Macro Final - 12

Name ____Rajesh Kandibanda________________________________ Score: ___/16

Macroeconomics Final Exam

Due Monday July 2 by 6:00 pm

Please type your answers to multiple choice questions in the following table. For the short-answer questions, please type the answers in the spaces provided below each question. Save the file with the

name "aaa bbb – Final. doc", where aaa is your first name and bbb is your last name.

Submit the file by emailing it to [email protected].

Please include “Final Exam” in the subject line of your email.

Late submissions will lose all points for the problem set.

Answer Form for Multiple Choice Questions

Question: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Answer: E C A A A E B D C C A B B D E

Part A. Multiple Choice Questions: Choose only one, most satisfactory answer for each question (0.75 point each).

1. In mid-1997, there was a financial crisis in Thailand which raised the risk premiums of all East Asian countries. Indonesians knew that this effect would prevent their banks from borrowing abroad and would force them to default on their debts unless the Central Bank bailed them out. At the same time, Indonesians understood that their central bank was under pressure to print money and bail out the banks. For about a year (mid-1997 to mid-1998) the central bank resisted the pressure but eventually gave in as expected and printed large sums of money and gave them to banks in exchange for their bad debts. What impact the people's expectation during mid-1997 to mid-1998 (before the actual money supply increase) must have had on GDP and inflation in Indonesia?

a) The expectation must have increased GDP and lowered the inflation rate.b) The expectation must have increased both GDP and the inflation rate.c) The expectation could not have affected GDP or the inflation rate.d) The expectation must have left GDP unchanged, but raised the inflation rate. e) The expectation must have lowered GDP and raised the inflation rate.

2. In many developing countries fiscal deficits tend to rise during election years because

a) Elections are typically scheduled during economic slowdowns when tax revenues decline.b) The public wants high deficits and incumbent politicians concede to the demand only when

they face the challenges of reelections.c) Politicians are tempted to spend more and prop up employment and incomes to reduce the

number of disgruntled voters. d) All of the above.e) None of the above.

3. The Taiwanese GDP fell below production capacity 2008 and 2009 as a result of the world financial crisis that started in mid-2008. Taiwan's financial system was quite sound and the impact of the world crisis on its economy was mainly through reduced foreign demand for the Taiwanese exports. Which

Macroeconomics, Exam 3 1

one of the following macroeconomic policies could have helped raise Taiwan's income level towards production in those years?

a) An increase in government expenditure.b) An increase in money supply.c) An increase in the real value of Taiwan's currency.d) Any combination of expansionary fiscal and monetary policies. e) None of the above.

4. Some discretion in monetary policy is socially desirable because

a) there is a need to adjust policy according to specific situations when the range of possible circumstances is complex.

b) the ability of policymakers to change policies at will is necessary to make the political system responsive to the voters’ demands.

c) investment would always be higher if the public expects the central bank to deviate from its announced policies.

d) fiscal policy is discretionary and must be counterbalanced by discretion in monetary policy.e) all of the above.

5. East Asian economies experienced major financial and economic crises during 1997-1999 and reduced their demands for oil and other raw materials sharply. This acted as a favorable supply shock for the US economy. The US macroeconomic policies remained unchanged during those years. The supply shock must have

a) increased GDP and lowered the inflation rate in the US. b) increased both GDP and the inflation rate in the US.c) lowered GDP and raised the inflation rate in the US. d) left GDP and the inflation rate in the US unchanged.e) left GDP unchanged, but raised the inflation rate in the US.

6. This questions is based on the article, “Investment: Prudence without a purpose”, published by The Economist on May 26, 2012. (It can be viewed through UIUC Library Online Resources. For your convenience, these articles are copied below.) The article, offers a number of reasons why China may not be over-investing domestically. Which one of the following is not one of those reasons?

a) China’s domestic investment is less than its savings.b) China’s financial investment opportunities in other countries have had low returns.c) China has been accused of not spending enough.d) China’s capital stock per person is still very low.e) China has invested in buildings that are yet to find occupants.

7. Some have argued that like Soviet Union, China’s investment-driven growth will come to a halt before long. The above-mentioned article, “Investment: Prudence without a purpose”, rejects this claim because

a) China is good at marshaling inputs of capital and labor, though not at generating growth in output per input.


http://www.economist.com/node/21555761


b) China’s total factor productivity growth has been the fastest in the world over the past decade.

c) Rather than being investment-driven, China’s growth is export-driven, which ensures continued growth.

d) China can continue to grow by investing in useless projects, thus keeping more scope to invest later.

8. This questions is based on the article, “Consumers: Dipping into the kitty”, published by The Economist on May 26, 2012. (It can be viewed through UIUC Library Online Resources. For your convenience, these articles are copied below.) The article argues that the consumption-income ratio is likely to rise in China because

a) people try to smooth their consumptions, so when income surged in 2000s, they saved a large part of it and now as income growth slows down, their consumption will not slow down as much.

b) learning to consume rapidly rising incomes takes time, and the Chinese are just learning to do so.

c) social spending is likely to rise as the government tries to expand social security and the safety net, thus crowding in private consumption.

d) All of the above.

9. According to the two articles mentioned above, “Investment: Prudence without a purpose” and “Consumers: Dipping into the kitty”, the government of China follows a number of policies that tend to raise the country’s savings rate. Which one of the following is not among those policies?

a) Chinese government caps interest rates on bank deposits to extract income from household depositors.

b) Chinese government induces banks to transfer the rents extracted from household depositors to large firm that are big savers.

c) Chinese government confiscates quarts of barley from the people, making them available as seed-corn instead.

d) Chinese government under-provides social security to the majority of the population, inducing them to save for themselves.

e) China’s household registration system keeps migrants unsettled and therefore unwilling to spend.

10. This question is based on the article, "Lessons of the 1930s" published by The Economist on December 10, 2011. It can be viewed through UIUC Library Online Resources. For your convenience, the article is copied below.

The article mentions a number of reasons why Great Depression became a much bigger disaster that it would otherwise have been. Based on the article, which one of the following factors is widely viewed by the economist as a key cause of the deepening of the Great Depression?

a) In the early 1930s, labor costs rose due to government intervention.b) In the early 1930s, the government’s regulatory burden on businesses more than doubled.c) In the early 1930s, fiscal and monetary policies became severely contractionary. d) In the early 1930s, fiscal and monetary authorities slashed taxes and interests rates.






e) In the early 1930s, various countries colluded over their exchange rate and trade policies.

11. According to the above-mentioned article, which one of the following may have contributed to the recovery of the US economy between 1933 and 1936?

a) Increased government spending. b) Roosevelt’s determination to get the budget balanced.c) Congress’s spending cuts. d) Congress’s tax increases. e) Doubling of the reserve requirements by the Fed.

12. According to the above-mentioned article, the evidence behind the claim that austerity could be expansionary, particularly if focused on spending cuts,

a) is quite strong and well corroborated.b) is questionable because it is based on misidentified austerity episodes. c) is strong if one takes account of contemporaneous macroeconomic changes in other countries.d) is corroborated by Britain’s economic growth following its fiscal consolidation in 2010.e) is questionable because it ignores the impact of changes in expectations about future tax

burdens.

