21/8/2014: Economy in a 'Not me, but maybe you?..' recovery

This is an unedited version of my column for the Village Magazine, June-July 2014 (date of filing: May 24, 2014)


There has been a uniformly singular analysis of the fallout from the European and local elections last week, the leitmotif of which is the view that the voters have vented their frustration and disappointment with the policies the coalition government. Majority of these policies, relate to the economy. Going into elections, candidate after candidate insisted on recounting the successes of the Fine Gael and Labour in reversing the pains of economic crisis: tens of thousands of jobs created, economy stabilised, property markets and investment on the upside and households finally facing into the prospect of tax cuts in the Budget 2015. Save for the contracting pharma sector – suffering from ills of the patent cliff unrelated to Ireland and the Government – things are getting brighter by the minute.

The voters bought none of these claims. Still, the question remains unanswered: has the economic decline been reversed during the years of coalition management?

It is a difficult question to tackle. So let us try and face up to the core facts with a measure of cold statistics.

In very broad terms, the economy can be broken into private consumption, Government consumption, private investment, public investment, and net exports (exports less imports) of goods and services. Everything, excluding net exports, taken together is known as the Final Domestic Demand. Adding to the demand net exports provides for the Gross Domestic Product. Adding to GDP inflows of payments on Irish investments abroad net of outflows of payments on foreign investments in Ireland gives the Gross National Product.

In the economy severely distorted by MNCs tax arbitrage and where foreign companies account for the entire trade surplus (the positive measure of net exports), the Domestic Demand is the measure of economic activity that most accurately measures what takes place in the country. It excludes the pharma sector and the ICT services exporters who are pushing massive accounting revenues and profits into our national balancesheet.

The simple statistical fact is that final domestic demand rose in Q4 2013 by EUR630 million compared to Q4 2012, although for the full year 2013 it was down EUR366 million, once we adjust for inflation. This means that 2013 was the sixth consecutive year of declines in domestic demand, but it also means that toward the year end things started to look a little sunnier.

Looking at the composition of our demand, both public and private consumption fell in 2013. These declines were moderated by a rise in gross domestic capital formation (or in more simple terms, investment), which rose EUR710 million year-on-year. Much of this ‘upside’ was Nama and IDA attracting foreign investors to Dublin. In other words, it had little to do with our real economy.

While on the topic of property investments: house prices and commercial real estate valuations did rise through 2013 in Dublin and trended down in the rest of the country. But since the on-set of 2014, things have gone slightly off the rails. National property prices index peaked at 70.0 in December 2013 and have slipped to 69.1 by March 2014. In Dublin, this decline was even more pronounced - from the local peak of 68.5 at the end of 2013 to 67.2 in February and March 2014. Building and construction activity picked up in 2013, with index of activity by value of construction up from 94.3 in Q4 2012 to 105.4 in Q4 2013 and volume up from 95.7 to 106.2 over the same period.

Here's the kicker, however: much of the above growth related to completions of already started projects and retrofits. Planning permissions for new construction, stripping out alterations, conversions and renovations fell year on year in Q4 2013 and were down over the full year. The pipeline of building permissions into the near future looks dire.

In contrast, contribution of industry, excluding building and construction to GDP was down EUR1.1 billion in 2013. Overall, of the five broad sectors of the economy contributing to our GDP, three posted decreases in activity compared to 2012 and two recorded increases.

Here's an interesting comparative. As Chart 1 below clearly shows, since the current Government came to power in Q1 2011, our real GDP in constant factor cost terms grew on average by less than 0.76% per annum. In the recovery of the 1990s this rate of growth was around 14 times faster. Agriculture, Forestry and Fishing; Industry; Distribution, Transport Software and Communication; and Public Administration and Defence – four out of five broad sectors of the economy are down over 3 years of Government tenure. Only Other Services (including Rent) sector was up. No prizes for guessing which sector is dominated by internet giants pumping tens of billions of revenues and profits earned elsewhere around the world into Ireland to be recycled to tax havens.

Things are even worse when we consider domestic economy excluding external trade. Personal Expenditure on Consumer Goods and Services shrunk 3% in the tenure of this Coalition, falling at an annual rate of 1%, Net Expenditure by Central and Local Government on Current Goods and Services is down at an annual rate of decline of 2.4%, while Gross Domestic Fixed Capital Formation fell at an average annual rate of almost 2.3%.

So by all metrics, save the one that covers Google & Co, the Coalition record to-date is hardly impressive.

Which leads us to another question: what is there to look forward to in the economy between now and the next general election?

Assuming the current Coalition remains in power through its term, there are some positive signs on the led-grey economic horizon. The data on these positives is not exactly convincing, but still, some signs are better than none.

Little as they matter in current environment with no established economy-wide trend and a lot of volatility, the Purchasing Manager Indices for Manufacturing and Services continue to move deep in the growth territory. Investment remains sluggish, with credit in the economy continuing to shrink and cost of loans continuing to rise gradually. But non-traditional sources of funding are showing signs of growth: investment funds, private equity and even some direct peer-to-peer lending.

As banks shift defaulting mortgages into 'restructured' portfolios of loans, numbers of new mortgages approvals, although volatile, are on a gentle upward slope. However, average value of mortgages approved continues to trend down.

