Kornai on Soft Budget Constraints

In his guest post on Willem Buiter's Maverecon, János Kornai gives an interesting take on the Global Financial Crisis through his research on Soft Budget Constraints (SBCs).

During the communist period in Hungary, firms, despite being given material incentives to be profitable (including profit shares to the owners), they also faced very high rates of rescue by the state when in financial trouble. Kornai argues the real effect of rescues like this is a modification of the budget constraint faced by the firm, to one that is effectively "soft". That is, the short-term spending decisions of a firm will be looser should there be little chance of firm closure.

This argument is subtly different from the Moral Hazard argument. Moral Hazard tells the story of what happens to a firm's taking of risk when it becomes either implicitly or explicitly insured. SBC theory tells us that a firm will not necessarily take more risk, but their spending decisions will generally be brought forward, as their intertemporal budget constraint is perceived as being "soft".

My third year students, who've just covered the Keynes-Ramsey condition in intertemporal consumption choice, will be able to see this as a direct application. If a firm's internal discount rate is greater than the perceived cost of capital (which is decreased, due to the likelihood of rescue), then present expansion of the firm will appear to be a cheaper "option" than waiting later to expand.

Weekly Links:

Paul Romer on Elinor Ostrom:

http://chartercities.org/blog/72/skyhooks-versus-cranes-the-nobel-prize-for-elinor-ostrom

Harry Clarke on climate change:

http://www.harryrclarke.com/2009/10/17/policy-responses-to-global-warming-under-uncertainty/

The Financial Times on a surprisingly peaceful bit of Afghanistan:

http://www.ft.com/cms/885d7916-e3aa-11dc-8799-0000779fd2ac.html?_i_referralObject=10620134&fromSearch=n

The problems with mis-specifying proxies (part 2)

...continued.

The famous paper in proposing Resources Curses as being more or less a fact was Sachs & Warner (1995). In their paper, they regress, against 1970-1990 GDP growth, a bunch of variables including: primary produce exports to GNP, land per capita, number of coups, revolutions, assasinations etc., school enrolment rates, and the like.

This paper is super-influential: Google Scholar says it is cited by 1416 other papers. Unfortunately, though, the result it concludes---that natural resource `abundance' is correlated with low economic growth---is ill-gotten. It all comes down to the choice of proxy: in their case, using natural resource exports to GNP as a proxy for natural resource abundance. This was picked up by Stijns (2005), who replicated their regressions but using per-capita coal, gas, and oil production as the proxy for the same explanatory variable---not a perfect proxy either.

This next bit should come as a real lesson to economists and students everywhere about the choice of choosing a proxy variable. The picture below is lifted directly from Sachs Warner (1997)---an updated version of their paper. It shows Zambia as being the most `resource abundant' country in the sample. According to natural resource estimates for 2000 by the World Bank (2005), Zambia had a proven stock of natural resources of $17.5B USD. Venezuela, according to the same study, at the same time had an estimate of proven stock of natural resources of $658B USD---some 38 times the `abundance'.



An incredible problem with the choice of a proxy like this is that it not only that it messes up the magnitudes, but also the ordering. It allows researchers to say very little about what they are trying to explain.

As far as the Sachs Warner paper goes, although it shows fairly conclusively there is a negative relationship between natural resource exports and economic growth (though this is likely an endogeniety error; name a rich country whose exports are comprised almost exclusively of resources), it fails to say much about "Natural Resource Abundance and Economic Growth"---the title.

The problems with mis-specifying proxies (part 1)

At the moment, my thesis research is on identifying ways of modelling the consequences of countries' endowments of natural resources. There is a huge literature on this topic, and so it is quite hard to try to include them all. However, at the very core, the claim which echoes through the literature is that of the so-called `Resource Curse'.

The Resource Curse hypothesis is that countries with large endowments of natural resources will grow slower than resource-poor countries. This counter-intuitive proposition uses several channels to explain itself. They can be divided into the Dutch-Disease literature, the Institutional literature, and the Learning-by-Doing literature.

The Dutch Disease literature claims that countries that export natural resources will see an increase in their real exchange rates, either through currency appreciation or inflation, and this squeezes out producers in other sectors. This argument is often extended to include that natural resource exports also increase labour and credit costs, also increasing the cost of doing business for factories and pubs.

The Institutional literature claims that the presence of natural resources changes the incentive structure of countries, and so to the extent that a country allows itself to become over-run by robber-barons (either domestically-bred or foreign), natural resources cause economic stagnation.

The Learning By Doing literature says that in countries with natural resource abundance, a greater proportion will be induced into working in the resource sector. This results in a smaller proportion of the population working in the services and manufacturing sectors---both of which tend to be associated with higher skills, and continual opportunities to Learn by Doing. The long-term consequence of this is that people spend too little time acquiring skills, and too much time digging holes.