13. According to the above-mentioned article, reliance on the gold standard for exchange rate determination in the early 1930s,

a) helped stabilize European economies and financial systems.b) contributed to destabilization of European economies and financial systems. c) had no impact on the stability of European economies and financial systems. d) had no similarity with the use of the euro system in Europe these days. e) freed central banks to expand the money supply and reflate their economies.

14. The trade policies that the governments followed after the collapse of the gold standard in the early 1930s have lessons for the ways in which the current economic crises around the world should be addressed. One of these lessons for the United States is that

a) the US should sanction any country that devalues its currency against the US dollar.b) the US should sanction any country that revalues its currency against the US dollar.c) the US should impose trade restrictions on imports from countries like China that manipulate

their currencies’ exchange rates.d) the US should coordinate its macroeconomic policies with other countries to avoid

competitive devaluations. e) the US should devalue its currency to expand its net exports and speed up its recovery

process.

15. Which one of the following is not a reason given in the above-mentioned article for why it has been easier to avoid an economic depression in the 2000s compared to the situation in the 1930s?

a) Nowadays, unemployment benefits reduce the decline in expenditure and act as an automatic stabilizer.

b) Nowadays, governments are less reluctant to spend and run deficits during recessions.


c) Nowadays, governments play much more extensive roles in national economies. d) Nowadays, few large economies are linked together through fixed exchange rates. e) Nowadays, tax rates are much lower, making it easier for the private sector to respond. f) Nowadays, there is a global leader that may be able to coordinate disaster response.g) Nowadays, international institutions are much stronger, and democracy is more firmly

entrenched.

Part B. Short-Answer and Algebraic Questions: (The numbers in square brackets give the breakdown of the points for various parts of each question. To receive full credit, please explain your answers.)

16. Some economists have argued that the fixed deficit and debt limits, such as those stipulated by the Maastricht Treaty, must be replaced by flexible ones that are delegated to an independent "Public Debt Board" that can be put in charge of managing fiscal policy aggregates. [For a survey of the debates concerning such institutions, see Xavier Debrun, David Hauner, and Manmohan S. Kumar, “Independent Fiscal Agencies,” Journal of Economic Surveys, Feb 2009, Vol. 23 Issue 1, p44-81. This article is attached to this assignment for your convenience.] The Debt Board can be fashioned after the model of the European Central Bank, which oversees the Union's monetary policy. Compare this alternative arrangement with the Maastricht Treaty rules and discuss their pros and cons. [1.25]

Maastricht criterion has fixed rules on fiscal debt and monetary policy whereas alternative arrangements like “Independent public debt board” are more flexible and advisory with the structure of FC (Financial council). The authors clearly elucidate the fact that there is a great degree of enforcement with the setting up independent and impartial agencies like the Debt board rather than merely enforcing Maastricht treaty which has rules like keeping the debt to 3% of GDP. Table 3 on page 71 clearly shows effectiveness (Positive correlation) of the FC’s and implementing fiscal targets by the governments. Countries that already have very restrictive fiscal rules generally are less inclined to setting up FC’s like the Public Debt board. The countries that tend to have less budgetary transparency tend to favor more active non-partisan bodies like the “Public Debt Board”. The FC model is more flexible and individual countries have their own non-partisan financial councils monitoring and providing advice however, Mastricht treaty simply mandates the rules on all the EU member states. EU’s member nations have different polictical climates, economic situation and very varying macro economic variables, hence strictly enforcing Maastricht does not address the issue of fiscal indiscipline and procycliclaity. Maastricht treaty was very difficult to be ratified among the European nations due to the complexity of the fiscal and geopolitical climate among the ratifying countries. It is merely trying to enforce a number while shelving the practical difficulties and sidelining the future fiscal opportunities. The FC’s don’t have a clear mandate and do not have complete discretion as they are merely advisory to the discretion of policy makers and what the political climate dictates. If the checks and balances are not strong there is a good chance the that FC is more likely to be ignored in the political process. Accountability at the FC’s like public debt board comes with the autonomy provided and the fiscal decentralization and separation of powers is necessary for FC’s performance. Conclusively, with various pro’s and con’s of the FC’s over mandates like Maastricht treaty, it is wise to say that FC’s like “Independent public Debt Board” have greater advantages over Mandates when dealing with a very diverse geopolitical and fiscal climate such as EU.


17. In an article on March 4, 2010, “Dealing with budget deficits: Who pays the bill?” The Economist argued that as a period of loose credit gives way to an era of austerity, the social cohesion of many nations will be put to the test. An accompanying article, “The Icesave referendum,” examines the consequences of not paying part of the public debt. Please answer the following questions based on the arguments and points made on the article. (These articles are copied below for your convenience. The original articles can be viewed through the UIUC Library website.)

(a) Many countries have difficulty reducing their budget deficits even when such reductions are in the collective interest of the people living in the country. What are the main reasons? [1]

It’s difficult to reduce budget deficit due to several reasons. First of all, if the economy is not doing well than the government is willing to spend more i.e. willing to run a larger deficit in order to generate growth / prevent recession. Also, increasing taxes affects the long term growth prospects even if economy is doing well.

Secondly, deficit can be reduced by several ways- increasing taxes, cutting down the benefits to welfare recipients (state pensioners and/or public health system recipients), issuing government bonds, making foreign investors pay etc. Government is likely to face opposition by the people who pay for it like - union workers or tax payers.

(b) What are the immediate solutions to the deficit reduction problem? [1]

The government needs to be more accurate in its accounting figures for the total debt and making those figures public. That is likely to help with the public acceptance of measures that will be taken to reduce deficit.

Economic growth is another solution. If economy is growing that would automatically translate to increased tax revenue for the government and reduced welfare payments by the government in form of unemployment benefits etc. Hence government should pursue policies that will encourage long term growth of the economy such as lower tax rate, flexible labor market etc.


http://www.economist.com/opinion/displaystory.cfm?story_id=15622367

http://www.economist.com/opinion/displaystory.cfm?story_id=15606221

(c) Walking away from the public debt is one way to deal with large accumulated debts that are hard to repay. What are the ramifications of this solution? [0.5]

If the government walks away from public debt than its credit rating would be lowered, increasing the interest rate for future borrowing. Government will also find it very hard to borrow money for its expenditures. This would also mean that the public sector employees or welfare recipients may not get paid causing social unrest.

It would also discourage foreign investors from investing in the country which would affect future economic growth.

(d) Inflation is viewed as another solution. How can this be done? What would happen to the IS and LM curves under this solution? Would income remain below production capacity or rise above it, at least for while, if this solution is used? Why is this option tempting? What are the dangers of opting for this solution? [1]

Inflation is defined as rate of growth of money supply minus rate of growth of aggregate real output or capacity growth-

π = m y

Government can generate inflation by rapidly increasing money supply using monetary policies such that money supply growth rate is higher than capacity growth rate causing excess demand or capacity shortage. In the short run this would cause LM curve to rotate downwards. The income would temporarily rise above the production capacity.

But in the long run the inflation would rise and LM curve would rotate leftwards towards actual production capacity and income would reduce.

This is a tempting option because of the following reason-

Real interest rate- r = (1+i)/(1+) 1

Based on the above equation the higher inflation () would actually reduce real value of debt or could even reduce the value of the principal of a loan if inflation is high enough.

