Dani Rodrik's weblog

After Peter Kenen

The world of economics lost another one of its giants this week, Peter Kenen. Kenen was a leading scholar in international economics, and the long-time director of Princeton’s famed International Finance Section, the publisher of a landmark series of essays on international economics. 

Kenen produced landmark work in international trade, international money and the global financial system. In the words of Paul Krugman, Kenen’s “combination of analytical force and real-world acumen has made him one of the most influential teachers of his generation.”

Kenen played a huge role in shaping my own career.  His was the first PhD course I took while at the Woodrow Wilson School, and his captivating lectures were a major reason I decided eventually to go for a PhD.  His words to the class in the opening lecture of his trade course still rings vividly in my ears: “the difference between domestic and international trade is that the latter crosses sovereign boundaries.”  In my own work, I am still grappling with the implications of this statement. 

Early on, Kenen saw something in me and took me under his wings. He pushed hard behind the scenes for my admission to the Economics doctoral program at Princeton, and eventually succeeded despite apparently strong reservations on the part of some of his colleagues.  (There seems to have been questions about my math skills…) He ensured financial support by hiring me as a RA.  He made me co-author on the paper that the research led to, my first publication in a bona fide economics journal.

My doctoral work eventually moved away from his own research interests, but he kept close tabs on me and remained a member of my dissertation committee. 

As I think back on my Princeton days, Kenen is at the center of some of the most vivid memories.  How can I forget him chain-smoking through international economics seminars (yes, you could do that at the time) or imitating Haberler’s and Leontief’s thick accents (Austrian and Russian, respectively) on the occasion of Kenen’s own PhD orals at Harvard?

Kenen was one of the greats of the economics profession.  But he was also a gracious and generous man who gave much to those around him. 

An interview on Europe, globalization, and the future of the Eurozone

(This is the English-language text of an interview published in the Swedish journal Respons)

The main argument in The Globalization Paradox is that we can’t simultaneously pursue economic globalization, democracy and national determination, but at most have two out of three. You also write that EU was the exception that tests the rule. Well, hasn’t the on-going crisis shown that this trilemma definitely also holds true for the EU? And hasn’t the crisis revealed that the European nations are not so similiar as it may have appeared? The differences between North and South Europe are perhaps so great that such a large union is an unrealistic project, not to mention the Eastern Europe?

Indeed. When I wrote that the EU was the “exception that tests the rule” I meant that the trilemma applied equally well there, and that the Euro zone was in fact a case in extremis of the trilemma. My thoughts have been further confirmed by developments since the book was completed.  Assuming that European nations do not want to give up democracy, the only choice that exists is the one between political integration and economic disintegration. Either Europe will make the leap to a fiscal and political union, or it will have to give up on a common currency and the dream of a truly unified single market.  That is what the trilemma suggests and the reality that the region has been living.

You are right that I may have exaggerated the similarity and unity that exists within Europe – or even the Euro zone. Perhaps I did not emphasize sufficiently the tension between deepening the union and broadening it with increased membership.

Building a political community, without which fiscal union cannot happen, requires the development of a sense of common political fate and destiny. Historically, this has been always an elite-driven project. France was not born a nation; it became a nation because it was made into one by its political and intellectual leaders through education, ideology, and a common narrative. In Europe, unfortunately, the reaction of leaders like Angela Merkel, at least at the outset of the crisis, was to emphasize the differences between North and South instead of the commonalities.  She allowed the crisis to be presented as a narrative of profligate, lazy Greeks versus hard-working, thrifty Germans – and not as a story of mutual dependence.  With that as a background, it is hard now to change course and make the case for a common political destiny.

So, even though the differences between nations are real, it is also the case that political leaders have fallen short in rising above their very short-term interests.

Globalization can perhaps be said to have reduced inequality in the world. Large parts of the Chinese population has risen out of poverty – if that can be attributed to globalization as such and not the Chinese way of adapting to it. But is there a connection between globalization and inequality within countries? It seems much easier to further accumulate wealth for the very rich in a deregulated economy.