Retail sales are faring much worse: value of retail sales in Q1 2014 remained static on Q4 2013 and is up only 0.6% y/y. Volume is up 0.2% q/q and is now 2.6% above Q1 2013 levels. Which means that deflation is still cutting into retail sector earnings, and with this trend, new hiring is still off the agenda of Irish retailers. However, encouragingly, retail sales have finally started to move in line with consumer confidence in recent months, although gains in retail sales still severely lag behind the confidence indicator, as the chart below shows.

Meanwhile, on the exports side, external demand for Irish goods and services might be improving at last, although you won't be able to tell this from the hard data, for now. The growth in global demand is yet to translate into indigenous exports growth for a number of reasons. Chiefly, growth in global trade volumes has shifted toward trade between middle income and emerging economies, away from advanced economies. This pattern of trade dis-favours Ireland. MNCs based here predominantly service the US and Europe, with the rest of the world being supplied from other countries. Our own exporters are having hard time getting a strong foothold in the merging markets. In 12 years since 2002, Irish exports to markets outside the EU and North America stagnated, as a share of our total exports at a miserably low 15-17%, as the chart below illustrates.

Growing our indigenous exports will require serious rebalancing of our sales and marketing efforts toward the markets outside our familiar geographies. The good news is that we have a ready base for such a push. Our competitive advantages are in the sectors where proximity to MNCs resulted in Irish indigenous startups gaining experience, intellectual property and access to early stage supply contracts, e.g. auxiliary services in international finance, ICT and biotech. The challenge, however, is to continue generating exports-oriented startups, while forcing more indigenously firms to export. The former requires financing and business development supports that are very scarce on the ground, especially for companies not clients of the Enterprise Ireland. The latter is a challenge no one has been able to tackle to-date.

Majority of companies operating in the Irish economy are engaged in reselling foreign goods and services without any serious value added to them. In order to push these firms into exporting, they need to identify potential ways for adding value to imported goods and services and then identify the markets and the path for entering these markets, where this value-added can generate sales. Parallel to this, Irish firms are facing an uphill battle to increase productivity of their capital and workforce to make certain that any value added is not consumed by the internal inefficiencies. While during the crisis, Irish economy regained some share of its competitiveness lost during the Celtic Garfield years of 2001-2008, these gains were achieved predominantly through two channels: productivity growth due to on-shoring of large-scale ICT services providers (Google, Amazon, etc), and due to massive jobs destruction in less-productive sectors, such as construction and retail, and other domestic services. Which, incidentally, shows that our Government’s claims of competitiveness gains are barely scratching the surface in terms of revealing the underlying trends in this economy. Stripping out the MNCs with their tax arbitrage, Irish economy is more competitive today than it was in 2004-2006 only because we are no longer employing builders and not adding more convenience shops to every street corner of every town. This is hardly a form of productivity gains that can make our products more competitive on supermarkets’ shelves in Canada or our services supplied to an Indonesian investment bank.

The final drag on the prospects for exports-led growth relates to skill sets required. These skills rest predominantly outside the current vast pool of the unemployed. Despite the claims of 70,000 new jobs created by the Government, data from CSO shows that in Q1 2014, there were only 49,500 fewer unemployed in Ireland than in Q1 2010, of which 14,314 came from higher numbers in state training programmes, such as JobBridge. Meanwhile, numbers of those in unemployment for over 1 year – the period commonly associated with long-term losses in skills and employability – declined by only 20,800 in 3 years of the current Coalition rule. If in Q1 2011 when this Government came to power, 57.5% of all unemployed were jobless for longer than 12 months, in Q1 2014 this proportion rose to 60.5%. Demographically, numbers of older workers (age 45 and older) without jobs rose by 5,900 during the tenure of the Coalition, and number of older workers out of jobs for more than 12 months is now up by 7,000.

While the Government has been successful in reversing the trend in rising unemployment, the progress to-date has been relatively weak compared to the enormous task at hand. Irish economy has been creating new jobs that suit skills and career progression of the younger workers – jobs that require excellent command of foreign languages, coding, technical services that cannot be easily taught to those of older age. Majority of new jobs being created are at the earlier stage of careers, meaning that they are basically of no use to mortgaged and indebted middle-age households with children and ageing parents. In addition, these starter-level jobs are not likely to improve pensions prospects for those currently unemployed, especially those of age above 45, when savings for retirement must be ramped up aggressively.


All of the above problems as well as opportunities are closely interlinked and reach across all groups and segments of our society and all sectors of our real economy. They require not just a policy response, but a coherent, long-term and comprehensive strategy. So far, such a strategy remains wanting. The Coalition might deserve credit for doing the hard thing over the last three years, but it still an open question whether it deserves the credit for doing the right thing.

17/8/2014: The Globalization Paradox and Land-linked Taxation

Couple of years ago, I wrote extensively on the efficiency of land-value or site-value taxes in raising public investment funding and alleviating the adverse impact of private rents accruing to landowners from public investment (see for example here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2047518 and more extensive version: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2029515). I have also covered the advantages offered by land-value taxation in the context of stabilising macroeconomic and tax environments and addressing key risks to these environments (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2029519).