However, there are dangers of this solution. First of creditors may increase the borrowing cost due to higher inflation. Secondly, if money supply is increased too much the to raise the demand, the prices will rise too fast causing hyper inflation leading to major economic instability and crisis.


Special report: China's economy

Investment

Prudence without a purpose

Misinvestment is a bigger problem than overinvestment

May 26th 2012 | from the print edition

China’s answer to Dubai

GENGHIS KHAN SQUARE in Kangbashi, a new city in the northern province of Inner Mongolia,

is as big as Tiananmen Square in Beijing. But unlike Tiananmen Square, it has only one

woman to sweep it. It takes her six hours, she says, though longer after the sandstorms that

sweep in from the Gobi desert. Kangbashi, or “new Ordos”, as it is known, is easy to clean

because it is all but empty. China’s most famous “ghost city”, it has attracted a lot of

journalists eager to illustrate China’s overinvestment, but not many residents.

Ordos was one of the prime exhibits in an infamous presentation by Jim Chanos, a well-

known short-seller, at the London School of Economics in January 2010. Mr Chanos argued

that China’s growth was predicated on an unsustainable mobilisation of capital—investment

that provides only for further investment. China, he quipped, was “Dubai times 1,000”.

His tongue-in-cheek reference to the bling-swept, debt-drenched emirate caused a stir. But

not everywhere in China shrinks from the comparison. One property development that

actively courts it is Phoenix Island, off the coast of tropical Sanya, China’s southernmost city.

It is a largely man-made islet, much like Dubai’s Palm Jumeirah. Its centrepiece will be a


http://www.economist.com/specialreports?year%5Bvalue%5D%5Byear%5D=2012&category=76983

http://www.economist.com/

curvaceous seven-star hotel, rather like Dubai’s Burj Al Arab, only shaped like a wishbone

not a sail. The five pod-like buildings already up resemble the unopened buds of some

strange flower. Coated in light-emitting diodes, they erupt into a lightshow at night,

featuring adverts for Chanel and Louis Vuitton.

After a visit to Ordos or Sanya, it is tempting to agree with Mr Chanos that China has

overinvested from its northern steppe to its southern shores. But what exactly does it mean

for a country to “overinvest”? One clear sign would be investment that was running well

ahead of saving, requiring heavy foreign borrowing and buying. The result could be a

currency crisis, like the Asian financial crisis of 1997-98. Some veterans of that episode

worry about China’s reckless investment in tasteless property. But although China invests

more of its GDP than those crisis-struck economies ever did, it also saves far more. It is a net

exporter of capital, as its controversial current-account surplus attests. Indeed, for every

critic bashing China for reckless investment spending there is another accusing it of

depressing world demand through excessive thrift. China is in the odd position of being cast

as both miser and wanton.

Even an extravagance like Kangbashi is best understood as an attempt to soak up saving.

The Ordos prefecture, to which it belongs, is home to a sixth of China’s coal reserves and a

third of its natural gas (not to mention its rare earths and soft goat’s wool). According to

Ting Lu of Bank of America Merrill Lynch, Kangbashi is an attempt to prevent Ordos’s

commodity earnings from disappearing to other parts of the country.

China as a whole saved an extraordinary 51% of its GDP last year. Until China’s investment

rate exceeds that share, there is no cause for concern, says Qu Hongbin of HSBC. Anything

China fails to invest at home must be invested overseas. “The most wasteful investment

China now has is US Treasuries,” he adds.

When talking about thrift, economists sometimes draw on a parable of prudence written

three centuries ago by Daniel Defoe. In that novel the resourceful Robinson Crusoe,

shipwrecked on a remote island, saves and replants four quarts of barley. The reward for his

thrift is a harvest of 80 quarts, a return of 1,900%.

Castaway capital

Investment is made out of saving, which requires consumption to be deferred. The returns to

investment must be set against the disadvantage of having to wait. In Robinson Crusoe, the

saving and the investing are both done by the same Englishman, alone on his island. In a

more complicated economy, households must save so that entrepreneurs can invest. In

most economies their saving is voluntary, but China has found ways of imposing the

patience its high investment rate requires.

Michael Pettis of Guanghua School of Management at Peking University argues that the

Chinese government suppresses consumption in favour of producers, many of them state-

owned. It keeps the currency undervalued, which makes imports expensive and exports

cheap, thereby discouraging the consumption of foreign goods and encouraging production

for foreign customers. It caps interest rates on bank deposits, depriving households of


interest income and transferring it to corporate borrowers. And because some of China’s

markets remain largely sheltered from competition, a few incumbent firms can extract high

prices and reinvest the profits. The government has, in effect, confiscated quarts of barley

from the people who might want to eat them, making them available as seedcorn instead.

What has China got in return? Investment, unlike consumption, is cumulative; it leaves

behind a stock of machinery, buildings and infrastructure. If China’s capital stock were

already too big for its needs, further thrift would indeed be pointless. In fact, though, the

country’s overall capital stock is still small relative to its population and medium-sized

relative to its economy. In 2010, its capital stock per person was only 7% of America’s

(converted at market exchange rates), according to Andrew Batson and Janet Zhang of GK

Dragonomics, a consultancy in Beijing. Even measured at purchasing-power parity, China

has only about a fifth of America’s capital stock per person, depending on how its PPP rate is

calculated.

Boom, boom

China needs to “produce lots more of almost everything”, argues Scott Sumner of Bentley

University, even if it does not produce “everything in the right order”. Its furious

homebuilding, for example, has unnerved the government and cast a shadow over its banks,

which worry about defaults on property loans. But it still needs more places for people to

live. In 2010 it had 140m-150m urban homes, according to Rosealea Yao of GK

Dragonomics, 85m short of the number of urban households. About three-quarters of

China’s migrant workers are squeezed into rented housing or dormitories provided by their

employer.

Nor is China’s capital stock conspicuously large relative to the size of its economy. It

amounted to about 2.5 times China’s GDP in 2008, according to the APO. That was the same


as America’s figure and much lower than Japan’s. Thanks to China’s stimulus-driven

investment spree, the ratio increased to 2.9 in 2010, but that still does not look wildly out of

line.

Malinvestors of great wealth

In Defoe’s tale, Robinson Crusoe spends five months making a canoe for himself, felling a

cedar-tree, paring away its branches and chiselling out its innards. Only after this

“inexpressible labour” does he find that the canoe is too heavy to be pushed the 100 yards

to the shore. That is not an example of overinvestment (Crusoe did need a canoe), but

“malinvestment”. Crusoe devoted his energy to the wrong enterprise in the wrong place.

It is surprisingly hard to show that China has overinvested, but easier to show that it has

invested unwisely. Of China’s misguided canoe-builders, two are worth singling out: its local

governments (see article) and its state-owned enterprises (SOEs).

China’s SOEs endured a dramatic downsizing and restructuring in the 1990s. Thousands of

them were allowed to go bankrupt, yet those that survived this cull remain a prominent

feature of Chinese capitalism. Even in the retail, wholesale and restaurant businesses there

are over 20,000 of them, according to Zhang Wenkui of China’s Development Research

Centre.

SOEs are responsible for about 35% of the fixed-asset investments made by Chinese firms.

They can invest so much because they have become immensely profitable. The 120 or so

big enterprises owned by the central government last year earned net profits of 917 billion

yuan ($142 billion), according to their supervisor, the State-owned Assets Supervision and

Administration Commission (SASAC). It cites their profitability as evidence of their efficiency.

