Sunday, 25 January 2015

Being an economist

A few months back The Economist had a great text about economists and how they are, apparently, getting too big for their britches. Here's a few excerpts: 
"...Despite their collective failure to predict the financial crisis ... economists are still very influential. They write newspaper columns, advise politicians and offer expensive consulting services to business-folk far more than other academics. 
 ...economists have come to believe that they are superior. A survey in 1985 found that just 9% of graduate students in economics at Harvard strongly believed that economics was “the most scientific of the social sciences”. But as economics became ever more mathematical, its practitioners grew in self-confidence. By 2003 54% of the graduate economists studying at Harvard strongly agreed with the statement... 
...economists demonstrate their self-belief in subtler ways too. Articles in the American Economic Review cite the top 25 political-science journals one-fifth as often as the articles in the American Political Science Reviewcite the top 25 economics journals. Another study found that American economics professors were less likely than their peers in other subjects to agree with the notion that “interdisciplinary knowledge is better than knowledge obtained by a single discipline.” 
"The odd thing, the authors argue, is that we believe in economists almost as much as they believe in themselves."
The paper the article refers to is available here.

If this is the norm, and if economists are suddenly developing a high opinion of themselves (justifiable to some extent, apart from the quacks), then this could be one of their biggest problems:

HT: Marginal revolution

No more scientific-based debates in the field. This may well lead to complacency and even more dangerously - confirmation bias. It is surprising that even during the current crisis debates in top journals have been absent. This probably has a lot to do with the ascent of economic blogs. The debates have simply moved there. However academic blogs, even very good ones, are not science. They're fun and useful for getting quick information, but they're not science. 

Another reason for the lack of journal-based debates is probably due to the fact that publication in a top economic journal takes a very long time (years even). Much longer than in natural sciences (see The Royal Society for example). So a debate between two opposing ideas is being done much quicker via blogs. Taking the discussion to a journal requires building a model, and/or a lot of empirical testing (which is certainly justified). 

However, if I was to be asked what's the biggest threat to economics as a science (fragile as it is), it would be that its models become an aim in themselves. That's what math is all about, and to some extent economists still tend to get preoccupied with math or game theory as the 'ultimate knowledge'. If one masters math, the saying goes, he/she must be a worthy scientist. Mastering math is only a necessary condition to be a worthy scientist. A sufficient one is to actually apply it. Math is a tool, as is game theory. You use tools to help you get a certain conclusion, a finding. But even more importantly one needs to test this finding using a rigorous scientific method. 

This is what makes me optimistic about the future of economics as a science. I'm seeing more and more academic papers based on applying a scientific method, experiment-based, and less and less focusing on what we can call politically-biased macro (Noah Smith has a lot to say about this, check it our here, here or here).

We all, of course, study economics to understand, influence and possibly (hopefully) design economic policy to make the economy better, more efficient. Even those with "wrong" ideas have only the best intentions. However, too much focus in economics has been placed on designing the "right" macroeconomic (fiscal or monetary) policy. In my opinion, the research direction should go the other way. First we experimentally test and analyze the current policies, find out what's wrong with them and then fix them. No grand scheme, no one-size-fits-all approach. A bottom-up, micro-based approach. This is why I subscribe to institutional economics. It's all about fixing one institution at a time and eventually change the paradigm. Changing informal institutions by changing the formal institutions. And vice versa. It's all self-perpetuating anyway. 

Friday, 2 January 2015

2015: Back to Realpolitik and back to growth

Well, well, well, it seems the Cold War era is back upon us. And I'm not just saying this as a consequence of a holiday season James Bond movie marathon that I watched. No, it's real, or to be more precise it's - Realpolitik! It seems that diplomats are setting the stage once again, and that the debate over Russia vs the West is likely to overtake the debate on the economy next year. Which is good on one hand as it implies that the economy is recovering so it's no longer the main focus of attention, but on the other hand it's bad since foreign policy standoffs only build uncertainty and are not good for economic recoveries. But overall the economy actually is expected to perform quite well next year (well, apart from Russia, but more on that below). Low oil prices will be the key in prompting a stronger recovery. The IMF links a 10% change in oil prices to roughly 0.2% change in global GDP. Prices that have fallen by 50% in the last 6 months are likely to be a significant boost to growth in 2015. The outlook, thus, is a positive one.


