Wednesday, 29 April 2009

IMF In The Dark

Last week, the IMF published its updated global forecasts, as part of the IMF World Economic Outlook, titled ‘Crisis and Recovery’. All the media, all around the world, was completely full of it (FT, NYT, Bloomberg, China Daily, Gulf News, Jakarta Post, The Times of SA, etc., etc.).

Given the hype, it is striking how different this 2009 growth forecasts is from those published half a year and a year ago. The IMF's 2009 world economy forecast, as published in April 2008, foresaw a global growth rate of 3.77%. This was 14 months after the inevitability of the global crunch had gone from being a fringe topic to being top of the agenda. Then half a year later, the 2009 forecast was pushed down to 3.03%. More than a month into the severe crisis (counting from 16 September 2009, when after Lehman Brothers folded in US time, the World woke up to a very different reality). Clearly, the IMF forecasters did not think that the challenges would not be met. Their world economy growth forecast was shaved only by 0.74 percentage points.

In its World Economic Outlook Database update, published last week, the IMF sees the world growth rate in 2009 at -1.32%. That is an astonishing 4.35 percentage point correction on a variable that averaged at 3.45% during the last two decades with a standard deviation of 1.05. In other words, the forecast does not have any meaning, apart from the IMF announcing that it thinks, that it is going to be ‘kinda bad’…

No meaning whatsoever. No meaning.

This is not the first time that the world financial markets, the economic policy makers, and the global economics community, have fallen for a confidently put precise number. I would have thought though that the experience of the past years might incline us to guard against such follies. And make us double check.

Here is a graph with the successive forecast updates from the IMF World Economic Outlook Database: April 2008 in green, October 2008 in blue, and April 2009 in red, with the forecast bit being a broken line.

The first thing to notice is that the forecast changes after the data comes out... The IMF's very complex and sophisticated system yielded an 'adaptive forecast'.

The second thing to notice is that there is always a sharp return to growth (the end of the recession) forecast for the next period. This picture will be familiar to anyone who has spent time listening to economic policy makers around the world explaining away their particular crisis, and trying to convince you that the good times are really just around the corner... I have not seen one treasury presenter, minister or lowly analyst, who would argue otherwise. For their eyes (and tongues) the crises are always about to be over. This experience makes you rather sceptical about graphs with an exceptionally quick return to the previously predicted growth trend.

Here is the same graph zoomed in on the current period.

This helps to point out one more thing: that the April 2008 IMF forecast for 2009 growth assumed that the crisis would already be over by now, and thus 2009 would be the year of recovery.

The uneasy feeling one is left with is not only that the IMF forecasting system is completely (fully, entirely, wholly, utterly, 100%) unreliable at a time when it really matters, but also that they are somewhat dishonest about it. When investment bank analysts produce a rosy picture of their respective instruments, that's sales. So is your average Treasury's similar efforts. But the IMF? Did that red line really have to go back to the trend within a couple of years? Is there any reason why we should believe that the forecasting system (one of the best in the world in my view) that produced this miserable result is going to be any better for the next period? Or should we face the fact that the IMF, and probably all governments around the world are in the dark about what is going to happen?

However, trying to be constructive...

I was wondering, if there was a pattern to the IMF's failure to forecast the world economy's crisis behaviour in a credible way. Are there common characteristics among the countries where there was a large IMF forecast correction, as opposed to the countries where there was a small one?

The second half of this post is a toy study asking that question. There are two hypotheses.

The first hypothesis assumes that there was a common, global shock to the world economy, which hit every country. Then the IMF forecasters might have been wrong about the size of the overall shock, but right about the reaction. If this were true, it might be possible to discern some common characteristic of governance among the effective adapters, and the absence of that characteristic among those struggling.

This hypothesis would be anecdotally supported by the qualitative observation that, among a group of similar countries in Eastern Europe (the best economics lab of recent years), those that have deeply divided societies are doing much worse in the current crisis. (The Baltics, Hungary, Romania, Ukraine all have pilarised elites).