But even now, returns on equity among SOEs are substantially lower than among private

firms. Nor do SOEs really “earn” their returns. The markets they occupy tend to be

uncompetitive, as the OECD has shown, and their inputs of land, energy and credit are

artificially cheap. Researchers at Unirule, a Beijing think-tank, have shown that the SOEs’

profits from 2001 to 2008 would have turned into big losses had they paid the market rate

for their loans and land.

Even if the SOEs deserved their large profits, they would not be able to reinvest them if they

paid proper dividends to their shareholders, principally the state. Since a 2007 reform,

dividends have increased to 5-15% of profits, depending on the industry. But in other

countries state enterprises typically pay out half, according to the World Bank. Moreover,

SOE dividends are not handed over to the finance ministry to spend as it sees fit but paid

into a special budget reserved for financing state enterprises. SOE dividends, in other words,

are divided among SOEs.

The wrong sort of investment

Loren Brandt and Zhu Xiaodong of the University of Toronto argue that China’s worst

imbalance is not between investment and consumption but between SOE investment and

private investment. According to their calculations, if state capitalists had not enjoyed



privileged access to capital, China could have achieved the same growth between 1978 and

2007 with an investment rate of only 21% of GDP, about half its actual rate. A similar

conclusion was reached by David Dollar, now at America’s Treasury, and Shang-Jin Wei of

Columbia Business School. They reckon that two-thirds of the capital employed by the SOEs

should have been invested by private firms instead. Karl Marx made his case for collective

ownership of the means of production in “Das Kapital”. Messrs Dollar and Wei called their

riposte “Das (Wasted) Kapital”.

Perhaps the best that can be said of China’s SOEs is that they give the country’s ruling party

a direct stake in the economy’s prosperity. Li-Wen Lin and Curtis Milhaupt of Columbia

University argue that the networks linking the party to the SOEs, and the SOEs to each

other, help to forge an “encompassing” coalition, a concept they draw from Mancur Olson, a

political scientist. The members of such a coalition “own so much of the society that they

have an important incentive to be actively concerned about how productive it is”. China’s

rulers not only own large swathes of industry, they have also installed their sons and

daughters in senior positions at the big firms.

The SOEs provide some reassurance that the government will remain committed to

economic growth, according to Mr Milhaupt and another co-author, Ronald Gilson. The party

officials embedded in them are like “hostages” to economic fortune, “the children of the

monarch placed in the hands of those who need to rely upon the monarch”. That gives

private entrepreneurs confidence, because the growth thus guaranteed will eventually

benefit them as well—although they will have to work harder for their rewards.

What are the implications of China’s malinvestment for its economic progress? At its worst,

China’s growth model adds insult to injury. It suppresses consumption and forces saving,

then misinvests the proceeds in speculative assets or excess capacity. It is as if Crusoe were

forced to scatter more than half his barley on the soil, then leave part of the harvest to rot.

The rot may not become apparent at once. Goods for which there is no demand at home can

be sold abroad. And surplus plant and machinery can be kept busy making capital goods for

another round of investment that will only add to the problem. But when the building dust

settles, a number of consequences become clear. First, consumption is lower than it could

be, because of the extra saving. GDP, properly measured, is also lower than it appears,

because so much of it is investment, and some of that investment is ultimately valueless. It

follows that the capital stock, properly measured, is also smaller than it seems, because a

lot of it is rotten. That would make for a very different kind of island parable, a tale of

needless austerity and squandered effort.

Fortunately there is another side to China’s story. It has not only accumulated physical

capital but also acquired more know-how, better technology and cleverer techniques. That is

why foreign multinationals in the country rely on local suppliers—and also why they fear

local rivals. A Chinese motorbike-maker studied by John Strauss of the University of

Southern California and his co-authors started out producing the metal casings for exhaust

pipes. Then it learnt how to make the whole pipe. Next it mastered the pistons. Eventually it

made the entire bike.


China “bears” like Mr Chanos sometimes neglect this side of the country’s progress. In his

2010 presentation he compared China to the Soviet Union, another empire in the east that

enjoyed a stretch of beguiling economic growth. Like the Soviet command economy, China

is good at marshalling inputs of capital and labour, he pointed out, but China has failed to

generate growth in output per input, just as the Soviet Union failed before it. Yet this

analogy with the Soviet Union is preposterous.

Economists refer to a rise in output per input of capital and labour as a gain in “total factor

productivity”. Such gains have many sources. One textile boss got 20% more out of his

seamstresses by playing background music in his factory, recalls Arnold Harberger of the

University of California at Los Angeles. The striking thing about the growth in China’s total

factor productivity is not its absence but its speed: the fastest in the world over the past

decade. Between 2000 and 2008 it contributed 43% of the country’s economic growth,

according to the APO. That is just as big a contribution as the brute accumulation of capital,

which accounted for 44% (excluding information technology). Thus even if some of China’s

recent investment has in fact been wasted, China’s progress cannot be written off.

And even if some of China’s past investment has been futile, adding nothing worthwhile to

the capital stock, there is a consolation: it will leave more scope to invest later, suggesting

that the country’s potential for growth is even larger than the optimists think. The right kind

of investment can still generate high returns. But what if the mistaken investments of the

past disrupt the financial system, preventing resources from being deployed more

effectively in the future?


Special report: China's economy

Consumers

Dipping into the kitty

Chinese consumption is about much more than shopping

May 26th 2012 | from the print edition

An

important source of demand

ZHANG GUIDONG GREW up on a farm in Anhui, a poor inland province, where China’s

economic reforms made a humble beginning. He left home for Beijing in 1995 with only a

few years’ schooling. First he sold belts and lighters in Tiananmen Square. When that was

banned, he joined some friends from back home in Beijing’s Silk Market, where he sold

vegetables and silk items to the staff of the embassies nearby.

The Silk Market is famous for selling brand-name goods at suspiciously low prices, often to

tourists who seem to enjoy the combination of rip-offs and knock-offs. Fined many times for

selling fakes, Mr Zhang eventually decided to change his strategy. He sought a licence to

sell genuine goods under the brand “Hello Kitty”. A white bobtailed cat that first appeared

on a purse in the 1970s, Kitty now counts as Asia’s answer to Mickey Mouse.

The brand’s guardians were initially worried by all the fakes on sale in the market, but in the

end they were persuaded that the place was trying to clean itself up. Mr Zhang’s business is

now doing well. In March he was set to move from his old ten-square-metre stall on the


http://www.economist.com/specialreports?year%5Bvalue%5D%5Byear%5D=2012&category=76983


ground floor to a 15-square-metre spot on the third floor, where the market is grouping its

more reputable outlets. Most of the other stallholders are also from the countryside, Mr

Zhang notes. “I never dreamt that I could one day have a life like this.”

Most people think of China as an industrial powerhouse, not a consumer’s paradise.

Household consumption as a percentage of GDP fell for ten years in a row from 2001. By the

end of that decade it amounted to only 34% of GDP, about 19 points below Japan’s lowest

post-war ratio and 15 points below South Korea’s. America’s consumption did not dip far

below 50% of GDP even during the second world war, as Mr Lardy of the Peterson Institute

for International Economics points out in his book, “Sustaining China’s Economic Growth”.

