Raise Taxes to Cure the Recession

Political debate in the United States is currently strangled by the failure of anyone to advocate raising taxes, however strong the arguments in favor. This is presumably the ultimate tribute to the genius of Grover Norquist, who has made it political suicide to even mention the possibility. The likely result is economic catastrophe, but that is of no consequence to the low-tax brigade.

In the long term, the consequence of a refusal to raise taxes will be to present the American people with a choice between the preservation of such elements of a welfare state (notably social security) as it has in the past built and continuing increases in the national debt. The CBO projects government spending on present trends at just over 22% of GDP in the first half of the 2020s and the tax take as slightly over 18% of GDP.

Insofar as growth occurs, one can run a secular deficit without an increase in the debt/GDP ratio, but that allows only for at most a 2% real gap. There is no way that discretionary expenditures can be cut enough (even if one is prepared to ignore the case for increasing some of them), since they are projected to amount to only about 5.5% of GDP (including defense). A reduction in mandatory expenditure (such as social security expenditure) would be needed, despite the increase in the number of claimants that is in prospect.

There is a second baleful long-term consequence of the refusal to consider tax increases. This is the need to achieve equality between debt and equity. At present debt is subsidized by being tax-free, with the result that corporations and banks (like governments) have far too much debt and far too little equity. Since we cannot afford yet more give-aways of tax revenue, the only way to square the circle is to tax debt. Logically tax reform, if it ever happens, should include the abolition of mortgage interest relief. But these reforms are also precluded by a refusal to raise taxes.

In the short term, I have long held that a switch in the composition of taxes could be helpful, but this also is precluded by the slogan of no new taxes. The particular switch that seems to me called for is to institute progressively a heavy tax on conventional energy, in return for a progressive reduction in taxes on things that we want to encourage, like income. The reason for believing that it could be helpful in the present situation in that it would provide a concrete incentive to undertake investment in the new energy industries; if it were done so as to be fiscally neutral, there would be no adverse impact on aggregate demand. The idea of a “carbon tax” has been around for many years, and was indeed considered (and rejected) by Congress at the start of the Clinton Administration. Politically, opponents of the carbon tax presented it as implying a tax increase; if instead it were presented as the price of an income tax reduction, it might be less unpopular with the general public. Of course, there is no hope of persuading Grover Norquist or the Exxons of this world.

What is new, at least to me, is an additional short-term case. This arises from an argument persuasively advanced by Andrew Smithers[1]: that the shift in managerial compensation from salary to bonus distorts management incentives in such a way as to bias managerial incentives toward the short-term. The argument is that managers are now largely compensated by bonuses, that most bonuses depend on recorded profit per share being higher than in the preceding period, and that it is therefore in their personal interest to risk the long-term future of the firm where there is a conflict with its short-term interest. 

Where do such conflicts arise? In regard to investment, where long-term a firm may need to expand its capacity by investing more, while in the short term it can make do with its existing facilities. And with regard to its price mark-up; short-term profits can typically be increased by charging more than is good for the firm in the long run. So one has an explanation of why firms are sitting on oodles of cash instead of investing as past experience suggests they can be expected to. Similarly, we suffer from more inflation than past experience would lead us to expect, given the extreme weakness of demand.

Changing these outcomes is essential to achieving a real recovery. The most straightforward way I can see of achieving this is to reverse the fact that managerial returns now come overwhelmingly from bonuses. And how to achieve that? How about using the tax system? Ideally one would want to impose a tax rate of about 98% on bonuses, as opposed to the present top rate of 39.6% plus state taxes, so that bonuses cease to be worthwhile.

A good approximation would be to raise the income tax rate on incomes over (say) $1 million to a rate of about 90%, which (combined with state taxes) would typically give a marginal rate of about 98% for those with incomes of over a million dollars a year. We were sold tax reductions with the argument that they are good for incentives, and there are high-earning individuals for whom this is surely true. But they earn over $1 million? The only persons who earn in that range are those with large assets and company CEOs on bonuses; the former do not need incentivizing and for the latter we have just argued that the incentives have a perverse outcome.

So it would be easy to design a program that would both promise to end the recession and improve the fiscal outlook. Of course, it won’t happen. For that we have to thank Grover Norquist and the low-tax brigade. 

[1] The Road to Recovery, Wiley, Chichester (UK), 2013.

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Raise Taxes to Cure the Recession

Political debate in the United States is currently strangled by the failure of anyone to advocate raising taxes, however strong the arguments in favor. This is presumably the ultimate tribute to the genius of Grover Norquist, who has made it political suicide to even mention the possibility. The likely result is economic catastrophe, but that is of no consequence to the low-tax brigade.

In the long term, the consequence of a refusal to raise taxes will be to present the American people with a choice between the preservation of such elements of a welfare state (notably social security) as it has in the past built and continuing increases in the national debt. The CBO projects government spending on present trends at just over 22% of GDP in the first half of the 2020s and the tax take as slightly over 18% of GDP.

Insofar as growth occurs, one can run a secular deficit without an increase in the debt/GDP ratio, but that allows only for at most a 2% real gap. There is no way that discretionary expenditures can be cut enough (even if one is prepared to ignore the case for increasing some of them), since they are projected to amount to only about 5.5% of GDP (including defense). A reduction in mandatory expenditure (such as social security expenditure) would be needed, despite the increase in the number of claimants that is in prospect.

There is a second baleful long-term consequence of the refusal to consider tax increases. This is the need to achieve equality between debt and equity. At present debt is subsidized by being tax-free, with the result that corporations and banks (like governments) have far too much debt and far too little equity. Since we cannot afford yet more give-aways of tax revenue, the only way to square the circle is to tax debt. Logically tax reform, if it ever happens, should include the abolition of mortgage interest relief. But these reforms are also precluded by a refusal to raise taxes.

In the short term, I have long held that a switch in the composition of taxes could be helpful, but this also is precluded by the slogan of no new taxes. The particular switch that seems to me called for is to institute progressively a heavy tax on conventional energy, in return for a progressive reduction in taxes on things that we want to encourage, like income. The reason for believing that it could be helpful in the present situation in that it would provide a concrete incentive to undertake investment in the new energy industries; if it were done so as to be fiscally neutral, there would be no adverse impact on aggregate demand. The idea of a “carbon tax” has been around for many years, and was indeed considered (and rejected) by Congress at the start of the Clinton Administration. Politically, opponents of the carbon tax presented it as implying a tax increase; if instead it were presented as the price of an income tax reduction, it might be less unpopular with the general public. Of course, there is no hope of persuading Grover Norquist or the Exxons of this world.

What is new, at least to me, is an additional short-term case. This arises from an argument persuasively advanced by Andrew Smithers[1]: that the shift in managerial compensation from salary to bonus distorts management incentives in such a way as to bias managerial incentives toward the short-term. The argument is that managers are now largely compensated by bonuses, that most bonuses depend on recorded profit per share being higher than in the preceding period, and that it is therefore in their personal interest to risk the long-term future of the firm where there is a conflict with its short-term interest.