A new paper by Schwerhoff, Gregor and Edenhofer, Ottmar, titled "The Globalization Paradox Revisited" (July 22, 2014, CESifo Working Paper Series No. 4878. http://ssrn.com/abstract=2469725) makes a similar argument, but within the context of the land linked taxes efficiency in alleviating a different problem. Note, emphasis in italics is mine.

Per authors: "According to the Globalization Paradox, globalization limits the freedom of choice for national governments. Capital mobility in particular induces tax competition, thus putting downward pressure on capital taxes. However, while capital mobility introduces the inefficiency of tax competition, it makes the allocation of capital more efficient. Whether national welfare and tax-financed public good provision increase or decrease through capital mobility depends on country characteristics. These characteristics include the relative capital endowment, the availability of taxes on fixed factors such as land and the preference for the public good. We compare the two second best settings of a closed economy and an economy with capital mobility to show that the relative capital endowment determines whether the net effect of capital mobility is positive. Fixed factor taxes have the potential to improve welfare by defusing the globalization trilemma through a reduction in the need for capital taxation."

17/8/2014: Disruptive Innovation, Experimentation and Entrepreneurship

Last week I highlighted several studies relating to human capital and entrepreneurship. Here, continuing with the theme, couple more.

First, a paper by Acemoglu, Daron and Akcigit, Ufuk and Celik, Murat Alp, titled "Young, Restless and Creative: Openness to Disruption and Creative Innovations" (February 1, 2014, MIT Department of Economics Working Paper No. 14-07: http://ssrn.com/abstract=2392109). Per authors: the study argues that "openness to new, unconventional and disruptive ideas has a first-order impact on creative innovations" where such innovations are defined as those "that break new ground in terms of knowledge creation". The problem, of course, is not that this is something new - if anything, this is trivial - but that we (as society and managerial systems, firms, enterprise ownership structures etc) have a very hard time managing disruptive innovation to achieve 'openness' to the ideas and the generators of such ideas that deliver true disruption.

"After presenting a motivating model focusing on the choice between incremental and radical innovation, and on how managers of different ages and human capital are sorted across different types of firms, we provide cross-country, firm-level and patent-level evidence consistent with this pattern. Our measures of creative innovations proxy for innovation quality (average number of citations per patent) and creativity (fraction of superstar innovators, the likelihood of a very high number of citations, and generality of patents). Our main proxy for openness to disruption is manager age. This variable is based on the idea that only companies or societies open to such disruption will allow the young to rise up within the hierarchy. Using this proxy at the country, firm or patent level, we present robust evidence that openness to disruption is associated with more creative innovations."

All of the above is fine. All is neat and well-argued and empirically backed. But, now, try and tell your average HR manager that the firm they work for should hire someone who breaks consensus and bends rules of logic, thinking and creativity?.. Or try telling them that standard CV/interview/test metrics they employ make hiring disruptive talent actually impossible, let alone difficult… And try telling them that majority of people graduating with 'right' degrees and offering 'right' references and credentials are actually deeply conformist, rather than disruptively innovative…



The second paper of interest is by Kerr, William R. and Nanda, Ramana and Rhodes-Kropf, Matthew, titled "Entrepreneurship as Experimentation" (July 28, 2014, Journal of Economic Perspectives: http://ssrn.com/abstract=2473226) argues that "…entrepreneurship is about experimentation: the probabilities of success are low, extremely skewed and unknowable until an investment is made." The most interesting bit in the above is the unknowable nature of the probability of success ex ante actual investment. This really cuts across the entire notion of angel financing…

"At a macro level experimentation by new firms underlies the Schumpeterian notion of creative destruction. However, at a micro level investment and continuation decisions are not always made in a competitive Darwinian contest. Instead, a few investors make decisions that are impacted by incentive, agency and coordination problems, often before a new idea even has a chance to compete in a market."

Another interesting issue is that the authors "contend that costs and constraints on the ability to experiment alter the type of organizational form surrounding innovation and influence when innovation is more likely to occur. These factors not only govern how much experimentation is undertaken in the economy, but also the trajectory of experimentation, with potentially very deep economic consequences."

The reason why it is go interest from my point of view is nine years ago, I tried to formulate some of these exact fundamentals in relationship between ability to take risks, experiment, innovate and the macro-economic policy environments in the paper available here: http://www.tcd.ie/Economics/TEP/2005_papers/TEP2.pdf

16/8/2014: Three Charts of Euro Area's Abysmal Growth Performance

Few charts to summarise the continued problems with growth in euro area and the 'peripheral' states:

First, consider changes in real GDP on pre-crisis peak:

Next, the weakest link in the euro area: Italy. This is really woeful - since hitting absolute lows, Italian economy continued to decline, steadily and with little sign of improvement.

The above also shows the miserable state of the euro area as a whole.

Another chart, to show changes on crisis-period absolute lows:

Note: the first 2 charts reference index to 2005=100, the last one references index to Q4 2006=100.

14/8/2014: Recessions and the Cost of Job Loss

Long-term unemployment has serious consequences in terms of

1. Reducing life-time earnings, including post-unemployment spell earnings;
2. Increasing life-time probability of future unemployment spells; and
3. Carrying severe costs in terms of reduced health, quality of life, mental health and social wellbeing.