But this declining ratio is deceptive. Consumption in China has actually been growing faster

than in any other big country. It is just that China’s GDP has been growing even more

rapidly.

Consumption always lags income, both on the way up and on the way down, argue Carl

Bonham of the University of Hawaii at Manoa and Calla Wiemer of the University of Southern

California. This is partly because people choose to “smooth” their consumption over time,

but also because people generally hesitate to abandon a lifestyle to which they have grown

accustomed. Although China’s output and income surged after 2000, its consumption habits

have yet to catch up.

Bootstrap businessmen from the boondocks do not always know what to do with their

newfound wealth, according to research by Jacqueline Elfick, a cultural anthropologist. One

couple, newly arrived in Shenzhen, lined their entire flat with bathroom tiles. Another

complained that their bathroom windows lacked the blue translucent glass found in rural

toilet blocks. A homebuyer who had never previously lived in anything bigger than a two-

room flat took a residence with six rooms, filling four of them with dining suites.

But consumer habits are evolving. In Shenzhen, notes Ms Elfick, the constant churn of the

population and relative absence of established hierarchies means “you are what you buy.”

The new rich announce themselves by spending profusely. They favour “heavy ornate

furniture in faux Baroque”. In Sanya, an advert for one luxury residence shows a painting of

Napoleon crossing the Alps hanging on the wall as a woman in a low-backed evening dress

lingers by the window.

But there is also a growing class of discerning customers who look down on ostentation.

They pride themselves on their appreciation of wine, tea and coffee. In Beijing the TV

screens that now pop up in taxis teach passengers how to judge a wine’s intensity and why

they should not overfill their glass. “Knowledge of how to consume has in itself become a

commodity,” Ms Elfick writes.

Just as consumption failed to grow as quickly as incomes over the past decade, it will fail to

slow as quickly over the decade to come. As China’s growth eases from 10% a year to

something closer to 7% during this decade, consumption will rise naturally as a share of

GDP.


Some economists think it has already begun to do so. Yiping Huang of Barclays Capital says

the official statistics fail to reflect a surge in consumer spending since 2008. They are

particularly bad at capturing extra spending on accommodation, such as rent payments by

tenants or the benefits enjoyed by owner-occupiers.

One proxy for consumer spending is retail sales, which have grown much faster than GDP in

recent years. Unfortunately, these statistics are no better at capturing expenditure on

accommodation. And in China they include many things other than household consumption,

such as government purchases and trade in industrial products like basic chemicals. But

even when those items are stripped out, Mr Huang shows, sales are rising fast.

He thinks that the level of expenditure as well as its growth may be understated. Despite

the conspicuous consumption, a lot of income and spending is hidden from the prying eyes

of taxmen and statisticians. The best effort to throw light on this shadow income is a study

by Wang Xialou of the National Economic Research Institute at the China Reform

Foundation. His team asked about 4,000 of their friends how much they earned and spent.

The answers they got were more candid, though also less representative, than official

surveys. After doing some statistical tricks to eliminate the bias, Mr Wang calculated that

the disposable income of China’s households was 9.3 trillion yuan ($1.4 trillion) higher than

the official 2008 figure of 14 trillion yuan. Drawing on this work, Mr Huang thinks that private

consumption may have accounted for 41% of GDP in 2010, about seven points higher than

the official figure (see chart 6).

Mr Huang’s calculations do not convince everybody, and even if they are right, they have

disturbing implications. Hidden income disproportionately benefits the better-off: the richest

10% of urban households take home over 60% of it. That might help explain why China is

now the world’s largest market for luxury goods, according to one estimate. If that hidden

income is counted, the top tenth of urban families are about 26 times better off than the

bottom tenth, not just nine times, as the official figures suggest. These figures make China’s

economic imbalances look better but its social inequities far worse.


However, there is another important source of final demand that is often neglected: the

government. Its consumption spending (on health care, education, subsidised rent and so

on) as a share of GDP has been growing since 2009, but it remains inadequate and uneven.

The patchwork state

China has greatly broadened its rural pension scheme, which collected contributions from

140m people in 2011, compared with under 80m a year before. But even now it reaches

only about 30% of the eligible population. The government has also expanded the coverage

of health insurance, bringing 95% of the population into the net, according to the OECD.

Patients now pay directly for only 35% of China’s total health spending, compared with well

over 60% ten years ago. But progress has not been uniform. China has one scheme for

urban workers, another for non-workers and a third for rural folk, each administered by

separate city or county governments. The contributions required and benefits provided differ

a lot between the three schemes. According to the OECD, the rural scheme pays out an

average of only $16 per person per year and covers only 41% of the cost of in-patient care.

In social as in economic policy, the government prefers local experimentation and piecemeal

expansion. That works well for economic reforms, but in social policy it fails to pool risk

efficiently. And the safety net is thin as well as patchy. This keeps down its cost to the

exchequer but leaves the population exposed to dangers such as debilitating illness or job

loss. Health benefits, for example, are capped, leaving patients uncovered for the worst

crises. And China’s hospital-centric health-care system provides only one general

practitioner for every 22,000 people.

Older Chinese grew up in a society where many of their consumption choices were dictated

by the state or by their workplace. They ate in state canteens and slept in state-provided

dormitories or flats. It was a grinding, tedious existence. But in discarding the “iron rice

bowl”, the Chinese state failed to provide alternatives, including health care and minimum

pensions. According to the World Bank, China spends only 5.7% of its GDP on these items

and other forms of social protection, such as payments to support the very poor. Other

countries in the same income category as China spend more than twice as much, an

average of 12.3%.

More social spending of the right kind would not crowd out private consumption. On the

contrary, it would encourage it. The patchiness of China’s safety net is one reason why

households save so much of their incomes. According to Emanuele Baldacci and other

economists at the IMF, a sustained rise in public spending by 1% of GDP, spread evenly

across health, education and pensions, would increase the ratio of household consumption

to GDP by 1.25 percentage points. The IMF’s Steven Barnett and Ray Brooks calculate that in

urban areas every extra yuan the government spends on health prompts an extra two yuan

of consumer spending.

Can China afford to spend so freely? In one sense, it cannot afford not to. If investment were

to falter and private consumption failed to compensate, China would be left with a big hole

in demand, jeopardising employment and growth. If the investment rate were to drop back


to its 2007 level, for example, the demand shortfall would run to over 6% of GDP. To make

up for that, the government would have to spend about 3.4 trillion yuan this year, or face

widespread joblessness. That is a substantial amount. With only a sixth of that sum, the

government could raise the incomes of all of China’s poor to the equivalent of $2 a day,

according to calculations by Dwight Perkins of Harvard. The point of such a thought

experiment is to demonstrate that China has enormous productive powers to mobilise, and

has to spend a lot to mobilise them fully.

There is another obvious measure, peculiar to China, that would lift consumer spending.

That is the earliest possible repeal of the country’s household registration system, or hukou,

which limits the access of rural migrants to public services in the cities where they work and

live. This keeps migrants unsettled and therefore unwilling to spend. Migrants without an

urban hukou spend 30% less than otherwise similar urban residents, according to research

by Binkai Chen of the Central University of Finance and Economics, Ming Lu of Fudan

University and Ninghua Zhong of Hong Kong University of Science and Technology.

