrary to free prices in a competitive market system and therefore useless in the eyes of ideologically pure Western advisors) and for the practical political reason of preventing the Communists from regaining power. In the following section, we will discuss what a careful examination of the underpinnings of Keynesian macroeconomics would have dictated for macroeconomic policy in the economies in transition. Keynes faced a serious dilemma from the start. Basic economics, based on competitive markets with constantly adjusting prices, said that the Great Depression should not be happening. Prices should drop to market-clearing levels to return the economy to optimal performance with full use of economic resources, including full employment of labor. The process might take time, so the generally accepted prescription was to wait. Furthermore, no modern economy, according to competitive market theory, could function for long without constant adjustments in relative prices to signal desired changes in the allocation of inputs. Thus, the problem would not persist and any cure not including price adjustments could not work. This is still true according to the microeconomic theory we discussed in the first half of this book. Keynes’s answer was bold: he discarded the theory of price adjustments in competitive markets. He assumed that prices and wages are fixed in the short run. (Marx had already used the alternative of discarding competitive markets via a theory of growing endemic monopolization.) The Soviet economy was already demonstrating that an economy could function and even prosper for a few years with prices and wages fixed by the state. So Keynes claimed his theory was only for the short run. When asked about the relevance of his theory in the long run, Keynes gave his famous reply that “in the long run, we are all dead.” The implication is that the short run persists while any of us are still alive, so the long run is irrelevant. To this day, economists often define “the short run” as the period in which prices and wage rates do not change. Once Keynes had removed the price adjustment mechanism, the theory allowed for idle resources, including severe unemployment, that were observable in the economy at the time. Furthermore, the Soviet example showed that idle resources did not always accompany fixed prices and wage

MACROECONOMICS 149

rates. So he did not have to argue this issue. The problem of unemployed resources could both exist and be fixed without resorting to changing price signals. Keynesian macroeconomic theory focuses on inadequate aggregate demand as the reason for unemployed resources. The culprits are savers, people who do not spend all their income. For example, if workers earn 100 euros, they have produced 100 euros of output. If all the workers spend all their income, then all the output will be bought. However, if they spend only 75 euros and save 25 euros, then only 75 euros worth of the produced goods will be bought. The other 25 euros worth will be unwanted inventory increase. In the next period, producers will forecast demand for only 75 euros worth of output and hire workers to produce only 50 euros worth of new output. The other 25 euros worth of demand will be satisfied by drawing down the unwanted inventory worth 25 euros from the previous period. However, now that the workers earn only 50 euros, they may be poor enough that they save nothing. If producers pay workers to produce more than 50 euros worth of output, workers will save some of their income and unwanted inventories will be left unbought. Eventually, through trial and error, the economy will move toward the equilibrium of 50 euros of output, only half its production potential. Keynes called this the “paradox of thrift”: each consumer’s attempt to save makes everyone poorer, as the aggregate demand is insufficient to absorb the supply. Production and income fall until saving (the leakage from aggregate demand) falls to zero. This was the cause of the Great Depression. The cure was to find other sources of aggregate demand. Soviet planners had the answer: the state would create aggregate demand by ordering workers to produce what the state wanted, and paying for it from the state coffers. Furthermore, since the Soviet Union was focused on long-term growth, which depends on increasing the capital stock, most of the state’s demand was for investment goods, I. Thus, the USSR had a state-mandated investment boom while the rest of the world was in a Depression. The paradox of thrift was canceled. Keynes did not propose adopting the Soviet system. Only an increase in aggregate demand was needed. He identified the same potential source, investment, I. However, he left it in the private business sector and treated it as exogenous, determined outside his system. So, now some saving, leakage from aggregate demand, would be replaced by exogenous investment, leakage into aggregate demand. But what if the exogenous level of investment was not enough? Then, government expenditures for real goods and services, G, could be calibrated to make up the difference. Consump-

150 CHAPTER 6

tion could also be adjusted by moving taxes and transfers up and down, since consumption is largely determined by current disposable income. Direct control of aggregate demand by the state, Soviet-style, is replaced in Keynesian macroeconomics by the state adjusting G directly and by adjusting C via disposable income by taxes and transfers. Using these two methods, government policy could move total aggregate demand toward the full-employment output level. Keynesian macroeconomics does not mess with investment, I, to increase economic growth by adding to the capital stock as the Soviet system did. I is left exogenous. Both systems replace the price signals of the competitive market system with signals from unwanted inventory increases and decreases to adjust output toward aggregate demand. Both systems in their basic form do not deal with exports and imports, the fourth component of aggregate demand. Keynes’s other major contribution to understanding aggregate demand is his concept of the multiplier. The multiplier multiplies the effect of any exogenous addition to, or subtraction from, aggregate demand. If G is increased by 100 euros, the first effect is to increase aggregate demand by 100 euros. But that expenditure also increases the incomes of the producers of the goods and services bought by the government. These producers are themselves consumers and savers. If they save 10 percent of their extra income and consume 90 percent, they spend 90 of the 100 euros they received. But those 90 euros are now income for a third round of producers/ consumers. They spend 90 percent of their 90 euros of extra income or 81 euros. The successive rounds continue in an infinite series. The sum of the infinite series of income/consumption rounds is the total multiplier or 1 + .9 + .9 raised to the power 2 + .9 raised to the power 3 + . . . + .9 raised to the power n + . . . ⫽ 1/(1 – .9) ⫽ 1/.1 ⫽ 10. The total effect of a 100 euro extra expenditure, if only 10 percent is saved in each round, is to add 10 ⫻ 100 ⫽ 1,000 euros to aggregate demand: the original 100 euros added to G plus 900 euros added to C in succeeding rounds. Reducing G has the same effect but in the opposite direction. Furthermore, the higher the propensity to consume out of each change in euro income, the higher the multiplier. Once again, however, an infinite series of transactions will require infinite time to execute (assuming that each transaction takes at least a little time). A key empirical question is: “How many transactions of the infinite series can be completed in the Keynesian short run?”

MACROECONOMICS 151

A Basic Keynesian Analysis of the Economies in Transition Basic Keynesian analysis focuses on the components of aggregate demand, estimates each, and uses fiscal policy to increase aggregate demand to get as close to full employment and maximum output as possible. The consumption function, given consumers’ uncertain futures, may well be to maintain some minimum consumption level and then save all income above that level to survive longer into the future. That is, both the permanent income hypothesis and the life-cycle spending hypothesis suggest a big change in the multiplier at the subsistence level of income. Below the subsistence level of income, consumers spend 100 percent of their income yielding a high multiplier (in theory, the mathematics says that if all consumers spend 100 percent of their income, the multiplier is infinite). However, if successive rounds of consumption increase the incomes of consumers with incomes above the subsistence level, these consumers save virtually all their income above the subsistence level. For them, the multiplier is only 1. Thus, if fiscal policy is to have a multiplier effect, two things must be done. First, everyone must receive the minimum subsistence level of income. This will have the maximum multiplier effect, nearly infinite until the multiplier gets truncated as soon as the additions to consumption start generating income for those whose incomes are above the subsistence level. These consumers must be sufficiently secure about their future incomes that they spend a significant portion of their additional income, raising the multiplier above 1. Both the life-cycle and permanent income hypotheses point toward the need to provide secure minimum income guarantees stretching into the future. Without these two measures, the multiplier will stay at or near 1, minimizing the effectiveness of fiscal policy. Given the risk and uncertainty of payoffs from investment, I will likely fall dramatically and stay near zero until the prospects for payoffs from investment improve. The burden of maintaining aggregate demand falls on fiscal policy. In basic Keynesian analysis, increasing G one euro is generally more effective than a transfer or tax cut of one euro. This is because the transfer or tax cut does not get the one euro at the beginning of the infinite series of income/consumption rounds. Thus, if the marginal propensity to consume out of additional income is zero, then the transfer or tax cut multiplier is 0/(1 – 0) ⫽ 0. That is, transfers or tax cuts to people who save all of it, add nothing to aggregate demand. But in our special case, a permanent and reliable increase in income above subsistence also

152 CHAPTER 6

increases the marginal propensity to consume, increasing the multiplier itself. None of this was done in the economies in transition. Transfers and expenditures were cut and taxes were raised to balance the budget and fight inflation. The basic Keynesian macroeconomic model, although ignored, proved to be valid and worked effectively in the wrong direction. Tight fiscal policy drove down aggregate demand. There are two more complications that Keynesian fiscal policy should have dealt with in transition. First, in the basic Keynesian model, maximum output and full employment output are identical. In the economies in transition with their suddenly obsolete capital, production bottlenecks, and breakdowns in transportation and communications, maximum output was probably well below full employment output, so even very effective fiscal policy would have been plagued by significant unemployment for some time. G should have been focused on closing the gap between maximum output and full employment output. In other words, G needed to flatten the aggregate supply curve and shift it right as well as shift the aggregate demand curve right. The pure Keynesian approach needed to be leavened with concern for the supply side. Second, the multiplier, dependent on an infinite series of consumption responses to income changes, is a fragile connection in transition. The infinite series are subject to truncation when they deliver income to people consuming above subsistence who save all of their income. Time is also important. How long does each income/consumption round in the multiplier take in calendar time? Can that calendar time be shortened? How? The essential descriptive features of the basic Keynesian fiscal approach are also empirical assumptions that must be validated or made real in the economy in question. This was true of some of the economies in transition and is still true of some of the “developing” economies today.

7 Monetary Policy and Its Prerequisites

In developed capitalist economies, monetary policy has become the most important tool in the stabilization of business cycles. Given its good performance under these conditions, monetary policy has been enthusiastically recommended to regulate economic activity in economies in transition and developing economies. In this chapter, we review the theory as presented in basic economics texts, but we examine each step in the theory as an assumption to be empirically verified or rejected. Keep in mind that successful use of monetary policy requires certain key assumptions to be true. If these key assumptions do not hold, then monetary policy will not work. Barter versus Money We begin with a closer look at barter, the alternative means of conducting transactions. Most basic economics texts establish the necessity of money by expending a few paragraphs deriding barter as so cumbersome and inefficient that it is not a practical alternative to money-based transactions. The elimination of barter as an alternative to money is essential to the theory of monetary policy because, for monetary policy to affect all participants in the economy, money must be essential to participating in the economy. If some part of the economy does not need money to function, then it will be outside the effects of monetary policy except to the extent that it interacts with the money-based part of the economy. Our first point is that most economics texts do not apply serious economic analysis when they refute barter as a means of conducting transac153

154 CHAPTER 7

tions. An economic analysis of barter versus money should list the advantages and disadvantages of both, and then determine the conditions under which one was superior to the other. While barter might be the best solution under certain conditions, as conditions and needs change to favor money-based transactions, barter will give way to money and vice versa. Instead, the implicit model of barter in economics texts seems to be one of people pushing carts, loaded with items they want to trade, around the countryside in hopes of intersecting with someone whose cart contains something they want to trade for. Given this scenario, it seems unlikely that barter could be a useful system, because it would only work if the individual pushing the cart happened upon another person with a cart and they happened to want each other’s goods. The use of money would be a clear improvement on this scenario, because it improves the chance that an exchange can take place; all that is needed is for one person to see something he wants in the other’s cart, it is no longer necessary for each to want the other’s goods. But this model of barter is a caricature of true barter. First, much can be done to improve the chances that the people pushing the carts will meet up with each other. One way to do this is to have customary market days in town or at the crossroads. Another way is to establish trading posts and full-time merchant shops. Trading posts and merchants can offer credit against future deliveries of goods or accept goods and promise to supply other goods in the future. Goods can even be priced in monetary terms without money ever being used. Second, many transactions are not haphazard, but regular and repetitive. Most transactions within households, and many transactions within close communities, in which the members trust each other, are barter. Individuals provide services to each other as needed without money even being mentioned. Exchange of services need not be simultaneous. Barter can also be part of an institutionalized custom. Your neighbors might help with your barn-raising, with the understanding that you will help with theirs. Third, repetitive transactions within trusting groups make theft almost impossible. If Granny brings her prepared foods to the village market every week to barter for other goods, any one who robs her will be found out as soon as they try to barter her prepared foods. One way to understand the use of barter versus money would be to measure the number of anonymous transactions in the market. If you need to purchase goods from people you do not know and trust, in face-to-face transactions or over long distance, then money is more useful. Use of money would increase as the number of anonymous transactions increased. We will not continue the discussion on barter except to note that, con-

MONETARY POLICY AND ITS PREREQUISITES 155

sidering all these factors, money is primarily superior to barter if you want to conduct one-way anonymous transactions and transactions with people you do not trust. We also note that barter became surprisingly prevalent and sophisticated in economies in transition. In fact, observers considered the increasing prevalence of barter, as opposed to money, transactions, as a sign of the breakdown of these economies, not as a creative adaptation to changing economic conditions. What Is Money Exactly? Most texts define money as something commonly accepted as a medium of exchange. By this, we mean that if you have something you want to exchange for something else, you will always accept money for what you have to exchange. You are willing to accept money because you are confident that when you do find someone who has what you want and is willing to exchange it, they will also always accept money for it. There are two other important uses for money: it is also a store of value and a unit of account. However, let us start with the medium of exchange. A typical example of early money was commodity money: for example, a coin or bar made out of those relatively rare but not very useful metals, gold and silver. These metals became almost universally accepted as money. Supplies of gold and silver were limited because they were hard to find and expensive to mine. Nevertheless, their supply could be increased if their purchasing power rose above exploration and extraction costs. Thus, the purchasing power of gold and silver was fairly stable except when very large deposits were found. Gold and silver are also malleable into convenient shapes and sizes and indestructible. Further, gold and silver are not used up in the production of goods and services as other valuable materials are. Modern money, however, is not commodity money. It is fiat money; that is, it is accepted in exchange for goods, services, assets, and payments simply because the government says it must be accepted. If the government falls and the money is not backed by a successor government, modern money becomes worthless. Thus, the existence of modern money is dependent on the power and longevity of the state. If the modern economy requires fiat money to exist and function, then the modern economy requires the modern state to exist and function. No state, no fiat money, no modern economy. When the Soviet Union disintegrated, each successor state issued its own fiat money to demonstrate that it was a true state. However, it is questionable whether all of the currencies issued by the newly independent states

156 CHAPTER 7

actually qualified as money. As we mentioned above, money has three basic functions: it is a medium of exchange, a store of value, and a unit of account. The new monies were only one accepted medium of exchange, competing with barter, U.S. dollars, and German deutsche marks. But the new currencies were not attractive as a store of value. First, they were susceptible to inflation, or even hyperinflation, which could reduce the purchasing power of savings with frightening speed. Second, some of the new countries went through currency reforms and changes, during which old currency was made worthless and new currency was introduced. Conversion of the old bills, coins, and bank accounts into new money was fraught with risk. The amounts that could be converted were restricted. The conversion process itself could attract thieves, tax inspectors, and corrupt officials. Further, conversion periods were short. Finally, the new currencies were fiat money, backed only by the new governments and their central banks—institutions that were not trustworthy, stable, or permanent. Given these circumstances, many chose to convert their savings into dollars, deutsche marks, goods inventories, or barter contracts for future goods and services as a safer store of value. Were the new currencies used as a unit of account? Formally, of course, they were, because most of the newly independent countries had laws that required all businesses to use the local currency for prices. However, in practice, these proved unwieldy. Shopkeepers are not pleased when they have to recalculate their prices every few days or even hours to keep up with hyperinflation. For this reason, the “conditional unit” (uslovnaya yedinitsa) was invented, and soon became common, especially in expensive restaurants and in stores that sold imported goods. Using the legal fiction of a theoretical “conditional unit” of currency, shopkeepers and restaurateurs gave prices in dollars, and then posted a sign showing the current rate between the dollar and the local currency. As the local currency lost value, the shopkeeper merely had to post a new exchange rate, rather than posting new prices for every individual item. Thus, in addition to the instability created with each new government backing its own new currency, there is another question to be addressed: did the new currencies fulfill all of the functions of money? We suggest that in most cases they did not, and contend that if a currency issued by a government does not perform these three functions, it is not money. In reading on economies in transition, one often reads about unstable governments, inflation, spreading use of barter, and dollarization, but not once to our knowledge was the conclusion drawn that the local currency was not functioning as money. If that were the case, then a domestic mon-

MONETARY POLICY AND ITS PREREQUISITES 157

etary policy based on controlling the supply of the domestically issued currency would be, at best, less effective and at worst, a farce. Modern Money—How It Works Modern money is divided into different types identified by numbers. M0 consists of currency and coins within the banking system and deposits by commercial banks in the central bank. M0 is often called high-powered money or the monetary base because it is the base upon which the banking system creates additional money. We will explain that process in a moment. M1 is the money that people and firms use to perform the three functions of money discussed above. M1 consists of currency and coin in circulation outside banks, as well as checking accounts (also called demand deposits) in banks. Currency and coin are bearer money, that is, it is accepted from the holder. Thus, for currency and coin to be useful as a store of value and a means of exchange, the state must provide reasonable security against theft, both while the money is being held and when it is being presented for exchange. Checking accounts add convenience and security for the account holder, but place additional requirements on the state. To pay in currency and coin, you must be in the same place at the same time as the recipient. Payment by check does not require this coincidence. Also, a check issued to a specific recipient is not bearer money. It is money only to the designated recipient and worthless to anyone else who handles it. Thus checks allow safe payment without the payer and recipient actually having to meet. To the functions of the state of enforcing acceptance of fiat money, controlling loss of its purchasing power, and preventing theft, we now add maintaining the trustworthiness of the banking system. This last requirement becomes more obvious as we explain the money multiplier. The money multiplier is the mechanism by which the banking system— even if the banking system represents only one commercial bank—multiplies M0 into the checking account portion of M1. Assume person A deposits 1,000 euros in cash in a demand deposit. The central bank requires the commercial bank to maintain, for example, a 10 percent reserve in case you appear unexpectedly and demand some of your money back. The commercial bank thus puts aside 100 euros in reserves in the form of M0, coin and currency in its vault, and a deposit it makes at the central bank. It is then free to loan out the other 900 euros to a borrower. Now someone else comes into the bank and takes out a loan. This

158 CHAPTER 7

person, person B, borrows the 900 euros—that is, the bank adds your 900 euros to B’s checking account. Because of the reserve requirement, the bank must hold an additional 90 euros in reserves to back this account. Once this is done, the bank still has 810 euros left that is not required reserves. To continue the example, the bank loans 810 euros to “C” by adding them to C’s account. To back this account it must set aside 10 percent of 810 euros, or 81 euros, as required reserves. And so on. If the bank repeats this process for an infinite number of additional loans, the sum of the infinite series of demand deposits created will be equal to (1/reserve requirement) ⫻ the original cash deposit ⫽ (1/0.1) ⫻ 1,000 euros ⫽ 10 ⫻ 1,000 euros ⫽ 10,000 euros

Assuming the money multiplier works, setting the reserve requirement is a powerful tool by which the central bank controls the overall supply of M1. The money multiplier has three obvious vulnerabilities. First, it is an infinite series and each new loan takes time. How long will it take for each loan in the series to be applied for, approved, and the money disbursed? The longer this process takes, the longer it takes for a change in monetary policy to change the money supply. The banking systems in transition and developing economies do not complete their loan processes in “New York minutes.” If each loan in the series takes two months, then in the first year 10,000 euros added to the banking system will add only the first six loans of the infinite series (4,685.59 euros to M1), which is less than half of the total multiplier effect of 10,000 euros added to M0. Even for the advanced U.S. economy, monetary policy takes six months or more to register in the real economy. The transmission process in transition and less developed economies is sure to be longer, probably much longer. The second vulnerability is leakage from the deposit-loan-redeposit process. In this situation people convert their loans to cash, and they put this cash somewhere safe, perhaps in a glass jar or under the mattress, or in any case not back into the banking system. If people store cash themselves rather than depositing it in checking accounts, this leakage reduces M0. The magnitude of this leakage depends on the level of confidence people have in their banks. Third, remember that the money multiplier works by commercial banks

MONETARY POLICY AND ITS PREREQUISITES 159

making loans. Loans require borrowers. Borrowers borrow because they expect that the rate of return from how the loan is spent will exceed the interest rate they pay on the loan. Also, lenders only lend with some assurance that the loan and interest due will be paid back. Thus, each loan requires enormous faith in the future on the part of the borrower and faith in the borrower and his plans for repayment on the part of the lender. Faith of both in the state’s ability to ensure that each acts honestly, and in the state’s ability to provide recourse if either the lender or borrower does not act honestly or is wrong in his assessment of the other are also required. If any or all of these vulnerabilities become serious problems, as they did in the economies in transition—and still do in developing economies—the money multiplier mechanism will be seriously impaired. An interesting question, which is not addressed in basic economics texts, is whether a banking system is actually required for this multiplier process to occur. Russian businesses proved that the answer was “no” by developing such a system through their supply chains in the mid-1990s, in response to extremely tight monetary policy that increased the opportunity cost of holding and using money. Remember that the money multiplier is based on proliferation of loans and on depositors’ trust that they will get their money back from the banking system. Russian firms reproduced this system among themselves by continuing to supply goods to their customers but not demanding that the customers pay for them—an important point, since most customers had no money. It is easy to see why Russian firms did this, given the difficult economic conditions they were in. If a firm demanded payment and bankrupted its customers, it might receive some of the payment—or it might not—and in any case, it would also go out of business since it had no customers left. Instead, firms, although continuing to make cash sales to customers who could pay, also extended credit to customers who could not pay, building up their accounts receivable. The firm, in turn, would receive the same treatment from its suppliers, accepting credit from them and building up its accounts payable. According to Russian law and accounting practice, the firm was technically solvent as long as its assets plus accounts receivable exceeded its accounts payable. A significant part of the Russian economy thus insulated itself from tight Russian monetary policy, surprising and infuriating Western advisors. If the advisors had been small business owners back in their home countries, they would not have been surprised by this phenomenon. For example, it is common practice for small construction and repair contractors to be granted credit by their suppliers of construction materials. This elim-