Refugees, Australia, & Boats

In an interview on the 7.30 Report a few nights ago, the Australian minister for Immigration, Chris Evans, made a strong point. Of the 438 asylum seekers onboard the Tampa, a Norwegian cargo ship which was refused entry to Australian waters in 2001, only one was not granted asylum by Australia or New Zealand.

If the majority of boatpeople are eventually granted asylum in Australia, and if Australia really wants to do something to stop people-smugglers, then there exists a smart way in which we could do so. Currently, asylum seekers pay smugglers tens of thousands of dollars to ferry them through South East Asia or the Mediterranean. I'm not against this pur sei---they're only filling a need---but they tend to do nasty things to their passengers from time to time. They don't observe Duty of Care.

If Australia ends up giving asylum seekers refuge, and if we don't like people-smugglers, then why doesn't Australia's government enter the market, and set a price on the processing/transportation of asylum seekers? Presumably, a price could be reached that would be high enough to limit numbers to an absorb-able figure, and similarly undercut people smugglers. If this was coupled with very strong policy against people smugglers (like sinking their boats), they wouldn't be able to reduce their price.

Isn't that pragmatic?

Favourable selection at the beach

Have you wondered why people look better in bikinis than in clothing? Wonder no more!

The other day, sitting on St Kilda beach, I got looking at all the pretty people. You are all aware I am an amazingly handsome man, with fully sick pectorals, and a washboard stomach; despite these (genetic) advantages, my Irish skin (which happily alternates between pink and white) had me keep my shirt on. I was able to resist taking my shirt off, in part, because the slightly more handsome men around me (who had that Mediterranean skin my kiddies will) would make me look ugly by comparison. I'm way to vain to be comparatively ugly.

A central idea in economics, credited to Akerlof (1970), is `adverse selection'. It states that when information about the quality of a good is known only by its seller, buyers will be prepared to pay only for the average quality. This leads sellers of superior goods to withdraw their goods from sale, lowering the average quality, and so the price buyers are willing to pay, ad infinitum.

`Favourable selection' then, is the inverse, and I believe, the reason for the beach being a damn sexy place.

Let's say we start with a warm day, and the average population at the beach. There are pretty people, and there are ugly people. The pretty people feel good (for they are pretty), and the ugly people feel less confident (for they are ugly).

The next warm day comes along, and everyone considers going to the beach. But, the ugly people remember last time--the beach made them feel ugly--and so choose to stay at home. This time, the average quality of the people increases, and people who felt good last time (for being less ugly than the truly ugly people) now feel ugly. This bunch stays at home next time, raising the quality again, and again, and again.

Hey presto, and St Kilda beach becomes a sample of the most tanned, buff, Goose-in-Top-Gun-looking people in the human population, while the ugly stay at home playing PS3.
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From a policy perspective, this presents a problem, as the beach ceases to be a public good, and becomes effectively excludable (even if the ugly exclude themselves)--there is a transfer of welfare (use of the beach) from the ugly to the pretty.

Do we have any ideas on how to correct this market failure?

Reading Ken Rogoff on the Isle of Singing Politicians

Sir,

I begin with an admission: when it comes to popular culture, my knowledge doesn't extend much past the third season of Macgyver. In Melbourne, this flaw results only in me being excluded from trivia teams. In Jakarta, a large Muslim town known as much for its love of western pop music as its corruption, such ignorance is up there with pork.

While driving through the city, our host, Wibi, asked me: "Mr James, do you know the Pussycat Doll?" Not exactly sure with what question he was propositioning me, and thinking (given the time of year it is) he may be referring to those good-luck-to-the-Chinese-bringing golden cats with waving arms, I looked about the car, hoping to clue on to what he was talking about. The passengers in the back seat (two friends from LaTrobe, our Javanese guide, and my girlfriend) were singing along to an irritating song on on one of Jakarta's dozen western channels, "I'm telling you, loosen up my buttons, baby (Uh huh)." "No, Mr James! The Radio!" Wibi pointed "Pussycat Doll!". As the clock rolled over 6.27, the Pussycat Doll song finished, with a tarty "Say what you going to do to me". Suddenly, the Adhan Maghrib (sung call to dusk prayer) sounded over the radio, and the singing in the back seat stopped. Ulluh here seems more omnipresent than at home.

A little over a decade ago, this country fell apart. Investors from home and abroad, in actions inevitable in an environment of poor policy and panic, pulled their investments from Indonesia, triggering bank failures, student riots, inter-ethnic massacres, and ultimately a revolution, in which Suharto, their longtime dictator, was deposed. From these events, the country is permanently marked. Now, democracy blooms; Reformasi has brought electoral advertising to every street corner and newspaper; editorials and satire alike highlight the flaws of the current rulers and the contestors; and average Abduls openly voice their political grievances--all of these, explained one host, would have resulted in vanishings under Suharto.

Despite this, many Indonesians have fond memories of Their Suharto: the Rich, because his pro-business rule (and patronage) saw them accrue Toorak lifestyles proper; the Poor, because his stable regime saw the most escape poverty and get refrigerators. Playing to this sentiment, the contenders for this year's election--the first direct election of a president in the young country's history--parade posters of themselves at His deathbed. Whether they are promising more of that kind of rule, I'm not sure.