This far we know. We also know that:

• Long-term unemployment effects start kicking in at around 3-6 months spell, rather than conventionally-measured 12 months spell
• Long-term unemployment is a problem most commonly associated with recessions; and
• Recessions-linked unemployment impacts those who have held the job prior to unemployment spell and those who are just starting their careers, with the latter suffering more significant effects of unemployment than the former.

A recent (December 2011) study by Davis, Steven J. and von Wachter, Till, titled "Recessions and the Cost of Job Loss" (NBER Working Paper No. w17638: http://ssrn.com/abstract=1967372) looks are the evidence on "the cumulative earnings losses associated with job displacement, drawing on longitudinal Social Security records for U.S. workers from 1974 to 2008."

The findings are striking:

• "In present value terms, men lose an average of 1.4 years of pre-displacement earnings if displaced in mass-layoff events that occur when the national unemployment rate is below 6 percent." So when national unemployment rate is close to frictional (or voluntary or alternatively when employment is close to full-employment rate - in the U.S. case around 5 percent), losing one job in large-scale unemployment generating event is bad. 
• But, "they lose a staggering 2.8 years of pre-displacement earnings if displaced when the unemployment rate exceeds 8 percent." So rate of losses doubles for a 50% rise in unemployment.
• The authors also "…characterize how present value earnings losses due to job displacement vary with business cycle conditions at the time of displacement. For men with 3 or more years of prior tenure who lose jobs in mass-layoff events  at larger firms, job displacement reduces the present value of future earnings by 12 percent in an  average year. The present value losses are high in all years, but they rise steeply with the  unemployment rate in the year of displacement. Present value losses for displacements that occur in recessions are nearly twice as large as for displacements in expansions. The entire  future path of earnings losses is much higher for displacements that occur in recessions. In short,  the present value earnings losses associated with job displacement are very large, and they are highly sensitive to labor market conditions at the time of displacement." Now, do tell me how on earth can we expect our pensions systems to be solvent in the future, following the Great Recession, given they were already insolvent prior to the crisis and given the effects of jobs losses on future earnings are so devastating?!

The authors "also document large cyclical movements in the incidence of job loss and job displacement and present evidence on how worker anxieties about job loss, wage cuts and job opportunities respond to contemporaneous economic conditions." Specifically they find that "…the available evidence indicates that cyclical fluctuations in worker perceptions and anxieties track actual labor market conditions rather closely, and that they respond quickly to deteriorations in the economic outlook. Gallup data, in particular, show a tremendous increase in worker anxieties about labor market prospects after the peak of the financial crisis in 2008 and 2009. They also show a recent return to the same high levels of anxiety. These data suggest that fears about job loss and other negative labor market outcomes are themselves a significant and costly aspect of economic downturns for a broad segment of the population. These findings also imply that workers are well aware of and concerned about the costly nature of job loss, especially in recessions."

Here's a chart to illustrate the empirical dynamics of earnings losses due to job loss.

14/8/2014: The Yugo Area Economy

Much has been already said about the disastrous GDP data for Q2 2014 posted today by the Eurostat.

Here is to add to the pile... Starting with the Eurostat grotesque or pathetic - or as I put it EUrwellian - language headlining zero growth as 'stable' performance:

Link here: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-14082014-AP/EN/2-14082014-AP-EN.PDF

I covered slowdown in the industrial production in the EU here: http://trueeconomics.blogspot.it/2014/08/1482014-euro-area-industrial-production.html

And as far as leading economic indicators go, today's miss on expectations is largely driven by the fact that said expectations for positive growth were based on superficially-optimistic data: PMIs, investors' surveys and asset markets performance (see here: http://trueeconomics.blogspot.it/2014/07/3172014-deflationary-trap-eurocoin.html).

But here's a much more worrying bit: there is preciously little in the data to be surprised about. Euro area has been sick - when it comes to growth - not for a quarter, nor for a year, not even for a decade. Here is a chart showing average annualised rates of growth over longer periods of time:

In no period (and I computed the above series for every 12 month period average from 1 year through 15 years) did the euro area average longer-term growth reached above 1% per annum.

The main point of this can be best seen by removing the extreme underperformance during the peak of the crisis and taking a trend, as shown in the chart below:

 As the red line clearly shows:

• Over the last 12 months, as dismal as its performance has been, growth in the euro area has outperformed its long term trend.
• Long-term trend growth in the euro area should be where it is: near/below zero.

There is a structural or a very-long-run recession/stagnation in the euro area and it coincides with two other factors:

1. Low cost of credit over the last 15 years, and
2. Low inflation over the lats 15 years

We are all sick and tired of hearing the words 'structural reforms', but it is painfully clear at this stage that the entire history of the euro area to-date is that of sustained weakness. The ECB has now firmly run out of any conventional tools for dealing with it. And this brings us back to where Jean Claude Trichet left us some years ago, before the crisis hit in 2008: the simple truth about Europe is that it has no real drivers for growth. Forget q/q starts-and-fails of the engine, this diesel can't take you to a grocery store, with kids on board or without...

Time to call it what it is: the Yugo Area Economy...