Where do such conflicts arise? In regard to investment, where long-term a firm may need to expand its capacity by investing more, while in the short term it can make do with its existing facilities. And with regard to its price mark-up; short-term profits can typically be increased by charging more than is good for the firm in the long run. So one has an explanation of why firms are sitting on oodles of cash instead of investing as past experience suggests they can be expected to. Similarly, we suffer from more inflation than past experience would lead us to expect, given the extreme weakness of demand.

Changing these outcomes is essential to achieving a real recovery. The most straightforward way I can see of achieving this is to reverse the fact that managerial returns now come overwhelmingly from bonuses. And how to achieve that? How about using the tax system? Ideally one would want to impose a tax rate of about 98% on bonuses, as opposed to the present top rate of 39.6% plus state taxes, so that bonuses cease to be worthwhile.

A good approximation would be to raise the income tax rate on incomes over (say) $1 million to a rate of about 90%, which (combined with state taxes) would typically give a marginal rate of about 98% for those with incomes of over a million dollars a year. We were sold tax reductions with the argument that they are good for incentives, and there are high-earning individuals for whom this is surely true. But they earn over $1 million? The only persons who earn in that range are those with large assets and company CEOs on bonuses; the former do not need incentivizing and for the latter we have just argued that the incentives have a perverse outcome.

So it would be easy to design a program that would both promise to end the recession and improve the fiscal outlook. Of course, it won’t happen. For that we have to thank Grover Norquist and the low-tax brigade.

[1] The Road to Recovery, Wiley, Chichester (UK), 2013.

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Should One Worry about the Prospect of Deflation?

It seems that there is now virtual unanimity in regarding deflation as a threat to be avoided at all costs, comparable in severity to the problem of inflation in the 1970s. This is despite the fact that my suggestion of many years ago to define deflation as referring to declining output was not adopted: it would be neater for all if one spoke of price changes in terms of inflation versus disinflation, and of output changes in terms of reflation versus deflation, instead of using the terms “deflation” as the opposite of inflation. But there can be no doubt that what people are concerned about is the possibility that prices will fall. 

How did such a concern come to dominate economists, despite the fact that (gently, and/or temporarily) falling prices were as common as (gently, and/or temporarily) rising prices over many centuries prior to 1914 in a period that people do not generally equate with disaster in the Western economies? As with so many of the propositions in economics, it seems to have originated with no less than John Maynard Keynes. In chaps. 19 to 21 of the General Theory, Keynes was mainly concerned to refute the notion that falling prices provide a simple antidote to unemployment, pointing out that the then-traditional analysis neglected the impact of lower prices on aggregate demand. Once this is done, the net effect is equal to that which operates by increasing the real value of the money stock; and this could be achieved more readily by monetary expansion than by price deflation. Ergo, declining prices had no role to play in rational demand management policy.

One can agree with this proposition without going overboard, as most contemporary economists do, regarding mild price declines as a social evil to be avoided at all costs. How one moved from the consensual position that it makes no sense to seek reflation via price declines to the dominant contemporary view that price declines represent a threat to the possibility of managing demand is far from evident, but it seems that this is what happened.

It has been customary to buttress this view with a reference to Japan. In fact, Japan has not suffered anything like a catastrophic decline during the supposed lost decades; living standards continued to improve (as measured by the rate of growth of real GDP per employed person) at a rate of about 0.8 percent per year. Admittedly this is distinctly less than in the previous 20, 30, or 40 years, but this is mainly because the opportunities of rapid growth were distinctly less, because by 1990 Japan had more or less caught up with the world technological frontier. It is also less than the 1.6 percent per year that the US enjoyed, but the income distribution deteriorated far less and the labor force participation rate improved by almost 5 percent, as opposed to the decline of over 4 percent in the US. (A “cheap” way of improving measured productivity is to reduce employment per capita.) There are difficulties in making a comparison with the Euro Area, because of its changing composition and the earlier absorption of East Germany by West Germany and its consequent entry into the Euro Area, but it seems that the rate of productivity increase there was broadly comparable to that in Japan.

The important thing to appreciate is that it is the real growth rate per capita that is the relevant determinant of the improvement in living standards, and not the growth rate of the total economy in real terms (still less is it the growth rate in nominal terms). The major determinant of the faster growth in the US has been faster population growth (of about 27 percent rather than 2 percent), which has almost zero welfare significance.[1] Admittedly the US enjoyed faster per capita real growth, but since – as is well-known – the benefits of this went almost exclusively to “the 1 percent”, even this is of minimal welfare significance.

Let us ask analytically what is the effect of a negative rate of inflation. It is a problem that is caused by the zero lower bound to the nominal interest rate. If this constraint is in operation, this makes it impossible to use monetary policy to reduce the real rate of interest when desired, which has an effect in reducing aggregate demand. But note (1) That under many circumstances it is possible to offset this undesired effect through a more expansionary fiscal policy; (2) That when this is not possible (because, for example, of constraints on fiscal policy) it may still be possible to use “unorthodox” monetary policy (like quantitative easing) and (3) That in the worst analysis the effect is confined to the interest elastic component of aggregate demand. Even when it cannot be offset, the effect on demand is thus likely to be modest. It is hardly comparable to the problem of stopping inflation in the early 1970s.

Since there is no empirical evidence that disinflation is likely to be disastrous, nor convincing theoretical reasons for fearing modest and/or temporary price declines, one is bound to conclude that the present fevered attempts to prevent “deflation” are misguided.

[1]  Until recently I would have said zero welfare significance, but then I read Thomas Piketty’s book Capital in the Twenty-first Century. This shows that the concentration of capital tends to approach s/g, where s is the propensity to save and g is the growth rate of population and growth due to invention. It follows that high population growth tends to retard the concentration of capital, which some of us would regard as a benefit. This is the only benefit I can see in fast population growth.

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“The Future of Manufacturing in Brazil: Deindustrialization in Debate” [REVIEW]

A Review Essay

“The Future of Manufacturing in Brazil: Deindustrialization in Debate”

By Edmar Bacha and Monica Baumgarten de Bolle

Review co-authored by John Williamson and Roberto Zagha[1]

As indicated by the subtitle, this book is spurred by the revival of the debate on deindustrialization in Brazil. The fundamental question is whether one needs to worry that the failure of industrial growth is going to lead to a more general slowdown of the Brazilian economy and, conversely, whether faster industrial growth is key to accelerated overall growth. It may be useful to precede the discussion of the contents of the book by a brief outline of our attitude to development, which is pretty orthodox.