160 CHAPTER 7

inates the need for them to get bank loans to buy the materials. The suppliers of construction materials in this example, however, are still part of the money economy. Russian companies expanded this practice on a grand scale, using barter, foreign currency, and any other methods available. The advisors were infuriated because Russian companies clearly demonstrated their ability to insulate themselves from tight monetary policy. Creativity and entrepreneurship, valued elsewhere, are not so valued when used to frustrate macroeconomic policy makers and their expert advisors. Let us return to the theory of monetary policy. Assuming all the factors to support the money multiplier are working, the chief tool of monetary policy to control the money supply is open-market operations, which is the purchase or sale of domestic government bonds. If the central bank wants to increase M0, it buys domestic government bonds in the open market. Since it pays with money, that money will end up deposited with a commercial bank and the commercial bank, in turn, will lend it out after keeping 10 percent as reserves. If the central bank wants to reduce the money supply, it sells domestic government bonds on the open market, is paid by check, and debits the check against the commercial bank’s deposit at the central bank, reducing its reserves. The bank must then reduce its loan portfolio by 10 times the reduction in its reserves. The money multiplier works this way too. Let us stay with the latter transaction: a tightening of monetary policy that reduces the money supply by the central bank selling domestic government bonds on the open market. This was the dominant policy in economies in transition as their central banks focused on fighting inflation (see Graph 7.1). The MS line is a vertical line because it is assumed the central bank controls the money supply independent of the current interest rate. The MD line slopes upward to the left because money holders are sensitive to the interest rate, the rate of return they give up for holding cash and checking accounts, neither of which pay interest. The higher the interest rate, the higher the opportunity cost of holding money, so people reduce their money holdings to buy interest-paying assets as the interest rate rises. At this point, let us summarize here the functions of the state for this process to work. The domestic currency must be accepted as fiat money. The state must enforce this acceptance and be seen as sufficiently stable and long-lived to continue to enforce it in the future. In addition to enforcing the acceptance of its currency and maintaining its purchasing power, the state must also ensure safety from theft and the honest functioning of all the banks in its system both with their customers and in maintaining required reserves. Furthermore, all depositors must have faith that they can get their funds from their deposits on demand. The state

MONETARY POLICY AND ITS PREREQUISITES 161

Graph 7.1 Tightening Monetary Policy Increases the Interest Rate So Long as Money Demand Is Stable or Increasing MS2

MS1

Interest Rate

12 10 8 6 MD3 4 MD2 2 0

MD1 1

2

3

4

5

6

7

8

Money Supply and Demand

almost always does this by guaranteeing that it will pay the depositor if the bank cannot. If the depositors lose faith in the banking system and the state’s guarantee, they will panic and withdraw their funds, causing the money multiplier to work in reverse and quickly collapse M1. Even isolated, small panics can cause enough random variation in M1 to overwhelm attempts to control M1 by monetary policy. Finally, the money multiplier itself is reduced in effectiveness if the deposit-loan-redeposit process takes too long, funds leak out of checking accounts and circulate as cash, or people do not want to borrow or banks do not want to lend. Note all of the factors that must be working properly for the money multiplier to work. And the money multiplier must be working for monetary policy to work. Yet when monetary policy was recommended as an important macroeconomic tool in transition economies, very little attention was paid to ascertaining whether the prerequisites for effective monetary policy were in place. We return now to the graph. The central bank wants to fight inflation, slow the rise in the price level, by reducing aggregate demand. It does this by raising the interest rate, that is, increasing the cost of borrowing funds for investment, I, the business component of aggregate demand. To raise the interest rate, the central bank reduces the money supply, that is, it shifts

162 CHAPTER 7

the vertical MS line left so that it intersects the unmoving MD line at a higher interest rate (see Graph 7.2). Note that the theory works so long as the MD line is either unmoving or shifts to the right for some reason. What could that reason be? If MD is transactions demand, then the demand to hold money increases with an increase in the value of transactions. The value of transactions in the economy increases if the sum of price multiplied by quantity for all goods and services increases. Even if real GDP is falling, if the price level is rising at a faster rate, then the transactions demand for money is increasing. That is, the MD curve is shifting right. This is important because for monetary policy to work, the MD curve must be unmoving or shifting right so that a leftward shift of the MS curve is sure to intersect the MD curve at a higher interest rate. But what if the MD curve is shifting left? Then monetary policy must shift the MS curve left even more for the interest rate to rise. If the MD curve also shifts left, then i will rise less, or not at all (see Graph 7.3). Why should the MD curve shift left? Why should the demand to hold money decline? There are two reasons. First, we know that the demand to hold money is sensitive to the opportunity cost of holding money, the interest rate, since the MD curve slopes up to the left. Remember that the reason for tightening monetary policy in the first place was to fight inflation, to slow the rising price level, P. But a rising price level reduces the value of money holdings. Inflation acts like a negative interest rate; the higher the inflation rate, the greater the loss in the purchasing power of money and any other assets with fixed money returns, such as bonds. So, the MD curve is shifting left with only the increasing transactions demand for money holdings to slow it. Now consider the possibility that there are methods available to conduct transactions without money. Although these methods may be expensive and cumbersome, they could still be worth the trouble if the inflation tax on money holdings is high enough. This is why introductory texts disparage barter but do not look at its costs and advantages too closely. Barter is a means of conducting transactions without money. As barter increases, the transactions demand for money decreases, that is, the MD curve shifts left. Let us summarize. If “real-world” conditions—hyperinflation coupled with uncertain government, competing foreign currencies, distrust of banks, availability of barter, informal credit arrangements—are taken into account, the money multiplier, the ability of the money supply to affect the interest rate, and therefore the effectiveness of monetary policy, will be seriously impaired. There are strong competitors to the use of the domestic currency for

MONETARY POLICY AND ITS PREREQUISITES 163

Graph 7.2 Tightening Monetary Policy Increases the Interest Rate with Stable Money Demand MS1

MS2

9 8 7

i2 6

Interest Rate

i1 5 4 3 2 1

MD

0

1

2

3

4

5

6

7

8

9

Money Supply and Demand

Graph 7.3 Tightening Monetary Policy Does Not Work If Money Demand Is Decreasing MS2

MS1

i2 if MD1 is stable

Interest Rate

i2 = i1 if MD1 goes to MD2

MD2

Money Supply and Demand

MD1

164 CHAPTER 7

transactions, including barter and alternative currencies such as the U.S. dollar. The purchasing power of money must be stable and expected to remain stable in the future if individuals and firms are to be content to hold the domestic currency as a store of value and to accept it as a means of payment. Ironically, the major function of monetary policy in the early years of transition was to fight inflation (rising prices), meaning the domestic currency was losing its value. When domestic money is losing its value, savings are held as goods inventories, as barter agreements for future goods and services, or in other currencies, yet the consequent reduction in the economic effectiveness of control of the supply of domestic M1 was not acknowledged. Ironically, there is an unrecognized aspect of monetary policy that affects real investment directly. When the central bank reduces the money supply via open market operations, it sells domestic government bonds to savers. Thus, domestic government bonds are a financial asset that competes for savings with the rights to returns from real investment, I. If savers buy government bonds, instead of providing their savings directly or indirectly via the banking system to finance I, I will drop and aggregate demand with it. This effect does not depend on the money multiplier. This brings us to our final comment. Since monetary policy controls aggregate demand by controlling investment, I, tight monetary policy sacrifices future growth for current price stability. Investment adds to the capital stock, increasing future output. In the aggregate demand–aggregate supply graph, I shifts the future aggregate supply curve to the right by increasing the capital stock. The rightward shift of the aggregate supply curve both increases output and reduces the price level. Chronic, or long term, use of tight monetary policy, if it is effective, reduces current I and therefore the future capital stock, reducing or even preventing the aggregate supply curve’s shift to the right over time. It will even shift left as wornout capital is not replaced by new investment (see Graph 7.4). Thus, a chronic, long-term tight monetary policy does more long-term damage than a monetary policy that is made ineffective for the reasons presented above. And chronic, long-term tight monetary policy was what most economies in transition tried to implement to fight chronic inflation. Additional Economic Distortions Due to Macroeconomic Policy We have discussed how, when tight monetary policy raises the interest rate and reduces investment, there is a reduction in economic growth. In addition to this effect, there is a more subtle distortion of the current output

MONETARY POLICY AND ITS PREREQUISITES 165

Graph 7.4 Effects of Tight Monetary Policy via Investment Short-run effect of tight monetary policy: I down, slows rightward shift of AS1. AS1 may even shift left

AS2

Price Level

AS1

effect of short-run Keynsian tight monetary policy, I down shifts AD left

stable price level

AD1

long-term tight monetary policy shifts AS curve left

AD2

Real GDP declines

mix. To set the stage, we first comment on the optimal inflation target rate and the nature of price indexes. Inflation is measured as the percentage increase in a price index. A price index is an arbitrarily defined weighted sum of prices. The index is arbitrary because the goods and services included, and the weights used to sum them, are a matter of judgment. For example, the consumer price index may be based on the basket of goods and services consumed by a family of four with average household income of a family of four. Or it could be based on the shares of all consumption expenditures for each good and service that everyone bought in a particular year. Alternatively, the weights given to each good may change each year with the changes in expenditure shares in each year. The GDP deflator, another price index, includes all final or end-use goods and services produced within the country for delivery to consumers, businesses, governments, and export markets. The index chosen depends on the government’s judgment of what should be measured. Once the price index to measure inflation has been chosen, then an inflation target is usually chosen. This target, like the makeup of price indexes, is an arbitrary decision. The European Central Bank has chosen 2 percent per year. The U.S. Federal Reserve target, less clearly defined,

166 CHAPTER 7

seems to be approximately 3 percent per year. The target inflation rate seems to be related to how low the measured inflation rate can be forced down without “big” decreases in output and “big” increases in unemployment (where “big” is defined by political acceptance). We suggest that a different approach is in order. The microeconomic function of changing relative prices in a well-functioning competitive market system is to reallocate inputs from goods and services in less demand to those in greater demand, and to ration demand away from more expensive goods and services to less expensive goods and services. For this allocation mechanism to work, all prices need to be flexible both upward and downward. Also, as the market system responds to these changes in supply and demand, there is no reason to expect an arbitrarily determined weighted sum of prices to hold a constant or nearly constant value. If, however, monetary and fiscal policy are used to keep the weighted sum of prices (the target price index) from increasing too rapidly, then it pays for each producer to try to make the price of his or her good or service “sticky downward” (that is, its price can rise easily but is resistant to falling). The reason is that monetary and fiscal policy will be tightened only to get the target price index growth back below some target rate. If the price of your good or service is sticky downward, then it will not adjust downward in response to tight monetary and fiscal policy as quickly or as much as the prices of other goods or services. These other goods and services, with downwardly flexible prices, will do all the downward adjusting. The conclusion is that use of tight monetary and fiscal policy to control aggregate demand to keep a price index down distorts the relative prices of goods and services away from optimal competitively determined market relative prices. This relative price distortion will then lead to distortion in the output mix of goods and services. There is even a business term for losing the ability to keep the price of a product up in the face of reduced aggregate demand. One says that the product has been “commoditized,” that is, its price is now flexible downward, similar to the price of an undifferentiated commodity with no price resistance in the face of falling aggregate demand. This is the second distortion of relative prices, this time of the current production mix due to the use of macroeconomic policy to fight inflation. A third distortion due to macroeconomic policy affects income and wealth distribution. This time, the problem is not tight monetary and fiscal policy, but periodic loose policies that result in intermittent bouts of high inflation. Lenin said that the way to destroy the capitalist system was to debauch the currency. The implicit assumption is that all classes in the system de-

MONETARY POLICY AND ITS PREREQUISITES 167

pend on a strong domestic currency. In Lenin’s model, debauching the currency would bring down the capitalist classes and lead the way to revolution. Imagine instead a system in which the capitalist class and the working class have different incentives regarding currency value. Suppose the capitalist class wants to keep the proletariat poor, so that they will be willing to work for low wages. The capitalist class, which controls monetary policy, can impoverish the proletariat with periodic bouts of inflation. To prevent the working class from protecting the real value of their savings by buying foreign assets that are not dependent on their home currency, the capitalist class can make “capital flight” illegal. The capitalists, however, can continue to use capital flight to protect their savings, because their wealth makes them practically immune to prosecution. The result is a system that profits the capitalist class at the expense of the working class. From the point of view of the capitalists, it is rather ingenious. They can impoverish their workers (lowering the cost of a key input to production), while protecting their own savings. They can also indulge in money-making schemes, such as taking out domestic-currency loans, holding them in foreign currency, and then repaying at a lower real value (because inflation has devalued the currency). As an added bonus, if capital flight is illegal, it is also de facto tax free. By now the reader will have recognized this scenario as a fairly accurate portrait of monetary policy in many economies in transition and developing economies. The periods of loose monetary policy and inflation provide a useful way to redistribute real wealth from the poor who hold domestic currency as their chief asset to the rich who have access to other assets. If one were to seek evidence of this effect, it should show up as a correlation between a history of repeated price inflation and continued high inequality of income and wealth distribution. This correlation appears both in the economies in transition in the 1990s and in some Latin American economies over longer periods of time.

8 Foreign Exchange Rates and Exchange Rate Crises

Foreign Exchange Rates One pillar of the basic theory on international financial markets has been the theory of trade-determined foreign exchange rates. Essentially, this theory holds that the exchange rate of a country’s currency is determined by trade. The currency appreciates and depreciates based on the demand for its exports and its own demand for imports. When more foreigners want to buy that country’s exports and fewer of the country’s residents want to import from foreign countries, then the currency appreciates. When the converse is true, the currency depreciates. Thus, a country that runs a trade surplus (its exports exceed its imports) will see its currency appreciate relative to the currencies of its trading partners. The currency appreciates because the trading partners bid up the price of the currency of the country whose exports they demand. But the currency appreciation has its own effect. It makes exports more expensive to foreigners. Exports become less attractive, and they decrease. The appreciation also makes imports from foreigners cheaper, so that imports increase. Thus, the theory of trade-based foreign exchange rates argues that exports will equal imports at the equilibrium exchange rate. The mechanism of flexible exchange rates on the international currency market automatically balances trade, so that the value of exports equals the value of imports. The theory of purchasing power parity exchange rates is sometimes 168

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 169

presented as an extension of this theory, and sometimes as a long-run alternative to it. Purchasing power parity exchange rates were originally developed to allow economists to compare the gross domestic product (GDP) of countries with different currencies. Since market exchange rates are volatile, if GDP is calculated using a market exchange rate, the GDP estimate will change whenever the exchange rate does. The constant changes make GDP comparisons awkward, and so the theory of purchasing power parity was developed. Purchasing power parity re-prices each product delivered to final demand in the economy at its U.S. dollar price and then adds them all to get that economy’s GDP in U.S. dollars. For example, if you were to price a haircut in some foreign country, you would use the U.S. dollar price for a similar haircut. You would not use the local price for a haircut, nor even the local price converted at the current exchange rate. When you calculated that country’s GDP all of the goods and services within it, including the haircut, would be valued as though purchased in the United States. This re-pricing of goods has powerful effects. Take China, for example. The GDP estimate for China is five times greater using purchasing power parity than it is when calculated in yuan and converted to dollars at the official rate. In fact, using purchasing power parity, China has a higher GDP than Japan does. China’s GDP becomes number two in the world after that of the United States. This is an important conclusion, and we agree that purchasing power parity is a significant advance in accurately comparing GDPs across countries. Where we disagree, however, is with the use of purchasing power parity currency conversion rates as long-term equilibrium market foreign exchange rates. To be fair, the textbooks do explain that trade-determined foreign exchange rates differ from purchasing power parity exchange rates. Their explanation is that the two differ “in the short run” due to transportation costs, trade barriers, and nontraded services. They usually note that “shortrun differences” between the two exchange rates may persist for years. But the fact is that “short-run differences” may persist indefinitely. They are not short-run differences; they are simply different. We strongly feel that the attempted use of domestic purchasing power parity exchange rates as long-term market equilibrium foreign exchange rates is mistaken for at least two reasons. Let us assume that foreign exchange rates on the open market are driven by exports and imports of real goods and services. Even if this is true, there is a difference between real goods and services produced and consumed within an economy and those exported and imported. Many of the

170 CHAPTER 8

goods and services produced and consumed in an economy are not traded with foreign countries. And even if they were, their share-weights in GDP and in foreign trade would still be very different. So, if we want to calculate the foreign exchange rate using purchasing power parity rates, we must use the things that are exported and imported, weighted as they are in exports and imports. It is not accurate to follow the existing practice, in which everything produced and consumed within the domestic economy is added up with the share-weights they have in the domestic economy. This is one problem. There is another. The volumes of foreign trade in financial assets, such as stocks, bonds, and foreign currencies, are much larger and more volatile than the volume of foreign trade in goods and services. Thus, financial assets should have high share-weights in calculations used to determine foreign exchange rates. However, trade in financial assets do not produce real goods and services, so it is not included in GDP. Financial assets have zero share-weight in GDP purchasing power parity calculations. Since financial assets are not real goods and services, they are not counted in GDP. Why is the misuse of purchasing power parity GDP conversion rates as long-term foreign exchange rates important? Because it gives a false impression that there are stable long-term equilibrium foreign exchange rates toward which global financial markets are moving. This false impression then buttresses the argument for fixed exchange rates. And fixed exchange rates are a key contributor to international financial crises. The Anomaly of Fixed Exchange Rates There is an interesting anomaly regarding domestic economic theory and the theory of the international financial system. Many economists who preach the optimality of flexible market prices for allocating resources within an economy see no contradiction in advocating fixed foreign exchange rates. In classical economic theory, changing prices are key to achieving equilibria. But the same classical economic theory holds that changing prices for foreign currencies are a source of volatility and uncertainty to be resisted—even at great cost. This leaves an important question unanswered. If the price of the foreign currency cannot change, how can exports and imports be brought back into balance? Answering this question is a real problem for economists who advocate fixed exchange rates. Fortunately, the problem was solved in 1752 by David Hume. In addition to tackling difficult issues in philosophy and religion in his Dialogues Con-

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 171

cerning Natural Religion, Hume also solved the truly difficult problem of how trade is brought into balance when the exchange rate is fixed. Hume’s theory recognized the key role of gold asset flows. In his time, the currencies of all European countries were based on gold. In economic terms, gold served as the monetary base, M0, underlying the money supply, M1. Imagine two countries that trade with each other. Assume one country is running a trade deficit. That is, its imports exceed its exports. The other country accumulates the deficit country’s currency, which it presents to the deficit country for gold. The trade-deficit country experiences a gold outflow, a loss of the gold reserves that back its currency. Since the country is on the gold standard (its currency is backed with gold), as the domestic gold supply contracts, so does the domestic money supply. As the domestic money supply contracts, there is a shortage of money for transactions. Nothing else has changed in the economy, so the same amount of transactions take place as before the trade deficit. How can the same volume of transactions take place with less money in the domestic economy? The answer is simple. The price level drops by the same percentage as the reduction in the money supply. When the prices for domestic goods drop, imports become relatively more expensive and exports become relatively cheaper. Domestic consumers find foreign imports more expensive, while foreign consumers find the country’s exports less expensive. Imports decrease and exports increase until foreign trade returns to balance. The analogous but opposite mechanism occurs simultaneously in the trading partner country, which is running a trade surplus. The trading partner is accumulating foreign currency, which is presented to foreign countries for gold. The increase in the domestic gold supply increases the money supply. However, there is no change in real domestic transactions. Therefore, prices rise. This country’s exports become more expensive, while its imports become relatively cheaper. As imports rise and exports fall, trade returns to balance. The disadvantage of David Hume’s price-gold flow mechanism is that the domestic prices in both economies must adjust to regain an equal balance of trade. The trade-surplus economy must undergo inflation and the trade-deficit economy must undergo deflation. Not all prices can rise and fall so easily. If some prices are stickier than others, then relative prices within the economy will be distorted at least temporarily, causing misallocation of resources. Furthermore, if workers in the deflating economy resist having their wages cut, and/or merchants resist cutting prices, then the adjustment will not happen right away. Unemploy-

172 CHAPTER 8

ment and recession will likely be necessary to force the needed reductions in prices and wages. If resistance to price and wage reductions is strong and the fixed exchange rate holds, then the economy may be doomed to long-term unemployment and recession. To understand Argentina’s recent crisis, apply the Hume price specie flow mechanism, but replace gold with U.S. dollars as the currency base (the M0). Keep Hume’s theory in mind as we discuss the problems of the economies in transition. They were advised to fix their exchange rates, so that competition from foreign imports would help fight inflation and stabilize the price level. They were also advised to tightly control their money supply (dependent now on foreign exchange reserves, not on gold reserves) to fight inflation. The result surprised many economic advisors. Foreign exchange flowed in and out of the country with little relation to trade, but with great volatility. The volatility threatened to play havoc with the domestic money supply. The central banks tried to disconnect the money supply from the volatile foreign exchange reserves through a process called “sterilization.” When a central bank exchanges foreign currency for its own currency, the money that it pays out increases the domestic money supply. To counteract the increase in the money supply (which would likely cause inflation), the central banks sell an equivalent amount of government bonds. The government bonds are paid for in domestic money. So the same amount of domestic money goes out of the economy as went in, with no net change. Note that sterilization prevents the Hume gold-flow price mechanism from working. Central bankers love to do this because it increases their foreign exchange reserves (real money, good anywhere in the world) and they pay with either domestic currency or government bonds that are paid off in domestic currency. Remember that central banks have the ability to print domestic money, as well as create central bank accounts in domestic money. There can therefore be no shortage of domestic money. Also, as we noted in Chapter 7, the domestic currency may or may not function as domestic money. This kind of sterilization fights inflation safely, in that no crisis occurs. But the gains from running a positive trade balance accrue to the central bank’s foreign exchange reserves rather than to the economy as a whole. Central bank foreign reserves represent real resources unavailable to the domestic economy for consumption and investment. They act like a tax that is collected but not spent.