14/8/2014: Euro Area Industrial Production H2 2014

With stagnant GDP and falling inflation, Euro area is set back into the rot of economic crisis, not that you'd notice as much from the Eurostat headline lauding 'stable' GDP print.

Here is the chart showing the miserable performance of the euro area's industrial production from end-June 2011 through 2014:

A message to Brussels: keep digging, folks...

And here's the same story in terms of average year-on-year growth rates for the last 3 years:

And the last 12 months:

13/8/2014: The Dutch Entrepreneurial Ecosystem Paradox

Staying the course of the previous two posts, here is another interesting study relating to entrepreneurship, this time looking into policy supports dimension.

The paper by Stam, Erik, titled "The Dutch Entrepreneurial Ecosystem" (July 29, 2014, http://ssrn.com/abstract=2473475) looks at the entrepreneurial ecosystem "in the Netherlands: how it has evolved, why the rate of solo self-employment has increased and how the entrepreneurial ecosystem can be adapted to increase productive entrepreneurship." This is of interest well beyond the Netherlands, as many (all) European countries are pursuing development of such ecosystems and as many European countries have witnessed significant increases in the rates of individual self-employment (self-employment with no related employees).

The authors "summarize and extend the entrepreneurial ecosystem literature with a model that includes framework conditions (formal institutions, culture, physical infrastructure, and demand) and systemic conditions (networks, leadership, finance, talent, new knowledge, and support services) that affect entrepreneurial outputs (entrepreneurial activity) and outcomes indicating value creation (productivity, income, employment and well-being)."

Per authors: "The Netherlands has seen a remarkable rise of independent entrepreneurship in the last decade. However, this rise of independent entrepreneurship reveals to be predominantly a rise in solo self-employment, not an increase in growth oriented and innovative entrepreneurship."

This is a common problem to Ireland: "The rise of self-employment in the Netherlands seems to have lowered unemployment rates, but it is unlikely that the rise of self-employment and new firm formation has positively affected innovation and in the end productivity growth over the period 1987-2013."

But the Netherlands self-employment rise is also idiosyncratic in part: "This rise of self-employment and new firm formation and stagnation of innovation is what we label the Dutch Entrepreneurship Paradox. Especially favorable fiscal treatment of self-employed, and an increasing demand for flexible labor, stimulated the growth in the number of solo self-employed since the early 2000s. There is a major policy task not to let entrepreneurship be a driver of productivity decline (or at best a flexible belt in the labor market), but to stimulate productive entrepreneurship instead." It is worth noting that in the majority of European countries, the solo self-employment is actually penalised via tax systems, rather than supported, as in the Netherlands.

On the policy front, to "increase productive entrepreneurship in the Netherlands, we propose four policy actions. Each action addresses a change in one of the four framework conditions of the entrepreneurial ecosystem:

• Changing formal institutions to enable labor mobility (development and circulation of talent); 
• Opening up public demand for entrepreneurs, to provide finance for new knowledge creation and application; 
• Stimulating a culture of entrepreneurship and entrepreneurial leadership; 
• Adapting or creating physical infrastructure to enhance knowledge circulation and networks."

12/8/2014: Experience, Earnings & differences Between Economies

In the previous post, I summarised recent research paper on entrepreneurial learning-by-doing (http://trueeconomics.blogspot.it/2014/08/1082014-serial-entrepreneurship.html). Here are some other recent papers on the topic of entrepreneurship and human capital.

First paper is by Lagakos, David and Moll, Benjamin and Porzio, Tommaso and Qian, Nancy, titled "Experience Matters: Human Capital and Development Accounting" (December 2012, CEPR Discussion Paper No. DP9253: http://ssrn.com/abstract=2210223). The authors use micro-level data from 36 countries to look at evolution (over time) of ratios of experience-to-earnings. They find that the ratios profiles are flatter in poor countries than in advanced economies. In other words, experience-linked returns are flatter in poorer economies, or put differently: for each year gained in experience, poor country workers gain less in earnings than their rich countries counterparts.

The paper does not aim to explain the reasons for this empirical regularity, though the authors do say that "…composition differences [of workers (e.g., by schooling attainment or sector of work)] explain very little of the cross-country differences in the steepness of experience-earnings profiles. …Amongst other possible explanations, we note that our main finding that experience-earnings profiles are flatter in poorer countries is consistent with a class of theories in which TFP and experience human capital accumulation are complementary (i.e., low TFP in poor countries depresses the incentives to accumulate human capital)."

What the authors do, however, is look at the role that differences in experience-earnings profiles found between countries can have on levels of development. "When the country-specific returns to experience are interpreted in such a development accounting framework -- and are therefore accounted for as part of human capital -- we find that human and physical capital differences can account for almost two thirds of the variation in cross-country income differences, as compared to less than half in previous studies."

Specifically, on human capital side, "We calculate the part of human capital due to experience and show that this is positively correlated with income, and furthermore that its cross-country dispersion is similar in magnitude to the dispersion of human capital due to schooling."

In the forthcoming article in the Village magazine, I challenge Thomas Piketty's interpretation of income and wealth inequality data, in part, on the grounds of his failure to reflect the role of human capital in generating financial returns. It looks like the above study provides some more support for my arguments.