There is no question that globalization has aggravated inequality within countries.  But we need to think of globalization in this context as part of a cluster of developments: new technologies, greater emphasis on markets, decline in unionization, and fiscal paralysis of many states. All these have had the consequence of raising the returns to skills and talents and reducing the bargaining power of blue collar workers and those who are unable to move across national borders with the same ease as capital.

But there are exceptions too.  One of the most encouraging trends in the last couple of decades is the decline in inequality in Brazil, Chile, and many other Latin American countries, which have traditionally been among the most unequal in the world. This shows that broad social programs as well as more narrowly targeted anti-poverty programs can still be pursued and are effective in open economies.  

This interview for the magazine Respons is intended to follow after a review of 4 new books in Swedish about the crisis of the EU, written by Sverker Gustavsson, professor of political science at Uppsala. The four Swedish authors he is discussing – Mats Persson, Johan Norberg, Stefan de Vylder and Björn Elmbrant – writes from different political positions, but all agree that it was a fundamental mistake to create a monetary union without a fiscal union. A fiscal union would have made it possible for the EU to transfer resources between countries and reduce the tensions that the common currency creates. Do you agree with this assessment, that a monetary union ought to have been accompanied by a fiscal union? Is a fiscal union a realistic project? Is it even desirable, or ought EU to take a different course, perhaps aim for a more limited economic union, which would allow the nation states to protect their social arrangements? Further, would a collapse of the eurozone necessarily be a bad thing? The nation-states may then perhaps be able to adopt policies more suited to their actual conditions and interests? Sweden for instance is doing fine outside the eurozone.

Pretty much all my economist friends in Sweden were in favor of joining the Euro. I haven’t encountered one who hasn’t changed his mind.

Yes, the idea that monetary union requires fiscal union has now become conventional wisdom. But it doesn’t go nearly far enough. What makes the U.S. a sustainable monetary union is not just that it operates within a fiscal union.  It is also that there is a common legal system (to deal with bankruptcy and cross-state bank liabilities), common deposit insurance and financial regulation, a true lender of last resort (in the form of the Federal Reserve), much greater labor mobility across state borders, and a federal constitution that severely curtails states’ sovereignty.  Perhaps most importantly, the system is underpinned by a federal political system which allows the residents of each state to directly elect their representatives in Washington, D.C., who can then represent their interests and argue for the kind of economic policies that these residents want pursued.

European political integration need not directly follow this model, but whatever form it takes, there is a very long way to go. Fiscal union in itself will not do the trick unless there are democratic mechanisms of accountability and representation that backs it up.

Which of course forces us to ask the question whether we can and really should try to go that far.  It turns out Sweden did do the right thing by staying out of the Euro zone. Now it benefits from having its own currency, its own fiscal policy, and its own financial regulations.  It remains the master of its own fate to a much greater extent. It remains a highly globalized economy, but has set its ambitions on this score at a somewhat lower level than the Euro zone countries.

Perhaps the Euro zone should similarly take a step back. Ultimately, that may well be the right answer.  The difficulty is how to engineer a retreat from a single currency when there is no obvious legal mechanism for doing so and when so much debt would have to be redenominated, reconfigured and redistributed. And how to do this in a manageable way when the slightest indication from governments that they are considering a break-up of the euro zone would cause a market panic and stampede out of the weaker economies.

It’s a nightmare just to think about it.  And yet, it is not clear if there is a realistic alternative.  That is Europe’s dilemma. Either more political Europe, or less economic Europe.  There is no stable in-between.          

The support for such a fiscal union, which also would be a transfer-union, seems rather eager among the populations in Europe, especially in those countries that will be paying, like Germany and Finland. To be politically possible, redistributions of this kind seem to demand a strong sense of affinity between those involved. It could be done between East and West Germans, but perhaps not between Germans and Greeks or Italians. If you look at the welfare states historically, they were able to transfer resources among the populations, but those nations were also homogeneous, like Sweden. Isn’t it dangerous to aim for a fiscal union when popular support for crossnational transferences is so weak – dangerous in the sense that it might create a general backlash against the union?

Yes you are right, but as I explained earlier, the difficulties are in part due to the framing of the crisis by Northern European leaders at the outset. Once you present the crisis as a result of Greek duplicity and profligacy, it becomes difficult to go back to your constituency and ask that you help the Greeks out with yet another bailout.