We take it for granted that developing countries can grow faster in per capita terms than the advanced ones, hence the possibility of catch-up.  The fundamental reason is that it is easier to learn what is already known—in terms of technologies, policies and institutions—than to create them from scratch.  The absorption of this knowledge takes multiple forms: imports of capital goods, FDI, investments in education, learning by doing, studies abroad, participation in international conferences, and so on.  This is not to say that no innovation occurs in developing countries: Brazil’s aviation or agro-industry, India’s pharmaceuticals, and China’s electronics provide examples.  However, the bulk of expansion relies on technologies invented elsewhere.

Catching up is not just a theoretical possibility.  It has happened and it has changed the lives of hundreds of millions of people.  Japan, Korea, Taiwan and Singapore are instances of countries whose per-capita incomes caught up with those of advanced economies in two generations (60 years).  China has grown at annual rates in excess of 10 percent for three decades, an achievement unprecedented in human history: Whereas in 1980 China’s per capita income accounted for less than 3 per cent of the US per capita income (in purchasing power parity terms), it reached 19 percent in 2010 (the last year for which per-capita data in PPP terms are available).  In the same period Korea’s per capita income grew from 21 percent of that in the US to 64 percent.  Within 20 years, China’s per capita income is expected to reach today’s average in the OECD countries. East Asian countries’ high rates of growth have been facilitated by export-oriented industrialization, massive investments in infrastructure and education, stable and highly competitive exchange rates, and high savings. Whether the extensive state intervention to promote some industries helped very much is still subject to dispute: there is also the example of Hong Kong, which developed similarly under the closest the world had ever seen to pure laissez-faire (at least until the Baltic countries achieved independence).  In contrast, at recent rates of growth Brazil will need several centuries to catch up with living standards in the West.

Brazil has experienced periods of high growth as well, which started well before East Asia’s take off.  Between the end of WWI in 1918 and 1980, GDP grew at a compound rate of 6.3 per cent, a rate comparable to East Asia’s more recent performance.  It was not a smooth process.  Over these 60 years there were periods of growth exceeding 10 percent per year, as well as periods when growth was negative or marginal.  Inflation was a recurrent problem.  There were balance of payments crises.  There were military dictatorships and returns to democracy. Over 1932-39, while the rest of the world was mired in the Great Depression, manufacturing in Brazil grew at a rate of 9 percent per year.  This was an incidental result of price support for coffee, which had the effect of bringing about expansionary fiscal and monetary policies—Keynesian policies driven by the political need to protect the incomes of the politically powerful coffee farmers.  During the 1940s and 1950s there was extensive state-driven industrialization when some of Brazil’s largest public enterprises were created, such as Companhia do Vale do Rio Doce in 1941, Companhia Siderurgica Nacional in 1942, and Petrobras in 1952.  There was an opening up of the economy in the 1960s and a return to protectionism in the 1970s  This is not the place to review the economic policies over these 60 years; it suffices to remember that the process was not linear; there were abrupt changes, corrections, but, perhaps crucially, a political will to grow.  The net result was highly positive.

Brazil’s growth came to a stop in 1980.  Had the growth continued at the rates of the previous 60 years, Brazil’s per capita income would be twice what it is today.  As it happened, GDP growth was close to zero in the 1980s, barely above the population growth rate in the 1990s, and just above 2 percent per-capita during 2000-12 (2.2 per cent per year to be exact)—still barely enough to catch up with advanced economies, where the long term per-capita growth rate is close to 2 percent.   As a result, Brazil’s per capita income as a share of the US per capita GDP has declined from 32 percent in 1980 to 20 percent at present.

Since 1980, total factor productivity growth (TFPG) was for a long time negative, as documented by several studies[2].  It picked up in the early 2000s, when growth accelerated.  One reason for the long period of low or negative TFPG is that employment grew more rapidly in lower productivity activities, mostly in the informal service sector.  One of the central insights of development economics is that economic development entails moving resources from low productivity activities to higher productivity ones.  As labor moves from agriculture into modern activities the overall productivity of the economy rises.  Even within the same sector, productivity increases when labor moves from informal to formal employment.  What happened in the post debt crisis years in Brazil is that employment grew mostly in the less productive parts of the service sector, and that the share of employment in manufacturing declined.  In 1981 agriculture accounted for 29 percent of employment, industry for 25 percent, and services for 46 percent.  In 2009 (the last year for which data are available from the WB), the corresponding figures are 17, 22 and 61 percent.  And while in recent years there has been a shift from informal to formal employment, the share of the labor force in informal employment continues to be very high.  Various estimates suggest between 33 and 50 percent[3].

The shift out of industry that prevailed in recent years differs from what we see in China, and may help explain the evolution of TFPG over the last two decades.  While the share of manufacturing in any economy declines when per-capita incomes reach higher levels, Brazil  may have  started this evolution too early—“de-industrialization”  may be premature or excessive in a country whose per-capita GDP is just 20  percent that of the US (in 2010) and far behind that of the advanced economies of East Asia.

Bacha’s and Baumgarten’s book is a timely contribution to the understanding and debate of Brazil’s surprising growth deceleration and the loss of momentum of its industrial development.  It contains pearls of analysis as well as surprising errors of omission and errors of commission.  These errors are as important as the insights because they reflect the state of mind of Brazil’s economists and policy makers In particular, one is surprised by the lack of interest on Brazil’s loss of growth momentum over 30 years, of curiosity on the reasons behind Asia’s high growth achievers, and of interest in the limited integration in the global economy in contrast with the fast growing Asian economies.   Is the premise that Brazil is so unique that there are no lessons to draw from the success of others?  Is it, as Fishlow suggests, that “God is Brazilian”?  Are the relevant comparators, as indicated in several of the papers, Australia, Canada, and Norway?  Or are they instead China, India, Vietnam, Korea, Japan?  Whatever the reason, exceptionalism is inimical to intellectual curiosity and to sound policy making.

Part I contains three chapters. The first is a revised and updated version of Albert Fishlow’s classic article describing Brazil’s import-substitution policy in the postwar years. Rich as this article is, it hardly fits with the title of the book, which one begins to think should have been called “The Past of Industrialization in Brazil”.  As in his other publications[4]  Fishlow is a constant optimist about Brazil, but one should be concerned that his optimism has been unscathed by three decades squandered in terms of economic growth.  It would have been useful to have a justification of his optimism.