There are some really interesting studies out there connecting economic growth to pilarisation (or fractionalisation) in a convincing way. Jose Montalvo and Marta Reynal-Querol for instance, in their paper, provide a strong case linking economic development to religious and ethnic polarisation. An analysis connecting their polarisation and pilarisation data to the IMF growth forecast correction would be then one way of following up on the East European observation about divided society. (This is how I while away my time...)

Sadly, this yielded a non-result. Although all three forecasts for 2009 growth (April, October 2008 and April 2009) are explained well by the four fractionalisation and polarisation variables of Reynal-Querol, confirming their original finding linking societal division to bad growth performance, none of them have any significant explanatory power vis-a-vis the IMF forecast correction. (One possible reason is that, although the dataset has 131 countries, almost all post-communist transition countries are missing. Hence the anecdotal observation cannot be checked either.)

An alternative approach would be to take indices measuring aspects of governance directly. The Bertelsmann Transition Index, for instance, is a useful set of measures of the 'matureness' of developing country governments. The results (n=117, a few countries from the BTI had to be dropped as they are not reported by the IMF, all mature economies are missing) are more promising. At first, at least. There are quite a lot of factors that have strong and significant explanatory power towards the IMF forecast correction: out of 77 variables there are 15 that have their (second degree polynomial OLS) AR-squared above 10%, the highest being 18%.

Yet, they are all going in the 'wrong' direction. The more advanced the country is, the higher the IMF forecast correction was. This cries for checking these results against the wealth of the nations, proxied by GDP per capita. And there it is: almost all of the effect is picked up by the GDP pc, almost nothing is left. Three variables remain with significant, if rather small, explanatory power: 'stateness', 'no religious dogmas', and 'UN education index'. They are still going in the 'wrong' direction, though, suggesting that the more advanced a country is, the larger the IMF correction was.

Thus Hypothesis 1 is rejected. The IMF forecast correction does not seem to pick up the effect of the respective governments' ability to adapt their policy to the crisis.

However, the above points to a different, second hypothesis. What if the IMF errors are linked to how developed a country is? For this I used the GDP per capita and the UN education index (the latter being the only one from the BTI significant set that is available for all the countries) to explain the IMF 2009 economic growth forecast correction.

The variables are:

IMF: forecast correction size (difference in IMF GDP growth forecast for the year 2009, as projected in Oct 2008, and Apr 2009);
EDU: UN education index (log);
GDP: GDP per capita (IMF data, for 2008; log).
Altogether 171 countries.

Regression 1. IMF on EDU. The AR-squared is 11%. Negative coefficient.

Regression 2. IMF on GDP. The AR-squared is 8%. Negative coefficient.

Regression 3. EDU on GDP. The AR-squared is 55%. The residual is then taken from this regression, with the name 'RES'. Positive coefficient.

Regression 4. IMF on RES. The AR-squared is 3%. Negative coefficient.

Regression 5. IMF on GDP and RES. AR-squared is 11%, with both being significant (P-values under 0.01 for both). Both have negative coefficients.

(All the above are linear OLS, with occasional mild heteroskedasticity.)

Thus it seems that Hypothesis 2 cannot be rejected. The IMF forecast correction tends to be stronger in the case of high GDP and high education levels. (Although the overall explanatory power is not very high, thus pinches of salt should remain at hand.)

In other words, the IMF thought that the rich and well-educated countries would not end up with much trouble on their hands. And they were very wrong.

By October, the credit crunch had been on the agenda for 18 months, and we were well after the Lehman-bankruptcy landmark. Thus, the IMF was very aware that the crisis was upon the global economy. In this light, the above results perhaps suggest that the IMF was in an 'effective government myth': if you are a rich, educated, non-dogmatic country, then you have good economic policy institutions, thus you will be able to react. It seems that no economic policy institution really worked, which surprised the policy optimists. (But, incidentally, not those who argued that national level policy could not possibly suffice without an effective global umbrella.)