Since last year's predictions were quite precise, I am hoping that this year they be even better.

The first big issue is: will the central bankers raise interest rates next year? This is now becoming increasingly likely. The FED will be first to do so amid a stronger recovery in the US. In March last year, the FOMC has announced a rate rise to about 1% in 2015, and slightly below 2% in 2016. The market has had time to adapt to this announcement and has reacted rather well. As I've stated back in March when the rate increase was announced, this won't cause any commotion on the markets, even in the short run. The BoE may follow them in this decision, while the ECB probably won't. The ECB will however go into even stronger quantitative easing next year, still buying time for structural reforms. Draghi has announced this last month, and from what I've heard in my trip to the ECB in the beginning of December, they are convinced they are doing everything they can to help Eurozone via low interest rates and unconventional monetary policies. So obviously the ECB won't directly start the recovery in Europe, this is still left upon Europe's governments. The Bank of Japan also will not increase interest rates next year.

What about the recovery? Is next year the year? Well, yes and no. Yes, as Europe (Eurozone) will continue to grow at around 1% as it did this year, however this won't mean that a robust recovery has started. Unemployment will stay high (particularly in France and Italy), despite some members improving their unemployment situation (Spain, Greece, Ireland, Portugal). Inflation will stay low (the threat of deflation is becoming Europe's serious long run issue), budget deficits will be lower than this year, and we might even see some structural reforms implemented (however their distribution will certainly be skewed and limited to a few countries). So in Europe the year is expected to be a year of positive trends, but they still won't be felt by the majority of its citizens. I stand by what I wrote last year: the recovery is happening despite, not because of the policies enacted by the politicians. It is being led by global growth fundamentals (energy booms, international trade, low oil prices, etc.), not by reforms from within. This still makes Europe fragile and sensitive to any external shocks. Which are plentiful nowadays.

The "it" country in Europe in terms of growth this year will be Ireland (3.5%). The country with the worst performance will be either Cyprus or Croatia (both probably around 0%, perhaps even negative growth).

In the United States I predict around 3% growth for next year, driven by a resurgent Silicon Valley boom, and by low oil prices. It's hard to precisely predict how low oil prices will affect the country, since the US is the world's biggest producer, consumer and importer of oil. However in net terms the US spends much more than it produces (as I've said, it is also the largest importer), so low oil prices will certainly provide a net benefit for the US economy. It might, however, hurt a lot of newly formed shale gas producers and hence contract their exports (along with a stronger dollar). In terms of monetary policy, falling oil prices will certainly push inflation expectations down, but all in all I don't expect the Fed postponing the interest rate increase because of it. The opportunity cost of sending a signal of uncertainty is too high for the Fed to renege on its announcements. 

In political terms, the current standoff remains. The Republicans and the Democrats will start preparing their candidates for the 2016 primaries (due to begin in January), where it seems very likely that the Democrats' strongest nominee will be Hillary Clinton. As for the Republicans many names are being thrown in, so it's hard to predict who might emerge as a likely candidate at this point. By the end of the year we might get a more clear picture.

In Japan, the growth rate will be positive, although less than 1%. It still suffers from many of the same problems as it did in the past 20 years, and Abenomics has clearly failed as the remedy it was hoping to be. The rise in consumption tax has hurt them much more than expected. Japan doesn't have a problem with unemployment as Europe clearly has, but its fiscal balance and gross public debt are still huge issues. Japan is a very puzzling story, a scenario that is very likely to capture Europe in the next 5 to 10 years. It seems that nothing works to prompt Japanese growth. Any short-term macro policies aimed at boosting growth are counterbalanced by a problematic fiscal situation. Japan remains in its limbo state for another year. 