At its bottom, this has nothing to do with morality. The economic fact is that the assumptions on which German lenders and the Southern borrowers acted have proved to be wrong and now both are in trouble. Neither Greek and Spanish borrowers, nor German and Dutch lenders can be absolved. This is a crisis of economic interdependence, not of morality.  Political leaders missed the chance of explaining this to their electorate.   

So the result is that we are where, as you suggest, the backlash is as likely to come from exasperated Northern countries as from Southern countries deep in economic crisis.

It is easy for an economist like me to blame it all on lack of political leadership – and God knows economists were at fault too, by consistently making over-optimistic projections on Greece, Spain, and so on – but this is where the ultimate blame lies.

Your position is that democracies have the right to protect their social arrangements. However, the European Court of Justice has consistently decided against the national arrangements, forcing the countries to adapt to globalization, according to a report by Martin Höpfer Armin Schäfer at Max Planck Institute. http://www.mpifg.de/pu/mpifg_dp/dp12-5.pdf

In your book, you point to the fact that a small group of central bankers made all the important decisions concerning financial globalization before WWI. They didn’t need to consult the people. Isn’t this a parallell to EU today? A small elite, far removed from people in general, makes all the important decisions? And won’t this also this time provoke a reaction?

Precisely.  That is why we have the trilemma. The more Europe has moved in the direction of the single market without Europeanizing its politics, the greater the democratic deficit has become, and the bigger the backlash.

That is why the new fiscal compact is problematic. It represents the same technocratic mindset that tries to squeeze all countries into the straitjacket of common rules, without simultaneously enabling democratic discussion and deliberation over those rules. Inter-governmental agreements are no substitute for democratic practices that transcend national borders.

Let me clarify something on the relationship between democracy and economic integration.  It is perfectly OK for executives and legislatures in democracies to sometimes restrict their freedom of action – through delegation to autonomous bodies or signing of international agreements. In fact, such restrictions may enhance the functioning of democracies.  

But there is no guarantee that the delegation/restriction that takes place to advance economic globalization necessarily improves the functioning of democracy.  Globalization-enhancing rules may overlap, but are not the same as democracy-enhancing rules. Europe is now at the point where it is single-mindedly pursuing the former agenda, not the latter one.  

The world was globalized before WWI and then a disastrous backlash set in. Are we heeding for a I backlash today? Many things are different of course. Europe has not been devastated by a war like WWI. Since fascism and national socialism were closely connected with the war experience, this backlash will perhaps not be so extreme. But it could still be a dangerous reaction, fueling intolerance and political extremism. In your article The end of the world as we know it you seem to be considering such a prospect. What can be done to avoid it?

There are reasons to be optimistic that a generalized cataclysm of that sort is less possible today. Too many things have changed: states and their social protections are stronger (which limit the social costs and disruptions) while political support for market mechanism is also stronger (making a generalized return to protectionism less likely).  And these are two sides of the same coin: generally markets have expanded alongside government-provided social insurance. 

One of the interesting things after the 2008 financial crisis was how little trade protectionism ensued. This was the most significant crisis since the Great Depression, and yet there was very little increase in trade barriers.  We can attribute this to that double development.

The exceptions are societies such as Greece and Spain which are in extreme distress, and are rapidly losing both of the advantages I just mentioned.  The radicalization of politics in these countries is quite a realistic possibility.

As for Europe at large, I do think an eventual break-up of the Euro zone can have serious political repercussions as well.  This will be seen inevitably as the collapse of the European project, and will severely tarnish the credibility of centrist politicians, who have been the project’s main supporters. It will be extremist groups that will benefit.

Did Microsoft steal its fonts from the Turkish army?

The Turkish court that sentenced more than 300 officers on coup plotting charges in September apparently thinks so.

The Turkish military has long set the ground rules for Turkish politics, and this was hailed as a landmark trial. Many saw it as the centerpiece of a democratic, mildly Islamist government’s long overdue reckoning with the army’s misdeeds. 