10/8/2014: Serial Entrepreneurship: Learning by Doing?

We often hear references to the U.S. entrepreneurial climate whereby one's failure at the first venture is commonly rewarded with an encouragement to start again. One of the alleged reasons for this climate emergence, the popular belief asserts, is that an entrepreneur learns from failure or success of the first venture to deploy this knowledge to achieve a greater success in the second entrepreneurial endeavour.

"Serial Entrepreneurship: Learning by Doing?" (NBER Working Paper No. w20312) by FRANCINE LAFONTAINE, and KATHRYN L. SHAW, looks are whether "Among typical entrepreneurs, is the serial entrepreneur more likely to succeed?" and "If so, why?"

The paper uses "a comprehensive and unique data set on all establishments started at any time between 1990 and 2011 to sell taxable goods and services in the state of Texas. An entrepreneur is defined as the owner of a new business. A serial entrepreneur is one who opens repeat businesses. The success of the business is measured by the duration over which the business is in operation."

And the conclusions are:

• "The data show that serial entrepreneurship is relatively uncommon in retail trade. Of the almost 2.3 million retail businesses of small owners of new businesses in our data, only 25 percent are started by owners who have started at least one business before, and only 8 percent are started by an owner who is still operating at least one other business started earlier."
• "However, once one becomes an entrepreneur for a second time, the probability of becoming one a third time, or fourth time, and so on, keeps rising."
• "Moreover, we find that an owner's prior experience at starting a business increases the longevity of the next business opened, and that controlling for person fixed effects, prior experience still matters."
• "Finally, experience at starting retail businesses in other sectors (e.g. a clothing store versus a repair shop) is beneficial as well, though not as much as same sector experience, and not in the restaurant sector."

The authors conclude that "prior experience imparts general skills that are useful in running the new business."

10/8/2014: Can EU Rely on Large Primary Surpluses to Solve its Debt Problem?

Another paper relating to debt corrections/deflations, this time covering the euro area case. "A Surplus of Ambition: Can Europe Rely on Large Primary Surpluses to Solve its Debt Problem?" (NBER Working Paper No. w20316) by Barry Eichengreen and Ugo Panizza tackle the hope that current account (external balances) surpluses can rescue Europe from debt overhangs.

Note: I covered a recent study published by NBER on the effectiveness of inflation in deflating public debts here: http://trueeconomics.blogspot.it/2014/08/1082014-inflating-away-public-debt-not.html.

Eichengreen and Panizza set out their case by pointing to the expectations and forecasts underpinning the thesis that current account surpluses can be persistent and large enough to deflate Europe's debts. "IMF forecasts and the EU’s Fiscal Compact foresee Europe’s heavily indebted countries running primary budget surpluses of as much as 5 percent of GDP for as long as 10 years in order to maintain debt sustainability and bring their debt/GDP ratios down to the Compact’s 60 percent target." More specifically: "The IMF, in its Fiscal Monitor (2013), sketches a scenario in which the obligations of heavily indebted European sovereigns first stabilize and then fall to the 60 percent level targeted by the EU’s Fiscal Compact by 2030. It makes assumptions regarding interest rates, growth rates and related variables and computes the cyclically adjusted primary budget surplus (the surplus exclusive of interest payments) consistent with this scenario. The heavier the debt, the higher the interest rate and the slower the growth rate, the larger is the requisite surplus. The average primary surplus in the decade 2020-2030 is calculated as

• 5.6 percent for Ireland, 
• 6.6 percent for Italy, 
• 5.9 percent for Portugal, 
• 4.0 percent for Spain, and 
• (wait for it…) 7.2 percent for Greece."

It is worth noting that Current Account Surpluses strategy for dealing with public debt overhang in Ireland has been aggressively promoted by the likes of the Bruegel Institute.

These are ridiculous levels of target current account surpluses. And Eichengreen and Panizza go all empirical on showing why.

"There are  both political and economic reasons for questioning whether they are plausible. As any resident of California can tell you, when tax revenues rise, legislators and their  constituents apply pressure to spend them." No need to go to California, just look at what the Irish Government is about to start doing in Budget 2015: buying up blocks of votes by fattening up public wages and spending. Ditto in Greece: "In 2014 Greece, when years of deficits and fiscal austerity, enjoyed its first primary surpluses; the government came under pressure to disburse a “social dividend” of €525 million to 500,000 low-income households ... Budgeting, as is well known, creates a common pool problem, and the larger the  surplus, the deeper and more tempting is the pool. Only countries with strong political and budgetary institutions may be able to mitigate this problem (de Haan, Jong-A-Pin and Mierau 2013)."

More significantly, Eichengreen and Panizza show that "primary surpluses this large and persistent are rare. In an extensive sample of high- and middle-income countries there are just 3 (non-overlapping) episodes where countries ran primary surpluses of at least 5 per cent of GDP for 10 years." These countries are: Singapore (clearly not a comparable case to Euro area countries), Ireland in the 1990s and New Zealand in the 1990s as well.