As a trainee economist, Java is both exciting and irritating. Virtually all of those who were acutely poor in 1985 are now not. The children in the relatively poor villages surrounding Probolinggo, Malang, Yogyakarta, and Jakarta--the towns we stayed--live the lives of our grandparents: filled with kites, bicycles, cigarettes, and directing traffic. There is still a massive division of wealth (there always has been), but the ranks of the elite are no longer closed to those close to political power. Our hosts in Malang, who have a waterfall in their house, are a fine example of what is achievable. Hermin, the mother, moved to Australia in the mid-1990s to pursue a PhD at LaTrobe, and now lectures in Chemistry at a University. Edy, the father, used savings he earned picking grapes in Mildura to open a series of restaurants, the revenue from which he plans to use to send his two sons to Melbourne to study. The future is bright.

Even the lives of peasant farmers, who are poor in most of the world, are more prosperous. A combination of their fine work ethic, fertile soil, modern methods, and willingness to till any hill or cliff, has provided most with high quality housing and the capacity to pay for highways to their villages. A few months ago, I went to Pulau Nias, an Indonesian island in the Indian Ocean, and saw the exact opposite. Farmers there, using inefficient organic methods (mainly for subsistence), contributed to the poverty of the place. And still I have friends who think the subsistence village lifestyle idyllic.

Away from the villages, in the cities, memories of the 1997-1998 financial crisis are fresh and rare, and those in charge recall what happened to Suharto. Consequently, the financial system has been reformed along two lines: the first would be termed `Conservative Finance', and the second `Populist Insurance'. Conservative Finance emphasises maintainable debt levels and economic efficiency, and has become popular in much of the world scarred by the crises of the 1990s--like Brazil, Malaysia, and Indonesia. Populist Insurance is my term for government policies which artificially increase employment to reduce the political tensions it causes, mainly by introducing employment incentives like tax breaks. Conservative Finance is great. It creates stability, encourages investment (by resulting in lower real interest rates), and reduces the likelihood of crises--remember, the current crisis is partly the result of very liberal approaches to debt. However, the Populist Insurance tendency of Indonesia's government concerns me. As it artificially reduces the cost of labour for businesses, firms tend to over-employ, and so divide simple tasks into unnecessarily labour-intensive steps. Three people man every bowser at a petrol station. It reminds me of an anecdote:

During the cultural revolution in China, Mao invited a western economist to witness some of the giant public works. The economist was taken to a damn under construction, and saw thousands of men in those wok-hats, each with a shovel, hard at work. "Why are your men using shovels?", he asked.
"Because it reduces unemployment." the party official responded.
"If it is unemployment you are trying to eliminate" the economist replied "why not give them spoons?"

There is an argument for reducing unemployment, but having people paid to be in unproductive positions simply reduces their earnings, by reducing the incentives to find employment in relatively highly productive high-wage sectors. A further adverse effect of these policies, which are designed to ease potential political tensions created by unemployment in favoured industries, is that it has resulted in a remarkably thin selection of things to spend one's money on. We four travellers, three being economics students, joke that in Indonesia you can buy only 47 different kind of widget, but have 6 billion of each. This makes the country more susceptible to problems.

Indonesia will escape the current financial crisis; it's house is in order, largely thanks to its Finance Minister, Sri Mulyani Indrawati, and her predecessor, Boediono. But given the problems in the world today, there still is much to be done. Ken Rogoff, one of my favourite economists, has written much on international economics (and was at one stage a senior economist at the IMF), but two of his pieces of research stand out in relation to Indonesia. The first*, from 1995, two years before the Asian Financial Crisis turned Indonesia inside out, was practically a how-to guide for hedge funds on how to target countries with fixed exchange rates for devaluation--a good way to make money quickly, but to also destroy an economy. (The authors were not so malicious in writing this work, but meant it instead as a policy analysis against fixed exchange rates). His warning was ignored by Indonesia--a fatal mistake. I highly recommend a more recent paper**, comparing past financial crises, their causes, and their results. It shows the Indonesian crisis as one of the largest, but shows the current crisis as fairly mild--there is quite a bit of `down-side'. If the short-term future looks anything like what Prof. Rogoff's research suggests could be possible, and Indonesia is used as a guage of the transformative power of crises, the next few years could be interesting.

While the candidates for this year's election in Indonesia sing in public (a strange campaign technique which seems to work) and the world lurches towards the economic abyss, it will not only be Indonesia who has learned from its crisis. Much of the advice being given today is in direct contrast to the advise given to Indonesia then. I only hope Messrs Swan and Rudd do not proscribe spoons to the economy as a sensible solution.

*Rogoff, K., Obstfeld, M. `The Mirage of Fixed Exchange Rates', Journal of Economic Perspectives, 1995
** Reinhart, c., Rogoff, K. `This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises', NBER Working Paper, 2008