If the charges in the case are to be believed, misdeeds there were aplenty. Prosecutors had in hand CDs, apparently from 2003 that contained detailed military plans to destabilize the country and dislodge the newly-elected AKP government from power.  According to the documents in the CDs, General Cetin Dogan, then commander of the Istanbul-based 1^st Army commander, and his collaborators had prepared horrific operations, including the downing of a Turkish military, the bombing of two mosques, and the targeting of Armenian intellectuals, in order to lay the groundwork for the coup. They had drawn up lists of journalists and politicians to be arrested, selected a new cabinet, and even prepared an economic program for the new government.

The trial was marred by irregularities from the very beginning.  The CDs were never properly authenticated beyond the date and author information in the metadata.  A report that found the documents could not be traced to military computers vanished.  Exonerating evidence uncovered by the prosecutors was placed under seal and hid from the defense.  The presiding judge, who had ruled previously in favor of some of the defendants’ requests, was replaced two days before the trial opened. The pleas of defendants who proved they were out of the country on the dates they supposedly authored the documents met no response. A growing list of anachronisms and other inconsistencies in the documents was passed over.  Meanwhile pro-government and Gulenist media had a field day, spreading rampant disinformation about the case and the defendants.

But the real shocker came when the court finally provided digital copies of the incriminating CDs to the defense, nearly two years after they had been delivered to the prosecutors.  American, German, and Turkish forensic experts hired by the defense were able to establish conclusively that the CDs had been forged.

And here is where Microsoft enters the picture.

The centerpiece of the prosecution’s case is a MS Word document, titled “Operation Sledgehammer.”  This document, which gives the case its name, describes the rationale for the military takeover and the broad contours of the plan.  It carries the date December 2002 and is has General Dogan’s name underneath. On the face of it, there is nothing in the digital file that would contradict this information.  The metadata shows a last-saved date of December 2002 and the putative author to be General Dogan’s chief of staff. (Dogan retired from the army in late 2003.) The CD on which it is found was apparently burned in a single session on March 2003. The document is written using the Arial font and was saved in MS Word 1997, both of which were widely in use in 2003.      

Yet when forensic experts looked more closely at the document with a Hex editor, which shows all the binary information on the file, they made a discovery that revealed that the metadata had been tampered with.  In plain sight on the raw file was a reference to “Calibri,” a font that Microsoft introduced with Office 2007 as the new default font for Word, and was first released to the public in mid-2006.  The only explanation for this anachronistic reference was that the file had been worked on with Office 2007 before it was ultimately saved in an earlier version of Word.  It was clear that “Operation Sledgehammer” could not have been produced and burned onto a CD in 2003.

Digital fingerprints of MS Office 2007 are in fact all over the documents on the incriminating CDs.  In addition to Calibri, there are references to the font Cambria and various XML schemas first introduced with Office 2007.  In one egregious instance, an Excel file was saved in Calibri so that the font is visible to the naked eye. The forgers apparently forgot to save the document in an earlier font. 

All these documents carry last-saved dates from 2002-2003, appear to have been authored by officers on duty at the time, and were burned on CDs that were apparently finalized in March 2003.  But the references to Office 2007 leave room for only one conclusion: these documents were in fact prepared years later on backdated computers, with the intention of framing the officers on trial.

Not surprisingly, when these findings were presented to the court, they met the same stony silence that had met earlier indications of forgery.  Turkish law allows courts to disregard forensic evidence presented by the defense.  Only forensic reports obtained by the court itself carry weight.  And the court pointedly refused to assign its own experts on the matter.

By now, even hard-core supporters of the prosecution have had to accept that the evidence in this case is deeply flawed.  They no longer talk about the obviously fabricated mosque-bombing, jet-downing, or assassination plans. They have shifted their accusations instead to the contents of a contingency planning seminar held under General Dogan’s supervision in March 2003.

The anonymous informant who passed on the forged CDs bundled them with authentic material, including voice recordings from the seminar.  The seminar focused on the army’s response to what was called a “worst-case scenario:” rising tensions with Greece compounded by domestic disturbances in the forms of an Islamist uprising.  The proceedings reveal an open secret, namely that there was a strong undercurrent of antipathy among the military towards Tayyip Erdogan and his party. 