"Analyzing a less restrictive definition of persistent surplus episodes (primary surpluses averaging at least 3 percent of GDP for 5 years), we find that surplus episodes are more likely when growth is strong, when the current account of the balance of payments is in surplus (savings rates are high), when the debt-to-GDP ratio is high (heightening the urgency of fiscal adjustment), and when the governing party controls all houses of parliament or congress (its bargaining position is strong). Left wing governments, strikingly, are more likely to run large, persistent primary surpluses. In advanced countries, proportional representation electoral systems that give rise to encompassing coalitions are associated with surplus episodes. The point estimates do not provide much encouragement for the view that a country like Italy will be able to run a primary budget surplus as large and persistent as officially projected."

Good luck spotting such governance institutions in the euro area 'periphery' nowadays. "Researchers at the Kiel Institute (2014) conclude that “assessment of historical developments in numerous countries leads to the conclusion that it is extremely difficult for a country to prevent its debt from increasing when the necessary primary surplus ratio reaches a critical level of more than 5 percent.”"

Eichengreen and Panizza take a sample of 54 emerging and advanced economies over the period 1974-2013. They show that "primary surpluses as large as 5 percent of GDP for as long as a decade are rare; there are just 3 such non-overlapping episodes  in the sample. These cases are special; they are economically and politically idiosyncratic in the sense that their incidence is not explicable by the usual economic and political correlates. Close examination of the three cases suggests that their experience does not scale."

As mentioned above, one case is Ireland, starting from 1991. "Ireland’s experience in the 1990s is widely pointed to by observers who insist  that Eurozone countries can escape their debt dilemma by running large, persistent primary surpluses. Ireland’s move to large primary surpluses was taken in response to an incipient debt crisis: after a period of deficits as high as 8 per cent of GDP, general government debt as a share of GDP reached 110 per cent in 1987. A new government then slashed public spending by 7 per cent of GDP, abolishing some long-standing government agencies, and offered a one-time tax amnesty to delinquents. The result was faster economic growth that then led to self-reinforcing favorable debt dynamics, as revenue growth accelerated and the debt-to-GDP ratio declined even more rapidly with the accelerating growth of its denominator. This is a classic case pointed to by those who believe in the existence of expansionary fiscal consolidations (Giavazzi and Pagano 1990). But it is important, equally, to emphasize that Ireland’s success in running large primary surpluses was supported by special circumstances. The country was able to devalue its currency – an option that is not available to individual Eurozone countries – enabling it sustain growth in the face of large public-spending cuts by crowding in exports. As a small economy, Ireland was in a favorable position to negotiate a national pact (known as the Program for National Recovery) that created confidence that the burden of fiscal austerity would be widely and fairly shared, a perception that helped those surpluses to be sustained. (Indeed, it is striking that every exception considered in this section is a small open economy.) Global growth was strong in the decade of the
1990s (the role of this facilitating condition is emphasized by Hagemann 2013). Ireland, like Belgium, was under special pressure to reduce its debt-to-GDP ratio in order to meet the Maastricht criteria and qualify for monetary union in 1999. Finally, the country’s multinational-friendly tax regime encouraged foreign corporations to book their profits in Ireland, which augmented revenues."

The point of this is that "Whether other Eurozone countries – and, indeed, Ireland itself – will be able to pursue a similar strategy in the future is dubious. Thus, while Irish experience has some general lessons for other countries, it also points to special circumstances that are likely to prevent its experience from being generalized."

Another country was New Zealand, starting with 1994. "New Zealand experienced chronic instability in the first half of the 1980s; the budget deficit was 9 percent of GDP in 1984, while the debt ratio was high and rising. Somewhat in the manner of Singapore, the country’s small size and highly open economy heightened the perceived urgency of correcting the resulting problems. New Zealand therefore adopted far-reaching and, in some sense, unprecedented institutional reforms. At the aggregate level, the Fiscal Responsibility Act of 1994 limited the scope for off-budget spending and creative accounting. It required the government to provide Parliament with a statement of its long-term fiscal objectives, a forecast of budget outcomes, and a statement of fiscal intentions explaining whether its budget forecasts were consistent with its budget objectives. It required prompt release of aggregate financial statements and regular auditing, using internationally accepted accounting practices. At the level of individual departments, the government set up a management framework that imposed strong separation between the role of ministers (political appointees who specified departmental objectives) and departmental CEOs (civil servants with leeway to choose tactics appropriate for delivering outputs). This separation was sustained by separating governmental departments into narrowly focused policy ministries and service-delivery agencies, and by adopting procedures that emphasized transparency, employing private-sector financial reporting and accounting rules, and by imposing accountability on technocratic decision makers (Mulgan 2004). As a result of these initiatives, New Zealand was able to cut public spending by more than 7 per cent of GDP. Revenues were augmented by privatization receipts, as political opposition to privatization of public services was successfully overcome. The cost of delivering remaining public services was limited by comprehensive deregulation
that subjected public providers to private competition. The upshot was more than a decade of 4+% primary surpluses, allowing the country to halve its debt ratio from 71 per cent of GDP in 1995 to 30 per cent in 2010."

Agin, problem is, New Zealand-style reforms might not be applicable to euro area countries. Even with this, "it is worth observing that it took full ten years from the implementation of the first reforms, in 1984, to the emergence of 4+% budget surpluses in New Zealand a decade later."