Mr Zhang, the Silk Market trader, is a good example of the system’s iniquity. He arrived in

Beijing 17 years ago. He has a house, a son, a business and even a licence from Hello Kitty.

But he still does not have a Beijing hukou.


Lessons of the 1930s

There could be trouble ahead

In 2008 the world dodged a second Depression by avoiding the mistakes that led

to the first. But there are further lessons to be learned for both Europe and

America

Dec 10th 2011 | from the print edition

“YOU’RE right, we did it,” Ben Bernanke told Milton Friedman in a speech celebrating the

Nobel laureate’s 90th birthday in 2002. He was referring to Mr Friedman’s conclusion that

central bankers were responsible for much of the suffering in the Depression. “But thanks to

you,” the future chairman of the Federal Reserve continued, “we won’t do it again.” Nine

years later Mr Bernanke’s peers are congratulating themselves for delivering on that

promise. “We prevented a Great Depression,” the Bank of England’s governor, Mervyn King,

told the Daily Telegraph in March this year.

The shock that hit the world economy in 2008 was on a par with that which launched the

Depression. In the 12 months following the economic peak in 2008, industrial production fell

by as much as it did in the first year of the Depression. Equity prices and global trade fell

more. Yet this time no depression followed. Although world industrial output dropped by

13% from peak to trough in what was definitely a deep recession, it fell by nearly 40% in the

1930s. American and European unemployment rates rose to barely more than 10% in the



recent crisis; they are estimated to have topped 25% in the 1930s. This remarkable

difference in outcomes owes a lot to lessons learned from the Depression.

Debate continues as to what made the Depression so long and deep. Some economists

emphasise structural factors such as labour costs. Amity Shlaes, an economic historian,

argues that “government intervention helped make the Depression Great.” She notes that

President Franklin Roosevelt criminalised farmers who sold chickens too cheaply and

“generated more paper than the entire legislative output of the federal government since

1789”. Her book, “The Forgotten Man”, is hugely influential among America’s Republicans.

Newt Gingrich loves it.

A more common view among economists, however, is that the simultaneous tightening of

fiscal and monetary policy turned a tough situation into an awful one. Governments made no

such mistake this time round. Where leaders slashed budgets and central banks raised rates

in the 1930s, policy was almost uniformly expansionary after the crash of 2008. Where

international co-operation fell apart during the Depression, leading to currency wars and

protectionism, leaders hung together in 2008 and 2009. Sir Mervyn has a point.

Look closer, however, and the picture is less comforting. For in two important—and related—

areas, the rich world could still make mistakes that were also made in the 1930s. It risks

repeating the fiscal tightening that produced America’s “recession within a depression” of

1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late

1920s and early 1930s, in which economies fell like dominoes under pressure from austerity,

tight money and the lack of a lender of last resort. There are, in short, further lessons to be

learned.

Riding for a fall

It was far easier to stimulate the economy in the 2000s than in the 1930s. Social safety nets

—introduced in the aftermath of the Depression—mean that today’s unemployed have

money to spend, providing a cushion against recession without any active intervention.

States are more relaxed about running deficits, and control much larger shares of national

economies. The package of public works, spending and tax cuts that President Herbert

Hoover introduced after the crash of 1929 amounted to less than 0.5% of GDP. President

Barack Obama’s stimulus plan, by contrast, was equivalent to 2-3% of GDP in both 2009 and

2010. Hoover’s entire budget covered only about 2.5% of GDP; Mr Obama’s takes 25% of

GDP and runs a deficit of 10%.

Roosevelt raised spending to 10.7% of output in 1934, by which point the American

economy was growing strongly. By 1936 inflation-adjusted GDP was back to 1929 levels. Just

how much the New Deal spending helped the recovery is still debated. Some economists,

such as John Cochrane of the University of Chicago and Robert Barro of Harvard, say not at

all. Fiscal measures never work, they say.

Those who think that fiscal measures do work nonetheless tend to believe that, in the 1930s,

spending was less important than monetary policy, which they see as the prime cause of

suffering. In a paper in 1989 Mr Bernanke and Martin Parkinson, now the top civil servant in


Australia’s finance ministry, wrote that rather than providing recovery itself “the New Deal is

better characterised as having ‘cleared the way’ for a natural recovery.” Others, such as

Paul Krugman, would ascribe a more positive role to stimulus spending.

Whatever relative importance is assigned to monetary and fiscal policy, though, there is

little doubt that their simultaneous tightening five years into the Depression led to a vicious

relapse. Spurred by his treasury secretary, Henry Morgenthau—who worried in 1935 that

“we cannot help but be riding for a fall unless we continue to decrease our deficit each year

and the budget is balanced”—Roosevelt urged fiscal restraint on Congress in 1937.

By that point the national debt had reached an unheard of 40% of GDP (huge by the

standards of the day, but half what Germany’s debt is now). Congress cut spending,

increased taxes and wiped out a deficit of 5.5% of GDP between 1936 and 1938. That was a

larger consolidation than Greece now faces over two years (see chart 1), but is much smaller

than what is planned for it in the longer term. At the same time the Federal Reserve doubled

reserve requirements between mid-1936 and mid-1937, encouraging banks to pull money

out of the economy. The Treasury began to restrict the money supply in step with the level

of gold imports. In 1937 and 1938, the recession within a depression brought a drop in real

GDP of 11% and an additional four percentage points of unemployment, which peaked at

13% or 19%, depending on how you count it.

The Snowdens of yesteryear

Today’s monetary policy hasn’t turned contractionary, as America’s did in the 1930s. As The

Economist went to press, the European Central Bank (ECB) was expected to announce a

further reduction in interest rates. But in many places fiscal policy is moving rapidly in that

direction. Mr Obama’s stimulus is winding down; state- and local-government cuts continue.

Republican candidates for the presidency echo the arguments of Mr Morgenthau, claiming

that deficit-financed stimulus spending has done little but add to the obligations of future

taxpayers. Mr Obama, like Roosevelt, has started to stress the need for budget-cutting. If


the current payroll-tax cut and emergency unemployment benefits were to lapse, growth

over the next year would be reduced by around one percentage point of GDP.

America is not alone. Under David Cameron, Britain’s hugely indebted government

introduced a harsh programme of fiscal consolidation in 2010 to avert a loss of confidence in

its creditworthiness. The rationale was similar to that for chancellor Philip Snowden’s

emergency austerity budget of 1931, with its tax rises and spending cuts. On that occasion

confidence was not restored, and Britain was forced to devalue the pound and abandon the

gold standard. On this occasion the measures have indeed boosted investor confidence, and

thus bond yields; that the country still faces a second recession is in large part due to the

euro zone’s woes. That said, the possibility of such shocks should always be a counsel for

caution when a government embarks on fiscal tightening.

Some say tightening need not hurt. In 2009 Alberto Alesina and Silvia Ardagna of Harvard

published a paper claiming that austerity could be expansionary, particularly if focused on

spending cuts, not tax increases. Budget cuts that reduce interest rates stimulate private

borrowing and investment, and by changing expectations about future tax burdens

governments can also boost growth. Others doubt it. An International Monetary Fund (IMF)

study in July this year found that Mr Alesina and Ms Ardagna misidentified episodes of

austerity and thus overstated the benefits of budget cuts, which typically bring contraction

not expansion.

