Having Small Government Should Never Be a Reason for Making It Bigger

It seems that the Grattan Institute argues in its submission to the National Reform Summit that because Australia's government is relatively small by the standards of other developed countries we can or should increase its size. This argument makes no sense to me, though it seems to be often made. Perhaps other countries spend inefficiently or perhaps Australians are not interested in spending on some of the things that those countries spend on. We should look first at the outcomes we have as a country and, if there are poor outcomes that Australians would like improved, we then need to ask whether government can make a difference. Only then does it make sense to ask whether spending or taxes should be higher. I don't think this is really a political statement, as I leave open the final choice on whether to increase the size of government or not. But it makes no sense to talk about increasing the size of government simply to be nearer OECD means.

As for whether we should change the taxation arrangements for superannuation the simplest, fairest, and possibly relatively efficient  approach is to use the same approach as US 401k and 403b funds and tax payouts at normal income tax rates but not tax contributions or earnings in the accumulation stage. It's simple to show that under reasonable assumptions that this approach generates higher retirement incomes than the current Australian approach. It also has the huge advantage of reducing bureaucracy. Self managed superannuation funds are costly to run in Australia because of the need for accounting and auditing to make sure that they are paying the correct taxes. In the US, an IRA is just like another brokerage account except for the rules on contributions and withdrawals, which can be managed by the broker.

Natural Resources and Economic Growth

Carlo Carraro, Marianne Fay, and Marzio Galeotti call for mainstream macroeconomics textbooks to talk about the role of natural resources in economic growth and development. This is something that ecological economists have been calling for 25 years plus. But it is good to see more people getting on board. I wonder though how much consensus there is on what we should teach students about this.

Growth in a Time of Debt

A 2010 NBER working paper by Reinhart and Rogoff (also published in AER P&P) claimed that countries grow slower when they have high public debt to GDP ratios. Frank Jotzo pointed me to a blog which shows that there seem that the result is heavily influenced by a single year of -7.9% growth in New Zealand when the debt/GDP ratio was above 90% and there are also mistakes in the analysis. These issues are described in this new working paper. Without the New Zealand data point and correcting the mistake, the average growth rate in the 7 countries with debt ratios above 90% is 1.4% and with NZ is 0.3%. Still that is lower than the growth rate at the lower debt ratios and the highest growth rate is at the lowest debt ratio. Still, the negative correlation between debt to GDP ratio and growth rate does look real. But what is needed is probably a fixed effects regression of annual growth rates data on debt ratios or something like that. Also, Figure 2 in Reinhart and Rogoff presents medians as well as means of growth rates, which is more robust way of dealing with this data:

Table 1 in Reinhart and Rogoff shows data from a longer period and NZ now has positive growth at high debt ratios. Here the relationship looks more fragile though still hanging on. They also present similar data for developing countries where the relationship seems to be present too. So, while there are clearly problems with this paper I think the blog linked above is overly negative on the results. Reinhart and Rogoff have also responded to this criticism.

The real question though is about causality. Does high debt cause slow growth or vice versa?

Stiglitz on the Great Depression and the Great Recession

Joseph Stiglitz argues that the Great Depression (1930s in the US) and the Great Recession (now in the US) have a common cause in maladjustment to structural change in the economy. In the 1930s it was an overhang of the shift of employment from farming to manufacturing and today from manufacturing to the service sector. It's an interesting thesis. Odd that he omitted some important sectors - retail/wholesale, transport, & government admin from his list of service sectors. Or are many service employees becoming obsolete in advanced economies?

Shadow Reserve Bank Board

CAMA is running a pilot project where a panel of Australian economists pick the Reserve Bank interest rate that they think is appropriate a few days before each RBA interest rate setting board meeting. It's not meant to be a prediction of what the RBA will do, but an indication of what they should do. Each economist can give a range of interest rates with different probabilities. August's chart is here:



So if this group constituted the RBA board they would leave interest rates unchanged at 4.75%. The most recent inflation report was above the RBA's band for desired inflation but partly driven by shocks from things like banana prices. The non-mining economy really seems to be very weak at the moment as the exchange rate hits a post-float record against the USD above $US1.10. My guess is that they will remain on hold.

All Watched Over By Machines of Loving Grace

An interesting take on the history of America in the last couple of decades. At least that's what I think it's about:

Inflation in China

As a follow up to my post on consumer price inflation in the US here are trends in the last couple of years in China:



Credit: CEIC.