For Germany next year won't be a year with strong economic growth. It will be around the European average of 1%. Introducing the minimum wage should have a neutral net effect on growth (as for many the minimum wage will just replace the benefits they've been receiving so there's no expected increase in consumption). The biggest drag on growth will be a balanced budget. But the Germans are well aware what they are sacrificing for this. For an ageing country overburdened with debt, balancing the budget is a necessity to prevent long term problems. Germany is today preventing the possible collapse of tomorrow. That is the smart way to do it. If (when?) a new structural shock hits Europe, Germany is probably the only country that will be ready for it. Losing a few years of strong growth to see your debt drop down to below 60% of GDP in 3 years, is worth it. Particularly since Germany has strong structural fundamentals that enable its productive capacities to flourish and make sure it can always count on its exports. And finally, low oil prices will certainly help Germany  in the following year. 

In the UK, the general election is coming up. The main prediction is that the Conservatives will stay in power, and that UKIP will become a parliamentary party (they already have two MPs in Parliament, but these were defectors from the Conservatives; UKIP has yet to perform well in a national election - and they will in 2015). On what do I base this prediction? Well, look at the pools, Labour is on a downward trend - its lead over the Conservatives went down from an average 8-9 p.p. in 2013 to about 2-3 p.p. in 2014. Next year it's only going to get worse for Labour as the economy continues to recover and as immigration takes the stage as the main issue in Britain. The problem with the polls is how they translate into actual seats. Having a 15% support for UKIP doesn't imply they get 15% of seats in Parliament. In the first-past-the-post system, it's all about getting wins in constituencies. Although it's hard to imagine a coalition of Conservatives and UKIP, I predict that the Conservatives will enjoy a minority government, with UKIP (and what's left of the LibDems) giving them support to form the government. I don't think there will be a National government of Conservatives and Labour, as some tend to predict. Not in these elections at least.

As for the economy, it will continue on a stable growth trajectory with around 2.5% GDP growth, and more importantly with unemployment declining and the budget deficit decreasing. Housing prices will continue to rise in Britain, although perhaps not as much in London, at least in the super-prime property market.

International relations

In terms of global, foreign policy predictions, many battles wait upon us.

By the end of last year no one saw the annexation of Crimea coming. It was one of those fat tail events that just take everyone by surprise. Another similar event was the rise of ISIS (or ISIL), a radical Islamist rebel group based in Iraq and Syria. Although few could have predicted their ascend last year, the rise of Islamist radicalism was an inevitable consequence of foreign military interventions in Iraq and the Middle East, lasting for more than 10 years by now (after all, they started gaining strength back in 2006).

How will these two major threats to stability be overcome? First off, the fight against ISIS is highly unpredictable. Currently the emphasis is for the Iraqi and Syrian armies to fight them off. So far the US and the NATO are only providing support in terms of training and equipment (US special forces are already there assisting with air strikes). However if things escalate beyond control, I wouldn't be too surprised to see the US putting troops back on the ground and leading the fight against ISIS. In his final two years in office Obama has nothing to lose with such a decision. But again, this will only happen if the conflict escalates beyond control and ISIS starts gaining more power. 

As for Ukraine, in 2015 it is likely to remain in its current status quo. Putin, facing domestic pressure of a declining economy for the first time in his 14-year reign, won't risk new conflicts over Ukraine, but is very likely to increase nationalist and protectionist rhetoric back home, primarily to protect his strong position. It is this rhetoric that will dominate the scene next year. 

The biggest pressure for Putin will be the price of oil. For a very long time (actually for the full duration of Putin's reign) Russia has profited heavily from high energy prices. Not anymore, as next year the price of Brent oil will probably drop below $50 per barrel at one point and will remain low throughout the first half of the year. Putin has failed to use the accumulated wealth from oil and gas earnings to structurally change Russia's economy, and reduce its dependence on energy prices. Even worse Putin has used the accumulated wealth as a typical dictator - to empower his cronies (his winning coalition), thus strengthening his hold on power. That was and still is bad for Russia, as its people are now painfully realizing as the Ruble has plunged about 40% against the dollar.
Oil prices, 1946-2014. Source
The sanctions from the EU aren't helpful either, as the Ruble will continue to decline if things remain the same, pilling up pressure on Putin. This will imply one of the following scenarios: the Russian central bank defends the nominal exchange rate by selling its foreign reserves, which could provide to be extremely costly and can push the country into a real recession (recall the Bank of England trying to protect the pound back in 1992 when Soros imposed a 27bn loss upon them); or having the government defend the exchange rate by engaging into austerity policies, which is also likely to push Russia into a recession. Leaving things as they are and allowing the currency to float with limited sales of reserves (a strategy the Russian central bank is applying) will also hurt the country economically next year. Russia is facing a serious economic crisis, in many ways self-imposed - dependency on oil and gas, cronyism, and foreign policy interventions have finally caught up with Putin. History is repeating itself for Russia, only this time their position of power was short-lived. However Putin won't go down that easily. That's why I expect a resurgence of Realpolitik in foreign relations. 