The second chapter is by Regis Bonelli, Samuel Pessoâ, and Silvia Mattos. They distinguish three possible reasons why industry is decreasing: a cyclical weakness of industry on a global basis; the integration of China, India, and other Asian countries with low labor costs into the global market; and the secular tendency for the weight of manufacturing to decline, as a counterpart to the increase of services. (As brought out in one of the subsequent papers, there is a fourth possible reason, which is capable of explaining differential national tendencies: abnormally high unit labor costs—or, for that matter, other national weaknesses in the industrial sector). The main part of the paper shows just how general the decline of manufacturing as a share of GDP has been. Brazil achieved its maximum of 27% in the middle of the 1970s, since when the share has declined about 1 percentage point of GDP every 5 years. They go on to calculate a regression equation (R2 adjusted = 0.42) that explains the share of manufacturing in GDP, as a function of per capita income and its square, population, the savings rate, population density, and the real exchange rate (not significant); one wishes the output of the commodity-producing sectors as a fraction of GDP had been included too. They conclude from this that Brazil (currently 0.14 to 0.15) lies only 1% of GDP below the lower confidence interval.  The implication is that Brazil’s deindustrialization is to be expected and is consistent with fundamentals. The corollary is that Brazil is condemned to continue to be a laggard in the world economy.

The third chapter is by Luiz Schymura and Mauricio Canêdo Pinheiro, and is the first where Industrial policy is discussed. The authors give the impression of being conflicted; they want to support industrial policy, but the reasons they give for this support are highly unconvincing. They end up by supporting “light” industrial policy, in the sense of either being restricted to the general provision of public goods or involving market interventions that benefit particular firms, but opposing “heavy” industrial policy, which according to their diagram involves both general provision of public goods and is designed to favor particular firms. The logic of their position escapes us.

Part II contains 4 chapters that explore the (very) short-term decline of manufacturing in Brazil and link it to external and internal macro-economic developments and policies.  The four papers complement each other and suggest that good luck for the country was actually bad for the industrial sector. Government policies did not have industrial growth as a priority and the decline in Brazil’s industrial growth was the passive and (except for one paper) inevitable result of the vagaries of the weather, international commodity prices, and other external shocks. The four papers are possibly the best in the book—analytical and well-researched—even though they recognize Brazil’s “de-industrialization” has been going on for more years than the few analyzed in their papers.

The first chapter, by Edmar Bacha, aims to explain the decline in industrial production from 18 percent of GDP in 2005 to 16 percent of GDP in 2011.  Starting in 2005 Brazil has experienced an episode of Dutch disease: a significant increase in the price of its commodity exports and capital inflows, both leading to a real appreciation of the currency.  The paper develops an accounting framework to estimate the windfall followed by a simple macro-economic model showing that this windfall, by allowing higher levels of domestic absorption, increased the demand for non-tradables and hence a shift of labor from tradables to non-tradables.  While the model explains the decline in the share of the manufacturing sector, it does not allow “what if” questions.  What if the government had introduced export taxes to capture a part of the windfall and hence partially offset expansionary public spending?  What if it had abandoned, or toned down, its expansionary public spending? What if it had taxed or introduced controls on inflows of capital more severely than it has?  What if it had accumulated reserves at a higher rate?  Or adopted a combination of all these policies?  The paper concludes on the need to develop a more complex dynamic model to answer these questions, and one can only applaud this plan. But it will be unfortunate if the absence of the ability to pose such questions is interpreted as an endorsement of the policies that produced them.

The paper by Affonso Celso Pastore, Marcelo Gazzano and Maria Cristina Pinnoti is another solid piece of analysis which seeks to explain the stagnation of the industrial sector since 2010.  It provides a counter-intuitive finding: the decline in the share of industry in the economy has been worsened by the fiscal and monetary counter-cyclical policies pursued in response to the 2008 crisis.  The expansion in domestic demand resulted (as estimated in the previous paper) in an increase in the demand for services and hence of wages in that sector. Like the Scandinavian model of inflation, they argue that both sectors must have equal wage increases, though they assert that it is the dominant sector numerically—the service sector, which employs 60 million versus the 20 million in manufacturing—that determines wage inflation. The resulting increase in unit costs in manufacturing did not offset the positive impact of interest rate reductions. The consequence was the reduction of capacity utilization in manufacturing and an increase in imports of industrial goods.  This explains the decline in capacity utilization in the industrial sector, despite the economy being close to full employment.

The third paper in this part is the interesting and clear paper by Beny Parnes and Gabriel Hartung, which examines the rise (2004-08) and decline (2008-12) of Brazilian industrial growth.  In fact, industrial production in 2012 was 2 percent below the level of 2008.  The authors raise the question:  was the industrial deceleration the result of a global shock, or the result of Brazilian domestic policies?    The industrial deceleration in Brazil was much faster, and lasted longer, than in other parts of the world, and industrial growth lagged behind such growth elsewhere.  The authors conclude that industrial deceleration in Brazil was the result of domestic policies; these increased domestic demand in response to the 2008 shock, reduced the fiscal surplus, and helped increase real wages.   Together with the appreciation of the nominal exchange rate, this led to an increase in the dollar unit cost of labor.  In fact, this increase already started in the early 2000s (see Table 1 of the paper) when the dollar unit cost of labor started to rise faster than in any of the competitive countries of East Asia, or Europe, or the US, both as a result of the appreciation of the exchange rate, and rises in real wages at rates higher than productivity growth.   As in the preceding paper, the rise in real wages—at rates above productivity growth–is the result of expanded demand for services.

The paper by Ilan Goldfajn and Aurelio Bicalio concludes Part II of the book. They use a VAR model to study the responses of industry and services to demand shocks. They confirm that one of the reasons behind the deceleration of industrial growth since 2008 was the expansionary fiscal and monetary policies adopted in the wake of the Lehman crisis, that generated strong demand for services rather than goods, with the resulting effects on wages noted in the paper of Pastore et al.

While the four papers contain interesting and insightful perspectives, the deceleration of Brazil’s industrial sector has had a much longer history than that examined in this part of the book, and one would have expected some questions to be explored, or at least posed, such as: why was Brazil able to grow its industry in the past and is failing now?  What were the motivations of governments that pushed growth? Has it been accepted that Brazil will not be able to catch up with the current level of industrialization?  At the time of writing growth is declining as the commodity price boom fades away. What are the policy actions that could help restore industrial dynamism?