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 173

The crisis occurs when foreign exchange flows out. To maintain the fixed exchange rate and currency convertibility, the central bank must buy domestic currency at the fixed rate whenever asked to do so. Then, to sterilize the withdrawal of domestic currency from the economy, the central bank buys back domestic government bonds, paying with domestic currency. This puts an equivalent amount of domestic currency back into the economy. Central bankers do not like this, because they lose foreign exchange reserves and all they gain are domestic government bonds. Furthermore, central banks do not always have enough foreign exchange to pay for all domestic money presented to them. Sometimes the central bank runs out of foreign exchange. When this happens, the bank cannot maintain its fixed exchange rate, the value of the domestic currency plummets, and a currency crisis occurs. The 1990s were filled with exchange rate crises, not confined to small or vulnerable economies. The British pound, the Italian lira, and the Swedish koruna were forced out of the Exchange Rate Mechanism (a European system of fixed exchange rates) in 1992. There followed the Mexican peso crisis of 1994, the Asian financial crisis of 1997 (which started with the Bulgarian crisis in the spring of 1997), the Russian crisis of 1998, followed by mini-crises in Ukraine and Kazakhstan in 1999, the Brazilian crisis of 1999, and the Argentine crisis of 2000–2002. These crises were a surprise to experts and investors alike. They should not have occurred. We believe that basic flaws in the theory of exchange rate determination, as presented in undergraduate texts and summarized above, are the reason. The theory did not serve well for the period of transition in the 1990s, and it will not serve any better in the future. First, much international trade (most oil contracts, for example), is conducted in U.S. dollars. This is true even when there is no U.S. actor in the transaction. For the current theories of exchange rate determination to work, each country’s sellers need to require payment in their home currency, or to convert payments received into their home currency. Further, as we noted in the section on monetary policy, the home currency may not be serving as a store of value and means of exchange even within the country, so that an exporter may use U.S. dollars or another “strong” currency even within his home country. This breaks the link between home country transactions and demand for home currency. Second, international trade in goods and services is small compared to international trade in financial assets: bank deposits in various currencies, government and corporate bonds, stocks, titles to real estate, and derivatives based on these assets. To update the trade-driven theory of foreign ex-

174 CHAPTER 8

changes rates, we need to add trade in financial assets to trade in goods and services. The updated theory indicates that a country’s currency will appreciate as demand grows for its financial assets, as well as for its goods and services. This explains the fact that the U.S. dollar has remained strong throughout the 1990s, despite persistent large U.S. trade deficits. In fact, the large U.S. trade deficits are possible because of growing global demand for U.S. financial assets. So what increases demand for a country’s financial assets? We cannot consume financial assets directly, so there is no consumption demand. Rather, demand for financial assets is driven by the desire to invest. We buy financial assets because we expect them to pay income in interest or dividends, or we expect them to increase in price to be resold later at a profit. The key word in that last sentence is “expect.” The present value of financial assets depends to a great extent on expectations. Logically then, the foreign exchange rate of a currency depends on the expectations of potential buyers for the future value of the country’s assets, versus the expectations of those same buyers for the future value of the assets offered by other countries. Note that this would still hold true if all financial assets were to be purchased in U.S. dollars. All that is required is that the interest, dividends, rents, or other income from the assets are paid in domestic currency. For example, if the assets are stocks, then the value of the stock will depend on the company’s profits, which in turn depends on the expected relative values of the currencies in which the company buys its inputs and sells its products. Assuming this is true, market-determined foreign exchange rates should be quite volatile. They should be just as volatile as the expectations of investors regarding the financial assets of various countries. Is the world then doomed to volatile exchange rates? We shall return to this issue soon. First, let us note that under this model fixed exchange rates are at least theoretically possible. We can update Hume’s price-gold flow mechanism by substituting modern financial assets (bank accounts in various currencies, stocks, bonds, and derivatives based on them) for gold. As in Hume’s price-gold flow mechanism, prices will change as the balance of trade changes. But now the price of financial assets will change; the price of goods and services will change less, and lags will develop. And the balance of trade in question is in financial assets rather than real goods and services. Let us say that global investors decide that some undeveloped country or economy in transition is really an emerging market. That is, their ex-

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 175

pectations are that the country’s assets will increase in value. The global investors acquire stocks, bonds, and the country’s currency. As demand rises, the value of these assets is bid up. The central bank merrily sells its domestic currency for foreign exchange and sterilizes the increase in the domestic money supply by selling government bonds, increasing its foreign exchange reserves. But domestic holders of domestic assets will want to do the same. As the prices of their domestic stocks and bonds rise, they will want to diversify their portfolios, that is, to sell some of their high-priced domestic financial assets for now relatively cheaper foreign assets. Just as their central bank increases its foreign exchange reserves, they will want to increase their holdings of foreign stocks, bonds, and foreign currency bank accounts. The more overvalued domestic assets appear to be, the more domestic holders of those assets will sell them and buy foreign assets. According to this scenario, domestic investors will continue selling domestic assets and buying foreign assets until they have achieved their desired degree of portfolio diversification, and the domestic and foreign asset price/expected return ratios are equal. What happens when expectations change and the foreign holders of domestic assets try to sell them? The prices drop relative to foreign assets. At this point, the domestic holders of foreign assets can trade back into domestic assets at a profit. This is our updated Hume asset flow price mechanism at work. This did not happen in the economies in transition, for two reasons. First, the internal financial infrastructure for buying and selling foreign assets was not in place. In fact, domestic assets were not sufficiently dispersed for most of the population to have financial portfolios at all. Second, most countries have laws against their citizens’ selling domestic assets and buying foreign assets. They call it “capital flight.” Lawmakers in developing countries prevent domestic investors from purchasing foreign investments, because they prefer that the money be channeled into investment at home. Just as lawmakers in Hume’s time prevented gold from leaving the country (its unsanctioned export was illegal), modern-day “financial mercantilists” prevent domestic money from leaving. By doing so, they not only limit their citizens’ legitimate investment opportunities, they also prevent the updated Hume adjustment mechanism from working. The standard theory states that opening to foreign trade should be the solution to imbalance between desired savings and desired investment. However, this has not turned out to be the case. If it were, then there should be no particular relation between the saving/GDP ratio and the investment/

176 CHAPTER 8

GDP ratio for the same country. High-saving countries might then have low investment, or vice versa. However, a classic study by Feldstein and Horioka found that for most countries, the saving/GDP ratio and the investment/GDP ratios were highly correlated. This is strong evidence that our revised Hume financial asset flow mechanism is not working in many countries. Restrictions on importing foreign assets means that all the gain from diversifying into foreign assets go to criminals expert in capital flight, just as in the past restrictions on import of goods benefited smugglers. Furthermore, gains from illegal foreign transactions are also de facto tax free. Naturally, the elites in each country are still able to invest in overseas assets, because their positions protect them from prosecution. As with inflationary monetary policy (discussed at the end of Chapter 7), the beneficiaries of investment restriction policies often include the policymakers themselves. If governments in transition economies allowed all citizens to participate in international investment, the result would be more diversification and increased wealth for many households. If ownership of, and trade in, foreign assets were legal, the government could tax both income and capital gains on these assets. The “wealth effect” from increased investment gains would increase aggregate demand with positive effects on the real domestic economy. Domestic households could also diversify their asset portfolios and at least partially escape domestic theft and corruption. Furthermore, while fixed exchange rates might still not be possible in the real international financial environment, the updated Hume financial asset flow mechanism should reduce their volatility. Floating Exchange Rates If the central bank allows its currency to float, there are two effects. First, the total relative asset price effect is split between the change in prices of domestic assets in domestic currency and the foreign exchange price of the domestic currency moving in the same direction as the prices of domestic assets. Thus, the real economy is affected by the changing relative prices of exported and imported goods and services, due to changes in the foreign exchange rate. We are thus back to the original argument for fixed exchange rates: to insulate the real domestic economy from exchange rate volatility. We repeat our arguments in favor of floating exchange rates. First, disruptions to the domestic real economy due to financial crises when fixed rates cannot be maintained are much larger than the effects of floating rate

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 177

volatility. Second, floating rate volatility is lessened by our updated Hume financial asset flow mechanism. Furthermore, even developed countries with a floating exchange rate may be suffering from the unwillingness to let the updated Hume financial asset flow mechanism function. Exchange Rate Crises As we noted above, the 1990s saw a series of international financial crises, all associated with the failure of fixed exchange rates. The history of these crises shows both a strong commitment to fixed exchange rates and their unreliability. We review them here again with more explanation. The decade opened with the costs of German reunification leading to inflation in Germany. The Bundesbank decreased its money supply and raised interest rates to fight the inflation. Holders of British pounds, Italian lira, and Swedish koruna sold those currencies for German marks to deposit them in German banks at the higher interest rates. The central banks of all the countries in the Exchange Rate Mechanism (ERM) lost German mark reserves as their domestic currencies were handed in for German marks at the fixed exchange rates. Currency speculators, George Soros the most prominent, saw a chance for big profits from forcing the central banks in the ERM to float their currencies. We explain their strategy in detail below. England, Italy, and Sweden, no longer able to maintain their fixed exchange rates with the German mark, suddenly left the ERM in 1992, letting their currencies float. (“Float” means that the currency’s price in terms of other currencies is no longer “fixed” by its central bank but is instead determined by the market minute to minute. Fixed currencies, forced to float, inevitably sink in price, because if the market price was the same or higher than the fixed price, the central bank could maintain the fixed price easily.) The Mexican peso crisis in 1994 was triggered by the North American Free Trade Agreement (NAFTA), which imposed asymmetrically large reductions in Mexico’s tariffs. (Note that there was no Canadian dollar crisis. The Canadian dollar floats and has depreciated against the U.S. dollar without crisis.) The Asian financial crisis began in July 1997 when Thailand was forced to float the baht against the dollar. Other Asian economies were forced to float their currencies in short order. Notably, China, Hong Kong, and Malaysia successfully maintained their fixed exchange rates to the U.S. dollar. This crisis was preceded by a successful attack on Bulgaria’s fixed exchange rate in the spring of 1997 (but if Bulgaria is included, then the catchy title “Asian financial crisis” cannot be used). In August 1998, Russia’s fixed ruble was forced to float (allowed to

178 CHAPTER 8

sink) when the Russian government defaulted on its bonds. In 1999, it was Brazil’s turn, and its currency quickly lost 40 percent of its value. This put great pressure on the Argentine peso, fixed to the dollar by a currency board. The Argentine currency board finally gave way in late 2001 and early 2002, as part of yet another crisis. In the meantime, twelve European countries created and adopted a new currency, the euro. The euro, floated from its creation, had lost about a quarter of its value against the U.S. dollar without crisis and has gained back about half of that loss in 2002 and early 2003, also without a crisis. This brief summary suggests a real problem with fixed exchange rates: they do not stay fixed. Yet many economists still recommended them. Why? First, fixed exchange rates reduce the risk and uncertainty of international trade, promoting the gains in overall economic efficiency due to trade. Second, a fixed exchange rate helps an economy fight inflation. When the price of a domestic good rises above the price of the imported substitute, buyers will buy the import rather than the domestic good, putting a ceiling on the price of the domestic good. If the home currency were allowed to depreciate, the imported substitute would itself become more expensive to the home buyer, so the price of the domestic good could rise as well. Both arguments have merit, but given the costs of lost production and employment from international financial crises (such as those listed above), the purported gains from trade and reducing inflation hardly seem worth the cost. As the above discussion and historical examples illustrate, our theory of exchange rate determination differs significantly from the tradedetermined theory of exchange rates still given in most textbooks. Below we present our theory of exchange rates and point out where our theory differs from the accepted theory. As economists put it, “money is a veil.” To understand what is really happening, one has to look behind or under the money to see what is happening in the real economy to real goods and services, their production, sales, and prices. This is doubly true with exchange rates, which are simply the price of one monetary unit in terms of another. We recommend that you think of an exchange rate as only one part of the price of anything you buy or sell that is priced in another currency. The other part is the price of the good in its home currency. For example, a French citizen using euros to buy a product from a U.S. catalog (with prices in dollars) must convert the dollar price to euros using the exchange rate to compare it to a similar product in a French catalog. Assume the item in the U.S. catalog is priced at $10. When the euro was first created, this item would have cost 8.33 euros, because the euro sold

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 179

for $1.20. In early 2002, when the euro cost $0.90, the same item would cost 11.11 euros. Obviously, if one is conducting a lot of purchases overseas, these price changes can be onerous. To protect its citizens from the risk and uncertainty of changing prices due to changing exchange rates, central banks sometimes fix the exchange rate of the home currency. This could be done in several ways. The most common fix in recent history has been a onesided fix to the U.S. dollar. It is one-sided because only the home central bank stands ready to trade its currency for U.S. dollars in unlimited amounts at a fixed exchange rate. The U.S. Federal Reserve makes no such commitment. If it did, the fixed exchange rate would be unbreakable since the U.S. Federal Reserve can print as much U.S. money (Federal Reserve notes) as needed to maintain the fixed exchange rate. Interestingly, standard theory does not recognize the distinction between two-sided and one-sided fixed exchange rates. Two-sided fixes are rare because each central bank must trust the other not to issue too much of its currency. Nevertheless, we think it is important to make the distinction, because it shows the inherent weakness of a one-sided fixed exchange rate. Central Banks and Fixed Exchange Rates A central bank buys assets, usually some combination of domestic government bonds, foreign money and foreign government bonds, and gold. The central bank pays for these assets with domestic money, either paper currency and coin or deposits in the central bank in the home currency. Thus, domestic money is the liabilities of the central bank. This is because if a legitimate customer presents domestic money to the central bank demanding central bank assets in return, the central bank must deliver assets in return for its own domestic money. Legitimate customers are usually home commercial banks and other central banks but may also include large international banks. Significantly, often the home country’s own citizens are not legitimate customers. Parts of the central bank’s liabilities are domestic cash in circulation and domestic cash and deposits in the central bank held by domestic commercial banks. These liabilities are M0 or the monetary base. The parts of M0 held by commercial banks (rather than circulating outside them) are the reserves that secure the loans made by the country’s commercial banks. Depending on the reserve requirement, the loans outstanding will greatly exceed the monetary base. If the reserve requirement is 10 percent, then the money multiplier will be 10 and the total money supply, M1, which includes checking accounts

180 CHAPTER 8

at commercial banks, can be expanded by loans by the commercial banks up to 10 times the part of M0 held by commercial banks as reserves. The central bank controls M1 by buying and selling domestic government bonds to control M0. If it buys bonds, it pays with domestic money, increasing M0. If it sells bonds, it collects domestic money, reducing M0. Now what happens when a central bank fixes a currency exchange rate and makes that currency fully convertible to other currencies? It declares that it will exchange either currency for the other at a fixed rate in unlimited amounts. (Note that you do not have to be a central bank to fix an exchange rate. You just have to have sufficient assets. If he wanted to, megabillionaire Bill Gates of Microsoft could fix the exchange rate between two small countries. He would simply exchange either currency for the other at his declared fixed rate, buying whichever currency he needed with his U.S. dollars.) If central bank customers want to buy the domestic currency, there is no problem. The central bank can either print more domestic currency or create domestic-currency central bank accounts as needed. But a crisis may occur when customers want to hand in domestic money for the foreign money reserves at the fixed exchange rate. The central bank’s foreign reserves can cover only part of the domestic money it has issued. This is because the central bank has also issued domestic money backed by other reserves, usually domestic government bonds and gold. These reserves are useless in maintaining the fixed exchange rate, because the bank’s customers will not accept domestic government bonds instead of foreign exchange. Nor is the gold much use in this case, because even a hint of increase in gold sales quickly lowers the price of gold worldwide. If customers keep handing domestic money into the central bank and demanding foreign reserves, the bank will be unable to meet their demands. It will either use up all of its foreign reserves trying to meet demand, or simply declare a moratorium on accepting domestic money in order to keep some foreign exchange in the vaults. Either way, the fixed exchange rate is now broken. The domestic currency “floats,” that is, its price as measured in foreign currency abruptly sinks. What happens when a currency implodes in this way? Anybody owing foreign currency debt backed by assets defined in the domestic currency may go bankrupt: their debts are suddenly much larger than the domestic currency assets intended to pay the debt. Pensions defined in domestic currency lose their purchasing power. Imports suddenly become much more expensive. This fuels inflation. The country is in economic trouble, likely very serious trouble. And all of this occurred because economists rec-

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 181

ommended a fixed exchange rate to reduce the risk and uncertainty of currency fluctuations in foreign transactions! We contend that fixed exchange rates do not reduce risk and uncertainty, although they may appear to for some period of time. Risk and uncertainty in economics behave much like energy in physics. They cannot be reduced or increased, neither created nor destroyed, only transferred. Thus, if risk and uncertainty seem to disappear, the correct question to ask is not “Why did the risk and uncertainty disappear?” (because the exchange rate was fixed) but “Where did the risk and uncertainty go?” The answer is that the risk and uncertainty are transferred to the central bank, and thus to the general population of the country, who depend on a stable currency. There is a further analogy to physics. As with energy, risk and uncertainty can be transferred to one place and remain concentrated there. This type of concentration is called a bomb. A central bank defending a fixed exchange rate with insufficient foreign reserves is full of pent-up risk. When all of this pent-up risk explodes into the economy at once, the analogy to a bomb is quite accurate. Speculative Attacks on Fixed Exchange Rates Fixed exchange rates are doubly dangerous economic policy: not only are the consequences of failure severe, but there is profit to be made in breaking the fixed rate. Profit for whom? Certainly not for the general population, the beleaguered central bank, or even necessarily politicians and elites who benefited from the fixed exchange rate while it lasted. But there are players who see great potential in the fixed exchange rate system. They have devised creative ways to liberate all that foreign exchange from the central bank, and make a killing on the eventual collapse. It is even legal—most of the time. The attack is called currency speculation. How does it work? First, borrow a lot of money, denominated in the local currency. A lot of money is defined here as enough to either exhaust the central bank’s reserves or bring them to the point at which collapse seems inevitable and the central bank will allow the currency to float (sink). Note that you will not have to do this alone. If the opportunity looks good, other speculators may mount their own attack, and some may even consult with you. You now have a loan that you must repay. You must repay the amount you have borrowed, plus interest. For example, HC is the quantity of home currency borrowed, and iHC is the interest rate. You owe:

182 CHAPTER 8

HC * (1 + iHC)

Now you present all of your borrowed home currency to the central bank, and demand that the bank exchange it for foreign reserves at the fixed exchange rate. The central bank must honor your request (if it wants to maintain the fixed rate) although it may lose quite a bit of its foreign reserves. You now hold foreign currency, call it FC, which you can deposit in a bank elsewhere and earn interest on it. The money you have in the bank is: FC ⫻ (1 + iFC)

The foreign currency you hold equals the home currency you previously held, at the fixed exchange rate, so that FC ⫽ Efx/hc ⫻ HC

where Efx/hc is the fixed exchange rate price of the home currency in terms of the foreign currency. Now it is time to reap the benefits of globalization, computerization, and all the other marvelous inventions, which have made financial transactions instantaneous and easy. If you have picked your currency well, other speculators will do the same as you have. Like sharks nibbling at a whale, they will nibble off bits of the central bank’s foreign exchange reserves piece by piece, until the majority of it has been transferred to the speculators’ bank accounts offshore. The home central bank will, of course, fight to keep from having to devalue its currency, perhaps securing foreign currency loans from the IMF or issuing bonds in the foreign currency. But speculators can extract that money too. Furthermore, requirements for “transparency” will ensure that the central bank publishes the amount of its foreign exchange reserves, so that speculators can see how close they are to victory. Eventually, barring a very clever central bank governor or tremendous luck, the central bank will give up, and the currency will float (sink). When the devaluation or depreciation of the home currency seems to be complete, you and your fellow speculators can use some of the foreign exchange (FC) that you have in your bank account to purchase some domestic currency at the new, lower rate. This money can be used to pay off your debts in the home currency. If the attack was successful, your foreign exchange holdings will exceed your home currency debts, that is,

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 183

FC * (1 + iFC) ⬎ HC * (1 + iHC)

As the equation shows, the speculators’ profits depend on how much the home currency falls as compared to the foreign currency, the interest owed for borrowing the home currency, and the interest collected on the foreign currency while waiting for the fixed exchange rate to be abandoned. Let us say that Edepreciated is the new exchange rate at which a speculator can buy the home currency to pay off the debt of home currency originally borrowed plus the interest due. Profit ⫽ (1 + ifc) ⫻ (Efx/hc ⫻ HC) – (1 + ihc) ⫻ HC ⫻ Edepreciated)

Naturally, the profit is denominated in foreign exchange, handy for stashing in overseas banks. Lest you think that this gambit is limited to shady operators or shaky currencies, we should point out that George Soros made over one billion pounds in just this manner when he “broke” the British pound in 1992. There are several ways to fight off a speculative attack. The most obvious is to amass foreign reserves. During the 1997 Asian financial crisis, China had foreign reserves exceeding $150 billion. Hong Kong and Taiwan had reserves in the $100 billion range. Central banks love to amass foreign reserves. However, these foreign reserves are resources earned from the domestic economy’s exports but not available to the domestic economy, so they have a real cost, like a tax that is collected but is not spent. Another tactic is to make a preemptive devaluation to reduce the difference between the new fixed exchange rate and the floating rate resulting from a successful speculative attack. This reduces the profits of late joiners to a speculative attack since they will be able to get less foreign reserve currency with their borrowed home currency. Unfortunately, this tactic seldom works because the devaluation is usually too little and too late. Speculators also see such devaluations as a sign that a forced full float is even more likely. Another way to reduce the profits from an attack is to raise iHC, the interest rate on borrowing the home currency. The central bank can do this by raising its interbank borrowing rate, which causes interest rates throughout the economy to climb. This will also happen automatically as speculators present home currency to the central bank for foreign reserves, because the amount they pull out reduces the domestic money supply, raising iHC. However, it also hurts the domestic economy, an effect we will discuss later. Some countries also make it difficult for speculators to borrow domestic