In China growth will fall below 7%, slightly below expectations. Will next year be the bubble burst for China? Maybe, maybe not. As I've learned from last year's predictions, predicting exactly when will the Chinese bubble burst is an unrewarding task. After all, this too is a fat tail event, so its occurrence will surely be surprising. As for the slight pessimism over China's slowdown, it is due primarily based on reports on weak property sales, a decline in fixed investments and the manufacturing sector, and expected low inflation and lower consumer spending. However let's not forget that low oil prices will significantly benefit China as well. China is the second largest net importer of oil. 

In India after a gloomy year expect the growth rate to accelerate under new leadership of Narendra Modi. There are many reasons for optimism in India; low oil prices will ease the pressure on high inflation and the current account deficit (India imports 70% of its oil consumption). This will enable India's central bank to cut interest rates in order to help the government promote some structural changes to India's economy (the government has already started applying reforms focused on better governance, fiscal prudence and ease of doing business, with the labor reform announced next year, in addition to attracting new investments from China and Japan). All this will help its economy grow above 6% next year. 

As for the rest of the emerging markets? A strong dollar certainly doesn't help, neither does the announced increase in interest rates from the Fed. Low commodity prices and low oil prices will hit the commodity and oil exporters (particularly in Africa and South America). Bond yields are on the rise in most of the emerging markets, so I do expect another growth slowdown next year for the EMs. 

Altogether, it will be a year of positive growth rates, but not everyone will feel it, particularly in Europe. Low oil prices will drive most of the positive growth in the West (and in India and China), but not everyone will be happy because of it. The international stage has been set for muscle flexing, something Putin is very good at (both figuratively and literally). It won't last too long, but in my opinion it will dominate the debates in the following year. I do hope that I'm wrong this time.

Happy new 2015! 

Friday, 26 December 2014

Hits and misses: Evaluation of last year's predictions

As 2014 is coming to an end, this is a good time to wrap up the year and look back at some of the events that passed us by, but most importantly it's a good time to present a quick overview of the predictions I've made in the beginning of the year and assess how good they were. 

I actually had quite a lot of hits, and only a few misses this year. I won't be modest in saying that I'm getting pretty good at this. Perhaps reading Bueno De Mesquita's "The Predictioneer's Game", and Nate Silver's "The Signal and the Noise" rubbed off some of its magic on me?  

Here goes (the predictions for 2014 were made on January 2nd 2014):

The Hits: 

1. "next year a stronger recovery should finally kick off in most of the Western world. Emerging markets will grow too, however less dynamically than before...In America the energy boom will reignite the recovery momentum...America's stronger growth will rub off on Europe as well, so we can finally expect to see the Eurozone with positive growth rates next year (around 1%)...."

This was spot on. The Eurozone grew at 0.8% (the EU at 1.3%), the US reignited their momentum, while the emerging markets slowed down (their growth dropped from an average 7% to 4.4%, amid rising bond yields). 

2. "Central banks will keep rates low in 2014."

This was kinda obvious.

3. "I often make predictions of the World and Euro Cup winners just before the tournament, and I often come close. This time my call is Germany...
...In the other half-final, I see Germany and Brazil, where Brazil will crumble under pressure and lose..."