Part III of the book contains three chapters.  That by Sergio G. Lazzarini, Marcos Sawaka Jank and Carlos F. Kiyoshi V. Inoue focuses on the effects of the commodity boom on Brazil’s industrial performance, and discusses whether this boom has been a blessing or a curse.  Ignoring six decades of theory and practice of development experience, the authors’ unambiguous answer is that it has been a blessing.  They debunk five “myths”: (1) value added in commodities is low; (2) the technological content of commodities is low; (3) the rents are captured by the political system; (4) there is a secular decline in the price of commodities; and (5) commodities are a cause of Brazil’s Dutch disease.   The power of their convictions finds no parallel in the paper’s reasoning or data, however.  The two concerns with a commodity economy are not that the value added is low: on the contrary, it is well known that a commodity economy is typically based on advanced technologies and capital intensive production methods, and hence labor productivity is very high (as the chapter illustrates). The concerns are, rather, that commodities have few linkages with the rest of the economy, and that they appreciate the exchange rate and reduce the competitiveness of labor-intensive and less technologically advanced sectors. Showing commodities add value and that labor is more productive than in the rest of the economy hardly addresses these two problems.  Regarding capture, the authors may be right that income inequality is more important than production of commodities per se.  They may also be right that through creative institutional design and state ownership Norway has been able to avoid the worst consequences of a resource curse.  But can Brazil import Norway’s (5 million people) income distribution? And is it realistic to base improvements in income distribution on the distribution of commodity rents as they suggest? Turning to the secular decline of commodity prices, the authors are right on the lack of evidence—that was settled a long time ago.  The authors are also right that volatility is and remains a problem.  Last but not least, the authors’ view that the Brazilian economy is sufficiently large and diversified to withstand Dutch disease relies is belied by the facts.   At $2.2 trillion (at market exchange rates) the economy of Brazil accounts for one fourth that of China, one-sixth that of the US, and 3 percent of the global economy.  The economic opportunities afforded by an economy more integrated in the rest of the world, in terms of export opportunities and economies of scale, vastly surpass those that can be achieved in an economy 3 percent the world size.

The second chapter, by Sandra Polonia Rios and Jose Tavares de Araujo Jr, starts on an optimistic note: it points out that Brazil’s manufacturing exports in 2011 were close to the 2008 historical record; industrial production in 2011 was 33 percent above its 1996 level; and that the share of exported manufacturing output increased from 9 percent in 1996 to 19 percent in 2005.  It then shows that sectors which grew the fastest are those where imports as a share of domestic production are the highest.  Fierce competition forced firms to respond through improved competitiveness: they adopted innovations generated abroad and expanded investments in R&D.  However, a 33 percent increase in manufacturing output from 1996 to 2011 amounts only to a 2 percent annual growth rate. Most sectors have lost export competitiveness. The performance of labor-intensive sectors has been particularly dismal, because of the emergence of low-wage China and other Asian economies.  The conclusion, rather exhortation, is that Brazilian manufacturing needs to increase its productivity—but the mechanism and dynamics of the process are left unspecified.

The last chapter in this part is a valuable contribution to the main theme of the book.  It shows that Brazil has been unable to participate in the growth of international trade, including the part based on value chains, mainly because of the country’s high tariffs.  Whereas in 2011 Brazil ranked 6th in terms of the size of its economy, it ranked 22nd by volume of exports.  Among some of the largest developing countries, Brazil has the highest tariffs on imports of capital goods, twice as high as China or Korea, and 60 percent higher than India’s.  In the case of intermediate goods, while the differential is less pronounced, Brazil has the highest rates among relevant comparators.  This is perhaps the best documented paper of this part of the book and the most useful in terms of its implications and conclusions.

The fourth part of the book consists of three chapters dealing with different aspects of industrial policy.  The first, by Mansueto de Almeida, reviews the recent literature on industrial policy, and makes the useful point that a large share of official (subsidized) lending by the National Development Bank (BNDES) has been dedicated to sectors which were already well established—thus not contributing to a more diversified industry.  The second paper, by Vinicios Carrasco and Joao Manuel Pinho de Mello, demonstrates the (well-known) fact that protection of an industrial sector is an implicit tax on consumers, but then goes on to the very useful and insightful exercise of documenting the effects of protection on one industrial product widely used in the construction industry: the steel reinforced bar (“rebars”).  It shows that a regulation (presumably) prevents imports of rebars below a certain grade, which is higher than that commonly used in European countries, the US, or China.  The result is that the price of rebars in Brazil is between 2 and 4 times that in other countries.  How seemingly benign (presumably safety) regulations end up providing what turns up to be huge protection to the domestic industry is a very important insight.  One would have liked to know more detail, and if it extends to other manufactured goods.  One suspects that high tariffs, and regulations of the type that apply to steel rebars, explain why imports in Brazil are so low in relation to its GDP.  The third paper of this part of the book, by Tiago Berriel, Marco Bonomo, and Carlos Viana de Carvalho, is an unusual exercise seeking to estimate the optimal composition (agriculture, industry and services) of the Brazilian economy, recognizing that an economy highly concentrated in the sectors in which it has the greatest comparative advantage runs the risk of low diversification and high variability of incomes.  It applies an analytical framework that establishes a trade-off between diversification and economic growth that concludes that the share of industry in Brazilian GDP is above optimal.  This is an interesting mental exercise, but it would be a mistake to take its result to heart.

The fifth and last part of the book consists of four chapters that explore different aspects of the Brazilian policies implemented in recent years.  The paper by Eduardo Augusto Guimaraes examines the effects of minimum local content requirements in industries supplying equipment and materials to Petrobras for oil and gas exploration.  It concludes that the local content requirements are excessive and lacking in a sense of priorities.  In particular, the policy should clearly identify the parts of the industry that have a long term potential and focus on those.

The well-researched paper by Leonardo Rezende analyzes the current system of government support to industrial innovation.  It contains two interesting conclusions.  The current system does not support industries that innovate and, in fact, supports mostly incumbents in the highly concentrated parts of the industrial sector (reinforcing the conclusion of Carrasco and Pinho de Mello).  The author recommends a reorientation of government support towards innovation in areas that would benefit a large number of firms—on the example of EMBRAPA (a large and highly successful agricultural research outfit responsible for much Brazilian progress in agriculture in the last three decades).

The last two papers of the book contain two different perspectives on the government’s recent decision to change the basis of social security taxes from wages to revenue of the firm.  The paper by Rogerio Werneck considers this change a mistake: social security benefits should be financed by those who benefit from them.  In addition, the change introduces cascading into the tax system.  The paper by Fernanda Guardado and Monica Baumgarten recognizes these shortcomings, but also highlights the fact that the change introduces a welcome counter cyclical component to the tax system.  They also make the point that this change has a long run effect, because it encourages the substitution of labor for capital  – and since they consider Brazil to be close to full employment, it is the use of capital that they argue should be encouraged in the long run.   Given the large share of informality in Brazil, the conclusion that one should encourage the substitution of capital for labor seems hasty.

So much for detailed review of the individual chapters which, in many cases, give the impression of complacency: Brazil had the great good fortune to enjoy improved terms of trade and abundant capital inflows that enabled it to run down its manufacturing industry without encountering a balance of payments problem. Presumably the impending reversal of this good fortune, if it occurs, will be regarded as a problem, but a separate problem. Commodities are a blessing rather than a curse. Industry is only one percentage point of GDP below the lower confidence interval in the analysis of Bonelli et al, while the paper of Terriel et al even concludes that it is too large. China, India, and other Asian countries are low wage economies against which Brazil cannot compete.  The size of Brazil’s economy can provide markets sufficiently large to support industrial development. And while one can only agree that Brazil’s industry needs to be internationally competitive, a theme in several of the chapters, the dynamics of this process are left unclear.  Why would firms invest to expand and modernize when some of the fundamentals of the economy are so unsupportive and uncertain?  The drama of growth lost for an entire generation does not seem to find a sufficiently large voice in the book; one would have liked a little more stridency on this issue.  For the millions of people in Brazil who are not fortunate enough to belong to the distinguished groups analyzing the economy and formulating policies, the decline of per capita income as a share of US per capita GDP from 32 percent in 1980 to 20 percent at present is nothing less than a silent tragedy of missed opportunities and squandered lives.