Many now use snippets of those conversations to argue that they constitute ample evidence of a coup plot on their own -- even if the digital Sledgehammer documents themselves are set aside. Never mind that there was no reference to Sledgehammer or any coup in the seminar; that the seminar was attended by observers from the high command in Ankara; that the prosecutors did not attribute any criminal activity to the seminar itself; that the bulk of those found guilty had nothing to do with the seminar; or that most seminar participants were not even indicted.

General Dogan’s two superiors at the time, the commander of the land forces and the chief of general staff, were two key witnesses who could have provided useful testimony.  The prosecutors claimed that the former had thwarted the Sledgehammer coup, without even bothering to question him. In public, both denied any knowledge of Sledgehammer, but said there had been irregularities in the way the seminar was carried out.  The defense repeatedly asked that they be called in as witnesses. The court refused. Did I say this was a kangaroo court?

My wife Pinar Dogan and I have been detailing the Sledgehammer fraud since the CDs first surfaced at the beginning of 2010. Cetin Dogan is my father-in-law, and we obviously have a personal stake in the matter. But our concern extends beyond this specific case and the 300-plus innocent individuals who have been found guilty in a sham trial. The evident framing and massive judicial misconduct on which the Sledgehammer case rests shines a bright light on the kind of country Turkey has become under Tayyip Erdogan and his Gulenist allies. Reminiscent of periods of military rule, the judiciary has turned into a tool for settling scores and remaking Turkish society and politics. The wave of entrapment has so far ensnared military officers, journalists, politicians, Kurdish activists – indeed opponents of all stripes. In a system that can put you behind bars because of a Word document with your name on it, no-one is safe.     

The defendants in the Sledgehammer travesty have at least one thing to look forward to. Their guilty verdict means they must have developed Calibri, Microsoft Office 2007’s default font, years before Microsoft says it did. Sorry, Microsoft, you have been caught out. You owe these officers billions of dollars.

Are Americans better off than the Dutch?

For a lot of questions, comparisons of per-capita GDP yield the correct answer to a first-order of approximation. For example, are Americans richer than the Chinese?  A comparison of GDPs per capita, adjusted for PPP differences, yields an unambiguous answer in favor of the U.S.  Yes, income may be distributed more unequally in the U.S., but that is largely irrelevant. As the chart below shows, very few Chinese are richer than the poorest Americans.  The distributions of income for the two countries barely overlap.   

(Note these data are for 2005. The Chinese distribution has caught up some with the U.S. one in the meantime.)

But what about the following question: Are Americans richer than the Dutch?  The average income in the U.S. is about 20 percent higher in the U.S. (again, adjusting for cost-of-living differences). So our inclination may be to answer in the affirmative.  But when average incomes do not differ by a large margin, income distributions do matter a lot. It turns out that the answer to the question depends very much on where in the income distribution we look at.

The following chart shows the average incomes of different income groups in the two countries. In each country, population is split into 20 equally-sized groups (“ventiles”), ranked from the poorest to the richest.

The two distributions cross, roughly at the middle.  The bottom 40% or so of the population is better off in the Netherlands, especially as we go lower in the distribution of income.  The bottom 5% have nearly double the income in the Netherlands.  The top 50%, by contrast, are significantly better off in the U.S.

So are the Americans better off than the Dutch? I cannot tell you.  But I can say that per-capita GDP or aggregate productivity numbers cannot answer the question.

By the way, these data on income distribution come via Branko Milanovic.  Check his book and web page.

And if you want to have more fun comparing income distributions across and within countries, check this puzzle.  (The answer is here).

More on manufacturing convergence

I have blogged before about a rather surprising result (to me at least) regarding productivity convergence in manufacturing.  Despite the lack of convergence among economies as a whole, there is apparently quite strong convergence within manufacturing industries.  What this means is that manufacturing sectors that are further away from the technological frontier tend to experience more rapid productivity growth.  And -- this is the really interesting part -- this happens regardless of the quality of domestic policies, institutions, or geography.  Manufacturing productivity converges even if you are in a remote country with lousy policies and institutions. In economics jargon, manufacturing industries are subject to unconditional convergence.

The earlier results were produced using UNIDO data at the 4-digit level of disaggregation.  The problem was that these data are patchy, and forced me to work with only few developing countries, over short-term horizons, and with only post-1990 data.