Whereas the US chart showed the levels of price indices this chart shows the rate of inflation. Inflation is China is currently at 4.9%. The fastest rising category is food, which has a much bigger budget share than the in the US, as is typical of developing economies. In contrast to the US, the cost of housing is rising quite strongly too. Inflation in China is not much of a surprise given the policy of undervaluing the RMB (relative to market equilibrium). This tends to be inflationary. One way of understanding things is that what matters is the real exchange rate not the nominal one. Though the nominal exchange isn't adjusting to make prices more equal in China and its trading partners the real exchange rate is adjusting through higher inflation in China than in the developed economies.

For more commentary on China, inflation, exchange rates etc see Michael Pettis' blog.

Consumer Price Inflation in the USA

The graph shows the increase in consumer prices over the last decade for the eight subcategories in the consumer price index (CPI) in the US and energy. Energy isn't a separate subcategory in the CPI but is included in the transport and housing categories. As you can see, energy prices are very volatile but have increased by more than other spending categories over this decade. The graph gives the impression that prices are still rising but yet the headline inflation figure for the US is very low. This is because housing has a more than 40% weight in the CPI and the cost of housing has been declining since 2008.

Visit the article I took the graph from for more charts and information including a stunning chart of college tuition and fees...

Review of Prosperity without Growth

Here is a draft of my review to be published in Ecological Economics of Prosperity without Growth:


Prosperity without Growth: Economics for a Finite Planet

By Tim Jackson, Earthscan, London, 2009.

Reviewed by David I. Stern

Usually, I find myself disagreeing with advocates of zero economic growth (defined as non-increasing GDP). First, a large part of the world’s population remains poor by any objective standard and second, I think they have the wrong end of the stick. If the reason that we are concerned about growth is its impacts on the environment we should control resource use and then let the economy determine the optimal level of output within the constraints that are set. And controlling resource use, hard as that has proven to be, is still likely to be both politically and practically an easier goal than somehow directly controlling growth. So, I was a little surprised to find myself agreeing with quite a lot of what Tim Jackson writes in Prosperity without Growth. Jackson is Economics Commissioner for the UK’s Sustainable Development Commission and Professor of Sustainable Development at the University of Surrey.

Jackson draws parallels between the global financial crisis and the looming ecological crisis. Anglophone (and some continental European) economies artificially boosted consumption in recent years by promoting very lax credit standards and low interest rates. Borrowing from the future to fund today’s fun. This irresponsibility, which met its denouement in the credit crunch is matched by the irresponsibility of borrowing resources and assimilative capacity from the future to fund today’s economic growth. In the case of mineral resources and even fossil fuels we could argue that we are developing the technology with which to “pay back” our borrowings but no such argument can be made on biodiversity and habitat loss and the build up of carbon in the atmosphere.

Jackson then reviews the lack of impact of income on national happiness after subsistence needs are met and asks whether growth is still necessary in order to maintain prosperity. Would a zero growth economy have rising unemployment as technology continues to advance (assuming technology does still advance and as implicitly assumed by Jackson in the main text that GDP is produced by a Cobb-Douglas function of capital and labor)? Such an economy will require less and less labor if wages rise. Either wages have to be constant or average hours worked would have to decline. Such an economy could be a utopia or a dystopia depending on which of these dominates and how the reduction in work hours is distributed. Following the lead of Peter Victor (2008), Jackson advocates some regulation of working hours. But, if we restrict the use of natural resources and resources are not good substitutes for capital and labor, as Jackson himself proposes in the Appendix, labor-augmenting technical change (on its own) in fact becomes rather futile (Jackson assumes technological change augments all inputs equally). This is because adding more effective labor to fixed resources has limited results when labor isn’t a substitute for resources. There is then no increasing labor productivity problem to solve. And if resources are good substitutes for labor then there really isn’t a problem with growth per se. Controlling the use of resources would have limited impact on growth and limiting growth would be the wrong focus.

Jackson also highlights the “myth of decoupling”. Though there have been improvements in the energy and resource intensity of GDP in many economies over time, in very few economies have these gains been more rapid than economic growth. Therefore, global energy and resource use and carbon emissions have continued to rise. Decoupling or environmental Kuznets curve effects are the exception rather than the rule. The rebound effect means that a focus on improving environmental efficiency will reduce impacts by less than one would naively think. Neither is there salvation in the service sector – most services are still fairly energy intensive in both their production and consumption. But, in order to achieve the ambitious goal of stabilizing atmospheric concentrations of carbon dioxide at 450ppm by 2050, global carbon intensity will have to decline by an unprecedented 7% per annum from now till then if population and income grow as expected under business as usual scenarios. Put another way, carbon intensity will have to improve 21 fold in the next 40 years. Jackson believes that that is more than can reasonably be achieved and, therefore, growth must come to an end.