So what have we learned? First, that the world's best global economy forecasting system is really, really bad. Second, that early hopes for being saved by government eminence were misplaced. The door is open to new ideas, I presume.

Saturday, 25 April 2009

Designing Taxation

Some years ago I got involved in the very practical exercise of designing a real tax system. It was in a transition country, in Europe, and it was messy.

I learned a number of lessons, some of which might be distantly relevant for the current fashion of re-designing tax systems. So, here they are.

Lesson number one. There is no possibility of an ‘engineering’ debate when it comes to taxes. Anyone who has seen the emergence of a real tax reform can attest: it is always political. And deeply so. For political scientists this is a triviality. However, for economists, far from it. For macro people are acutely aware that - apart from the politically sensitive reallocation of resources - the choice of tax system always has major consequences for the efficiency of the economy. Politicians are usually pre-occupied with the slicing of the pie, and tend to ignore the fact that the way it is sliced is a key determinant of the size of the pie. Economists tend to ignore, in turn, that it is ultimately the politicians who do the slicing.

Thus the first lesson I learned back in those days was that whatever the arguments were (Vickrey-Mirrlees's optimal taxation, Laffer-curved based, progressive or flat) - in real life they are always employed to support a political position. You need to know them all well, otherwise your opponents will slaughter you, but they are still just covers in an essentially political debate.

The upshot is that almost all tax systems have efficiency flaws. So, if you happen to find yourself on the losing side of the ‘debate’, at least you can always attack the winners with valid arguments.

Lesson number two. Even if you wanted to see the project as an ‘engineering’ problem removed from politics, there is no clear evidence about what the ‘best’ solution is. The two tails are covered: we know what is definitely not best. No taxation, no government services: clearly only for the nutcase anarchists. And total taxation leads to the disappearance of economic activity whatsoever, as proven by the total disaster that real world communism was. However, as for the refinements that represent something in the middle, the jury is out. In fact, probably they have gone home and will never come back. There are simply too many countries with too many peculiarities to control for to give a general answer.

Again, the upshot is that you will be hard pressed to find an ‘ultimate piece of evidence’ either for or against any in-between, sensible-sounding solution. So, any real tax system can always be attacked and defended using a carefully selected set of proxy cases from around the world.

However, that means the game is on. If you are a non-political, macroeconomy efficiency maximising social engineer, then you do get to design your optimal tax system. You can play lego with it. You import elements from different countries, from different historical periods, and try to see if they’d work. It can be a surprising amount of fun.

Lesson number three. The hitch is that when you present your freshly finished, super-innovative tax regime you will certainly hit a wall. Big time. First, the revenue people from the Ministry of Finance or Treasury will scream about the added uncertainty any change to the tax system necessarily brings. You may try to look at their models, and argue that they have as little real idea about the revenues as you. But still they have been doing the budget for years (probably decades), and there is no amount of economics argument that you can possibly come up with to counterbalance the fright of the politicians when they are told by the Revenues Experts that inevitable crisis, and the End Of The World is upon us. Unless a gag is put on you, the Risky Economist, your feet are immersed into concrete, and you are promptly tossed into the river.

This wall of macro-accounting conservatism is the main reason why major tax reforms are always the product of crises. Nobody takes the risk in normal times. In meltdown, you might have a chance to push your ideas through. You will still be seen as nuts, anyway.

Lesson number four. Politics is always political. This is sometimes forgotten by economic advisors, but is definitely the case.

The only time when I had a real chance to push through what I thought to be the best tax solution, it would have been a political coup. The freshly elected minority party I was harassing with my ideas needed to cheat on the freshly elected majority party via a clandestine co-operation with the freshly ousted, and much despised, former majority party. I did have an emotional stake in the previous campaign, so this was not exactly my idea of a first best solution. But it would have allowed an important piece of policy to go through.