Key conclusion of the study is that "On balance, this analysis does not leave us optimistic that Europe’s crisis countries will be able to run primary budget surpluses as large and persistent as officially projected." Which leaves us with the menu of options that is highly unpleasant. If current account surpluses approach to debt-deflation fails, and if inflation is not a solution (as noted here: http://trueeconomics.blogspot.it/2014/08/1082014-inflating-away-public-debt-not.html) then we are left with the old favourites: debt forgiveness (not likely within the euro area), foreign aid (impossible within the euro area on any appreciable scale), or debt restructuring (already done several times and more forthcoming - just watch Irish Government 'early repayment' of IMF loans).

10/8/2014: Inflating Away the Public Debt? Not so fast...

There is a lot of talk amongst Irish and european policymakers about the big great hope for deflating public debts across euro area periphery: the prospect of inflation taking chunks out of the real debt burdens. This hope is based on a major misunderstanding of history. In many a cases, in the presence of debt overhang, higher inflation does help erode the real value of debt. Alas, "While across centuries and countries, a common way that sovereigns have paid for high public debt is by having higher, and sometimes even hyper, inflation, this rarely came without some or all of fiscal consolidation, financial repression, and partial default (Reinhart and Rogoff, 2009)." This quote starts the new NBER paper, titled "Inflating Away the Public Debt? An Empirical Assessment" by Jens Hilscher, Alon Raviv, and Ricardo Reis )NBER Working Paper No. 20339, July 2014)

In other words, it remains to not entirely clear just how effective inflation can be in current environment, given there are no defaults and there are no direct and aggressive financial repression measures implemented in the majority of the advanced economies, yet.

The NBER paper takes on the issue from the U.S. debt perspective. Per authors, "…with U.S. total public debt at its highest ratio of GDP since 1947, would higher inflation be an effective way to pay for it?"

"Providing an answer requires tackling two separate issues:

1. "The first is to calculate by how much would 1% unanticipated and permanently higher inflation lower the debt burden. If all of the U.S. public debt outstanding in 2012 (101% of GDP) were held in private hands, if it were all nominal, and if it all had a maturity equal to the average (5.4 years), then a quick back-of-the-envelope answer is 5.5%.1 However, we will show that this approximation is misleading. In fact, we estimate that the probability that the reduction in U.S. debt is as large as 5.5% of GDP is below 0.05%. The approximation is inaccurate since the underlying assumptions are inaccurate. The debt number is exaggerated because large shares of the debt are either held by other branches of the government or have payments indexed to inflation and the maturity number is inaccurate because it does not take into account the maturity composition of privately-held nominal debt."
2. "The second issue is that assuming a sudden and permanent increase in inflation by an arbitrary amount (1% in the above example) is empirically not helpful. After all, if the price level could suddenly jump to infinity, the entire nominal debt burden would be trivially eliminated. It is important first to recognize that …if investors anticipated sudden infinite inflation, they would not be willing to hold government debt at a positive price. Second, the central bank does not perfectly control inflation, so that even if it wanted to raise inflation by 1% it might not be able to. Moreover, there are many possible paths to achieving higher inflation, either doing so gradually or suddenly, permanently or transitorily, in an expected or unexpected way, and we would like to know how they vary in effectiveness. Therefore, it is important to consider counterfactual experiments that economic agents believe are possible."

The authors "calculate novel value-at-risk measures of the debt debasement due to inflation, and ...consider a rich set of counterfactual inflation distributions to investigate what drives the results. Using all these inputs, [authors] calculate the probability that the present value of debt debasement due to inflation is larger than any given threshold. The 5th percentile of this value at risk calculation is a mere 3.1% of GDP, and any loss above 4.2% has less than 1% probability. Interestingly, much of the effect of inflation would fall on foreign holders of the government debt, who hold the longer maturities. The Federal Reserve, which also holds longer maturities, would also suffer larger capital losses."

The paper also "…explores the role of an active policy tool that interacts with inflation and is often used in developing countries: financial repression. It drives a wedge between market interest rates and the interest rate on government bonds, and acts as a tax on the existing holders of the government debt. We show that extreme financial repression, where bondholders are paid with reserves at the central bank which they must hold for a fixed number of periods, is equivalent to ex post extending the maturity of the debt. Under such circumstances inflation has a much larger impact, such that if repression lasts for a decade, permanently higher inflation that previously lowered the real value of debt by 3.7% now lowers it by 23% of GDP."

In short, there is no miracle inflationary resolution of the U.S. debt conundrum. And similarly, there is probably none for the euro area sovereigns stuck with debts in excess of 90-100% of GDP. The pain of inflation alone is simply not enough to magic away debts. Instead, the pain of inflation will have to be coupled with the added pain of financial repression, and in the euro area case, this pain will befall more domestic investors and savers, than in the U.S. case simply due to differences in debt holdings. While no one expects the financial repression in the euro area to match that deployed in Greece and Cyprus, one can expect the financial repression measures (higher taxation in general, higher taxation of savings and overseas investments, higher rates of cash extraction from consumers via public sector pricing and higher concentrations in the financial services sector to increase rates of cash extraction by the banks) are here to stay and to most likely get worse before things can improve a decade later.

The myth of higher inflation as a (relatively) painless salvation to our debt ills is getting thinner and thinner...