Painfully accurate! (painfully for Brazil of course)

4. "In Europe, the EU parliamentary elections in May will give rise to anti-EU parties (both far-left and far-right), mostly thanks to low turnout and discontent with economic recovery from the majority of the population."

Yet another painfully accurate prediction. 

5. "In the UK, growth will be better than last year, probably somewhere around 2%. It will mostly rest upon the housing recovery and an improving global environment."

Not too far off, growth will probably be around 2.6% for this year. 

6. "The Scots will vote no. The majority of the population is Scotland doesn't want independence, but rather more power for their country within the Union... They will get this, but not next year."

Got that one right too, even on the long term issue of constitutional reform in Britain.

7. - 12. A number of predictions for the US came out true:

"An immigration reform is expected sometime next year...
...Obamacare, the hot issue in America, will not be repealed. The individual mandate will be triggered in 2014, but despite this many will still stay uninsured...
...The health spending budget will rise even higher, currently around 18% of GDP. This will most likely hurt the Democrats in the November midterm Congressional elections, ... but the power struggle in Washington will remain as it is...
...The recovery will continue steadily with the country growing at around 3%, led by a housing recovery and an energy boom."

Only one miss here: "the power struggle in Washington will remain as it is"

Republicans got hold over the Senate. However one can say that the power struggle on the line President vs Congress did actually remain as it is.

13. "India expects general elections in 2014, where Narendra Modi is expected to become the next PM. The economy will remain to be weak, suffering from high inflation, a large budget deficit, weak currency, rising debt and loss of international confidence." 

Modi did become the PM (and it was a landslide victory), while India's economy remained structurally weak. It does however have reasons for optimism in 2015 (in part due to declining oil prices), but that will be covered in next week's post, in the predictions for 2015. 

14. "In Brazil ... I don't expect the mass protests that have happened last summer during the Confederations Cup to be repeated this summer."

15. "The recovery is not happening because of the policies enacted by the politicians, it is happening despite them (like the housing and energy booms or the reemergence of international trade). It will be bad if the politicians take this good news lightly and halt the necessary reforms. Unfortunately, it seems that this is exactly what will happen." 

A warning sign that went unnoticed. Particularly in France and Italy, so it seems. 

The Misses:

1. "Japan too will continue with positive results, riding on Abenomics, although it will most likely fail to lift inflation to the targeted 2% next year." 

I predicted correctly that inflation will stay low, but I was way too optimistic on Abenomics. I blame it on the bias of the Economist. I got carried away after reading their optimistic reports on Abe as the Japanese Superman (I'm not kidding, this was even a cover of an issue in 2013).

2. "Latvia will once again be the fastest growing member at around 4% growth...
...the largest negative growth will face Greece or Slovenia (around -1%)..."

Latvia grew (at 2.6%), but it wasn't the fastest growing member. This esteemed title went to Ireland (4.6%). Greece was a miss (kudos to Greece for finally reaching positive growth figures, even if marginal) as was Slovenia. The worst was - Cyprus (-2.8%, according to the EC). Note: these estimates don't take into consideration the final quarter of 2014, but already we can notice the trends and declare "victors". 

3. "Chinese growth will drop down below 7%. Will next year be the year of the bubble burst in China? Possibly." 

Underestimating China again? Oh well, maybe next year.

4. Brazil: "I'm not sure Rousseff will hold onto power." 

She did. A very narrow victory (51.6%), but a victory nonetheless.

5. "World Cup: The wild horse will be Belgium, which could reach the half-finals, where it will probably face Spain or Uruguay. In the other half-final, I see Germany and Brazil, where Brazil will crumble under pressure and lose, but will go on and win the third place playoff." 

Ok, so Spain and Uruguay were misses, as was the Brazilian third place, but Belgium did ok, didn't it?

Under the radar: 

I didn't include anything on the Ukrainian situation, as by the end of last year it merely started unfolding. This set the stage for a whole new, cold-war-reminiscent, foreign policy battle that hardly anyone could have anticipated. For Putin I stated that the Sochi Winter Olympics are "expected to be a combination of extravagance, glamour, waste and corruption. But also it will be a new showcase of Putin's power to the rest of the world."