Somehow, the party leader was convinced that such a trick on the majority party could have been fun - I suspect that he actually cared some of the time - and so he tested the idea in a press leak. He received floods of phone calls from old ladies, who did not know the first thing about the tax system, or care at that, but hated the idea that we would co-operate with the other side. The tax coup did not happen. The country lost all its previous competitive advantage, slid into government overspending, and is now on the brink of bankruptcy… (yes, it is all my fault).

Tax is always political. Even if it was not, there is no obvious ‘best’ solution. Even if there was, there is a murderous bureaucratic conservatism against anything new. And even if a crisis helped you struggle through that, the constituents the politicians play to have no idea about taxes, but very strong preferences nonetheless. Good luck.

Wednesday, 22 April 2009

Rules Versus Discretion, Once More

(About the emotional decision making of the Global Economy)

One of the earliest posts of this blog was about policy rules and policy discretion. The original economics model is generally used to provide evidence for how short term optimisation of policy can screw up your long term rules, and thus lead to a sub-optimal outcome. It is an economy level procrastination problem, which - on the individual level - is also well described, by the behavioural economics lot.

A ‘rational expectations’ approach to the rules versus discretion problem, however, changes it a bit. In this form, the economic agents come up with new assumptions about policy rules when they see the policy maker’s short termist behaviour. And thus not only do the originally announced or implied policy rules go out of the window with the discretionary measures, but new rules also emerge. This is especially the case when the policy maker herself does not have any idea what is going on. Which is, incidentally, the situation now…

Given the above, it is striking how little is discussed about the long term consequences of all these semi-random and fully-random and even-more-random policy ‘innovations’ that governments around the world keep coming up with.

Like, what is going to be the long term consequence of a government backed mortgage payment holiday during crisis? How on Earth will anybody be able to come up with any robust probability function for mortgage defaults? Like: if the debtor gets into trouble, she defaults, unless, there are a lot of others, who are also in trouble, and all of these happen to be the constituencies of the ruling political party… Now try to squeeze that into an algorithm…

Or what is going to be the basis for assessing financial risk? Where will bank valuations come from? Will you have to categorise financial institutions into sizes, the big ones being saved for sure? Is it going to be a continuous distribution? Is there going to be a threshold for triggering government action? How many peaks will this distribution function have? E.g., you don’t save the first big one, then save all further big ones, until too many need saving. Or maybe just one or two more… I would shake the hands of the bank equity analyst who can deal with this one in any credible way.

Or countries. What will be the default probability assigned to any country? Now are these lower or higher than before? Lower, for the behaviour of the global governing institutions the past months suggests that no country is being allowed to run into real bankruptcy. But higher, for if these institutions run out of money, or more importantly political capital, then a lot of countries will default at the same time, pulling each other down.

The trouble is that although all of the above can be modelled, but not in any robust way.

Hence the importance of short term discretionary policies re-defining long term rules. Seeing how these novel ‘rules’ come to life is really disheartening. As if we all, as individuals would make our most important, long lasting decisions based on ad hoc emotional impulses.

Which, incidentally, we all do, of course… Life is a mess for everyone, even if you happen to be the Global Economy.

Tuesday, 14 April 2009

One More Cup For You, Perhaps?

Now that the economic forecasting profession has sunk to the standards of the tea leaf reading lot, it might be worth highlighting the occasional shine through of light. Consider the FT's interview with Cao Jianhai (spread into two articles, on property prices and on macro data). His cautious assessment of the outlook for the Chinese economy should warn all those who read too much into the recent Chinese data. Especially given that the latest fad is to base speedy global recovery scenarios on expecting China's rapid regeneration. And, given that unlike many verbose observers, Cao Jinhai might actually know what he is talking about...