Roberto Perotti of Bocconi University has studied examples of expansion at times of

austerity and showed that it is almost always attributable to rising exports associated with

currency depreciation. In the 1930s the contractionary impact of America’s fiscal cuts was

mitigated to some extent by an improvement in net exports; America’s trade balance swung

from a deficit of 0.2% of GDP to a surplus of 1.1% of GDP between 1936 and 1938. Now,

most of the world is cutting budgets and not every economy can reduce the pain by

boosting exports.

The importance of monetary policy in the 1930s might suggest that central banks could

offset the effects of fiscal cuts. In 2010 the IMF wrote that Britain’s expansionary monetary

policy should mitigate the contractionary impact of big budget cuts and “establish the basis

for sustainable recovery”. Yet Britain is now close to recession and unemployment is rising,

suggesting limits to what a central bank can do.

The move to austerity is most dramatic within the euro zone—which can least afford it.

Operating without floating currencies or a lender of last resort, its present predicament

carries painful echoes of the gold-standard world of the early 1930s.

In the mid-1920s, after an initially untenable schedule of war reparations payments was

revised, French and American creditors struck by the possibility of rapid growth in the

battered German economy began to pile in. The massive flow of capital helped fund

Germany’s sovereign obligations and led to soaring wages. Germany underwent a credit-

driven boom like those seen on the European periphery in the mid-2000s.


In 1928 and 1929 the party ended and the flow of capital reversed. First, investors sent their

money to America to bet on its soaring market. Then they yanked it out of Germany in

response to financial panic. To defend its gold reserves, Germany’s Reichsbank was forced

to raise interest rates. Suddenly deprived of foreign money, and unable to rely on exports

for growth as the earlier boom generated an unsustainable rise in wages, Germany turned to

austerity to meet its obligations, as Ireland, Portugal, Greece and Spain have done. A

country with a floating currency could expect a silver lining to capital outflows: the exchange

rate would fall, boosting exports. But Germany’s exchange rate was fixed by the gold

standard. Competitiveness could only be restored through a slow decline in wages, which

occurred even as unemployment rose.

As the screws tightened, banks came under pressure. The Austrian economy faced troubles

like those in Germany, and in 1931 the failure of Austria’s largest bank, Credit Anstalt,

triggered a loss of confidence in the banks that quickly spread. As pressure built in

Germany, the leaders of the largest economies repeatedly met to discuss the possibility of

assistance for the flailing economy. But the French, in particular, would brook no reduction

in Germany’s debt and reparations payments.

Recognising that the absence of a lender of last resort was fuelling panic, the governor of

the Bank of England, Montagu Norman, proposed the creation of an international lender. He

recommended a fund be set up and capitalised with $250m, to be leveraged up by an

additional $750m and empowered to lend to governments and banks in need of capital. The

plan, probably too modest, went nowhere because France and America, owners of the gold

needed for the leveraging, didn’t like it.

So the dominoes fell. Just two months after the Credit Anstalt bankruptcy a big German

bank, Danatbank, failed. The government was forced to introduce capital controls and

suspend gold payments, in effect unpegging its currency. Germany’s economy collapsed,

and the horrors of the 1930s began.


It is all dreadfully familiar (though no European country is about to elect another Hitler).

Membership in the euro zone, like adherence to the gold standard, means that

uncompetitive countries can’t devalue their currencies to reduce trade deficits. Austerity

brings with it a vicious circle of decline, squeezing domestic demand and raising

unemployment, thereby hurting revenues, sustaining big deficits and draining away

confidence in banks and sovereign debt. As residents of the periphery move their money to

safer banks in the core, the money supply declines, just as it did in the 1930s (see chart 2).

High-level meetings with creditor nations bring no surcease. There is no lender of last resort.

Though the European Financial Stability Facility (EFSF) has got further off the ground than

Norman’s scheme, which it chillingly resembles, euro-zone leaders have yet to find a way to

leverage its €440 billion up to €2 trillion.

Even if they succeed, that may be too little to end the panic. Investors driven by turmoil in

Italian markets are pre-emptively reducing their exposure to banks and sovereign bonds

elsewhere in the euro zone. Even countries with relatively robust economies such as France

and the Netherlands have not been spared. No matter how secure an economy’s fiscal

position, a short-term liquidity crunch driven by panic can drive it into insolvency.

History need not repeat itself. Norman’s Bank of England was created in the 17th century to

lend to the government when necessary; central banks have always been obliged to lend to

governments when others will not. The ECB could take on this role. It is prohibited by its

charter from buying debt directly from governments, but it can purchase debt securities on

the secondary market. It has been doing so piecemeal and could declare its intention to do


so systematically. Its power to create an unlimited amount of money would allow it credibly

to announce its willingness to buy any bonds markets want to sell, thus removing the main

cause of panic and contagion.

This week France and Germany proposed the adoption of legally binding budgetary “golden

rules” by euro-zone members, ahead of a summit of European leaders in Brussels on

December 8th-9th. Mario Draghi, the ECB’s new president, has hinted that were a fiscal pact

to be agreed, the ECB might buy bonds on a larger scale. What scale he has in mind,

though, is unclear. Jens Weidmann, president of Germany’s Bundesbank and an influential

member of the ECB’s governing council, has clearly stated that the ECB “must not be” the

euro zone’s lender of last resort.

Where this path leads

On the present course, conditions in developed economies look like getting worse before

they get better. Growth in America and Britain will probably be less than 2% in 2012 on

current policy, and in both recession is quite possible. A euro-zone recession is likely. The

ECB could improve the euro zone’s economic outlook by loosening its monetary policy, but

widespread austerity and uncertainty will be difficult to overcome. As in 1931 and 2008, a

grave financial crisis may cause a large drop in output. That, in turn, would place more

pressure on euro-zone economies struggling to avoid default.

As panic built in 1931, country after country faced capital flight. The effort to defend against

bank and currency runs prompted rounds of austerity and plummeting money supplies in

pressured economies, helping generate the collapse in output and employment that turned

a nasty downturn into a Depression. It took the end of the gold standard, which freed central

banks to expand the money supply and reflate their economies, to spark recovery. Today

the ECB has the tools needed to salvage the situation without breaking up the euro. But the

fact that the ECB and euro-zone governments have options does not mean that they will

take them.


Then and now

The collapse of the gold standard led to recovery, but caused terrible economic damage as

countries erected trade barriers to stem the flood of imports from those that had devalued

their currencies. Governments elected to fight unemployment experimented with wage and

price controls, cartelisation of industry and other interventions that often impeded the

recovery enabled by expansionary monetary and fiscal policies. In the worst-hit countries

long-suffering citizens turned to fascism in the false hope of relief.

The world today is better placed to cope with disaster than it was in the 1930s. Then, most

large economies were on the gold standard. Today, the euro zone represents less than 15%

of world output. In developed countries unemployment, scourge though it is, does not lead

to utter destitution as it did in the 1930s. Then, the world lacked a global leader; today,

America is probably still up to the job of co-ordinating disaster response in troubled times.

International institutions are much stronger, and democracy is more firmly entrenched.