In the meantime, UNIDO issued its 2-digit data base (INDSTAT2), which covers many more countries and goes back to the 1960s.  So I redid everything with the new data, not without some trepidation -- for you never know what new data will produce.  But the results were equally striking and robust. Here is the scatter plot that illustrates the central finding, using the baseline sample (which looks for each country at the latest decade that has data):

 

Each dot in this scatter plot represents a 2-digit manufacturing industry in a particular country.  The variable on the vertical axis is the growth of labor productivity in that industry, controlling for period, industry, and period X industry fixed effects.

The estimated rate of convergence (in my baseline sample) is 2.9 percent.  This means that industries that are, say, a tenth of the way to the technology frontier (roughly the bottom 20 percent of the industries in my sample) experience a convergence boost in their labor productivity growth of 6.7 percentage points per annum (0.029 × ln(10)).

Here is the pattern for specific industries, where the convergence is also readily observable:

The new data allow me also to look at what economists call “sigma-convergence,” that is convergence in productivity levels.  Even though I have a smaller sample (of 63 countries) to work with for this exercise, I still find substantial sigma convergence. Here is the picture for manufacturing as a whole, over the 1995-2005 decade:

Notice how the two peaks have moved closer over the decade.  The difference of 10 log-points represents roughly a 10 percent reduction in dispersion.

All this begs the question why economies as a whole do not convergence, if manufacturing experiences strong convergence.  The answer turns out to have three components.

First, non-manufacturing does not exhibit convergence.  Second, manufacturing’s impact on aggregate convergence is curtailed by its very small share of employment, especially in the poorer countries.  Third, the growth boost from reallocation – the shift of labor from non-manufacturing to more productive manufacturing – is not sufficiently and systematically greater in poorer economies.  Taken together, these three facts account for the absence of aggregate convergence.

Almost all of the growth miracles of the last 60 years were based on rapid industrialization. Today, technological changes and global competition are fostering rapid de-industrialization (in terms of employment shares) almost everywhere.  This makes me wonder whether the kind of rapid growth experienced by countries like South Korea, Taiwan, and China will ever become possible elsewhere.   

The new paper can be downloaded here.

What Next at the World Bank?

Guest Post by Danny Leipziger,Professor of International Business at George Washington University, and former Vice President for Poverty Reduction and Economic Management at the World Bank

A new president will take over the World Bank on July 1^st. Dr. Jim Kim inherits a venerable institution that has lost its way. As a lender, the Bank peaked with its massive precautionary lending in 2008-2009, only to be left capital poor. As an adviser, it has lost too many experienced staff to be taken seriously by more adept policy officials in borrowing countries. And as a voice for development, it has grown faint. To be sure, the Bank still has assets, its past reputation among them, but it is precariously perched, being surpassed and outclassed by regional banks, by the IMF, and by new lenders.

Re-enforcing this rather bleak diagnosis is the fact that senior officials of the Bank have lost hope; staff are now told that policy briefings with Ministers are a thing of the past, that others can analyze World Bank data better than the economists in-house, and that budget constraints limit the Bank’s ability to reach for new challenges. This is the institution that Jim Kim inherits. It needn’t have come to this. A recent Diagnostic Report of the 1818 Society, the Bank retirees group, noted many self-inflicted wounds caused by poor management, excessive decentralization and lack of accountability, mission creep, and horrific human resource policies.

Faced with this situation, a new CEO might be inclined to look for the silver bullet of one new initiative, one new partnership, or one new theme. That would be a colossal error. Turnaround management will require a new business model for the 65 year-old development bank. That new model should include retrenchment into regional hubs, staff reductions, a new organizational structure, and a return to a sensible human resource policy. The World Bank staff, its primary asset, needs to be recruited from the best places and needs to embody the best global skills. Only then will they get their meeting with ministers.

Its financial model needs to be rethought to gain more leverage from existing capital and to start lending to sub-national entities that will for the next decade be the growth drivers and either the greatest polluters or largest carbon-reducers. Its mission must change from an excessive focus on fragile states and its IDA business to a better balance with middle-income engagements based on bundled services of expertise, financing, and convening power. This work cannot be done by term- contracted appointees with neither the requisite experience nor the institutional memory of knowing what has worked and what has failed in the past.