Unfortunately, Jackson misinterprets the estimates of the cost of climate policy generated by computable general equilibrium (CGE) models, writing: “The Stern Review famously argued that “the annual costs of achieving stabilization… are around 1 per cent of global GDP.” After mentioning some other estimates he writes: “Though all these numbers look rather small, there’s something very confusing about cost estimates like these: they are already about the same order of magnitude as the difference between a growing economy and a non-growing economy. So if these costs really represent an annual hit of around 2-3 per cent of GDP they would essentially already wipe out growth” (83-84). It is hard to believe, but CGE models actually state that climate policies would cause GDP to be lower by 2-3% in 2050 than it would otherwise be rather than grow at 2-3% less each year. An economy that grows at 2% less each year has GDP that is 54% lower after 40 years.

This is actually a central point. Prosperity without Growth argues that decarbonization with growth is too hard. Therefore, growth must halt. But leading mainstream economics policy models state that the costs of climate policy are very low and, therefore, there is no incompatibility between growth and decarbonization. I suspect that the truth is somewhere in the middle. Moderate cuts in emissions (20-30%) are likely to be very cheap. But once efficiency and fuel-switching options are exhausted the switch to solar and nuclear energy may have much higher costs. Reviewing the parameter values in CGE models, I think that they may overestimate the ease with which consumers can substitute away from fossil-fuel intensive goods and services.
On the other hand, as Jackson points out, growth as we know it looks set to continue the trend to higher resource prices that we saw leading up to the record oil prices of mid-2008. Can business as usual growth continue anyway in the face of rising resource scarcity?

The book is an easy read and despite my disagreements on some points has plenty of substance. There is also much more in this book – discussions of consumerism and governance for example – than I can cover in this review. Jackson rounds off the book with a set of specific policy proposals and a vision of the transition to sustainability. The policy proposals (presumably directed at developed economies such as the United Kingdom) are:

Establishing the limits: caps on emissions and resource use and targets for reduction; green tax reform; support for ecological transition in developing economies.

I wholeheartedly agree with all these suggestions.

Fixing the economic model: Here Jackson proposes a mix of changes to the practice of economics – green accounting and developing an “ecological macro-economics” – and practical measures like investment in green infrastructure and new financial regulation such as the Tobin tax and increasing bank reserve ratios.

Of course, I think ecological macro-economics should be encouraged but I am less enthusiastic about green accounting – more data on the state of the environment is of course valuable but aggregating that data into the national accounts using monetary valuation can give us false indications about sustainability (see Stern, 1997). 100% reserve banking appears to be favored by some ecological economists but is a complete non-starter as it literally means that banks cannot make loans. These are then money warehouses rather than financial intermediaries. Outlawing short-selling and imposing the Tobin tax are likely to make financial systems less efficient. But we should look at limiting the size of financial institutions and regulating credit more tightly again.

Changing the social logic: Policies on working time, inequality, “measuring capabilities”, strengthening social capital, and dismantling consumerism.

If reduced growth in a resource-constrained economy does lead to reduced labor demand we may need new policies to address increasing inequality. Not all societies and individuals will prefer the approaches advocated by Jackson. Limiting employment hours along French lines would drive the more entrepreneurial into self-employment perhaps increasing inequality further. On the other hand, competition for status probably really does result in “positional externalities”. But incentives are more appropriate than blunt one-size fits all regulation.

In conclusion, I think that we should not treat this book as a necessarily correct diagnosis of our predicament and prescription for our future. But it does provide a very thought-provoking research and policy agenda for ecological economists who understand the size of the challenges we face.

References
Stern D. I. (1997) The capital theory approach to sustainability: a critical appraisal, Journal of Economic Issues 31, 145-173.

Victor P. (2008) Managing without Growth: Slower by Design, not Disaster, Edward Elgar, Cheltenham.

Why $950?

The Australian government announced its second stimulus package today. Included is a bonus payment of "up to $A950" for every worker earning less than $A100k per year. What an odd number. But the exchange rate with the U.S. Dollar is currently 63 U.S. cents to an Australian Dollar, and if you haven't guessed already, $A950 is exactly $US600, which was the amount of the "stimulus payment" in the first U.S. stimulus package.