Even so, prolonged economic weakness is contributing to a broad rethinking of the value of

liberal capitalism. Countries scrapping for scarce demand are now intervening in currency

markets—the Swiss are fed up with their franc appreciating against the euro. America’s

Senate has sought to punish China for currency manipulation with tariffs. Within Europe the

turmoil of the euro crisis is encouraging ugly nationalists, some of them racist. Their

extremism is mild when compared with the continent-wrecking horrors of Nazism, but that

hardly makes it welcome.

The situation is not yet beyond repair. But the task of repairing it grows harder the longer it

is delayed. The lessons of the 1930s spared the world a lot of economic pain after the shock


of the 2008 financial crisis. It is not too late to recall other critical lessons of the Depression.

Ignore them, and history may well repeat itself.


Dealing with budget deficits

Who pays the bill?

Throughout the rich world battle lines are being drawn in the coming fight over

deficit reduction

Mar 4th 2010 | From The Economist print edition

WHEN friends go out to dinner, the convivial atmosphere can be shattered once the waiter

brings the bill. A pleasant evening can descend into a dispute about who had a starter and

who ordered the lobster. Running a public-sector deficit is similar: the arguments start when

the tab has to be paid.

The battles will be all the more fierce this time around because the deficits are so large and

likely in the short term to stay that way. With developed economies still weak, many

governments are (often rightly) keen to run large deficits for a while longer. But the bond

markets are getting impatient, especially with weaker European countries. Greece was

forced to announce a third austerity package this week, after its initial efforts failed to

reassure either the markets or its neighbours (see article). Although Britain has a lower

debt-to-GDP ratio than Greece and its debt has an average maturity of 14 years, sterling

also wobbled this week, with investors spooked by the prospect of a hung parliament. True,

the three biggest rich-world economies, the United States, Germany and Japan, are under

less pressure. But Japan has high debt levels and America has the government-bankrupting

cost of ageing baby-boomers.

If the world were run by economists, deficit reduction would be a very complicated balancing

act. For politicians one question may well dominate all others: who is going to pay? The

candidates differ from country to country, but the list usually includes taxpayers, public-



sector workers, entitlement recipients (such as state pensioners or public-health users),

foreign investors and future generations. Already battle lines are being drawn: witness the

strikes by Greece’s public-sector unions and the tea parties thrown by America’s tax

protesters.

Two immediate answers appear, which should be easier for politicians to embrace than all

those spending cuts and tax rises. The first is to be honest about the size of the problem.

Public-sector accounting is Enronesque. Creditors will punish governments with dodgy

numbers, as the Greeks have discovered. And voters can hardly make judgments about

what to scale back if they do not know what promises have been made. Talk in continental

Europe of an “Anglo-Saxon” conspiracy of greedy speculators is also dishonest. The

speculators did not invent the deficits. As one bank analyst has tartly remarked: “You can’t

blame the mirror for your ugly face.”

The second is to focus on economic growth. Higher growth reassures markets, increases tax

revenues and reduces spending on unemployment benefits and other welfare payments. So

politicians should eschew policies that reduce the long-term growth rate, such as

protectionism or higher taxes, and focus instead on measures that boost the growth

potential, such as more flexible labour markets and other productivity-enhancing reforms.

No matter what taxes it raises, Japan will not solve its fiscal woes without faster growth.

Many European governments are walking into the same trap.

Even assuming that most governments tell the truth a bit more and their economies grow a

bit faster, there will still be hard choices. The main fault-line is often intergenerational. Some

promises, particularly on public-sector pensions and health care, may impose too great a

burden on the next generation. Middle-aged Americans have written cheques on the

accounts of their children. Scaling back those promises, for example by raising the pension

age, is a prerequisite for getting public finances in order just about everywhere, even if it

will not do much to reduce the deficit in the short term.

The more immediate fight, which is already starting to break out in many European

countries, is between taxpayers and public-sector workers, and between raising taxes and

cutting public spending (see article). Politically, the contest is evenly matched, pitting

powerful unions against the biggest taxpayers—corporations and high-earners—who often

have the ear of politicians. In terms of economics, though, the bulk of the adjustment should

come in the form of spending cuts.

There is no alternative

The state had to step in during the credit crunch, given the scale of the banking crisis, but

this expansion of its scope should be temporary. This is not just ideological bias on our part;

economic studies suggest that fiscal adjustments that rely on spending cuts do better than

those based on tax rises. Yes, some tax rises may be necessary, if only out of the political

necessity of persuading the electorate that the burden is being shared. But tax rises, like

Japan’s in 1997, can kill a recovery.


In the past some governments have dealt with debts by walking away from them. Iceland is

voting on a milder form of that solution this weekend (see article). The graver threat this

time is that countries are tempted to diminish their debts through higher inflation. But that

would be a dangerous option to adopt and may not even be possible, given that markets can

see such policies coming and demand higher bond yields.

Whichever path governments choose will be hard. As a period of loose credit gives way to an

era of austerity, the social cohesion of many nations will be put to the test. Not all countries

will pass. Over the next few years the careers of many politicians will be made and broken in

the bond market.


The Icesave referendum

No, thanks

The ramifications of a likely no vote may not be pleasant

Mar 4th 2010 | REYKJAVIK | From The Economist print edition

ICELAND’S president is usually an apolitical and little-known figurehead. But Olafur Ragnar

Grimsson has become a national hero for his refusal to sign a law passed narrowly in late

December by the Althingi, Iceland’s parliament, to repay Britain and the Netherlands. The

British and Dutch governments had felt obliged to bail out their depositors in Icesave, a bust

internet operation owned by Landsbanki, a failed Icelandic bank, and they now expect

Iceland to reimburse them. But thanks to the president’s obduracy, the law is going to a

referendum on March 6th, and it seems certain to be rejected by a huge majority.

The voters and the president will doubtless rejoice, but the aftermath of a negative vote

may not be good for either the country or its government. Johanna Sigurdardottir, the prime

minister, leads a coalition that was shaky before the vote and could yet collapse altogether.

Even more worrying is the knock-on effect for Iceland’s $4.6 billion IMF programme. The

fund says that this should not depend on the Icesave dispute. But the Nordic countries that

are offering bilateral loans in support of the IMF’s rescue package are refusing to go ahead.

Without their backing, the IMF deal is frozen. The financial pressure is mounting. To satisfy

its creditors, Iceland must find some $2 billion in 2011 and $500m in 2012. Moody’s has

given warning that the dwindling chances of a deal over Icesave may lead it to join other

rating agencies in downgrading Iceland’s debt to junk.

The dispute is also clouding Ms Sigurdardottir’s aspirations to join the European Union. On

February 24th the European Commission recommended that EU membership talks should

begin, and hinted that Iceland could join quite soon. But largely because of Icesave, public

opinion in Iceland is shifting. Polls suggest that half the voters are now against joining the

EU, and only a third in favour.

The British and Dutch governments deny that they are impeding either Iceland’s IMF deal or

its EU accession. But there is no doubt that they have used these levers to extract stiff terms

over the Icesave repayment. In recent talks aimed at avoiding the referendum, the Icelandic

government secured a slightly better offer from the two governments. But it was never

going to be enough to satisfy the voters, who firmly believe that the nefarious duo are

profiteering from the woes of a small country caught up in a global financial crisis. That

belief will endure unless the British and Dutch suddenly get more generous.



Documents

Macro Final - 12