Most of all, the Bank needs to get it "mo-jo" back! It has been on its heels since 2005. It has not reacted to new global challenges to redefine its role. It failed to capture the climate change agenda; it responded to the financial crisis with one-time lending, but failed to provide the risk mitigation instruments that emerging market economies want; and it has not responded well to the growth and employment challenges facing middle-income countries. And it has lost its intellectual leadership on issues that matter to those not in the developed world.

New leadership can turn the World Bank around, but piecemeal reforms will not work. Visionary leadership and hands-on management is required, and one can only hope that President Kim will have the perspicacity and the perseverance to re-invent the Bank, restore its excellence, and regain global relevance.

What I learned in Latvia

I spent a few short days in Latvia last week. My meetings centered on industrial policy, which Latvia is serious about – quite interestingly for a country that is often viewed as a hotbed of conservative economics. But my time there also gave me an opportunity to reflect on the country’s much discussed response to economic crisis.

Briefly, Latvia rejected much external advice and did not devalue, despite a huge current account deficit that exceeded 20% of GDP in 2007. The lat had been pegged to the euro in anticipation of Eurozone entry and the government refused to do anything that would jeopardize that goal. The IMF were told to go home if they were going to insist on devaluation. 

In the end, the country implemented a radical fiscal contraction that pushed the country back into external surplus. The shock produced a loss of output of almost 20% of GDP in one year, and a rise in unemployment to 18.4% (from 6% in 2007). By 2011, the worst seemed over and the economy grew at a healthy rate of 5.5%, one of the highest in Europe. 

If you listen to advocates of fiscal austerity, such as central bank governor Ilmārs Rimševičs, Latvia is a huge success -- an example for Greece, Spain and others on how to do it. On the plus side, growth has returned faster than most anticipated, exports are up, unemployment has come down, and the political system appears more stable than it has been for some time. Despite complaints about the legal framework and poor implementation, foreign investors are reasonably satisfied. Eurozone entry is still planned for 2014.

On the negative side, the collapse in GDP was the deepest any country experienced during the present crisis. Even though a recovery seems apace, the country is still far from recuperating to output levels prior to the crisis (see chart).  Iceland, which was hit with an even larger financial crisis, imposed capital controls, devalued its currency, and avoided as sharp an economic contraction as Latvia. When I brought up this counterfactual, Rimševičs cut me short and argued that Iceland benefited from special export conditions.   

Even though Latvia’s external imbalance was eliminated, it is not clear that there has been a sizable improvement in competitiveness.  The much vaunted internal devaluation has been small. Wage cuts have been mostly in the public sector, where they don’t really help with export competitiveness.  Private sector wages have been surprisingly resilient.  As the next chart shows, the unit labor costs-based measure of the real exchange rate has come down (depreciated) only moderately, following a huge rise over 2004-2008. Consequently, it is not at all clear whether Latvia has regained sufficient competitiveness to sustain growth without running sizable external deficits yet again.  

To an outsider what is the most striking aspect of the Latvian experience is the relative absence of political conflict and social strife during what must have been a catastrophic economic crisis. When I brought up the news articles that mentioned Lativa’s largest street protests since the Russian occupation at the height of the crisis, my hosts assured me that these were in fact minor. Just a few hundred people, acting up for the cameras, they said.  Greece this was not.

Why? Not because the political system is particularly functional (there are in fact too many small parties) or there are no ethnic cleavages (the Latvian-Russian divide remains deep). I was told that Latvians are stoic people, that they keep their problems to themselves. 

The main lesson I take from all this is the need to avoid easy generalizations that do not respect country peculiarities. Fiscal austerity missionaries are surely off base when they say Latvia’s experience decisively proves Keynesians and advocates of currency depreciation wrong.  It is too early to judge the Latvian experience a success.  But it is also too early to say Latvia has been a failure.  Growth may continue, in which case the country will look better and better.