184 CHAPTER 8

currency. China does this explicitly. Malaysia did it successfully with ad hoc administrative controls on lending of its domestic curency, the ringgit, both in 1997 and in previous, less-publicized attacks. Chile has had a unique approach. The central bank has required borrowers of its currency to put 30 percent of the amount borrowed into a Chilean account that pays no interest. This significantly reduced the net payoff from a speculative attack. For example, ignoring interest rate effects, a $100 speculation which forced a 50 percent depreciation of a fixed currency would double the original $100, a yield of 100 percent. But with 30 percent of the $100 held hostage in a Chilean currency account, the speculator would double only the $70 available for the speculative attack to $140. The $30 in Chilean currency would lose half its value to $15. So the net yield from the same 50 percent depreciation of the Chilean currency would be only $155 or a return of only 55 percent. Chile’s approach has been effective in deterring speculative attacks. As noted above, central banks are vulnerable to speculative attacks on their fixed exchange rates because they issue money not only for foreign exchange, but also for both domestic government bonds and gold. So the bank has less foreign reserves than it has liabilities in the form of domestic M0 issued. There is one way to avoid this: institute a currency board. A currency board differs from a central bank in that a currency board can only buy foreign reserves with its domestic money and can hold only foreign money as reserves. That is, M0 is 100 percent backed by foreign reserves. A currency board makes speculative attack more difficult, but not impossible. Hong Kong has a currency board, the Hong Kong Monetary Authority (HKMA), yet it was subjected to a speculative attack. It is a rather interesting story, because both sides were so clever in their tactics. The speculators knew they could not break the fixed exchange rate, because of the currency board. But, they reasoned, if they borrowed large amounts of domestic currency they would force up interest rates, and therefore affect stock prices on the Stock Exchange of Hong Kong. Everyone knows that when interest rates go up, stock prices tend to go down. The speculators borrowed shares on the Hong Kong exchange and sold them at high prices (short sales). They used the proceeds from these sales and additional borrowed Hong Kong dollars to buy U.S. dollar reserves from the HKMA. This reduction in the money supply increased interest rates and stock prices fell. The speculators were betting that they could get the stock prices to go down, buy back the shares they had borrowed at much lower prices, and

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 185

make a tidy profit on the difference. They did not anticipate an active defense by the HKMA. The HKMA discovered the scheme and bought shares for itself, which kept the share prices from falling. This defeated the speculators, and also turned a profit for the HKMA when it later sold its shares. The HKMA was later criticized for interfering in the stock market. We think they did an excellent job defeating a speculative attack aimed at the stock market, rather than the exchange rate. We also think, however, that Hong Kong would be better off with a floating exchange rate. But speculative attacks are not the only reason for financial crises. Several recent currency crises—the Russian financial crisis in 1998, Brazil’s abandonment of its fixed exchange rate with 40 percent depreciation in 1999, Argentina’s crisis and abandonment of its currency board in 2001— were not attributed to speculative attacks. To fully explain these crises, we believe that the basic theory of exchange rate determination should be updated, to take into account changes that occurred mostly in the 1990s. With this goal in mind, we further expand our theory of exchange rate determination. It differs substantially from the theory found in textbooks. Our Theory of Exchange Rate Determination There are two basic motives for holding money, that is, a currency: to conduct transactions and as a store of value or purchasing power. This second motive leads to currency speculation, as people seek to hold currencies that they think offer the best chance of gaining in purchasing power relative to other currencies. For this reason, it is sometimes called the speculative demand for money. Your transactions demand for a currency is a function of what you can buy with a currency, how much you want what you can buy with the currency, and the prices in that currency for what you can buy with it. Note that the transactions demand for a currency may be partly outside its country’s borders. For example, the fact that most global oil trade is conducted in U.S. dollars increases the demand for U.S. dollars even among oil buyers and sellers outside the U.S. who do not trade with the United States. Furthermore, an increase in the price of oil will increase the demand for U.S. dollar balances to conduct oil trade. Bonds and Their Use in Fixed Exchange Rate Regimes The 1990s were not only the period of transition for former centrally planned economies. They were also the years of emerging market econo-

186 CHAPTER 8

mies. The economies of the former Soviet Union and Eastern Europe were both. The economies in transition and emerging market economies underwent privatization and opened their economies to foreign investment. Former state enterprises became private companies that issued stock to be bought on new stock markets, debt to be bought by foreign banks, and corporate bonds to be sold to foreign investors. Governments began to issue and sell government bonds on new domestic bond markets. This explosion of financial and real assets that could be bought with the currencies of emerging market economies dramatically increased what could be bought with those currencies, and thus increased the transaction demand for those currencies. Furthermore, as the prices of those assets rose, so did the demand for the currencies needed, not only to buy, but also to trade them. The creation in emerging market economies of new financial assets and active markets to trade financial assets contributed greatly to the transactions demand for their currencies needed to trade those assets. This brings us to the second motive for holding a currency, the speculative motive. The key difference between assets, including currencies, that are traded on the capital account, and real goods and services traded on the current account, is that asset prices are driven solely by expectations about their future. People buy stocks because they expect their prices to go up. They buy bonds because they expect to collect interest and get their principal back at maturity. They buy a currency because they expect it to appreciate. They may even buy and hold a currency with a fixed exchange rate because they expect another floating currency to depreciate against it. Western optimism about the transition and emerging market economies created a strong demand for the assets of these economies, including their currencies. They were expected to expand their export-led growth and to improve their efficiency and profitability. These factors, in turn, would increase their governments’ tax revenues. All this made their stocks and bonds very attractive to foreign investors. Even as late as 1996–1997, foreign investors were complaining loudly about being excluded from the lucrative Russian government bond (GKO) market (picture sheep bleating at the abattoir door to be let in), and a Russia fund was among the top-performing mutual funds in the United States. The inflow of money (export of assets) on the capital account increased the equilibrium value of these countries’ currencies above their fixed rates. Outflows of money (imports of foreign assets), which would have tended to reduce currency values, were illegal, condemned as “capital flight,” and impossible for most households due to lack of financial infrastructure. The

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 187

updated Hume financial asset flow mechanism was prevented from working. Western economic advisors generally approved of this on the grounds that it kept domestic savings at home to finance domestic investment. One result was an increase in the foreign reserves of emerging market and transition economy central banks, making their fixed exchange rates look very secure. However, the demand for assets, unlike trade patterns, is wholly dependent on expectations about the future and therefore is just as volatile as those expectations. As it became clear that exports would not continue to grow as fast as previously expected and that their prices (for Russian oil, for example) were falling, investors reduced their inflated profit expectations and became concerned about the abilities of companies and governments to meet their debt obligations. Investors began selling off their assets for domestic currencies, and converting the currencies to U.S. dollars. As they did so, the central banks experienced substantial losses of their foreign reserves. Several abandoned their fixed exchange rates. We believe that these rapid changes in expectations precipitated the Russian crisis in August 1998 (when the Russian government even defaulted on its bonds, severely reducing domestic commercial banks’ reserves), the Brazilian crisis in 1999, and the Argentine crisis of late 2000–2001. Let us discuss the Argentine crisis in more detail. Argentina had a currency board, and currency boards are supposed to be invulnerable to exchange rate crises because all their M0 is backed by foreign reserves. However, Argentina had several serious problems, not addressed by the currency board. First, the Argentine peso was fixed to the U.S. dollar. Thus, when Argentina’s competitors on global markets, for both goods and financial assets, depreciated their currencies, Argentine goods and assets became more expensive, and less competitive, in comparison. The most devastating change occurred when the Brazilian real depreciated by 40 percent in 1999. Under Mercosur, Argentina and Brazil had reduced their barriers to trade with each other. Brazil’s depreciation meant that Argentina would run a large trade deficit with Brazil. It also meant that Brazil’s exports of both goods and assets would be cheaper than Argentina’s on global markets. Remember that the exchange rate is only part of the price of an export. The other part is the domestic price in the domestic currency. So, for the export price of a good or asset to fall, either the domestic currency must depreciate and/or the domestic price in the domestic currency must fall. Argentina’s peso was fixed to the U.S. dollar, which meant that it ap-

188 CHAPTER 8

preciated against the depreciating floating currencies of its competitors for the export of both goods and assets. Thus, the Argentine peso prices of both goods and assets had to fall substantially if they were to be exported. The prices of financial assets are very flexible both up and down. So Argentine bond prices fell, and interest rates rose. Stock prices also fell. Foreign direct investment was redirected elsewhere, often to Brazil, where complementary inputs to production were cheaper. One can think of foreign direct investment as the “export” of the ownership of physical investment assets. The prices of real goods and services, especially labor, however, are often very sticky, especially downward. If the prices will not fall sufficiently to clear markets, then unsold goods pile up in unwanted inventories, and services, including labor services, go unsold, that is, unemployment rises. This is what happens when neither the exchange rate part of total prices nor the domestic price part of total prices can fall sufficiently so that demand is high enough to buy the total supplied. Argentina’s domestic prices, especially for labor, are “sticky downward,” making them a poor candidate for a fixed exchange rate. (Both China and Hong Kong suffered much less from the foreign exchange part of their total prices being fixed because their domestic prices are “flexible downward.” Both have experienced significant deflation in the prices of real goods and services since 1997.) The presence of a currency board fooled investors into thinking that the peso was firmly fixed. Thus, Argentina was able to finance its deficits by exporting government debt, much of it to the International Monetary Fund (IMF). However, a currency board’s defense of its fixed exchange rate is not painless. As the domestic M0 is presented to the currency board for its foreign reserves, M1 must contract, raising interest rates and stifling the domestic economy. A currency board basically holds its own economy hostage, threatening to stifle it with high interest rates as it is forced to redeem its M0 for foreign reserves. Eventually, the hostage rebels. Our recommendation is to let exchange rates float. Flexible exchange rates provide more flexibility in the total prices of both real goods and services and of financial assets. Flexible prices clear markets and increase overall economic efficiency. They also dissipate risk and uncertainty into smaller problems rather than concentrating risk and uncertainty into a critical mass suitable for explosive crises. Crises may also occur under flexible exchange rates but they will be much less explosive.

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 189

Confusion About Exchange Rate Systems In all honesty, it is difficult to understand the commitment to fixed foreign exchange rates held by many mainstream economists. To begin with, fixed foreign exchange rates contradict basic economic theory, which proves that freely moving competitive prices are an absolute requirement for the market system to work. Foreign exchange rates are just a kind of price: the price of one currency in terms of another. Why should the prices for currencies be fixed when all others float? It is especially puzzling when you consider that freely floating exchange rates perform economic functions analogous to those of other freely floating prices in achieving market equilibrium. The exchange rate is also a part of the price for anything bought in one currency and sold in another. As such, it absorbs part of the total required price changes for markets to clear. We have no good explanation to propose. In our view, floating exchange rates should logically be as much a part of economic orthodoxy as floating prices in the domestic economy. There are three often-missed characteristics of fixed exchange rates. First, fixed exchange rates are one-sided: the fixed exchange rate is maintained by only one member of the fixed pair. If the fix were two-sided, the currency peg would be immune to speculative attack. After all, each country could supply unlimited reserves of its own currency to defend the other’s currency against speculators. But this arrangement has been tried only once to the best of our knowledge: between Belgium and Luxembourg before they adopted the euro. This plan was so successful that it went absolutely unremarked outside the small circle of those directly concerned. (Apparently a scheme that results in neither a currency crisis nor any other controversy is bound for economic obscurity.) Second, fixed exchange rates are transitive. When both Argentina and China fixed their currencies to the U.S. dollar, they also fixed them to each other. Such unintended fixed exchange rates do have consequences. For example, Argentina could not compete with China for foreign investment by allowing its currency to depreciate, effectively reducing the prices of all its real and financial assets to foreigners. Similarly, Hong Kong cannot compete with Shanghai through currency depreciation. Throughout the 1990s and into the 2000s, China has been a major recipient of foreign direct and financial investment, while other economies with their currencies fixed to the U.S. dollar and, thus, to the Chinese yuan, were not. There are reasons to fix currencies, of course. Robert Mundell received

190 CHAPTER 8

the Nobel Prize in economics for his theory of optimal currency areas, which states that countries’ currencies should be fixed to each other if they trade a lot and have large cross-border movements of labor and capital. But China and Argentina did not fulfill Mundell’s criteria for an optimal currency area. Argentina’s main trading partner within Mercosur is Brazil, while China and Argentina hardly trade at all. Mundell’s theory of the optimal currency area suggests that Brazil and Argentina would have been better off with a two-sided fix of their exchange rate to each other rather than each trying to maintain a one-sided fix to the U.S. dollar. (This arrangement was not tried because each country feared high inflation if its currency was fixed to the other’s. The country with the lower inflation would have had an advantage in exporting to the other. The price competition of imports would foster reductions in the inflation rate in the importing country, but would also foster inflation in the exporting country by reducing domestic supplies of the exported goods and services.) Third, fixed exchange rates are also incomplete. China’s yuan and the Argentine peso (during the period it was fixed to the dollar) both floated against the yen, the euro, and all other currencies not fixed directly or via another currency to the U.S. dollar. Thus, currencies with fixed exchange rates continue to float against other currencies. Furthermore, a fixed exchange rate may be broken by the actions of another country. For example, when Brazil dropped its fixed exchange rate to the U.S. dollar, the Argentine peso suddenly was forced to appreciate about 40 percent against the Brazilian currency. Economic theory has been silent on the peculiar effects of fixed exchange rates that are one-sided, transitive, and incomplete. Given the complex interconnections of global foreign exchange markets, it is hard to believe that these peculiarities have no effects. Fixed exchange rates have proven to be destabilizing and costly in the real world. The collapse of the Bretton Woods system in the early 1970s was followed by efforts to fix exchange rates within the European Monetary System in the late 1970s. The 1990s saw an epidemic of international financial crises with fixed exchange rates at their core: the U.K. pound and Italian lira in 1992; the Mexican peso in 1994; the East Asian crises in 1997; the Russian crisis in 1998; and the Argentine crisis in 2000–2001. If airliners crashed as often as the international financial system, the aeronautical engineers responsible would be, if not under criminal charges, at least out of work. Economists’ commitment to fixed foreign exchange rates has “evolved.” That is, the staggering evidence against fixed exchange rates has forced economists to reconsider the theory. It is now generally recognized that a

FOREIGN EXCHANGE RATES AND EXCHANGE RATE CRISES 191

country can, at any one time, use only two of these three policy options: a fixed exchange rate; free movement of money and other financial assets across its borders; and an independent domestic monetary policy. As discussed earlier, Argentina chose to drop its independent monetary policy in favor of an open economy and a fixed exchange rate to the dollar. This decision mired the Argentine economy in unemployment and underinvestment, which should be countered by monetary policy, but which was instead allowed to run unchecked because of the country’s commitment to the fixed exchange rate. The population lost patience with this policy at the end of 2001, with well-known results. The fact that European countries have abandoned the idea of a fixed exchange rate arrangement, like the one that was broken by speculative attack in 1992, and adopted a single currency, is a de facto admission that the only truly fixed exchange rate is a common currency. The “evolution” away from fixed and toward market-determined foreign exchange rates is still incomplete. The new consensus among mainstream economists is that foreign exchange rates, although not fixed, should be very stable and predictable, making smooth adjustments to economic shocks. We disagree. Foreign exchange rates should quickly and accurately signal the need to reallocate aggregate demand or factor inputs (or both) across currency borders. They should also signal in advance the expected effects of bad economic, political, or social policies within a currency area. If these early signals forestall bad policies before they are fully executed, so much the better. We have already discussed the advantages of allowing free household capital movement across borders. The diversification and increase in household wealth will stabilize the consumption function and increase the spending multiplier, making fiscal and monetary policy more effective. Furthermore, free capital movements both inward and outward by both foreigners and domestic residents combined with our updated Hume financial asset flow mechanism will also lead to less volatile foreign exchange rates. The foreign exchange rate is only part of the price one pays for a foreign asset. The other part is the price of the asset in its home currency. Since domestic asset prices in their home currency are themselves highly flexible, the total price of any financial asset to foreigners can change dramatically—even if there is little or no change in the foreign exchange rate. This is in sharp contrast to the original Hume price gold flow mechanism, which requires the general price level of all goods and services in an economy to move up and down if the exchange rate is fixed. One cannot

192 CHAPTER 8

have both fixed domestic prices and a fixed foreign exchange rate. The original Hume mechanism proposed that all domestic prices suffer constant flux for the sake of a fixed foreign exchange rate. We suggest the opposite: fully flexible domestic prices and exchange rates with no restrictions on trade in goods, services, and financial assets—and with the updated Hume asset flow mechanism allowed to function—will result in less volatile exchange rates.

9 Transition in the Context of the International Financial System

In previous chapters, we have discussed how domestic government policies in the countries in transition resulted in poor economic outcomes. Problems also occurred during their entry into the international financial system. As with domestic economic policy in the economies in transition, theories about the international financial system were misapplied or misunderstood. Following expert advice, the countries in transition simultaneously liberalized their economies and opened their capital markets. The combination increased volatility and produced perverse incentives for investment and spending. A flood of foreign capital flowed into these fragile economies, but poorly developed financial infrastructures meant that the economies could not channel capital inflows into the most productive uses. Much was wasted or stolen. When the financial crises of 1998–1999 hit, most foreign and domestic investors lost their shirts. A few well-connected players used the crisis to enrich themselves, but in general it was an economic catastrophe. Everyone able to pull their money out did, leaving the transition economies poorer than before, and with more unequal and unfair redistributions of wealth. The debilitating outcome of these crises for the economies in transition was not predicted and serves to illustrate a major problem in economic understanding. While economists have studied international finance in detail, the theory of international finance—as presented in basic economic texts—has not kept up with real life. Every time a financial crisis occurs, it seems to surprise both economists and the investors who listen to them. This is partially because international financial markets evolve faster 193

194 CHAPTER 9

than economic theory. A hard look at the economic theory surrounding international financial markets is in order. This reassessment should combine the rigor of economic theory with the experience of practitioners who work in international financial markets. Supply and Demand in Asset Markets Let us turn now to supply and demand curves in asset markets. The supply curve in the short run in an asset market is a vertical line, meaning that the quantity of an asset supplied does not respond to changes in the current price in the short run. Issuing new stock or new bonds takes time. As does loaning funds to increase the domestic money supply, M1, which includes the bank accounts in various currencies that are also traded assets. The short run here is very short. These kinds of financial assets are actively traded on world markets, with prices changing second to second. Adding to the supply of assets with new issues or reducing the supply of assets by buybacks takes time, usually months. So the asset supply curve is vertical and stable in the short run. Another peculiarity of assets, the demand for assets, is determined by the difference between their current price and each potential buyer’s expected future price. Thus, the demand curve for assets resembles our standard demand curve (see Graph 9.1). If only one buyer thinks the future price of the asset will reach 10 euros, then she will be the only buyer at a current price just below 10 euros. If the current price is at 9 euros, then other potential buyers who think the future price is above 9 euros but below 10 euros will also want to buy the asset. They add their demand to that of our first more optimistic investor, so at 9 euros the point on the demand curve is below and to the right of the point on the demand curve at 10 euros. Again, the asset demand curve is normal, sloping down to the right. However, it shifts up and down and changes steepness with changing expectations. If everyone on the asset demand curve increases their expected future price of the asset by one euro, the entire demand curve shifts up by one euro (because the difference between the expected future price and each possible current price increases by one euro). Thus, the demand curve fluctuates with changing expectations about the future price of the asset (see Graph 9.2). The current equilibrium price of each asset is determined by the intersection of the steady and vertical supply curve and a demand curve that vibrates (or oscillates) up and down with expectations about the future

TRANSITION IN THE CONTEXT OF THE INTERNATIONAL FINANCIAL SYSTEM 195

Graph 9.1 Short Run Supply and Demand Curves for Assets

Asset Price

Supply

Demand

Asset Quantity

Graph 9.2 The Demand Curve for Assets Responds to Changing Expectations

Asset Price

Supply

Demand

Asset Quantity

196 CHAPTER 9

price of the asset. Therefore, the foreign exchange values of the currencies used to trade the asset also vibrate. Note that we did not assume that assets are traded in their domestic currency. Many non-U.S. assets are bought for U.S. dollars, so the foreign exchange rates of the U.S. dollar fluctuate with global asset trading activity. But for most countries, much of their domestic assets are traded in the home currency. So, as foreigners’ price expectations for a country’s assets rise, they buy more of the country’s currency to purchase the country’s assets. When expectations are that the price of domestic assets will rise, the country’s currency tends toward appreciation. If the country’s exchange rate is floating, it appreciates automatically. If the country’s currency is fixed, the central bank’s currency reserves rise, as foreigners buy into the now undervalued currency. If the country’s exchange rate is semifixed (a “dirty,” or “managed” float), then the central bank decides how much to allow the currency to rise and how much to allow its foreign reserves to rise. The process works in reverse when foreigners’ price expectations for a country’s assets fall. Note also that a country can weaken the link between its exchange rate and expectations about its financial assets by allowing its financial assets to be traded in other currencies, for example, in U.S. dollars, in either domestic or international asset markets. This is another way to reduce exchange rate volatility. Financial Assets in the Transition Prior to the transition, there were no publicly traded financial assets in the former communist countries. There was therefore no track record for performance on which expectations could be based. The countries had rapidly privatized many enterprises, which then issued stocks on the newly established stock exchanges. Foreign investors, optimistic about the worth of the new enterprises, sent a wave of money into these markets that dramatically raised prices. Short-term portfolio investment, because of its volatility and the sheer volume of capital, was very destabilizing to the economies in transition. A wave of money swept in from Western investors, and the temptations of quick wealth had their effects on the stock markets and banks of the transition economies. Governments also saw their chance. Many transition governments issued bonds with short maturities and high rates of return. Foreign investors