One can therefore understand that, in August 2013, as reported in the newspaper Valor[5], Edmar Bacha had a nightmare the night preceding a trip to Sāo Paulo to present and discuss the book with a group of prominent industrialists.  In the nightmare, the building hosting the Federation of Sāo Paulo Industrialists (FIESP) had become an industrial museum.  In a sudden reversal of fortunes, however, the building was restored as the Federation of Manufacturing Exporters of Sāo Paulo, the message being that to grow faster Brazil needs to orient its industry towards exports.

A few weeks later, Bacha published a paper[6] which, reinforcing the conclusions of the paper in this book, recognizes that the euphoria of 2004-12 was unsustainable and due to a bout of good luck, a windfall which is now over, and that “the Brazilian economy is sick”.   According to the paper, the closedness of the economy is responsible for this state of affairs.  Both in terms of exports and imports relative to the size of the economy, Brazil lags well behind other economies.  The solution is to adopt policies that would integrate the country more closely in the global economy and be a larger participant in world trade (Brazil’s share of world exports declined from 2 percent in the 1950s to half that at present).    A clear message is that—as was the case during the years of the “miracle” — Brazil needs to expand the role of exports in its economy and growth strategy.  Higher exports would tend to result in a larger industrial sector, though how much larger is not something on which we would be dogmatic. (The one thing that is clear on the latter is that it was a mistake to allow the industrial sector to be squeezed by temporary booms in commodities and capital imports.)

To implement a growth-oriented strategy, Bacha suggests three types of reforms, to be introduced gradually: fiscal, reduction of import protection, and preferential trade agreements.  The fiscal proposal is to emulate a policy introduced in Israel that constrains expenditure growth to one-half of the GDP growth of the previous ten years.  The second pillar would consist of a reduction of import tariffs over several years, together with elimination of all the preferences granted domestic industry (in the form of local content requirements, preferences in government procurement, and technical specifications different from those accepted internationally), compensated by devaluation.   In an Annex to the paper, the author provides more details on how to maintain the competitiveness of the real exchange rate, including through restrictions on capital inflows.  This is a refreshingly novel recognition of the role of the exchange rate in an export-oriented growth strategy and of the costs of an open capital account.  There has been ample recognition[7] on the need to manage financial flows in a manner that does not damage the real economy and does not appreciate the exchange rate unduly.  These lessons from recent decades of the development experience have been well assimilated in East Asia.  In Brazil, however, there has been a Churchillian aspiration to a strong currency with little awareness or even discussion of its costs.  The greatest contribution of “The Future of Industrialization in Brazil” may have been to prepare the ground for a paper that recognizes that Brazil needs an export-oriented growth strategy and that this strategy is closely related to a more open import regime and a more competitive exchange rate.


[1] John Williamson was a senior fellow associated with the Petersen Institute from 1981 to 2012; Roberto Zagha has recently retired from the World Bank and wrote this paper while a visiting fellow at the Hoover Institute, Stanford University, which he thanks for the support afforded to complete this work.  The Portuguese version of this paper has been submitted to the Journal “Estudos Economicos”

[2] Bacha, Edmar and Regis Bonelli, “Crescimento Brasileiro Revisitado” in “Desenvolvimento Economico: Uma Perspectiva Brasileira”, volume edited by Veloso, Fernando; and Ferreira, Pedro Cavalcanti; Pessoâ–Elsevier, 2013; Bosworth, Barry and Susan M. Collins (2003). “The Empirics of Growth: An Update.”  Brookings Papers on Economic Activity (2).  McMillan, Margaret S. and Dani Rodrik, “Globalization, Structural Change and Productivity Growth” NBER Working Paper 17143 June 2011

[3] Holanda Barbosa Filho, Fernando, e Veloso, Fernando: “A Contribuição da Formalização para a Elevação Recente da Produtividade do Trabalho no Brasil”  IBRE/FGV, 2013

[4] Fishlow, Albert “Starting Over: Brazil Since 1985” Brookings Institution Press, Washington DC 2011;  “O novo Brasil: as conquistas políticas, econômicas, sociais e nas relações internacionais”,  Saint Paul Editora, Sao Paulo; “Down But Not Out.” Foreign Policy May 18, 2012.

[5] Valor Economico of August 27, 2013, “O sonho de Bacha”

[6] Bacha, Edmar (2013): Integrar Para Crescer: O Brasil na Economia mundial.  Paper presented at the National Forum Brasil,  Estratégia de Desenvolvimento Industrial com Maior Inserção Internacional e Fortalecimento da Competitividade. Rio de Janeiro: BNDES.

[7]  Jeanne, Olivier, Subramanian, Arvind, and Williamson, John (2012), Who Needs to Open the Capital Account? Petersen Institute for International Economics; Rodrik, Dani (1998) Who Needs Capital Account Convertibility?” in Essays in International Finance, Princeton University, May 1998;   Rogoff, Ken (1999), International Institutions for Reducing Global Financial Instability,” Journal of Economic Perspectives, Vol. 13 (Fall), pp. 21-42and “Rethinking capital controls: When should we keep an open mind?”, Finance and Development, December 2002, Volume 39, Number 4; Williamson, John (1995), The Management of Capital Inflows, in Pensamiento Iberoamericacon, January-June 1995.

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Review of Joe Studwell, How Asia Works: Success and Failure in the World’s Most Dynamic Region

In this book, the author lays out what he takes to be the conditions for catch-up growth à la Gerschenkron. These are essentially three. The first is land reform: letting the peasants own their own land and supporting this by the necessary ancillary services will result in maximizing output per hectare (and the labor input), with consequences that include a burst of output, increased savings, the creation of rural markets for urban-produced goods, without jeopardizing a ready-made supply of labor for the new urban industries. The second is the development of an industrial sector under heavy infant-industry protection, disciplined by the requirement of export success, and its progressive expansion into ever more advanced fields. The third is the use of a repressed financial system under government control in order to promote the first two conditions. He argues that this was the formula first pioneered by Meiji Japan and subsequently copied elsewhere in N.E. Asia (postwar Japan followed by Korea and Taiwan, and he hopes now China).

He also considers Indonesia, Malaysia, the Philippines, and Thailand (S.E. Asia), and dismisses claims that they have enjoyed comparable success. They failed to implement a serous land reform, nor did any of them institute an industrial policy aimed at growing industry and pushing it into ever more advanced fields. Entrepreneurs were not required to assist in “developmental” causes when privileges were extended to them, nor were the privileges dependent on revealed success, e.g. in exporting. Accordingly they have no chance of becoming developed.