Many in the global forecast profession have argued that the steady Chinese real estate demand will be the ultimate factor we will look back to as the cornerstone of the global recovery. Now here is the Cao-forecast:
average urban residential property prices to fall by 40 to 50 per cent over the next two years from their levels at the end of 2008.[...] Prices may not fall in the near term but I expect a collapse starting next year, followed by many years of stagnation.
He also pointed out that the positive stats people are so excited about were at least partially due to measuring fake transactions as people try to buy into the government stimulus...

The volume of empty apartments across the country hit 91m sq metres at the end of last year, up 32.3 per cent from a year earlier, according to official figures.

Those numbers included neither the huge volumes of completed real estate projects whose owners are waiting for market conditions to improve before they put them on the market, nor the estimated 587m sq m or apartments sold in the past five years but left empty by their owners.
[Cao Jinhai] says positive signs in the property sector are being partly driven by a surge in bank lending, which grew a record Rmb1,890bn in March, bringing the total for the first quarter to Rmb4,580bn. That is more than the entire amount of fresh loans extended last year and nearing the government's full-year target of at least Rmb5,000bn in 2009.

On Thursday, government is expected to announce first quarter GDP growth of 6-7 per cent. But without the surge in new loans, growth would have been closer to 4 per cent, by internal government estimates.

"External trade is dead and it is impossible to force domestic consumption to take up the slack immediately, so we have to rely on bank lending for now," said an official who asked not to be named since he was not authorised to speak to the media. "But the government will never allow the banks to lend like this for the entire year because otherwise we will face hyperinflation and that is what the government is most afraid of."
In my experience, CASS is one of the best places to turn to when one tries to understand what is going on in the Chinese economy. (Here is another one, though.) And thus, to put it bluntly: do not expect global momentum coming from China anytime soon.

Thursday, 9 April 2009

Hopelessness At The Bottom Of The Pit

Emerging markets have always been an enigma for economists. They are poor, but unlike the ‘poor’ countries, they have a lot of economic dynamism. They have functioning governments, and they have economic institutions such as a central bank, or a stock exchange, like the developed world, but these are often erratic in their effectiveness. But most of all, these countries, should they be in East Asia, Central Europe, Latin America, or southern Africa, always tended to produce macroeconomic numbers that would be impossible for mature economies. Our models and theories that work for the developed world (or at least used to) were unable to explain a host of phenomenon in the emerging markets. Hence the regular use of the adjective ‘miracle’.

For instance, in a developed country, it is impossible to have the kind of simultaneous fall of budget deficit, current account deficit, inflation, and unemployment that is frequently observed in emerging economies. It just does not happen. Moreover, a host of theories tell us why it should and will not happen. Unless, of course, you are undergoing rapid structural change in your economy, a typical dynamics of emerging markets. And there you are, a miracle is born.

Now, we have a couple of negative miracles on our hand... Similar to the positive versions, economics has hardly any standardised handle on the problem.

One of the very interesting phenomena in the upswing phase of emerging market development is the switch from export momentum to domestic one. It is interesting, for in almost all the cases, much of the domestic demand that is seen as inherent, home grown etc., keeps being dependent on export performance. It is easier to see this in smaller countries, such as Thailand, Poland, or South Africa, but the past two years also shed light on the very same phenomenon in some of the larger ones, such as Brazil, Russia, and - increasingly obviously - China. Remember the arguments about domestic dynamics in the emerging markets being the new global driving force, voiced at the beginning of this crisis? (This myth fully endorsed by the political classes of the above mentioned emerging markets, less for lack of understanding, and more for good old fashioned political populism. And they were just warming up.)

The trouble is that once you realise that domestic demand is indirectly linked to export performance to larger extent than you previously thought (and overall, to a very large extent, especially in the longer run), then your options to weather the crisis are suddenly radically diminished. Especially this kind of crisis, where the global economy is shrinking to such an extent. For all economies, emerging or mature, this translates into policies that try to generate domestic demand, rather than export competitiveness. At first, you would try the old fashioned way: monetary easing with fiscal tightening (or at least the promise of the latter). Then, when it does not work (independent whether the reason for disfunctionality lies in the monetary transmission mechanism being screwed up by the local excesses of the capital markets, or the lack of a global policy framework), you move on to the next level: fiscal stimulus. It is less sophisticated, bears more long term risks for your economic system, but hey, that’s what’s left.