TRANSITION IN THE CONTEXT OF THE INTERNATIONAL FINANCIAL SYSTEM 197

welcomed the chance to buy bonds from the new market economies because they paid higher interest than bonds in developed countries. Of course, the higher payoff reflected that these bonds were anything but sure investments. But many investors, buoyed by optimism and by soaring stock prices at home, were willing to take the risk. In this welcoming environment, governments found it easier to issue bonds than to collect taxes. Long-run asset supply curves shifted up and to the right in response to the corresponding shift up and to the right of asset demand. We note here a unique feature of financial assets: in the long run, barring regulatory limits, financial assets can be created to match any increase in demand. After all, demand for financial assets is just an offer of money for promises about the future, and promises can be broken without giving the money back or, at least, not all of it (see Graph 9.3). Throughout much of the 1990s (until the 1998 crises), mistaken optimism about the ease of transition led foreign investors to pile into these new emerging markets. As a result of these two shifts (supply increasing to meet an increase in demand) financial asset prices and quantities rose dramatically. In 1997, the Russian stock market was the top performer in the world, even in U.S. dollar terms. There were several interrelated reasons for this. First, the Russian stock markets were dominated by Russian oil companies, whose stocks soared because of rising oil prices and the expectation of rising profits. Rising oil prices also meant that government tax revenues were expected to rise, so demand for the high-return Russian government bonds grew. Optimistic expectations increased both the prices and trading activity in Russian stocks and bonds, which, in turn, would have increased the foreign exchange value of the ruble. But since the ruble exchange rate was fixed, the inflow of foreign money both added to central bank foreign reserves and to illegal “capital flight.” The updated Hume financial asset flow mechanism was not allowed to balance out the massive inflow of foreign money. The mechanism would have caused the floating ruble to appreciate. Then, an outflow of domestic household money to buy foreign assets cheaply would have balanced out the inflow of foreign money to buy domestic assets. But the fixed Russian exchange rate and the limits on capital outflow meant that as the currency appreciated, the central banks simply accumulated more foreign reserves, and illegal capital flight increased. Domestic households did not see the purchasing power of their domestic money increase. Law-abiding domestic households were prevented by law, and by the lack of domestic financial infrastructure, from diversifying their savings

198 CHAPTER 9

Graph 9.3

Asset Price

The Supply of Financial Assets, Given Time, Can Be Expanded to Meet an Increase in Demand

D2 S2

D1 S1

Asset Quantity

portfolios by buying foreign assets. Capital flight was a privilege reserved for rich scofflaws. The fact that it was illegal did not prevent it from occurring. It just made it tax free. When the expectations of foreign investors for the future prices of the assets of economies in transition became more pessimistic (or realistic) the tidal wave of foreign money flowed out as quickly as it had flowed in. In the Russian case, expectations were lowered by a drop in the oil price to $10 per barrel, with the expectation that the price would stay low for some time. Other triggers applied to other countries, but the trend was the same. This drained the foreign exchange reserves of the central banks, which lost the ability to defend the now overvalued fixed exchange rate. The result was severe monetary crisis. The central banks of the transition economies were forced to abandon their fixed exchange rates. As soon as the currencies floated, they sank in value. Investors became alarmed that governments in transition might not be able to pay off the bonds they had issued. Their concerns were wellfounded, as the Russian government made spectacularly clear with its de-

TRANSITION IN THE CONTEXT OF THE INTERNATIONAL FINANCIAL SYSTEM 199

fault on August 18, 1998. The Russian stock market dropped along with the ruble and the Russian government bonds (GKOs). The lesson was short lived, however. In 2001, the Russian stock market was again a top performer in U.S. dollar terms. The Pilgrim Russia mutual fund was the top performing U.S. mutual fund in U.S. dollar terms, and foreign investors were again buying Russian financial assets. Why the extreme volatility? Why do not investors learn? Let us look more carefully at the supply and demand curves for an asset. We noted above that the updated Hume financial asset-flow mechanism was prevented from functioning. The current price of the asset is on the vertical axis and the quantity of the asset (in this case the number of share available) is on the horizontal axis. In the very short run, the supply of shares is fixed, so the supply curve is a vertical line. The demand curve slopes down to the right. It is a function of the expected rate of return from buying this asset, (EP – P)/P, compared with the expected rates of return from buying other assets. (EP is the expected future price, say 11 euros. P is the current price, say, 10 euros. The expected rate of return is (11 – 10)/10 ⫽ 1/10 ⫽ 10%). People will demand more of the stock at a lower current price, P, causing the demand curve to slope down to the right (see Graph 9.4). As expectations about the future price change, the demand curve will vibrate or oscillate up and down, as we have noted above, and the equilibrium, market-clearing price will go up and down. Changes in expectations are the source of changes in the demand curve and therefore of price volatility. There is another important factor. How are expectations formed? We have implicitly assumed that the expectations about the future price of the asset are independent of the current price, that is, that the expected price (EP) is not a function of the current price (P). Whatever stability exists in asset markets is based on this assumption. For example, take the classic means of valuing stocks, called “fundamental analysis.” Analysts look at the company’s past performance, likely revenues, costs, and profits. They then estimate what the company will be worth in the future and divide by the number of shares to get the expected future share price, EP. (EP ⫺ P)/P ⫽ Rate of Return

Note that the current share price does not enter into the process: P does not affect EP. The current price appears only at the very end, when the

200 CHAPTER 9

Graph 9.4 Demand Curve Oscillating

Asset Price

Supply

Demand

Asset Quantity

rate of return from buying the shares is compared with the rates of return from buying other assets. But not everyone uses fundamental analysis to make decisions. In fact, many casual investors (and some not-so-casual ones) become trend followers or momentum investors. In this case, their expectation of the future price of the stock is swayed by its current price. When many investors begin making this assumption, the steepness of the demand curve increases. Assume for simplicity that EP ⫽ P (1 + k), where k is some constant equal to or greater than –1. That is, the expected future price is expected to be some fixed percentage above or below the current price. Then the demand curve, which is a function of (EP – P)/P, becomes a function of (EP ⫺ P)/P ⫽ (P ⫻ (1 + k) ⫺ P)/P ⫽ (P + (P ⫻ k) ⫺ P)/P ⫽ 1 + k ⫺ 1 ⫽ k.

Since k is a constant and the demand curve is a function of k, then the demand curve for trend followers is also a constant, a vertical line. As long as P is rising, trend followers buy. When P begins to fall, trend followers sell. They keep selling as long as P falls. In this market, the aggregate demand curve is the sum of the vertical demand curve for trend followers and the downward-sloping demand curve

TRANSITION IN THE CONTEXT OF THE INTERNATIONAL FINANCIAL SYSTEM 201

for fundamental analysts. The balance between these two types of investors determines the shape of the demand curve. The demand curve becomes steeper as trend followers become more dominant and, in the extreme case that all investors become trend followers, the demand curve becomes a vertical line. When the demand curve is a vertical line, there is the same demand at every current price P (see Graph 9.5). As the demand curve becomes steeper, small shifts left or right cause larger and larger changes in the equilibrium price (the equilibrium price is the price at which the supply and demand curves intersect). In the extreme case in which the demand curve becomes perfectly vertical, it either no longer intercepts the supply curve or intersects it everywhere. There is no equilibrium price. The market breaks down. Of course, fundamental analysis of the assets in economies in transition is particularly difficult. There is little historical information, the workings of the companies are opaque and difficult to analyze, and the whole market suffers from uncertainty about the future. This makes trend following by investors, and its consequent instability for asset prices, more likely. Summary The economies in transition opened their new asset markets to tidal waves of foreign capital inflows and outflows while attempting to maintain fixed foreign exchange rates. Foreign exchange rates and asset prices are extremely volatile in economies in transition, but the reasons for this were not fully understood or addressed. In Chapter 8, we discussed the standard theory that foreign exchange rates change in response to changing relative demands for a country’s exports and imports of real goods and services and, indeed, will bring them into balance. We take issue with this theory, and offer a revised theory that foreign exchange rates are determined by changing relative demands for all exports and imports, including financial assets, as well as real goods and services. However, since relative demands for financial assets depend on relative expectations, they are as volatile as the expectations on which they depend. The volatility in relative expectations for financial assets is imparted to foreign exchange rates. To exacerbate the problem, the laws in many countries and the policies followed by the central banks prevented the updated Hume financial asset flow mechanism from performing its stabilizing function. Not only were domestic households prevented from buying foreign assets, but inflows of foreign capital were “sterilized” to prevent them from affecting the money supply. With sterilization, the benefit of running a trade surplus went en-

202 CHAPTER 9

Graph 9.5 Steeper Demand Curve

Asset Price

Supply

Demand

Asset Quantity

tirely to the central bank’s foreign exchange reserves, and to those capable of illegal “capital flight.” Financial assets are by nature volatile in economies in transition. The difficulty of using fundamental analysis in asset evaluations led to increased use of trend following by investors. This, in turn, exacerbated asset price volatility and made market breakdowns nearly inevitable. The financial policies followed by the transition economies—both for their own, sometimes corrupt reasons, and as a result of following expert advice—were flawed. They reflected a fundamental misunderstanding of how the international financial system works. Economies in transition and emerging market economies were exceptionally vulnerable, with their new financial assets and asset markets. The results were instability, currency and financial crises, and extreme volatility in financial asset markets and exchange rates.

10 The Consequences for Open-Economy Macroeconomics

In Chapter 6 we discussed closed-economy macroeconomic theory—macroeconomic theory for an economy in which international trade and financial asset flows are so minor that their effects on the domestic economy can be safely ignored. In Chapter 8 we discussed the theory of the international financial system and proposed a revised theory of foreign exchange rate determination. We turn now to open-economy macroeconomics, the combination of the two. The consequences of our revised theory of foreign exchange rate determination for open-economy macroeconomics are serious and will be discussed in this chapter. Let us begin with the theory of how exports and imports affect the domestic economy. In standard open-economy macroeconomic theory, exports and imports of real goods and services are added together. The exports are given a positive sign and imports are given a negative sign. The resulting sum, “net exports,” is used in calculating gross domestic product (GDP). The net exports figure is simply added onto the end of the GDP categories of aggregate demand, so that GDP ⫽ C + I + G + Net Exports

Thus, net exports are considered to affect the domestic economy only in that they add to or subtract from aggregate demand. The effects of net exports on aggregate supply are ignored. But in reality, these effects can be important. Imports of investment goods and services can increase a country’s productive capacity. Also, key inputs into current production, 203

204 CHAPTER 10

including fuel, power, and key components in manufactured goods, may be imported instead of being produced domestically. In these cases, the effect of imports is to shift the aggregate supply curve to the right. The disregard of aggregate supply effects is shown most clearly in the standard textbook graph showing the effects of changes in net exports on GDP (see Graph 10.1). Aggregate demand (AD) is on the vertical axis and GDP is on the horizontal axis with the same scale on both axes. There is no aggregate supply curve. Instead there is a straight line emanating from the origin and extending northeast at an angle of 45 degrees. Equilibrium GDP is determined by the intersection of the aggregate demand line with the 45-degree line. There is no way to display aggregate supply effects. The 45-degree line in the graph implicitly assumes that aggregate supply adjusts automatically and instantaneously to changes in aggregate demand. The depiction of net exports is also revealing. The closed-economy AD line, composed of C + I + G slopes upward to the right with a slope less than 45 degrees. The slope is less than 45 degrees because as AD increases, the income generated is not all spent. Some of it leaks out of aggregate demand into savings. Thus an addition of 100 euros to AD will raise the AD line vertically by 100 euros but will result in an eventual addition to GDP of 100 euros times the multiplier. This spending multiplier is analogous to the money multiplier described in Chapter 7, only here the leakage from the spending flow is savings. Thus, after an infinite number of spending transactions, the spending multiplier sums to 1 divided by the saving rate. For example, if the saving rate is 10 percent or 0.1, then the multiplier is 1/ 0.1 ⫽ 10 and a 100 euro addition to aggregate demand will, after an infinite number of spending transactions, add 10 multiplied by 100 ⫽ 1,000 euros to GDP. Adding exports, so that AD is now equal to C + I + G + Exports, results in a new AD line above the first one and parallel to it (see Graph 10.2). The theory assumes that a country’s exports depend not on its own income, but on the incomes of the foreign buyers of its exports. Thus, when a country’s GDP rises, its exports do not. Imports are different however: they increase with domestic income. Thus, when we add imports, so that AD ⫽ C + I + G + Exports – Imports, this line will be both below GDP ⫽ C + I + G + Exports, and have a lower slope. Imports are a purely negative drag on aggregate demand. They reduce the slope of the AD curve because, like saving, they are a leakage out of aggregate demand. Remember that the closed economy multiplier for aggregate demand was 1/marginal propensity to save, so that the higher the saving rate, the

THE CONSEQUENCES FOR OPEN-ECONOMY MACROECONOMICS 205

Graph 10.1

AD

GDP Is Determined by the Intersection of the AD Line and the 45-Degree Line

AD = C + I + G

45˚

E

GDP

Graph 10.2

AD

Aggregate Demand with Exports

AD = C + I + G + exports constant exports

AD = C + I + G

45˚

E1

E2

GDP

206 CHAPTER 10

lower the AD multiplier to get equilibrium GDP and the lower the upward slope of the AD line. The open-economy multiplier is now (1/[marginal propensity to save + marginal propensity to import]), so the AD multiplier is even lower, as is the slope of the AD line (see Graph 10.3). But in economies in transition, as we have shown, aggregate supply did not respond automatically to changes in aggregate demand. The 45-degree line is not valid. We need a full aggregate supply curve (see Graph 10.4). In the economies in transition, the most desirable outcome of any transaction was to be paid in U.S. dollars, preferably offshore. The reasons for this are quite rational, and have been discussed in previous chapters. As a result, even key domestically produced inputs were exported instead of being used in domestic production. Foreign buyers, after all, could provide both the hard currency payment and the offshore location. Exports shifted the aggregate supply curve to the left, as well as shifting the aggregate demand curve right. The result of the two shifts is to increase the price level (inflation), but the effect on GDP is ambiguous (see Graph 10.5). Is there reason to suspect that the marginal propensity to import will be especially high in economies in transition? The answer, we believe, is yes. It follows from our revised permanent income hypothesis, as well as the disconnection of the updated Hume financial asset flow mechanism. Remember that the revised permanent income hypothesis focuses on consumers whose future incomes are uncertain. Knowing that future survival will depend on their savings, they save almost all of their income beyond some subsistence level of consumption. Given the opportunity, they would diversify their saving portfolio by buying foreign assets (as lawmakers see it, they would engage in capital flight). But the laws of their country and lack of reliable financial infrastructure prevents most people from engaging in capital flight. Investing in domestic financial assets is risky. The home currency may lose value through inflation and the banks are unreliable. Domestically produced goods can be saved for future consumption (especially if you can store them, as with canned food). But the best way to diversify the household savings portfolio is high-value imported durables and imported goods suitable for storage. This is especially true if there is a wealthy class sure to provide a ready market for imported goods in the future. Thus the need to save, coupled with the lack of worthy investment opportunities and an untrustworthy currency, leads to significantly augmented consumption demand for imported consumption goods, especially highvalue storable goods. Since households cannot import foreign assets, they turn to importing foreign real goods as a store of value for their savings. There are other reasons why economies in transition and developing

THE CONSEQUENCES FOR OPEN-ECONOMY MACROECONOMICS 207

Graph 10.3

AD

Aggregate Demand with Exports Minus Imports

AD = C + I + G + exports

AD = C + I + G + exports – imports 45˚ E3

E2

GDP

Graph 10.4 Aggregate Supply and Demand

Price Index

AS

AD

Real GDP

208 CHAPTER 10

Graph 10.5 Effect of Exports on Aggregate Supply and Demand in Transition Increases the Price Level AS – exports

AS

P2

Price Index

P1

AD + exports AD

GDP

countries have an exceptionally high marginal propensity to import. Investment demand may not be high, but what exists will likely have a very large import component. Modern technology, machinery, and equipment will probably not be produced domestically, and must be imported. Government expenditures on up-to-date military equipment will largely depend on imports. Information technology, such as computers and communications equipment for both government and commercial use, will most likely come from imports. Even the transition itself—the complex process of deregulation, writing new laws, privatization, and marketization—will require imported consulting and advisory services. For all these reasons, the marginal propensity to import in economies in transition is very high. Combined with the high marginal propensity to save, this means that the spending multiplier is very low, reducing the ability of both monetary and fiscal policy to stimulate aggregate demand. In the aggregate demand GDP graph described above, the AD ⫽ C + I + G + Exports – Imports line is almost flat and monetary and fiscal policy can shift it right or left, but have only a minimal effect on GDP or the price level. The way to increase GDP is to shift the aggregate supply curve right (see Graph 10.6). Given the importance of financial asset flows, it would be useful to

THE CONSEQUENCES FOR OPEN-ECONOMY MACROECONOMICS 209

Graph 10.6

Price Index

Shifting Aggregate Supply Curve Right Increases GDP

AS1

AS2

AD

Supply

GDP

calculate a marginal propensity to import financial assets. However, it would not be straightforward to do so. For one thing, its effect on the real economy spending multiplier would be more complex than the straightforward negative effects of the marginal propensities to save and import on the spending multiplier. In the short run, importing foreign assets is simply another source of spending leakage from the demand for domestic real goods and services. We add one more minus to the denominator of the real economy spending multiplier, which becomes 1/(1 ⫺ marginal propensity to save ⫺ marginal propensity to import real goods and services + or ⫺ marginal propensity to import foreign assets)

However, in the longer run, the ownership of foreign assets has both a wealth effect and a portfolio diversification effect, which increases both the level and reliability of expected future permanent income, which in turn increases the current marginal propensity to consume and reduces the marginal propensity to save. This reduces the leakage from the spending stream and increases the multiplier in the longer run. It also explains why

210 CHAPTER 10

the marginal propensity to import foreign assets can be either positive or negative. In simpler terms, people feel more confident about their future income, so they save less and spend more now. But if you get into a conversation with an economist, do not dismiss the long complex explanation above in favor of the previous simple “rule of thumb.” For most experts, it is the long complex explanation (using beloved economic jargon and reference to accepted economic theories) that will capture their attention and interest. If you want to discuss economic theories, especially the rather unorthodox ones we propose in this book, you must translate your arguments into the language of the experts that you hope to engage. Monetary and Fiscal Policy under Fixed and Floating Exchange Rates Under the standard theory of exchange rate determination, a fixed foreign exchange rate renders monetary policy ineffective. The reasoning is that, with a fixed foreign exchange rate, maintaining the fixed exchange rate must be the priority for monetary policy, regardless of domestic economic conditions. Recall that a fixed exchange rate means that the domestic central bank stands ready to buy or sell its home currency at the fixed exchange rate. It must exchange whatever currency is presented, regardless of the effects on the money supply. In other words, the bank must expand and contract the monetary base (M0), and therefore expand and contract the domestic money supply (M1) via the money multiplier, without regard to the desirable monetary policy under domestic economic conditions. This means that fiscal policy is the only effective macroeconomic policy tool under a fixed exchange rate. However, in a floating exchange rate regime, monetary policy is an effective tool. It need not be used to maintain the fixed foreign exchange rate, so M0 can be expanded and contracted with domestic economic conditions in mind. Three comments on fixed versus floating exchange rate regimes. First, fixed exchange rates are almost always one-sided fixes. Only one country commits to maintain the “peg” (“peg” is a term used by economists as shorthand for “fixed exchange rate” or “fixed price”), generally the financially weaker of the two. For example, there are several countries that fix their currencies’ exchange rates to the U.S. dollar, but the rate is maintained entirely by each country’s central bank. The U.S Federal Reserve makes no commitment to buy and sell at the fixed exchange rates—if it did, they would certainly hold.

THE CONSEQUENCES FOR OPEN-ECONOMY MACROECONOMICS 211

Second, even a country with a fixed exchange rate is fixed against only one other currency (or combination of other currencies). Against all other currencies, the exchange rate floats—excepting, of course, in other countries fixed to the same peg. For example, the Hong Kong dollar is fixed to the U.S. dollar, but floats against the Japanese yen and the euro. When the Argentine peso was fixed to the U.S. dollar as well, the Hong Kong dollar and the Argentine peso were fixed to each other. Now, neither Hong Kong nor Argentina set out to fix their currencies to each other. Complications can result, which we will discuss later. These complications are, unfortunately, not treated in basic economic theory. Third, if our revised theory of exchange rate determination is correct, then domestic fiscal and monetary policy affect the foreign exchange rate by affecting the expected rate of return on domestic assets. Thus, fiscal and monetary policies that increase the expected return on domestic assets will also appreciate the domestic currency. Furthermore, all government and central bank policies that affect the expected rates of return on domestic assets will affect the foreign exchange rate. This would explain why the prices of domestic assets, as well as a country’s currency, may rise or fall with minor political and economic announcements. Foreign exchange rates show exquisite sensitivity to various factors—in fact, to any factor that affects expectations about the rates of return on domestic assets. Our revised theory is also just as flexible as the standard theory. For example, an increase in government spending, according to the standard theory, increases aggregate demand, which in turn increases GDP and the transactions demand for money. The increase in money demand raises the interest rate, which, assuming that foreign interest rates and expectations about future exchange rates have not changed, causes the home currency to appreciate. However, if the fiscal expansion is viewed as inflationary, it will change expectations about the future exchange rate. Specifically, it will bring about an expectation that the currency will depreciate in the future. The expected future depreciation causes a current depreciation. In the revised theory, the same fiscal stimulus can also affect the foreign exchange rate either way, depending on how it is perceived. If an increase in government spending is seen as adding to aggregate demand, and the expectation is that returns on domestic assets will increase, then the home currency will appreciate. If the new spending is seen as inflationary, and the expectation is that inflation will reduce the real rate of return on domestic assets, or if the new spending will bring about tight monetary and fiscal policies in the future, then the home currency will depreciate.