Of course, countries are required to lie through their teeth in order to implement his strategy. His hero is Park Cheung-hee, who was prepared to assure the Americans that he was aiming to enhance free markets at the same time that he actually did the opposite. But Studwell admits that there is a problem with his prescriptions, which are aimed at development. For an advanced economy, it is quite appropriate to pursue efficiency. The problem is in knowing when to switch from caring for development to pursuing efficiency. Korea accidentally made the switch right, at the time of the Korean crisis in 1997, when its policies were fortuitously controlled by the IMF. Japan failed to make the switch, as a result of which it has suffered 2 lost decades.

One suspects that there may be other problems with his prescriptions besides the self-diagnosed one. Before elaborating on these, let me say what a pleasure it was to read a literate defense of land reform again, emphasizing the importance of accompanying land reform by the provision of extension services, credit, marketing, etc. This is a reform that we have almost forgotten about in recent years, yet it is surely of vital importance. The problem is that it involves destroying some people’s property rights, unless full compensation is paid, which tends to be expensive. That is why historically major land reforms have occurred only in the wake of major wars, when the rulers had no qualms about raiding people’s property rights, since these were widely regarded as having been illegitimately acquired. My guess is that under current conditions it would be worth compensating fully, even though this would add to government debt. (A compromise is available to countries that have previously imposed a land tax: pay compensation at the declared value of land, which is usually a gross under-estimate of its actual value.)

It is also a pleasure to have the logic of the industrial policies pursued in NE Asia laid out so clearly, though I am not filled with the same zeal for them as for the agricultural policies. Buying them essentially requires a similar act of faith to that involved in signing on to the neoclassical economics he so fervently despises, and accepting that there is no other way to develop except by the dirigiste strategy that he so well outlines. But is that really true? When I was young the developed countries comprised Western Europe and what Angus Maddison has called the “European offshoots”. To those we must now add not only Japan, Korea, and Taiwan, but also Southern Europe, Israel, Hong Kong, and Singapore.

It is difficult to know what Studwell would make of Southern Europe (at least outside Italy, which he considers to have developed properly) and Israel. But Studwell tells us quite explicitly that he is not going to consider Hong Kong and Singapore, because they are merely “anomalous port financial havens” (p. 63). The implication is that it is wrong to compare city-states to “real” countries. This would make sense if the cities normally sacrificed for the benefit of their hinterland, but surely they have, on the contrary, generally exploited their hinterlands, so that it is more and not less difficult for a city-state to develop. Of course, addition of Hong Kong and Singapore to the comparators is devastating to his thesis. Hong Kong developed under the purest laissez-faire that I know of; its addition to the list of comparators suggests that we look to what the countries of NE Asia have in common—competitive exchange rates, reputable educational systems, demographic transitions, and high savings—rather than to what is different between them—industrial policy—in explaining their success. And the inclusion of Singapore in the reference set would force him to admit that part of SE Asia has already made it.

His attitude to SE Asia is in fact something of a mystery. He says on p.160 that it is difficult for him to see how any of the Asian stock markets contributed to development. Let me tell him: by letting firms raise money, and without the danger of strangling themselves by excessive leverage. On p. 166 he tells us that Thailand had been going completely the wrong way prior to 1997, but two pages before that he told us that Thailand was the world’s fastest developing country over the decade 1987-96. He added that this did not signify real development. In the sense in which he defines real development, as implying mastery of more advanced techniques, this may be right, but it makes one wonder about his definition. If there are alternative paths to advanced-country living standards that maybe involve less sacrifice of the current generation, why not take them?

Let us suppose for the sake of the argument that Studwell is correct in his description of how NE Asia developed. (I have a feeling that he is closer to the truth than all those who tried to make out that they succeeded because they were really paragons of liberal virtue.) At the same time, he does not convince me that this is the only route to development. What stands out from his description is the price that was paid for developmental success: he records how Korean businessmen were at one stage locked up (p. 89); foreign holidays by Koreans were banned as late as the 1980s (p. 149); the high rates of inflation that were endured by Koreans right up to the 1980s; the negative real rates of interest paid on Korean deposits and even in the kerb market when there was a crisis (p. 149); and so on. (Not to mention the deprivations experienced by Chinese consumers as the counterpart to the massive accumulation of reserves—reserves that will have a negative yield—by the People’s Bank of China.) Surely development à la NE Asia works, but it works at a terrible cost to the first (and maybe second) generations. If (as I argue above) there are alternative routes to high-income status and these alternatives demand fewer sacrifices en route, then one has to judge the demand that countries master ever more advanced techniques as quixotic.

Another paper that I read (in Portuguese) simultaneously with this book calculates the expected proportion of GDP contributed by industry over the period 2001-07, the expected proportion being determined by a regression equation containing per capita income, its square, population, and population density (Bonelli, Pessoa, and Matos 2013). An extract of their results shows:

Observed value         Lower limit     Expected value      Upper limit

Brazil                          0.15                      0.16                      0.18                      0.20

China                          0.32                      0.22                     0.28                      0.33

Germany                    0.21                      0.16                      0.19                      0.21

India                           0.15                      0.18                      0.22                      0.26

Japan                          0.21                      0.19                      0.21                      0.24

Korea                          0.24                      0.20                     0.22                     0.24

Thailand                     0.34                      0.17                      0.20                     0.23

UK                               0.13                      0.13                      0.16                      0.19

US                               0.14                      0.10                      0.14                      0.17

None of the NE Asian countries, nor Germany for that matter, are shown as falling significantly above the expected proportion of income. Ironically, the one country exhibiting clear signs of what they dub the “Soviet disease” (the opposite to the famous Dutch disease) is Thailand. Ah, but doubtless Studwell would fault them for having the wrong type of industry!

Let me note in closing that Studwell uses the term “Washington Consensus” with great frequency and always in what I think of as the populist sense. In n.3 he asserts, quite wrongly, that in introducing the term I favored floating exchange rates and unrestricted capital mobility: in fact I was quite explicit in condemning both. It is this that distinguishes the populist sense of the term (“populist” because it is used to signify policies that would discredit it in the minds of the audiences addressed) from my initial usage.

To return to the main theme, I welcome, though without much hope of his making an impact, the emphasis on land reform. But to assert that real development consists only of the process of mastering ever more advanced industrial techniques condemns most countries to remaining undeveloped. It has still to be proved that most countries cannot aspire to developed-country living standards without mastering the most advanced techniques. Unless this happens to be true, the notion of having a separate economics of development and then changing over to a concern with efficiency at some point in time, makes no sense.