Well, Putin used something else to showcase his power. Something much more convincing - the Russian army.

And with this image I wish all my readers a Merry Christmas and a Happy New 2015!

Monday, 15 December 2014

Why Germany is right to "hold Europe ransom"

As I've stated in an earlier post, my recent trip to Germany has been full of positive experiences. Most importantly I gained insight into why Germany (i.e. its formal institutions) feels so strongly about the agenda for structural reforms and why it opposes any alternatives, particularly looser monetary policy and the idea that Germany should stimulate its economy to raise European aggregate demand.

A country that was once called the "Sick man of Europe", was the first to undergo painful reforms. Back in 2003 they started with preparation and implementation of the so-called Agenda 2010, which I covered on several occasions in the blog (see here or here). The Agenda carried a series of reforms, but the most notable and important ones were the labor market reforms (i.e. Hartz reforms), because of which Germany was able to cushion the blow of the 2008/09 crisis. Germany had the lowest increase in unemployment (virtually none) of all European countries during the crisis. 

The labor market reforms necessitated a joint approach from all sides, so the negotiations that started in 2003 included the federal government, businesses, unions, parliamentary representatives (i.e. all political parties) and even scientists. The centerpiece of the labor market reform was to curb the power of unions and craft guilds, making it easier for the young to enter the market, while contributing to the labor market flexibilization. The unemployment benefits were cut (a German can draw unemployment benefits only around half as long as an American), tax reliefs were introduced to those hiring, in addition to a whole set of marginal but important measures. The initial reaction was, as always, a shock. Unemployment increased as businesses started optimizing their labor intake (and hence firing more), coupled with dissatisfaction among the unions and guilds which in the end cost Chancellor Schroeder the elections. But the system was reformed. And it was precisely because of these reforms that Germany weathered the crisis much better than any other country in Europe. 

Leading by example: a balanced budget 

And once again Germany is leading the way in showing how to get out of the mess of unsustainable debt and sluggish growth. It is leading by example - next fiscal year Germany will have a balanced budget for the first time in decades. According to the debt projections, labor market trends and most importantly demographic trends (an ageing population), cutting debt is essential. An old population overburdened with debt is no promising future. Which is precisely why the number one priority of the government at this moment is to cut debt. How does one do that? "Easy", start by balancing your budget. The figures below show a strong statement of intent: Germany intends to have a budget surplus until the debt-to-GDP level is cut down to the Maastricht ratio of 60%. According to the existing projections, Germany will achieve this in 2018, so in only four years! Take note Eurozone periphery, this is what proper austerity looks like: 

Source: Federal Ministry of Finance
Source: Federal Ministry of Finance
Will this affect their GDP growth? Most surely. Growth will remain to be low at around 1 to 2% in the next few years, but just like in 2003, the system needs to be changed. And in this case the system needs a debt decrease. The opportunity cost of a temporary slowdown is low enough to justify the austerity approach applied by the Germans.

Criticism from the EU

However this zero deficit approach generates fierce criticism across the EU. Many have stated that Germany should continue to pile up debt to keep aggregate demand in Europe higher. They blame Germany on "holding Europe ransom" by forcing them into austerity without providing any relief. Germany should, according to the critics, provide more fiscal stimuli into Europe (indirectly of course) to help the rest recover as quickly as Germany did. However the German logic makes more sense. Germany is not in a recession (contraction) so it sees no point in applying the classical counter-cyclical solutions such as large spending hikes. Instead they opt for encouraging private investments instead of large public investments. This is best done with measures such as capital gains tax write-offs, lower corporate taxes, lower income taxes and other regulatory and non-regulatory (legal) measures aimed at helping businesses grow (see here a short guide for attracting foreign investments). Attracting private investments is the right approach, everything else in a state of unsustainable debt is wrong. FYI, private investments in Germany consist of 17% of its GDP, whereas public ones consists of only 1.8%. 

Germany has its own problems it needs to take care of. As mentioned, with an ageing population large public debt becomes a big problem. Not now, but in the near future. And Germany wants to address this issue immediately, not wait until it's too late. 