212 CHAPTER 10

Some important points. First, the conclusions drawn from our revised theory of foreign exchange rate determination differ from those drawn from the standard theory mostly in that our revised theory is more inclusive. It includes all policies that affect the expected returns from domestic assets, not just monetary and fiscal policies. These other policies are especially important in economies in transition and in developing economies, for which property rights, the legal infrastructure, and the honesty and reliability of the government are not yet firmly established. Economists accustomed to dealing with settled financial systems in advanced economies concentrate on monetary and fiscal policies, because these are usually the only policies subject to significant change. But in economies in transition and developing economies the effects of other policies may dwarf the effects of monetary and fiscal policies. It may be helpful to spell out what “other policies” are taken into account by our more general theory of foreign exchange rate determination. They include maintaining a stable macroeconomic environment; guaranteeing dependable property rights for both tangible and intellectual investments; allowing full foreign exchange convertibility in both directions; ensuring profit repatriation rights; and fostering general political, social, and economic stability. Second, expectations play a special role in both the standard theory and in our revised theory. The critical role played by expectations means that causality in financial markets can run backwards in time. Expected future effects, or even changes in the perceived probabilities of future effects, determine today’s asset prices. Expectations about the future determine the present. Reasoning with Accounting Identities Accounting identities are pairs of variables, or combinations of variables, that are always equal because their components are defined that way. They are, therefore, very useful to economists. There are two potential pitfalls in reasoning with accounting identities however. First, they do not reveal causality. Second, they may hide important information about how variables are defined and aggregated. An example may be helpful. We will work through one accounting identity, as it might be developed in a standard basic economics textbook, starting with the basic accounts for real GDP. All the variables represent flows over one year. First take savings: not savings as we commonly think of them, but savings as represented in GDP—as a failure to spend income. Income is

THE CONSEQUENCES FOR OPEN-ECONOMY MACROECONOMICS 213

earned in producing real goods and services. If it is not spent, then some real goods and services are not consumed. These real goods and services had to go somewhere. It turns out that the unconsumed goods and services went to provide for future consumption. This is the GDP meaning of “investment”: investment as provision for future consumption. Total Saving ⫽ Total Investment

In an economy open to trade, the unconsumed goods and services either go into domestic investment, which will produce goods and services in future years, or into net exports, which earn the right to import goods and services to consume in future years. This is how this year’s saving for the future is turned into actual consumption in future years. There are three groups of savers in an economy: households that do not spend all they earn, SH; businesses that retain earnings, SB; and governments that tax more than they spend, T – G. We can expand our identity now to SH + SB + T ⫺ G ⫽ I + Exports ⫺ Imports

By definition, this identity is true. That is to say, the terms that make up the identity have been defined in such a way that the two sides must always be equal. This identity is used in texts to show that economies can have negative savings and investment as well as positive savings and investment, as long as they are equal. They can do this if imports exceed the sum of exports plus investment, I. Trade provides another way to save for the future. The economy can export more than it imports and hold the foreign exchange earned to buy imports in later years. That is, it holds foreign currency to buy real goods and services in the future instead of holding the real goods and services in I. There is an attribute to this identity usually not discussed in the basic texts. This identity can be expanded to show how this process can go horribly wrong, as it did in the economies in transition. To do this, we need to break domestic investment I into its components. Domestic investment is comprised of three categories: Gross Fixed Investment (GFI; Equipment and Structures); Desired Additions to Inventories (Desired INV); and Unwanted Additions to Inventories (Unwanted INV). In economic terms,

214 CHAPTER 10

I ⫽ GFI + Desired INV + Unwanted INV

Investment is more than making machines and building factories for future production. It can also mean simply storing goods for future consumption. Further, there are “goods in process,” such as unfinished buildings, that may belong in either desired or unwanted additions to inventories. Note that additions to inventories can be negative. This happens when inventories are consumed. If inventory consumption exceeds gross fixed investment then I can be negative. Now our accounting identity for saving and investment can be rewritten as follows: SH + SB + T ⫺ G ⫽ GFI + Desired INV + Unwanted INV + Exports ⫺ Imports

In this form, the identity can tell an important story. In economies in transition, SH was very high because households were trying to save. So was SB, as enterprise managers stripped assets, sold them, and tried to get the proceeds out of the country. Government saving was generally negative. Budget deficits were the rule rather than the exception. GFI was low because of the uncertain business future. Desired inventories increased dramatically but not enough, due to problems of secure storage and desired mix. In uncertain times, many private citizens wanted to buy durable and storable goods for future consumption or sale. This should register in the identity as SH and desired INV. (In practice, however, it is added to C.) Unfortunately, it was not possible to safely store enough durables to counter the many uncertainties. (One of our favorite anecdotes comes from a “man on the street” interview during the transition period. The man was asked what his biggest problem was. He said his small apartment was full and he could not fit any more stuff in it.) That leaves exports. But manufactured goods from economies in transition were not competitive on world markets and the European Union had little interest in importing agricultural products and processed foods. So what about commodities? Some, such as oil and gas, found ready markets. Others, such as steel, faced anti-dumping tariffs. Much of what was produced but not consumed domestically could not be exported. Thus, the capacity for desired investment was not able to absorb the massive desired saving. As you can see, neither exports nor gross fixed investment expanded much during the period of transition. They may even have contracted. Desired inventories expanded, but not enough, due to storage and logistical

THE CONSEQUENCES FOR OPEN-ECONOMY MACROECONOMICS 215

problems. None of these terms on the right side of the equation expanded enough to balance the enormous unspent income from households and businesses. But the accounting identity must still hold. So where did the savings go? In the economies in transition, the unspent income went into unwanted inventories. Unsold goods piled up. But production of those unsold goods had to be counted in current GDP, since capital and labor services were paid for (or at least payment was promised), and the GDP accounting identity must also hold. In short, the saving was wasted. What happened in future years? The unwanted inventories were “written off,” that is, their prices are marked down to whatever price they could bring on the market. If they could not be sold at all, their prices were marked down to zero and they were thrown away. How does this affect GDP? It does not! GDP is a measure of current flows (usually taken over one year) of labor and capital services on the production side and final goods and services on the end-use side. All labor and capital services and all goods and services provided are marked at current prices, to ensure that the GDP identity holds. GDP is not adjusted later for changing prices in inventories, investment goods, or foreign exchange. Thus, much of the GDP produced by the economies in transition was written off in later years as unwanted inventories. And how do businesses respond to unwanted inventories? They cut production until the inventories are disposed of through sale or are simply thrown away. This process should be emphasized in all textbooks that present the identity equation we started with at the beginning of this chapter. The “saving into investment” problem is not limited to the economies in transition. We have already noted that Japan’s government has spent vast amounts of money on unnecessary construction, in an attempt to add to aggregate demand and bring the country out of recession. The unnecessary construction adds to current GDP but not to productive assets. It adds to unwanted inventories of structures that must be written off later. As another example, the information technology bubble in the United States added greatly to GDP in 1995–1999. Large amounts of high-tech goods were added to inventories, and much fiber-optic cable was buried. Some of the high-tech goods now sell for 10 cents on the dollar and much of the fiber-optic cable is “unlit,” that is, not in use. Yet the U.S. GDP for the years 1995–1999 will not be revised downward for these reasons. (They could be revised for other reasons, however. U.S. GDP figures are not absolutely final until ten years have passed.) As you can see, we are now using the saving-investment identity to

216 CHAPTER 10

show the great risk involved in saving for the future. The investments made with savings may turn out to be in undesired inventories. Or, if the inventories turn out to be desired, they may still not pay off, due to technological obsolescence, rot, or damage in storage. But these problems, however real, will not be reflected in GDP or the GDP growth rate. The GDP measure is not designed to include changes in the prices of inventories of goods or foreign assets. The Case of Japan Japan had trouble with its own “transition” in the 1990s. The Japanese economy has been in recession or stagnation due to chronic lack of aggregate demand since the investment bubble burst in 1990. Japan’s population is hard working, high saving, and includes a growing share of the elderly. These potential investors live on an island with few new investment opportunities of worth. Japanese households should be diversifying their asset portfolios and increasing their wealth by using their massive savings to buy foreign assets. However, the government of Japan severely restricts the investment opportunities open to law-abiding Japanese investors. High-saving Japanese households, who would like to secure their retirement incomes, have little access to foreign assets (although access may be improving slowly). Instead, they have two choices. They can open a bank savings account, or put money in the postal savings system. Interest rates on both investments are very low. Were Japanese investors allowed to invest their wealth in profitable overseas markets, the wealth effect would increase consumption by Japanese households. Weak aggregate demand is one of the major causes of the recession, and increased consumption would do much to remedy this. The massive imports of assets would cause the Japanese yen to depreciate, making Japanese exports to the world cheaper and imports more expensive. The resulting increase in net exports would also add to aggregate demand. Remember our expanded permanent income hypothesis from Chapter 3. Our expansion of the hypothesis states that households with uncertain permanent incomes will save almost all their income (beyond some acceptable minimal level of current consumption). Japan is living proof of this theory. Japanese households save as much as they can, even at near-zero interest rates. Because of the high levels of savings, Japan’s fiscal expenditure multiplier is only 1. This situation, not covered in basic economic theory, makes standard Keynesian fiscal stimulus ineffective. This is why the Japanese

THE CONSEQUENCES FOR OPEN-ECONOMY MACROECONOMICS 217

government’s fiscal stimulus (the short-run Keynesian policy of increasing government expenditures) has had little effect although applied for over a decade. Japan suffers from large government deficits, mounting government debt, and investment projects that do not pay off. The country is running out of places that can be cemented over to provide work for construction companies. It is ironic that the same failures to carefully examine and verify the assumptions underlying standard macroeconomic policy prescriptions have plagued both economies in transition and at least one advanced economy over the same time period.

11 Benevolent and Malevolent Markets

The Rational Basis for Stock Market Bubbles Investment bubbles, which are apparently baseless run-ups in asset prices followed by rapid price declines, have been well documented. The U.S. information technology stock market bubble that deflated beginning in March 2000 is one recent example. Most explanations of investment bubbles have focused on “herd behavior,” “irrational exuberance,” and other seemingly irrational behaviors. Manifestation of these behaviors would appear to contradict the efficient markets hypothesis, which is a cornerstone of traditional economic theory. After all, either investors are rational or they are not. In the aftermath of the latest bubble, many finance courses present both traditional theory and the possibility of irrational behavior (explored by the new and growing field of behavioral finance) to allow students to draw their own conclusions. Our discussion below suggests that herd behavior and stock market bubbles can actually be based on rational decision making. While this resolves the question of how behavioral finance and traditional economics can coexist, there is also a significant cost. It implies that rational market decisionmaking need not necessarily lead to efficient markets. We start with the apparent irrationality of herd behavior for the individual animal. Why would an individual animal join a herd sure to be found and attacked by predators? Since herd behavior is so prevalent in the animal kingdom, it must provide an evolutionary advantage. Otherwise, herd animals would have become extinct long ago. One solution to this apparent 218

BENEVOLENT AND MALEVOLENT MARKETS 219

contradiction (favored by evolutionary biologists) is that the herding instinct is advantageous for the survival of the genes of the herding species, even if not for individual animals. According to this theory, each individual animal stays with the herd against its own individual interest because the evolutionary advantage for the genes it carries leads the herding instinct to be genetically “hard-wired” into its genes. Similarly, humans have hard-wired instincts that were previously, and may still be, genetic advantages. These may include baseless optimism and hope, an inflated sense of one’s own abilities, herding, and even altruism. When these hard-wired instincts influence investment decisions in markets, however, they may lead to apparently irrational market behavior that impairs the efficient operation of markets. Behavioral finance investigates and analyzes such behavior. Schools try to teach their students who will participate in financial markets—whether MBA’s, finance majors, or economists—to replace instinctive decision making with rational decision making that works in markets. This is only one example of how human societies curb, channel, suppress, or develop genetically hard-wired instincts for the good of both society and individuals. After all, history is full of market “bubbles,” followed inevitably by “crashes,” in which many investors lose their shirts, their homes, or worse (after the great stock market crash of 1929, some investors took their own lives).1 This latest crash (in 2000) has not been quite as dramatic, but we may not have seen the last of its effects. So why has not instinctive “irrational exuberance” been trained out of investors? Are our business schools no match for this hard-wired instinct? Is the urge to irrational market behavior such a strong genetic inheritance that we cannot curb it? The deeper we get into these questions, the more difficult and tangled the issue becomes. So, let us begin again with a different question: Is there a survival advantage for an individual animal to join and stay with a herd? The answer is “yes.” Predators conserve their energy and avoid debilitating injury by bringing down the easiest kill within range. A lone animal is by definition the easiest kill within range and, if found by predators who must eat, will be attacked. But if our lone animal joins a herd, the chances of being attacked drop, not only because he is only one of many targets, but also because the odds favor there being weaker animals in the herd. Typically, predators will stampede a herd to identify the weakest animals, which will give them the easiest kill with the least risk of injury. The larger the herd, the larger the probability that the herd contains animals weaker than the last joiner. This explains why joining a herd is rational for each individual animal, strong or weak.

220 CHAPTER 11

Now what about animals who trade in financial markets? Does it pay to join the herd? It turns out that it is rational for each individual trader to join the herd during the upswing in prices produced by a rising market. This is true even if he or she considers the upswing baseless and irrational. There is money to be made in a bubble, so long as more individuals will buy in and keep prices rising. This is the seeming paradox of stock market bubbles: it is rational to take advantage of irrational price swings by buying in, provided the bubble will continue to expand, that is, that prices will continue to rise. Each new joiner has presumably determined this. Each guesses that everyone else has made the same calculation. Assuming the market rises, everyone benefits by joining in. The combined effect of all this individual rational behavior (based on the assumed nature and functions of markets and on expectations of others’ behavior) is that an “irrational” bubble will be fed by rational investors. Of course, each investor, being rational, plans to sell out before the bubble bursts. What we suggest will be difficult for mainstream economists to accept. Like behavioral finance, our idea threatens important economic models and theories. We are essentially proposing that markets may produce perverse results from rational behavior. We hope that this alternative explanation for irrational markets will result, if not in acceptance, at least in rational investigation of how and why collective decision making by rational individuals can lead to collective irrational behavior. We might also suggest that economists reconsider the theoretical requirement seen in many economic models and theories, that investors be rational and markets be efficient. Given that neither is likely, economists would perhaps be better off constructing models that, though not optimizing, allowed for market manias, panics, and crashes, as we have experienced in the 1990s and no doubt will continue to experience. The Theory of Efficient Markets Efficient market theory, at the heart of so-called modern financial economics, argues that a share price accurately reflects all available information relevant to the value of a company. According to this theory, provided all the information necessary to calculate a firm’s true profits is disclosed, it does not matter what the firm reports as its profits. Even if a firm ignores the cost of stock options for executives when calculating its profits, the market will not.2 Economists have identified weaknesses in the efficient market theory. Arbitrage does not work as it should. Investors who know the true value

BENEVOLENT AND MALEVOLENT MARKETS 221

of a share do not necessarily drive out investors who do not. The psychological biases of investors appear to affect share prices. Markets, in other words, are not truly efficient, and shareholders may be misled by reported profits that exclude the cost of options. The efficient market theory is based on competitive general equilibrium market theory as applied to any competitive market. In Chapter 3, we pointed out that the theory works beautifully for a single disturbance or change with enough time for all market participants to adjust. We called this the theory of the single Brownian move, to contrast it with the theory of Brownian motion in physics. Brownian motion is change in response to continual random shocks, not to a single shock. We have argued that if efficient market theory were to be relevant to real-world markets, including financial markets, it would have to prove that markets adjust correctly and quickly to continual random shocks, not just a single shock. We concluded that this cannot be proven and that real-world markets are often overwhelmed by random shocks. Further, earlier in this chapter we argued that it is rational for speculators to buy into irrational stock market bubbles, since they can make profits as long as they sell before the bubble bursts. There is, however, an even stronger way to attack efficient market theory: use the same reasoning to develop a malevolent market theory. Efficient market theory believes in the best of all worlds. According to this theory, a strong desire for profits, combined with Darwinian competition, will result in the best and smartest investors driving out the incompetent and naive. The financial jungle will then be populated by those best suited to use all available information to determine the true values of the assets traded in the market. Current market prices will represent the best current estimate of the assets’ true values, prices will only change when new information becomes available, and all current information will be included in current prices. Furthermore, since Darwinian competition leaves only the best and brightest as market players, it should become increasingly harder to deceive investors over time. However, there is one catch. According to the efficient markets theory, the best and brightest players, those most profit driven and most competitive, will still only earn the market rate of return. After all, the markets are efficient, so that all known information is contained in the price of the assets. In such a market there would be no “incredible deals,” regardless of how clever one was. Are these players likely to be content with the same return that their slower and less competitive brethren receive? We think not. Instead, given strong incentives based on expectations of higher profits, we suggest that

222 CHAPTER 11

some of these winners of the Darwinian market will analyze the ways honest investors develop their expectations of future asset prices and methodically deceive them about the true future asset prices, in order to induce them to buy high and sell low. This deception of honest investors will be the source of extra profits for the manipulators. We believe that the same arguments that support the efficient market theory also support a malevolent market theory, in which markets are manipulated by the “worst and brightest” for profits exceeding the market rate of return, which are obtainable by deceiving honest investors. Given this reasoning, there are two long-run equilibrium outcomes. Most likely, if honest investors are continually deceived, they will eventually abandon the market, leaving the manipulators to try to deceive each other. The market will then collapse as first all honest investors and then lessskilled manipulators learn from their losses and abandon the market. However, a brief review of economic history finds few instances of predominantly malevolent market manipulation destroying a market completely. There are two reasons for this. First, faith in markets is basic to economists’ worldview, so that market crashes are usually blamed on naive or misguided behavior, not on malevolent behavior. However, a careful review by economic historians might turn up some examples of malevolent markets driving honest investors out of the market completely, particularly in economies in transition, colonial stock markets, and other venues out of the bright floodlights of public scrutiny and government regulation. These crashes might have been blamed on other causes, or simply received little attention. Second, governments intervene when the functioning of useful markets is threatened. For example, the U.S. Government has intervened to regulate markets after significant crashes on at least two occasions in recent history: after the Great Crash in 1929; and in the current flurry of investigations into accounting standards and market manipulation after the stock market bubble burst in 2000 and the Enron, Arthur Andersen, and WorldCom scandals were revealed in 2002. Of course in real life, neither the purely efficient market nor the truly malevolent market exists. Most markets are more or less efficient, or more or less malevolent, with trends moving in either direction due to internal market manipulation versus internal and external regulation. The United States, United Kingdom, and Western European markets are perhaps as close to efficient as a large market can be expected to be. Certainly, until recently the U.S. market was thought to be so. And some economies in transition—most notably Russia during the speculative boom and bust in 1998—exhibit almost entirely malevolent markets. Most interesting to us are cases in which experts believed strongly that

BENEVOLENT AND MALEVOLENT MARKETS 223

a market was efficient, when in fact it was malevolent. For example, in the U.S. stock market bubble of the late 1990s, the market was widely supposed to be efficient, but with the benefit of hindsight it seems clear that a malevolent cycle was taking place. We have discussed one possible long-run equilibrium outcome, in which honest investors leave the market and only malevolent speculators remain. An alternative long-run equilibrium outcome assumes that honest but naive investors and less-skilled manipulators keep returning to the malevolent market with new funds because they think they can win and/or because they enjoy the activity. In this case, the popularity of the stock market would be closely tied to the human love of gambling. With all the ups and downs in fashion and taste, gambling seems to be one of the most constant human pursuits and the gambling industry a good investment. While gambling on the stock market can be ruinous, investors in well-regulated markets have found that companies that provide gambling services to others can be quite profitable. (Enronically, to the best of our knowledge, companies in the gambling industry have not been forced to restate their profits due to accounting problems.) In the stock market or the casino, a rational bet on human irrationality can be a moneymaker. We do not mean to suggest that the efficient markets hypothesis is invalid. Rather, we suggest that both efficient and malevolent markets should be understood and discussed. Each can be relevant and useful in understanding real world markets; like blades of a scissors, neither is much use without the other. Markets are neither perfectly efficient nor perfectly malevolent except in the constructs of theory. Markets in the real world range between the two extremes, and there is a continual tug-of-war between malevolent market manipulators and honest investors who want honest markets. Honest investors push the government to restrain the malevolent market manipulators when their abuses become too costly and too obvious. Malevolent market manipulators (sometimes in cooperation with well-meaning free market proponents) constantly try to pressure and influence governments and other regulatory bodies to give them a freer hand. The result is a continually shifting equilibrium between the extremes of malevolent and efficient markets. A key function of government is to push markets toward the efficiency extreme and away from the malevolent manipulated extreme. Despite sophisticated and rigorous analysis, many economists do not favor regulatory practices that push markets in the right direction. This is in part because they rely on the efficient market hypothesis, without recognizing its malevolent alter ego. Economists’ support of extensive stock options for senior corporate ex-

224 CHAPTER 11

ecutives is an example of this lack of understanding. In the last ten or fifteen years, it has become very popular to reward senior corporate executives with stock options, which grant the right (but not the obligation) to buy the company stock at a fixed price within a period of time. This provides a strong personal incentive for the executives to raise the price of the stock, so as to personally benefit from the “spread” between their options’ buying price and the market price. Until recently this practice was hailed as a way to align the interests of the executives with those of the shareholders. The practice was supported in business schools, in textbooks, in economic reviews, and in the press. A careful review of the incentives generated revealed that the executives were being motivated to increase the price of the stock in the short term, rather than the health of the company in the long term. We have already pointed out that every business school student learns as a mantra the following rule: the first job of every manager is to maximize shareholder value. In other words, the first job of every manager is to raise the stock price as much as possible. When managers found their pay tied to the stock price, this incentive was strengthened. This practice both fueled, and was fueled by, the speculative stock bubble, which collapsed in 2000. We are now discovering that it also fueled shady accounting practices intended to boost investors’ expectations; and thus boost stock price. Why did economists support this practice? Consider stock options in the context of efficient market theory, which guarantees that the current market price of the stock is in fact the best estimate of the true current value of the company (the stock price cannot be manipulated or boosted, and it reflects all current information). Given efficient markets, stock options are effective management incentives. The problem is that economists viewed stock options through the rose-tinted glasses of efficient markets theory without viewing them also through the dark glasses of malevolent markets theory. Economists failed to understand the importance of timing on creating the right incentives for managers. Let us consider the effect of stock options on one manager, who is both rational and well informed as to the way markets work. Let us say that she took control of the company on a fouryear employment contract, and that her stock options can be executed only in the fourth year of her tenure. If our manager is rational, she wants to maximize her payoff, which means maximizing the price of the company’s stock in the fourth year. It follows that, if at all possible, she will engineer a price spike some time during that period, in order to sell out and go on to her next job with a rosy halo of success from the great job she did in maximizing shareholder value.