References

Bonelli, Regis, Samuel Pessoa, and Silvia Matos. 2013. “Desindustrialzação no Brasil: fatos e interpretação”, in E. Bacha and M. Baugareten, eds., O Futuro da Indústria no Brasil (Rio de Janeiro: Editora José Olympio Ltda).

Studwell, Joe. 2013. How Asia Works: Success and Failure in the World’s Most Dynamic Region. (New York: Grove Press.)

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Corporate Taxation

The OECD has just announced a program of “detailed work on about a dozen of the most contentious issues, including the treatment of digital businesses and the rules on transfer pricing” in furtherance of its proposed Action Plan on tackling base erosion and profit shifting caused by globalization. There is a much simpler way of achieving the objective of tackling base erosion and profit shifting by corporations seeking “tax efficiency” than that being pursued by the OECD, which appears to have signed on to the idea of country-by-country reporting as the main modification of the current system. This is the idea usually described as unitary taxation, meaning common worldwide taxation of corporate profits.

Unitary taxation is usually criticized as diminishing national sovereignty. This is of course correct; the rate of unitary taxation would be set on a worldwide basis rather than by individual nation states. The question is how much this costs nations when the forces of tax competition oblige them to impose much the same levy for fear of losing revenue. There are those who believe that their particular nations gain by tax competition and would therefore oppose anything that would curtail it, but their attitude can be criticized as myopic; any short-run gain comes at the expense of other countries and lasts only as long as those other countries do not reduce their tax rates. The only logical basis for opposing unitary taxation is that it would help maintain the rate of corporate taxation, which will be judged undesirable by those who wish to see the abolition of all corporate taxation (for which there is some economic logic, though the likely cost would be further concentration of income).

Unitary taxation would demand a formula for sharing out the profits of a multinational company between the countries where it operates. There is no ambiguity about the distribution of sales, apart from those introduced by the variability of exchange rates, which could easily be resolved by adoption of a convention (e.g. to use the rates officially announced monthly by the IMF). There is a further important addition to ambiguity in the case of costs, since these include the costs of capital, and of research and development. These may, or may not, be amortized over several years. My inclination would be to leave this decision up to the individual firm, providing only that it sticks with the same rule each year. In addition, there would need to be a value-judgment regarding the rule for combining costs and sales. I cannot see that one needs to vary this by industry, although doubtless this case will be argued by some. A simple rule of 50:50 would seem as good as any.

Under these conventions, country A would be entitled to receive from firm X a payment equal to

t[½α(A) + ½β(A)]π

where t is the rate of corporate taxation, α(A) is the share of firm X’s revenues derived from A, β(A) is the share of firm X’s costs in A, and π is the firm’s worldwide profit (= ΣiRi – ΣiCi = R – C, where R is the firm’s total revenue and C is its total costs).

The great advantage of this approach is that it would dispense with the need for rules on transfer pricing, at the cost of a sacrifice of national sovereignty that is largely mythical. It seems a modest price to pay.

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The UK Fiscal Debate

When the present government was first formed, I expressed support for the fiscal strategy outlined by George Osborne, the new Chancellor, subject to the understanding that the pace of fiscal tightening would be scaled back in the event of outcomes for the real economy markedly worse than forecast. I continue to feel unease at the prospect of a new burst of fiscal expansion designed to reignite the economy, as is being widely advocated in professional circles. Why?

It is not that I doubt the truths of Keynesian economics, let alone the proposition that it is better to have big deficits when there is excess aggregate supply and to make up the lost revenue by raising taxes and/or reducing expenditure when the economy is in boom. Of course, the reluctance of many of the present Keynesians to support large fiscal surpluses during the last boom (in 2005-08) hardly gives them great credibility. (Similarly, most British economists refuse to acknowledge that fixing the sterling rate by joining the euro when it was first formed would have had the great virtue of ruling out as immediately inflationary the irresponsible fiscal policies of the pre-2007 years.) But all that is water under the bridge. The basic reason for concern at the prospect of renewed fiscal expansion is because this involves adding to debt. And high debt is a bad thing: because it involves transferring income to the present generation (which has already done quite nicely, thanks Jack) from future generations; because it involves lowering the potential growth rate (this has not been denied in the Rogoff-Reinhardt controversy); because it increases the chance of a currency collapse. And there can be no doubt that fiscal expansion would increase the level of debt, and the ratio of debt to potential GDP (the conceptually relevant measure), even though it is true enough that it is not certain that it would increase the ratio of debt to actual GDP, as many of the proponents of fiscal expansion have argued with great vehemence. No one sensible (i.e. someone who has absorbed Keynesian economics and not subsequently engaged in an intellectual abnegation called “rejecting Keynes”) denies that a reduction in fiscal expansion is likely to reduce the level of GDP in the short term. But the essence of economics is weighing off one good against another, and the question is whether this means that the lower debt is bought at too high a price. There seem to me to be two arguments as to why a lower debt may be worth sacrificing some current income. The first argument is that one cannot be sure that there will be the possibility of reversing the increase in debt while there is still time. It is all very well to proclaim, the principle that fiscal policy should be tightened when times are good, but this takes it for granted that times will improve. A danger in delaying action is that if recovery does not follow promptly even with fiscal expansion then it may become necessary to tighten policy at an even more inopportune time. Indeed, the present government has argued that it found itself in this situation: that if only there had been tighter policies in the past, there would be less need to tighten policy now. Admittedly the argument that there is no alternative but to tighten policy now is highly speculative: It is only true if a continuation of existing spending policies without a tax increase to pay for them (or a new stimulus, where that is what is being urged) threatens to tip the economy into crisis. But the counter-argument that because the government is currently able to borrow at low interest rates this danger can be ignored is unpersuasive: a few weeks before the Greek crisis started the Greek sovereign was able to borrow at only a few basis points more than Germany. In other words, one cannot predict how or when a crisis will emerge. All one can say with any confidence is that actions which violate the transversality conditions1 will sooner or later generate a crisis. Hence it is safer to avoid violating the transversality conditions, knowing that one cannot predict the next crisis. The other danger with delay is that the tightening may never happen, for political reasons. No politician will welcome the prospect of having his time in office remembered for the fiscal contraction undertaken, and there are countervailing arguments. They look phony enough to anyone with an economics education, but that does not mean that they do not have political appeal. Can’t you already hear it: You want to cut expenditure when we have the resources to afford it? Already the reduction in the budget deficit in the United States in recent weeks (written on May 18, 2013) is being cited as reducing the need to cut public expenditure. It is asking a lot to expect politicians to take actions that are contrary to common sense just because they are theoretically correct. So if one does not reduce spending (or raise taxes) when times are difficult, it may never get cut at all. So where does this lead me? To the same place as the IMF: Advocacy of less fiscal contraction in the short run than is currently planned, within a framework of regarding fiscal contraction as generally a good thing.

1 The transversality conditions are those that guarantee solvency in the long run.
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