Furthermore the rest of Europe isn't far away from the German problem. They too are overburdened with debt, and Europe in general is ageing. Demanding large stimuli and further indebtedness is self-defeating, particularly in the long run, which isn't so far away. Even in the short run it won't cause the effect it is supposed to. Why? Because the private sector deleveraging in Europe as well. Two IMF economists show why this is a drag on growth particularly if all three major sectors of the economy (government, households and corporates) have high debt levels:

Source: VoxEU
The other reason is lack of lending. Banks are safe (according to the latest ECB stress test), but still unwilling to lend. And then we reach monetary policy. Critics of the ECB (and hence the Bundesbank) call for looser monetary policy, i.e. for a more expansionary approach. According to this argument it would be best to simultaneously apply both expansionary monetary policy and an expansionary fiscal policy to raise European aggregate demand. And then do the reforms, which everyone agrees are necessary. 

Where have I seen this approach fail most recently? Oh, that's right, Abenomics, the policy package of Japanese PM Shinzo Abe aimed at finally pulling Japan out of a 20-year-long stagnation. It's not so wise however to use the same policies that have failed consistently for 20 years and then hoping that suddenly they will make a difference. Even if applied simultaneously

Europe tries to do the same thing. Avoid a painful solution and provide persistent short-term stimuli, hoping that at one point they will make it. Economics doesn't work that way unfortunately. Not when there's so many structural unbalances as they are today in Europe (and Japan). Which is why, in my honest opinion, Germany holds the key to Europe's success. Leading by example in balancing their budget, while forcing structural reforms upon other nations is the only way to go for Europe. Everything else leaves them in a state of Japanese-style decades-long stagnation.

***

Addendum: One of the most commendable things about Germany's economic policies is the continued increase of investment in education. Despite the crisis and the (brief) recovery period, Germany increased spending on education from 3% to GDP before the crisis to almost 5% to GDP in 2014. This will be increasing even more, as the Germans have recognized where the foundations for long-run growth lie in (see here for greater detail). 
Source: Federal Ministry of Finance

Sunday, 7 December 2014

The German Social market economy

I've spent the entire last week in Germany, as a part of a delegation of Croatian economists and economic experts, organized by the Konrad Adenauer Stiftung (KAS). The idea was to visit the main economic and political institutions in Germany and open a dialogue on the problems facing Croatia, but primarily to learn about the experiences of the German solutions/responses to the crisis through the conceptual framework of their Social market economy (i.e. the German ordoliberalism). We have visited a series of institutions, starting with the Bundesbank and the ECB in Frankfurt, and ending with the Ministries of Finance, Economy and Energy, Labour and Social Affairs, and even the Office of the Chancellor, all in Berlin. In the middle we visited a series of other noteworthy institutions like BaFin (the regulator of financial services), the Council of Economic Experts, DIW institute, the banking association, a few members of parliament and so on. I plan to write a separate post on some of the main outtakes of the trip, with emphasis on how the Germans see their role in Eurozone, opposed to how the rest of Europe sees it. And rightly so. Before I descend into commenting the actual state of the German economy, I would like to extend a few thoughts on their "unique" idea of the so-called Social market economy. 

But first a little bit about the trip initiators and organizers, the Konrad Adenauer Stiftung. KAS is a political foundation (stiftung means foundation), associated with but independent of the German center-right party CDU which currently holds power in Germany. The idea of the Stiftung is to promote the ideas of freedom, liberty, peace and justice, democratic consolidation, and development, mainly through their civic education programs, but also to provide a basis for political action, all around the world. A similar institution to KAS is a foundation called Friedrich Ebert Stiftung (FES) aligned with the social democratic SPD. Both of these political foundations act as a sort of a shadow embassy outside of Germany, that connect their own parties (parties they're aligned with) with the opposition and in-office party of the country they reside in. In addition to this role, they both act to promote the civil society. KAS has offices in more than 120 countries worldwide, and thus serves a foreign policy role as well. For example they had an important role in the reconciliation and partnership between Germany and Israel, a relationship previously rebuilt by the Chancellor whose name the foundation carries - Konrad Adenauer. Rebuilding this relationship was crucial for Germany after WWII, and was the final step towards designing a new German society, one based on strong institutions, competition and democracy. Or in other words - ordoliberalism. 