This leaves emerging markets in an odd place. Their monetary toolbox had already been generally weaker than that of mature economies. Furthermore, they do not have the advantage of them being the ‘safety’ bit in ‘flight to safety’, thus liquidity dries up even faster. And as domestic demand turns out to be much more dependent on the - collapsing - exports, they would need disproportionately large fiscal stimuli. In most emerging markets, the space for the latter had already been tight. The government spending needs - and demands - during the rapid structural change years had been phenomenal, pretty much exhausting the fiscal capacities. And of course there are those that had been irresponsible on top of it (Hungary, Argentina, Iceland, Ukraine, I am talking to you!).

So, you are an emerging market crisis-policy-maker. What can you do? You will certainly go to the end of your fiscal abilities, if there is any left. But, for most, this direction will yield very little. The only strategy there is left for you to play is going back to ‘emerging markets amidst globalisation 101’, and return to generating export momentum. This is a tall order, for the global markets are contracting, and countries are locking up. However, you do not have much else left. (Especially, if the crisis lasts much longer, and even those little remaining fiscal capacities will have been used up.) Some emerging markets will be able to play this game very well. Look at the behaviour of Singapore during crises of the past decades, for a textbook case. Some others, however, will have major problems, for their past lack of structural reforms and the tax legacy of their past, and current, fiscal overspending will leave no room for measures to improve export competitiveness.

Significant currency devaluation (with or without government default), or serious social discontent will follow. Or both.

Tuesday, 7 April 2009

Letter from Sydney

(A guestpost from my travelling friend and corespondent, Balázs Szendrői.)

In this day of global multiculti, we constantly walk past, and sometimes interact with, people whose cultural background is very different from ours. But this was not always so. Here in Australia, I am reminded of one affair in particular, in recent (painful) memory, relatively well-documented, which took one party completely by surprise: when the Australian Aboriginal communities first spotted The White Man.

Talk about a complexity difference: the typical toolkit of mainland Aborigines consisted of 31 items; that of Tasmanian Aborigines had only seven. Captain Cook's hair styling alone, recorded on contemporary paintings, must have needed more tools than that. But the first encounters between whites and Aborigines were made difficult by more than just "the differences in the technology set".

One misunderstanding concerned skin colour. Apparently black corpses become whiter with time. On top of that, one of the Aboriginal burial practices consisted of removing an outer skin layer, leaving behind a pinkish corpse, looking not unlike the newcomers; in South Australia, the Aborigines actually called the first Europeans "grinkai", a word also used for "peeled corpse". So who else were these white creatures, but spirits returning from the afterlife? Of course they forgot how to speak properly, because of the shock. Moreover, they became sexually amorphous: from a distance, they looked like women, with no facial hair, but upon closer examination they exhibited male features too. Expeditionary parties were sometimes called upon to reveal their gender - with proof! That's what I call the beginning of a beautiful friendship.

Once gender established, it seems to have been traditional among Aboriginal communities to offer their women to travellers who passed through the country, as a friendly gesture, for the night they spent in the neighbourhood. White Man knew two answers to this: either politely refuse, which amounted in Aboriginal customs to a hostile response, or else, assume that his hosts thought nothing about sharing women, so return again and again and assume that any woman of his choice could always be his. This of course broke several taboos, including incest, since by befriending one of the women, the others apparently became sisters to him.

After this, came smallpox, abductions, the dreadful choices involved in entering the Native Police, and other all-too-familiar stories, leading to the Lost Generation. It will take more than Cathy Freeman's Sydney Olympic Gold to atone for all that.