BENEVOLENT AND MALEVOLENT MARKETS 225

Our manager’s focus is very likely skewed by the attempt to engineer this price spike. She may care little for the state of the company afterward. In the fifth year, her money will be safely in the bank, and she may well have moved on to another company. One might protest that a conscientious manager will avoid taking shortterm steps that might disadvantage the company, despite the chance for personal gain. Indeed she might, if her conscience were particularly strong. But in that case, the desirable outcome has occurred despite the stock options incentive, not because of it. Let us consider an alternative case. Imagine that our manager will receive her stock options in sixty components, only one of which can be exercised in any given month during the four years. In that case, the rational manager would maximize her profit by quickly improving performance, and holding that improvement over the entire four years. We might leave our manager an additional twelve components, which could only be exercised in the year after her contract expired. This system would eliminate the incentives for price spikes, and encourage managers to focus on medium-term (rather than short-term) performance. A carefully structured option package is key to influencing both management performance and the price of the stock over time. While a wellstructured incentive can be quite positive, a badly structured options package can retard or even reduce the overall long-term profitability of a company. Why are so few companies using a longer-term incentive package like the one we describe? Because there is a strong incentive among the most informed and powerful actors in the markets—chief executive officers (CEOs), wealthy investors, investment banks—to keep the present system, which can bring large payoffs to a clever manipulator. There is no economy without political economy. We have discussed the effect that stock options have on management incentives. There is also an effect on the market. Investors know the details of the CEO’s option package, and they know the CEO will hope to maximize the stock value around the time the options mature. In this case, will a wise investor follow the classic buy and hold strategy? No, other factors being equal, a wise investor will buy just before the options mature, and sell when the CEO does in order to maximize his own return. The CEO knows this, and is depending on increased investor attention around the time her stock options mature to further increase their value. Take another step. Suppose that savvy investors and many executives are in on the same game. How would the market react? We might expect a spike in reported profits (perhaps due to accounting manipulation) by

226 CHAPTER 11

many companies at the end of their CEO’s tenure, and a corresponding bull market beginning just before options matured and ending abruptly soon after the CEO’s departure. The bull market would draw in new, naive buyers, who believe in the efficient markets theory, and conclude that the rising stock prices are indicative of previously unrecognized improvements in performance. These naive buyers add to the payoff that executives receive, since they drive the prices of the stocks even higher. Soon after the options are exercised at or near the price spikes, reported profits drop, stock prices drop, and the stock market bubble deflates, perhaps as quickly as it appeared. This pattern will be familiar to anyone who invested in the stock market in the 1990s, as well as to the millions of disappointed investors throughout the ages who have joined in, and lost their shirts in, speculative bubbles. Whether through stock options or some other device, there has always been some mechanism whereby executives and canny investors can benefit at the expense of naive investors. The malevolent market has always coexisted and competed with the efficient market in the real world even if not in economic theory. We hope our discussion has led the reader to suspect that real-world markets are much more complex and prone to manipulation than efficient market theory indicates. Caveat emptor: Let the buyer beware.

12 Japan: The First Demographic Transition

In previous chapters, we have focused on two major transitions in the 1990s: the transition from central planning and communism to market capitalism and the global integration of national financial systems. We have argued that failure of economic theory to fully understand these transitions has led to bad policies that made the transitions unnecessarily painful and costly. Yet another major transition has received attention in the 1990s: the demographic transition of the advanced economies from youth-dominated to senior-dominated societies. Japan is of interest because it is a developed and wealthy economy facing a demographic transition. In this chapter, we argue that Japan’s economic problems in the 1990s are due largely to its demographic future, not a result of current politics. An aging society in a country with an advanced economy is not a problem, but an opportunity—if managed properly. We are probably lucky that Japan is undergoing this transition first: perhaps they can show us the way. Dire Stats No one doubts that the Japanese economy is in trouble. Since 1990, Japanese banks have accumulated bad loans that range from 7 percent to 15 percent of GDP. Government debt, which was approximately 60 percent of GDP in 1990, is now approximately 130 percent. A real estate bubble has burst: urban commercial property is now worth 15 percent of its peak value. Peoples’ homes are now worth much less than 227

228 CHAPTER 12

they were ten years ago, perhaps much less than when they purchased them. A stock market bubble has also burst: by 2002 the Nikkei 225 (a Japanese stock market index) has fallen to only 25 percent of its 1989 peak value. People who invested their savings in the stock market are suffering along with those who invested in their homes. Unemployment, which was as low as 2 percent in 1990, has climbed steadily to over 5 percent. This plays havoc with a society that values longterm (even lifetime) employment and social stability. The “Asian miracle” seems to be on the rocks: the Japanese economy, which in the late 1980s had a projected long-term average growth rate of 10 percent, has had four recessions since 1990. GDP is falling. The GDP deflator has registered average annual deflation of 1 percent since 1995. The currency has been depreciating, with the yen dropping 13 percent against the dollar in 2001. Round Up the Usual Suspects Who is blamed for this mess? Oddly, the same people and institutions who were credited with the economic miracle of Japan, Inc. in the 1980s. The society based on consensus, commitment to common goals, and teamwork, which executed zero-defect manufacturing and export-led growth so brilliantly in the 1980s, is now considered hidebound and resistant to change for the same reasons. In just ten years, Japan Inc.’s virtues have soured to vices. Politicians have been found corrupt. The Liberal Democratic Party dominates. Farmers have more electoral power than their numbers warrant. The government is trying to supplement aggregate demand by a massive campaign of road-building and other public construction, influenced as much by corrupt insider politics as by potential economic benefit. Before these well-known problems are given the blame for Japan’s economic woes, consider this: we are trying to explain a huge change in Japan’s economic performance from the 1980s to the 1990s. The change in economic performance was abrupt and severe—logically it ought to be caused by some abrupt change in Japan’s economic drivers. The problems we have listed are certainly serious, but they did not suddenly get worse around 1990. They are not sufficient to explain the sudden reversal in Japan’s economic performance and prospects. Take almost any item from a list of Japan’s internal problems and you will find that China is much worse off, and has been for a long time. If bad debt, corruption, and inefficient public works programs are the problem, then China’s economic performance and prospects should be much worse than Japan’s. Instead, the controversy about China is whether GDP

JAPAN: THE FIRST DEMOGRAPHIC TRANSITION 229

grew by or over 7 percent or “only” around 5 percent in the last few years, and whether it will continue at this rate. Even the most committed China cynics concede that China’s growth rate is around 5 percent, even as they list economic, political, and social problems for China much worse than Japan’s. Should Japan adopt the China model to achieve China’s economic prospects? Don’t answer: this last question is meant to be ironic. What Changed around 1990? In the late 1980s and early 1990s, it became increasingly clear that the emerging Asian tigers were successfully copying Japanese manufacturing practices and the Japanese strategy of export-led growth. Even U.S. auto companies were learning lean manufacturing. Much of the world seemed to be competing with Japan for export markets and adopting Japan’s successful strategies. The limits to export-led growth for Japan became apparent around 1990. Japan’s currency was too strong and its labor force too well paid to compete with Asia’s emerging low-cost exporters except at the high-end of most product markets. And if exports do not grow fast enough, then domestic aggregate demand must grow faster to compensate. But Japanese consumers were “too thrifty.” In other words, when economic trouble looms, the Japanese have learned that it is better to save than spend (we may wish we had learned this lesson ourselves!). But where were consumers to place their savings? We have already mentioned that savers who deposit money in Japanese banks get very little return on their money. The small condominium apartments and houses typical in Japan, often sitting on expensive small plots of land, could not hold many more consumer durables. And Japanese households could not easily diversify into foreign assets, such as U.S. stocks and bonds. Instead of spending or investing in foreign assets, Japanese consumers invested in their mortgaged homes, the postal savings system, and domestic financial assets, such as annuities, insurance policies, and shares in Japanese companies. The problem was, and is, that the growth in value of all these assets depends on further growth in aggregate demand. Since export-led growth has been limited by copy-cat competitors, this is mostly domestic demand. Thus, household wealth was built on continuing growth in domestic aggregate demand. The mortgaged homes would increase in value only if more Japanese would want to buy more and better homes as they got richer. Consumers were not the only ones relying on growth in domestic assets. The Japanese insurance companies used the premiums they received for

230 CHAPTER 12

insurance policies and annuities to buy domestic company stocks and real estate. But the values of Japanese company stocks would rise only if domestic and export demand for Japanese companies’ products would also rise. The high prices of Japanese real estate would continue to rise only if a growing Japanese population and economy increased demand for Japanese real estate. Thus, the high and rising prices of almost all Japanese household assets depended on rising domestic aggregate demand. This is not new. For almost all economies, rising domestic asset prices depend ultimately on rising domestic aggregate demand. However, Japan’s demographic projections clearly forecast falling aggregate demand. This is natural, as a large percentage of the population ages and passes on, but it means bleak forecasts. And unlike most countries, there are no countertrends to balance the trend toward an aging and shrinking population. There is no Japanese Diaspora that might return home. Demographers do not predict a rebound in Japanese fertility rates. Even if fertility rates were to change, the increase in the working-age population would take two decades to begin to register. Mass immigration is one option. But so far the Japanese have resisted this, for understandable reasons. They have a remarkably safe and stable society by world standards, and the mixed success of mass immigration into Western Europe and the United States has not encouraged them to consider changing their social model. Further, opening their country to young immigrant dependents would exacerbate rather than offset a growing domestic population of aged dependents. Unlike the United States and Western Europe, the islands of Japan are hardly vulnerable to unwanted immigration. With good demographic data to work from, and no countervailing trends, the demographic projections for Japan are probably quite accurate. These projections clearly point to declining aggregate demand as the population declines, and big changes in the composition of aggregate demand as the population ages. First, we will discuss the problem of declining population. As we noted in Chapter 9, the unique feature of assets is that their current value depends on the stream of income they are expected to earn in the future. When the expected future income stream of an asset declines, the price of the asset drops immediately. We suggest that the primary driver of the collapse of share and real estate prices in Japan in the 1990s is the growing realization that these assets will generate much less income than was earlier believed. As noted above, the limits to growth in export demand can already be

JAPAN: THE FIRST DEMOGRAPHIC TRANSITION 231

seen. Our attention therefore is focused on the prospects for long-term growth in domestic aggregate demand. It is clear that there will be fewer Japanese families to buy homes, so home prices in the future will fall. We have already noted that when an asset’s price is expected to fall, the expectation brings the price decline from the future back into the present. The price of the asset falls immediately. Similarly for all other assets whose values depend on the income stream from producing and selling future goods and services in Japan. Their current values and their stock prices drop immediately for the same reason. Japanese stock and real estate prices have been declining for a decade. The decline has continued for so long because it has taken a decade or more for the population to realize that the primary driver for asset prices is lower future income streams from a declining and aging population. The realization still has not hit Japan’s policymakers. Japanese economists are applying standard Keynesian remedies: expansionary monetary and fiscal policies designed to correct short-term cyclical declines in aggregate demand. These remedies have not worked for a decade—strong evidence that the problem has been misdiagnosed. Assuming our diagnosis is correct, what effects would Japanese economic policies have on aggregate demand? We start with a declining and aging population that has just seen its household wealth and, therefore, its expected future income streams cut dramatically and made much more uncertain. This should sound familiar, for it is similar to the situation that households in the transition in the former USSR and Eastern Europe found themselves in. We apply again our modified permanent income hypothesis, which states that when future expected income drops and becomes more uncertain, households will save more out of current income against the uncertain future. In the extreme, if they save 100 percent of their income beyond some minimal basic consumption level, both the fiscal and monetary multipliers drop to one and expansionary monetary and fiscal policies become much less effective. This resembles Japan’s situation, in which monetary policy has failed to stimulate demand even at very low interest rates and government spending programs also have little effect. What have been the effects of Japanese policy on household expected permanent income? Loose monetary policy has reduced household interest income on their savings. Government guarantees on yen bank deposits are being cut back just as those banks’ problems are making the headlines. Insurance companies are threatening to default on annuities and life insurance policies and asking the government to let them get away with it. One recommended policy remedy for Japan is similar to what we sug-

232 CHAPTER 12

gested for the economies in transition: put a floor under household permanent income to make it more secure and predictable, rather than less. The more secure households feel about their future income, the more they will spend now, adding to aggregate demand and raising the level of the fiscal and monetary policy multipliers. Some Western economists have even suggested that the central bank should increase the money supply to turn the deflation into inflation to force households to spend their money before it loses too much of its purchasing power. However, we believe that debauching the currency in Japan will do no more good than it did in the former Soviet Union and Eastern Europe. The threat to debauch the currency did have one important effect: Japanese consumers decided they had better ensure their savings would hold value. Lacking the ability to buy foreign financial assets (such as U.S. Treasury bills), they chose gold as the next best thing. Japanese gold purchases were credited with driving gold prices over $300 per ounce in 2001 and 2002. Gold hoarding is a classic response to bad economic policy. Japanese policymakers and their Western economic advisors should take note. With domestic assets declining in value, Japanese households should have been, and should now be, diversifying their asset portfolios globally. Diversification of household portfolios increases permanent income and reduces its uncertainty. This both increases domestic aggregate demand and increases the marginal propensity to consume, raising the income multiplier, making monetary and fiscal policy more effective. In addition, the outflow of yen to buy foreign assets will weaken the yen, helping Japanese exports. Instead, Japanese economic policies have wasted money on unwanted public works projects, have failed to stimulate aggregate demand, and now are increasing the risk to household savings by reducing deposit insurance. To add insult to injury, aging citizens who have worked hard and saved for their retirement can open the financial pages and regularly read statistics on what a heavy and growing burden they are on the working-age population. What Is Not to Be Done? We start with what is not to be done. Short-term Keynesian monetary and fiscal policy will not work in Japan’s case. Even zero interest rates will not encourage the purchase of assets whose prices are declining. Expansionary fiscal policy, in this case government-financed production of unwanted

JAPAN: THE FIRST DEMOGRAPHIC TRANSITION 233

physical assets, will not work either. It wastes resources and creates an obligation to pay for the labor, capital, and material inputs used in their production. These obligations cannot be met because the physical assets will not produce an income stream in the future. The physical assets have near zero value as soon as they are built. This predicament is so difficult to comprehend, and its consequences so dire, that the Japanese financial sector and the government have spent a decade devising accounting tricks to prevent asset prices from falling further and registering the true value of the assets for all to see. Deflation is not a problem. It is simply a price signal that says you are producing the wrong things. If the thermometer in your house drops, it means the furnace is not producing enough heat. The correct policy is to fix the furnace, not to put a candle under the thermometer and boost the reading. Unfortunately, Japanese policy, often encouraged by Western advisors, has been to try to prevent the deflation from registering on the various financial thermometers, such as the stock market indexes and real estate prices. The government is the homeowner who does not know how to fix the furnace, so he has busied himself with what he does know: construction projects around the house. As he builds one thing after another, the house just gets colder. The wife and kids (Japanese citizens) know that his construction projects will not warm the house. They have what economists call “rational expectations.” They know that the candle under the thermometer does not mean the house is warmer, that the furnace needs to be fixed, and that the construction projects are just creating worthless clutter and running up bills for construction materials. Someone has to focus the homeowner on this problem and explain how to fix it. Then What Is to Be Done? If the problem is an aging population, and acquiring more young people is not a feasible solution, then only one solution remains. The aging population must live longer, and during their longer lives continue to be vigorous producers and consumers. We have already outlined the means to this end in our discussion of sovereign governance: the key role of the state in creating property rights and market incentives and in lowering transaction costs so that markets can efficiently accomplish what its citizens want. In Chapter 4, we suggested the creation of “health souls” as income-producing assets for health organizations in the same way that athletes are income-producing assets for sports organizations. In our example, health organization profits in-

234 CHAPTER 12

crease as their human assets age and retain their mental and physical capabilities to be vigorous workers and consumers. Death and declining mental and physical capabilities among their human assets become financial losses for the health organizations. Thus, market incentives are aligned with what the citizens want: longer and better lives, not more highways and bridges. This is what we mean by “sovereign governance,” the key role of the government in creating property rights and incentive systems so that a well-functioning market system can deliver what its citizens want. There is also a practical human capital efficiency issue that is not yet recognized in economics. Advanced societies now invest between 18 and 26 years of training and education in each worker/consumer for 39 to 47 years of productive life (assuming retirement at 65) followed by about 13 years as a burden on society, waiting for death. That is at best 1.5 years of productive work life for each year of expensive dependence (47 working years divided by the sum of 18 years of childhood and 13 years in retirement). If people were treated like other capital equipment, teams of engineers and MBAs would be working feverishly to extend the working and consuming life of such expensive equipment. We would see MBAs in human resources management and in marketing earning double degrees in geriatric studies. They are not doing so now, because nobody can currently “own” the human capital equipment and make a profit by maintaining them. Our proposal detailed in Chapter 4 aligns market incentives with making human capital live longer and healthier lives, with maximum retention of mental and physical capabilities. This is another example of what we mean by “sovereign governance.” How would society change if the productive life of human capital equipment rose to sixty years and beyond, and the “unproductive” (to the economy) death-watch period dropped to near zero? It would certainly change the mix of aggregate demand, an issue mentioned earlier. We leave these fascinating and important questions for further research. We suggested at the beginning of this chapter that the rest of us are fortunate that Japan faces this demographic crisis—this combination of problem and opportunity—first among the nations of the world. This is because all those virtues that Japan displayed and used so successfully in the 1980s are still present, and will be needed for this major advance in sovereign governance. The society to lead the way must be stable, able to commit to common goals, and ready to cooperate to solve the many problems that will arise in execution of such a complex strategy. Perhaps most

JAPAN: THE FIRST DEMOGRAPHIC TRANSITION 235

importantly, the society must value its older citizens, a virtue for which the Japanese are rightly famous. Japan already leads the world in having a capable and active senior population. From the 1950s through the 1980s, all the elements of Japanese society cooperated to create a remarkably prosperous and peaceful society. These national characteristics make Japan our best hope to lead the way for the rest of us.

Conclusion

We close this book with some questions we hope will intrigue our readers. What is the best way to learn about a country? How could one best understand the economic theories discussed in this book and their effects? And are these two questions related? Many observers and practitioners live in the country that they study. This is a valuable experience, but we wonder whether it is sufficient. Suppose you are a country expert on Russia, and you go to live there for a period of years. You might be immersed in the culture and traditions, but the local economy would still be largely unexperienced. After all, your assets, pension rights, medical insurance, your entire personal financial future remains safely at home. Alternatively, imagine that you stayed physically at home. However, you borrowed as much as you possibly could, sold all of your assets, and then converted the proceeds—your total personal wealth, in fact—to Russian rubles and deposited it all in Russian banks. Or perhaps you used your entire personal wealth to purchase Russian stocks through a Russian stockbroker. You would then be caught in the same Catch-22, the malign logic of economic collapse that we have described in this book. Now ask yourself— go ahead, be honest—what might you be willing to do to escape or improve that future? Incentives for corruption, theft, and capital flight are not limited to one culture or ideology. Nor do they stem from lack of expert advice. Instead, they follow the inexorable forces that underlie economic theory. It was 237

238 CONCLUSION

these forces—largely unrecognized even in hindsight, because of their challenge to accepted basic economic orthodoxy—that took hold of the welleducated and resilient populations of the economies in transition and reduced them to poverty. We hope this book will be useful in pointing out some of the problems with economic advice provided to the economies in transition. However, this is only half of our goal. When theory and reality fail to correspond for extended lengths of time and in crucial areas, a re-thinking of the theory is in order. We suggest that there are blind spots in accepted basic economic theory. This book is intended to identify some of these, and to spur challenge, debate, and research. Finally, we hope that economists and practitioners alike will keep in mind that the science of economics is intimately connected with human lives and welfare. Our ironic proposal that economists invest their assets in transition economies makes this connection clear. To be fully understood, economics needs to be felt, not just studied.

Notes

Introduction 1. Paul A. Samuelson and William D. Nordhaus, Economics (New York: McGraw Hill, 1998), p. 14. 2. For those wishing to read more on these issues, an excellent place to start is Marie Lavigne’s The Economics of Transition: From Socialist Economy to Market Economy, 2d ed. (New York: St. Martin’s, 1999) and the works cited therein. 3. Economics, like political science, is taught differently in Europe than in the United States. Some European texts may already be further along in integrating the role of government into their basic economic texts.

Chapter 1. The Basic Market Mechanism 1. Karl Marx, Das Kapital: A Critique of Political Economy (Washington, DC: Regnery Publishing, 1996). 2. “Perfectly price discriminating” means that the authority gets each seller to sell at his cost and no more and gets each buyer to pay the maximum he would be able and willing to pay for his food basket. 3. These data are taken from Stanley Fischer and Ratna Sahay, “Taking Stock,” Finance & Development (September 2000). 4. This helps explain why farmers seldom finance agricultural R&D. It is financed either by city dwellers through government or by agricultural supply firms. 5. The transition in China has proceeded more smoothly than in the former Soviet countries, in part because of two microeconomic advantages. Chinese reforms started with peasant agriculture, the sector of the economy with the fewest backward supply dependencies. Further, the Chinese Communist Party made increases in output, not price stability, the key target. Both these factors tended to 239

240 NOTES TO CHAPTERS 1–2

flatten supply curves to the right of the equilibrium point, so that rightward shifts in the demand curves resulted mostly in output increases. 6. We will not do the math here. But an additional verbal explanation may be helpful. Adapting the rural/urban relationship to trade theory, the rural agricultural economy “exports” food to the urban manufacturing economy and “imports” manufactures. The Marshall-Lerner condition, which we adapt here from foreign trade theory, states that changes in the “exchange rate” (in this case, the price of agricultural products relative to the price of manufactures) will balance trade only if the sum of the elasticities of demand in the two economies, relative to the exchange rate, is greater than one. Thus, if farmers’ demand for manufactures is sufficiently inelastic (because they need them to live, and to work on their farms), and citydwellers’ demand for food is sufficiently inelastic (the sum of the two elasticities is less than one), then a good harvest will impoverish farmers, because agricultural prices will fall more than agricultural output sales rise. The more farmers grow and sell, the more agricultural prices decline, so that their total revenue falls. Alternatively, poor harvests impoverish city dwellers as agricultural prices rise, but agricultural quantity supplied does not.