Social Market Economy

So what is the Social market economy (in German: Soziale Marktwirtschaft)? According to the prevalent German interpretation it represents a type of market capitalism combined with policies promoting social insurance (protection for the poor, unemployed, health benefits, etc.). It is based on the idea that markets must be in the center, coordinating the economy (prices), while market participants must be constrained by strong and enforceable institutional rules. It is a system based on competition, order, and most of all on setting a clear institutional framework in which the market actors must participate.

Germans are proud of this model, introduced by the great Ludwig Erhard (pictured) back in 1949, who was then a Minister of the Economy, under Chancellor Konrad Adenauer. Erhard was the Economy minister for the entire duration of Adenauer's Chancellorship (14 years, from 1949 to 1963), and succeeded him as the next Chancellor from 1963 to 1966. He is widely lauded as the creator of the Social market economy, presented at the time as the compromising "Third way", something between the laissez faire Anglo-Saxon liberal capitalism (which was still, in the mind of the Germans, to blame for the Great Depression of the 1930s), and the communist central planning system (introduced during the Weimar Republic and fully applied during National Socialism). Germany needed something new at the time, an idea that transcends the fallen ideologies of the past. It needed, for the first time in its history, to apply a truly capitalist, market democracy.

That's why the model was so successful. From 1949, Germany, for the first time in its history, has introduced a democratic system with a market economy. The term most usually related to Erhard and this initial period of German democratic consolidation is the German economic miracle, which has in the 1960s and 1970s crated an economic powerhouse that Germany is today. It didn't start without problems however. In the begining, after the destruction of the Second World War, Germany was under occupation and under price controls and rationing. Housing was destroyed, industrial production as well, food production halved, inflation was an open threat yet again, and a lot of male population died in the war. The task seemed impossible, particularly due to the country being split in half and the animosity arising among its occupiers. But Erhard was stubborn enough to push through his reform despite the fact that many opposed it at the time. Even the allies weren't sure of his ideas. But he abolished the price controls and rationing of food, he limited monopoly power by introducing antitrust laws, reduced marginal tax rates (from 95% to 18% marginal rate), introduced a new currency reform to bring back price stability (and eventually turn the German Mark into the strongest currency in Europe). All the reforms came as an initial shocks, particularly the contraction of the money supply, but the stage was set for Germany to take flight. Literary overnight the country came to life. 


One might ask how is this economic model any different from the one applied in most of Europe today? A market economy with a welfare state - that's what Europe basically is. Some are more successful at it (Germany, Scandinavia, even the UK), while some are less (France, Italy, Spain) - relatively speaking. Who is to say the UK isn't based on the very same principles, even during the Thatcher era? A strong market-based economy, which has a notable social category. The difference here is not so much Germany vs rest of Europe, as it is Germany vs the United States. However the difference here is also in the margins. The US has something called cut-throat capitalism which fosters huge innovation and a keen trial and error process, while Germany (as well as the rest of Europe) has cuddly capitalism, which also innovates but to a lesser extent primarily due to a more lenient trial and error process. (These terms are used by Daron Acemoglu in a very interesting paper he co-authored with Robinson and Verdier, and which raised quite a discussion back when it's working paper version was published).  In Germany for example if you start a business and fail once, you don't dare repeating the same mistake again. In the US it is quite common to start over 4 or 5 times before finding the right recipe for success. After all Merkel recently expressed concern that there is no German Google or German Facebook. There is a reason why this is so, and why those kind of companies originate in the US, not in Europe. Which is not to say one system is better than the other. Both have their strengths, but both have weaknesses as well. The US exhibits higher levels of inequality because of this (even if we look at it historically), but due to its entrepreneurial spirit it has a much shorter time span for recovery and a much quicker response time than Europe. 

Overall, the German success is a unique story, but it's not a unique economic system. It is a market democracy with strong institutions. As easy as this sounds, for many countries there's still a long way to achieve it.