Chapter 2. Firms and the Markets They Operate In 1. Economist Herbert Simon won the Nobel Prize in 1978 for his work to demonstrate this insight. 2. Diminishing returns means that each increment in a single input, with other inputs fixed, yields less output than previous increments of that input. 3. China has structured its reforms to try to avoid this pitfall. After stateowned enterprises, its largest firm group is TVEs (township and village enterprises), which are collectively owned by the employees and local communities. This local community ownership strengthens the incentive for managers to include in their management decisions the effects on the community of their decisions and the effects of the community’s opinions of them on their lives and the lives of their families. There is strong “social governance” of managerial behavior. While a system of community influence on enterprise management is imperfect, and may also have negative effects, including corruption, it is still superior to one in which enterprise managers have little or no stake in the community. 4. The pecking-order theory is generally attributed to S.C. Myers, “The Capital Structure Puzzle,” Journal of Finance 39 (July 1984), pp. 575–592. 5. We draw here on well-established economic theory on firms and finance decisions. Pioneering work on this was done by Nobel laureates F. Modigliani and M. Miller. See, for example, F. Modigliani and M. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review 48 (June 1958), pp. 261–297. 6. Ibid. 7. That is, firms do not borrow from professional “loan sharks” or other mafia to make investments unless they are very sure of success! One could postulate a shadow “hurdle rate,” which an investment must exceed before a “real” debt (i.e., one that must be repaid) will be taken out. 8. Arbitrage is buying a good or an asset when or where it is cheaper and selling it at a later time or in another place where it is more expensive. As arbitrage

NOTES TO CHAPTERS 2–4 241

continues, the price gap being exploited narrows to the cost of holding the good over time or the cost of transporting it to the market where its price is higher. Then arbitrage stops. Well-functioning economies have little arbitrage, because almost all the price differences have already been found, exploited, and closed. 9. Estimates vary—this one is from Business Week’s International Edition: “Bye-bye Babushkas,” by Sabrina Tavernise, October 2, 2000. 10. Some analysts appear to be surprised when successful and well-known Russian enterprises, such as Gasprom, or firms, such as the syndicate based upon Vladimir Potanin’s Interros, follow these rules to the letter. From their own point of view, managers are merely repeating the same highly rational decisions that led them to success and wealth in the first place. 11. China’s transition provides an excellent example of this technique. In China, some enterprises were liberalized and allowed to trade at the market price, which was somewhat higher than the “official” government-set price. Other enterprises continued trading at the government price. The opportunity was crystal clear. Connected individuals immediately began exploiting this price differential in creative ways, for example, buying at the government price and selling at the market price while claiming to have bought at the market price or sold at the government price. 12. A famous quote from the highly respected economist J.R. Hicks, in his paper “Annual Survey of Economic Theory: The Theory of Monopoly,” published in Econometrica 3:1 (January 1935), pp. 1-20. 13. With the opening up of the former Soviet Union, new information came to light about this and other tragedies. Sources on this famine include Miron Dolot, Execution by Hunger: The Hidden Holocaust (New York: W.W. Norton, 1985); Geoffrey Hosking, The First Socialist Society: A History of the Soviet Union from Within (Cambridge, MA: Harvard University Press, 1985).

Chapter 3. The Factors of Production 1. The United States is a major beneficiary of this practice, since it leads savers to invest their savings by getting dollars any way they can and holding them (often literally “under the mattress”) even if they collect no interest. The gain to the United States is called seignorage. Seignorage is the value of the real goods and services that the United States imports in exchange for the dollars provided to foreign savers, who hold the dollars rather than demanding real goods and services exports or investment income from the United States in return. 2. The Economist, November 4, 2000, p. 118, data drawn from IMF sources. 3. A good definition of neomercantilism is given in David Balaam and Michael Veseth, Introduction to International Political Economy, 2d ed. (Upper Saddle River, NJ: Prentice-Hall, 2001), pp. 25–43.

Chapter 4. The Role of Government 1. The net value of the asset, NVA, with no tax is equal to 10 times the net profit. Now add a wealth tax, wt, equal to a fixed percentage of the net value of the asset. Then NVA ⫽ 10 * (10,000 – NVA * wt). 2. The Economist, February 3, 2001, p. 108.

242 NOTES TO CHAPTERS 6 AND 11

Chapter 6. Macroeconomics 1. Marie Lavigne, The Economics of Transition from Socialist Economy to Market Economy, 2d ed. (New York: St. Martin’s, 1999), p. 114.

Chapter 11. Benevolent and Malevolent Markets 1. An excellent book on speculative bubbles, a must-read for anyone interested in this subject, is Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises, 4th ed. (New York: Wiley, 2000). The phenomenon has been observed by novelists as well, particularly in English literature; one of our favorites is Anthony Trollope, The Way We Live Now (New York: Oxford University Press, 1999). 2. An excellent summary of this concept was provided recently in “Coming Clean on Stock Options,” The Economist, April 27, 2002, p. 71. The article focuses on stock options, and provides an excellent brief summary of efficient market theory and its generally recognized weaknesses.

Index

Accounting identities, 212–216 Africa, 142 Agriculture, 239–240n5 cooperatives, 69–70 and EU, 34, 60 and government policies, 34–37 market economics, 32–36 supply and demand curves, 30–31 transition economies, 58–61 Arbitrage, 51, 70, 220, 240–241n8 Argentina, 74, 172, 178, 187–191, 211 Asian crisis, 139, 177, 183–185, 188, 211 Barter, 96, 153–155, 156, 162, 164 Bounded rationality theory, 40 Brazil, 178, 185 Britain, 173, 177 Bubbles, market, 215, 218–220, 222, 226– 227 Bulgaria, 14, 173, 177 Canada, 177 Capital capital equipment, 65–66 and financing, 48–51 and peasant parable, 65–66 theory of, classical, 65–75 transaction cooperatives, 69–70 transition economies, 70–75 unequal income/wealth, 72–74 Capitalism government role, 92–93 and transparency, 43

Central banks, 165, 172–173, 179–181, 183, 198 Central planning, 9, 12 and Keynesian macroeconomics, 147–150 and monopoly, 53 supply and demand, 8–10 and transition economies, 41–42, 160–164, 165 Chile, 74, 184 China, 131, 169, 183–184, 188–190, 229, 239–240n5 Coase Theorem, 101–102, 107 Competition, 9–10 global market, 88 imperfect, transition, 53–62 and neomercantilism, 88 Competitive general equilibrium theory, 75– 79 Consumption conspicuous, 104 and disposable income, 140 and income, 18–19 and life-cycle model, 142 permanent income hypothesis, 141 and saving, 65, 140 wealth effect, 142 Cooperatives, 44–45, 69–70 Corruption, 19, 22, 228 capital markets, 70 firms, transition, 43, 46, 49–50 and government decision making, 93–94 and “invisible hand,” 94 patronage/self-interest, 43, 52, 241n11 243

244 INDEX

Creative destruction (Schumpeter), 103, 105 Czech Republic, xiii, 14, 61, 74 Dead Souls (Nikolai Gogol), 108–109 Deregulation, 31, 37–38 Dialogues Concerning Natural Religion, 170– 171 Economics and customary social norm dependency, 69 modeling needs, 81–82 need for practical analysis/science, 89 and Pareto optimal outcomes, 81–82 and psychology/sociology, 77–78, 142– 143, 144, 221 The Economics of Transition from Socialist Economy to Market Economy, 130, 239n2 Efficient market theory, 220–222, 223 Elasticity/inelasticity demand, 26, 29–32 and necessities, 29, 31–32 prices, 23–32 supply, 23–26 transition economies, 23–24 Enterprises. See Firms Equilibrium achieving optimal state, 145 adjustment measurement, 119–123 fluid nature, 146–147 static, 12 supply and demand, 4–6, 7–12 European Union (EU), 34, 60 Exchange rates, foreign bonds use, 185–188 and central banks, 172–173, 179–181, 183, 198 clarification, 189–192 crises, 172–173, 177–179, 187–188 and currency boards, 184 fixed, 82–83, 170–176, 179–185, 198, 210– 212 floating, 82, 176–177, 188, 210–212 and Hume mechanism, 170, 172, 174, 191– 192, 206 and monetary/fiscal policy, 210–212 optimal currency areas, 190 and prices/wages, 171–172 and purchasing power, 168–170 rate determination theory, 185–192 speculative attacks on, 181–185 trade-determined, 168, 169 volatility, 174, 178, 181 Externalities, 15, 91–92, 101–102, 107

Factor incomes, 63–65 Financing, 48–51, 74 Firms, 39–41, 46–51. See also Theory of the firm Fiscal policy, 124–125 aggregate supply/demand, 135–136, 137 government role as, 92 and inflation, 135–136, 137 and multiplier effect, 151 tight, 127, 128 Foreign trade and domestic market, 88–89 and exchange rates, 82 financial services import, 89 microeconomics, 79–89 monopoly/monopsony, 61–62 OPEC, 89 protectionism/tariffs, 83–89 theory of foreign trade, 82 trade deficit/surplus, 171 France, 178 Friedman, Milton, 141 The General Theory of Employment, Interest, and Money, 114, 126, 147 Germany, 177 Gini coefficient, 103–105 Global market and competition (classic liberal theory), 88 equilibrium point, 83 neomercantilism, 88 prices and domestic market, 85, 87 Government role agriculture, 34–37 bail outs, 64 as borrower, 71 and capitalism, 92–93 Coase Theorem, 101–102, 107 decision-making process, 93–94 externality balancing, 91–92 and factor incomes, 64 and fiscal/monetary policy, 92 and market system, 93 and property rights, 102 and public choice, 93–94, 100 public finance, 94–100 public goods, 92 regulation, 90–91, 100–102 as riverbank (allegorical), 90–91 transition economies, 71 Great Depression, xv, 126, 130, 147, 148, 149 Gross domestic product (GDP) input-output table, 116–118 sector-of-origin measure, 136–137 and technology, 139, 215

INDEX 245

transition economies, xiii–xiv, 14, 138– 139 as wealth measure, 136–139 Health care example, 107–111 “Health soul” process, 109, 233–234 Hong Kong, 183–185, 188, 211 Hume, David, 170–172, 174–175, 177, 187, 191–192, 206 Hungary, xiii, 14, 74 Income, 76 benefits cutoffs, 105–106 Gini coefficient, 103–105 Lorenz curve, 103–105 maintenance, 19, 20–21 and pension funds, 104–105 permanent income hypothesis, 94 redistribution, 72–74, 92, 102–103 Inflation, 71 demand curve shifting, 19 and economic growth, 133–134 fiscal/monetary policy, 135–136, 137 optimal target rate, 165–166 and transition stabilization, 19–20 Infrastructure, 22, 68–69 Input-output table, 112–123, 145 An Inquiry into the Nature and Causes of the Wealth of Nations, 112 Interest rates, 71–72, 143 International Monetary Fund (IMF), 72, 83, 188 Investment fundamental analysis, 199–200 interest rate sensitivity, 143 return on investment, 72 safe access, 74 from savings, 68 of state, 68–69 under mattress accounts, 70, 241n1 Western advice on, 69, 71, 72 Italy, 173, 177 Japan (1990s+), 169, 216–217 aggregate demand, 229–231 demography, 230, 233–235 and permanent income security, 232 the problem, 227–229 real estate, 227–231 Kazakhstan, 14, 173 Keynes, John Maynard, 19, 114, 126, 147 Keynesian model aggregate supply/demand, 139–144, 149– 151 consumption, 139–144, 149–150

fiscal stimulus, 216–217 multiplier concept, 150 overview, 147–148 paradox of thrift, 149 prices/wages in short run, 148 short-term, 149, 150, 232–233 and Soviet model, 149–150 and transition economies, 151–152 Labor unions, 56–57, 64 Lavigne, Marie, 130 Lenin, Vladimir Ilyich, 166–167 Leontief, Wasily, 121 Life-cycle consumption model, 142, 151 Lorenz curve, 103–105 Macroeconomics, 112, 114 and central planning, 147–150 commoditized products, 166 and income/wealth, 166–167 inflation target rate, 165–166 open-economy, 203–210 overview, 147–148 price index levels, 131–134 Malaysia, 184 Malevolent market theory, 222–226 Market mechanism advanced economies, 32–36 agriculture, 32–36 behavioral stability, 10 consumer surplus, 6, 7 equilibrium, 4–6, 7–12 market dynamics, 12–13 non-market price commerce, 6–13 overview, 3–6 producer surplus, 5–6 supply and demand overview, 3–6 Markets analysis, 17–18 asset, 194–196 and dual economy, 34, 36 integration, 22 interdependence, 22 measurement, 22 and monopsony, 57 optimal, 88 system evolution, 93 Market theory, 222–226 Marshall-Lerner condition, 34, 36, 58 Marshall Plan, 130 Marx, Karl, 58, 148 Mexico, 173, 177 Microeconomics, 148 of Adam Smith, 65 and cooperative enterprise, 44–45 foreign trade, 79–89

246 INDEX

Microeconomics (continued ) price adjustment mechanism, 148 price flexibility, 166 theory of the firm, 39–41, 42 theory song, 57 and virtual economy, 55 Modigliani, Franco, 142 Monetary policy, 92, 125–126 aggregate supply/demand, 135–136, 137 cost-benefit analysis, 142–143 and inflation, 135–136, 137 tight, 127, 129, 143 transition economies, 71, 159, 164–165, 176 Money, 155–164, 165 Monopoly, 53, 57n and foreign trade, 61–62 and game theory, 10 and market economies, 76–77 tariffs, 85, 88 Monopsony, 53–61 combating, 56–57 and competitive general equilibrium, 76–78 and foreign trade, 61–62 and game theory, 10 history (USSR/Warsaw Pact), 58–61 and noncompetitive market economies, 76– 77 and oligopsony, 55 social services, 54 tariffs, 85, 88 Multinational corporations, 122 Mundell, Robert, 189–190 Necessities and inelasticity, 29, 31–32 and transition, 80–81 North American Free Trade Agreement (NAFTA), 177 Oligopoly, 57, 61–62, 72, 96 and competitive general equilibrium, 76– 78 tariffs, 85, 88 Oligopsony, 57, 61–62 and competitive general equilibrium, 76– 78 and foreign trade, 61–62 and monopsony, 55 tariffs, 85, 88 Organization for Economic Cooperation and Development (OECD), 99 Organization of Petroleum Exporting Countries (OPEC), 89, 130 Pareto optimal outcomes, 75, 76, 81–82 Peasant farmer parable, 7–12, 65–66

Pecking orders, financing, 48–50 Pensions, 19, 104–105, 142 Permanent income hypothesis and consumer behavior, 141, 206 in Japan, 131–232 minimum income guarantees, 151, 232 and public choice theory, 94, 100 and subsistence multiplier, 151 Poland, xiii, 14, 61, 74 Political economy, 12, 225 Prices. See also Inflation elasticity, 23–32, 166 and floors, 34, 35, 36 index number theory, 132 price indexes, 131–134, 165–166 and volatility, 32 Privatization, 40–41, 46, 122 Production incentives, 18 indexes, 132 Property ownership, 19 rights, 102 Protectionism/tariffs, 83–89 Public choice theory, 93–94, 100 Public finance luxury taxes, 95 Western advice on, 95 Research needed, 78–79 Retirement benefits, 19, 104–105, 142 Russia, 177–178, 185. See also Union of Soviet Socialist Republics (USSR) aggregate supply/demand, 135 creativity (business), 160 food costs, 133 GDP drop, transition, 14 investment, 74, 198 life span/retirement, 142 money multiplier without banks, 159 Pilgrim Russia mutual fund, 199 tight money insulation, 159–160 Savings and consumption, 65, 144 in Japan, 229 and Joseph Stalin’s policies, 69 noninvestment of, 70 and peasant parable, 65–66 process vulnerabilities, 68 and stable financial systems, 68, 69 and supply, 65, 66–68 taxing of, 68–69 transfer to investment, 68 in transition economies, 50 Schroeder, Gertrude, 100 Schumpeter, Joseph A., 103, 105

INDEX 247

Simon, Herbert, 40, 240n1 Smith, Adam, 112 invisible hand, 94, 131 theory of capital, 65 South America, 74 Sovereign governance, 107–111 Stabilization, 130, 131 Stalin, Joseph, 69 Supply and demand aggregate supply/demand, 127–128, 130– 131, 135, 139–144, 149–151, 229– 231 agriculture curves, 30–31 in asset markets, 194–196 central planning, 8–10 consumer surplus, 6, 7 demand curve, 15, 17–18, 24–25, 28, 29– 30 external factor analysis, 15 and imports, 85, 86 intersection of, 3–6 kinked supply/demand curves, 20, 21 non-market price commerce, 6–13 peasant farmer parable, 7–12 producer surplus, 5–6 rightward supply/demand shifts, 20, 21 savings in economy, 66–68 schedule of, 3–4 shifting curves, 15, 16 supply curve, 19, 20, 24–28, 26, 28 and tariffs, 85, 86 and technology, 15, 16 and world trade, 83–89 Sweden, 173, 177 Tariffs/protectionism, 83–89 Taxes appraisal built in, 96–97 behavior modification, 96 collection, 98 confiscatory, 19 income redistribution, 102–103 income taxes, 95–96, 97–98 on luxury, 95 payroll, 95–96 and political stability, 103 of productivity, 95–96, 99 risk compensation, 98, 103 and social stability, 103 tradeoffs, 102–106 transition economies, 152 VAT (value-added taxes), 95–96, 98 wealth tax, 97–98, 99 Theory of the firm, 39–46, 51–53, 57n Tools competitive general equilibrium, 77 economic activity measurement, 112–123

Gini coefficient, 103–105 input-output table, 112–123 Lorenz curve, 103–105 Transition economies aggregate supply/demand, 127–128, 130– 131, 135 aggregate supply shifts, 127, 129, 206, 208–209 aging population, 108–109 arbitrage, 51, 70 and assets, 70, 96, 175–176, 187, 196– 201, 209–210 banking, trust in, 160–161 barter, 96, 156, 162, 164 bond issuance, 185–186, 196, 198–199 borrowing by government, 71 and business, 98–99, 122, 144–147 capital flight, 71–73, 96, 98, 175, 186, 202 capital markets, 70–75, 140 and capital theory, classical, 71–73 from central planning, 13 and comparative advantage, 80–81, 82 competition, 42, 53–62 and consumer goods, 82, 141, 206–208 corporate governance, 46, 107 corruption, 43, 46, 70, 93–94, 96, 100, 240n3 cost of doing business, 22 demand reduction, 19–20 deposit-loan-redeposit leakage, 158 disposable income, 19 dynamic connected markets, 13 economic theory debate, 73 environmental damage, 60 exchange rates, 82 fiat money, new, 155–156 financing, 48–49, 74 and fixed costs, enterprises, 41–42 and foreign financial institutions, 73, 74 foreign investment, 186, 194–201 foreign money, 70–71, 73, 74, 156 foreign trade, 175–176 GDP drop, xiii–xiv, 14, 127 goals, firms, 47 and government decision making, 93–94 government regulation, 100–101 and have-nots, 13 Hume financial asset flow mechanism, 176, 187, 206 imports, 82, 141, 206–208 and incentive responses, 122 income distribution, 19, 72–74, 76 income taxes, 96, 97–98 and inflation, 19–20, 71, 127, 160–166 infrastructure, 22 input-output model, 147 instability of, 98

248 INDEX

Transition economies (continued ) interest group influence, 100–101 interest rates, 71–72 and international financial system, 193– 202 inventories, 141, 215 investment, 69, 71–72, 74, 196, 198–200, 206 Keynesian analysis, 19, 148–152 lending, 158 life span changes, 142 macroeconomics, 126–127, 160 markets, 17–18, 22, 64–65, 122 under mattress savings, 70 monetary policy, 71, 159, 164–165, 176 and money multiplier mechanism, 158– 159, 161 and monopoly, 53, 62, 100 and monopsony, 53–57, 62, 100 and multinational corporations, 122 and multiplier, Keynesian, 152 and oligopoly, 72, 96, 100 and oligopsony, 62, 100 payroll taxes, 98 prices, 23–24, 133–134, 165–166 principal/agent problems, 47 privatization, 40–41, 46, 122 production decline, xic, 7 research needed, 78–79 reserve exhaustion, 82 risk-taking, 98 savings, 50, 70, 71, 140–141 self-interest, 47–48, 49–50 and short-term outlook, 100 stabilization, 19–20, 127, 130, 131 to static markets, 13 and subsidized necessities, 80–81 supply capacity growth, 22 supply/demand curves, 20, 22 supply side Keynesian leavening, 152 taxes, 71, 96–97, 98, 99–100, 152. See also types of taxes under this main heading technology, 72, 208 tight money policy, 159–160 transfers, 152 treadmill of reforms, 100 under-protection, 92–93 unemployment, 152 and U.S. dollars, 70–71, 164, 196, 206 value-added taxes, 96, 98 virtual economy, 55 and wealth, 72–74, 142, 167, 176

wealth tax, 97–98, 99 welfare tradeoffs, 76 Western advice. See Western advice to transition economies Ukraine, 14, 173 Union of Soviet Socialist Republics (USSR) GDP measure errors, 138–139 monopsony history, 58–61 and paradox of thrift, 149 United States Agency for International Development (USAID), 60 U.S. Federal Reserve, 130, 165–166, 179 Variance measures, 134–136 Veblen, Thorstein, 104 Venezuela, 74 Vietnam, 139 Wages, 64, 98, 148, 171–172 Warsaw Pact/Eastern bloc, 58–61 Wealth and consumption, 142 distribution, 72–74, 166–167 GDP as measure of, 136–139 and investment goods, 138 redistribution, 167 Wealth of Nations, Inquiry into the Nature and Causes of, 112 Welfare, 19, 81 Western advice to transition economies, xiv aggregate supply/demand, 127, 128, 130, 131, 135 on capital flight, 73–74 using comparative advantage, 80–81, 83 exchange rates, 82 and flexible price anomaly, 82–83 and foreign exchange rates, 187 GDP measure errors, 138–139 and imperfect competition, 62 on inflation, 127 marketization/privatization, 122 on savings/investment, 69, 71, 72 on stabilization, 127, 130 stigmatization, xiv taxes, 95 and tight money, 160 treadmill of reforms, 100 Western market economies and have-nots, 12 market competition, 9–10 and monopsony, 54, 55 stability of, 122

About the Authors

Daniel R. Kazmer, Ph.D., is a Research Associate in the Institute for European, Russian, and Eurasian Studies at George Washington University. He has been a teacher and practitioner of economics for thirty years. He wrote this book to help reconnect basic economics to the most challenging economic reality, the Transition. Michele Konrad holds an MBA and Master of Science in Foreign Service from Georgetown University. Her undergraduate alma mater is the University of Virginia. She has studied and worked in transition economies since 1995.