One thing we can say for sure, however, is that the kind of drastic fiscal austerity that proved feasible in Latvia would not be possible in many other countries.  Rimševičs and others stress that Latvian policy was successful because they took it on the chin and implemented the fiscal measures with speed and determination.   Perhaps.  But it is also true that they got away with vastly underestimating the costs of their measures.  Latvian policy makers had expected a 10% fall in GDP in 2009; instead they got one that was nearly twice as large.  The real secret of their success is that they did not have a revolution on their hands.  

Apportioning blame between politicians and technocrats

Look at the chart below, and you will go a good way towards understanding why the problem with Greece has been allowed to get worse and worse (the proverbial “kicking the can down the road”) to the point where it may have become too late.

The chart shows the IMF’s growth projections for Greece in each of its successive World Economic Outlook (WEO) publications, along with the actual realizations.  The WEO come out twice a year.

As the chart makes clear, the IMF’s growth projections were consistently too optimistic.  Some of this was due no doubt to the fact that the Greek crisis caught the IMF – like most everyone – unprepared.  But the IMF’s later projections, once the Greek economy entered an IMF program, are less easy to justify.

For example, in April 2010 the IMF’s growth projection for 2011 was a decline of 1.1 percent. The projected decline increased to 2.6 percent in October 2010, to 3 percent in April 2011, and to 5 percent in October 2011.  Actual growth outcome for 2011 was -6.7 percent!

Now some of this can be chalked up to the fact that the Greeks did not deliver as much “structural reform” as they promised.  But this is at best part of it. In fact, the programs were built on the assumption that there would be magical and large productivity gains from reforms such as liberalizing the professions and labor markets, which were never realized.

The fact is that technocrats at the IMF and elsewhere made it easier for politicians to delay the reckoning by putting together economic programs that didn’t hang together from day one.  With optimistic growth projections, debt dynamics looked a lot better, which in turn made it look like sustainability was around the corner.

There is an important lesson here for the next round in Spain. Economists have to do a better and more honest job.  When programs don’t add up, they have to say it loud and clear.

Ideas, interests, and a video

This has been a long-standing concern of mine: what are the respective roles of ideas iand interests in shaping policy outcomes?

The most widely held theory of politics is also the simplest: the powerful get what they want. Financial regulation is driven by the interests of banks, health policy by the interests of insurance companies, and tax policy by the interests of the rich. Those who can influence government the most – through their control of resources, information, access, or sheer threat of violence – eventually get their way.

It’s the same globally. Foreign policy is determined, it is said, first and foremost by national interests – not affinities with other nations or concern for the global community. International agreements are impossible unless they are aligned with the interests of the United States and, increasingly, other rising major powers. In authoritarian regimes, policies are the direct expression of the interests of the ruler and his cronies.

It is a compelling narrative, one with which we can readily explain how politics so often generates perverse outcomes. Whether in democracies, dictatorships, or in the international arena, those outcomes reflect the ability of narrow, special interests to achieve results that harm the majority.

Paradoxically, economists tend to operate within a worldview that ascribes paramount role to interests, as when they complain about the role of powerful banking lobbies in driving bad/inadequate regulation. Yet, banks' and policy makers' conception of where their interests lie is powerfully shaped by ideas that economists generate and disseminate.

More generally, ideas play a crucial role in helping define who we are, what our interests are, and how those interests are best realized.

More here.  You get a video on this and other matters as a bonus.

What Turkey’s political-military trials reveal about the country’s democracy

To understand what is happening in Turkey’s murky world of judicial politics these days, it helps to imagine you are watching the closing scenes of a Hollywood courtroom drama.

The movie’s protagonist stands accused of attempted murder. The prosecutor has produced a set of elaborate plans that the defendant allegedly drew up to poison an opponent. The plan was aborted, the prosecutor says, when a friend of the defendant got wind of the plot and alerted the intended target.

The defendant proclaims his innocence and denies vehemently that he had made such plans. He says the materials on which the prosecutor rests his case are forgeries. He submits to the court several reports from technical experts that conclude the documents were prepared on computers whose system clocks and usernames had been altered to frame him.

He also produces evidence that his hand-writing was forged. He shows that prosecutors concealed from the court exculpating evidence recovered during their investigation. He points out that the friend who supposedly uncovered the plot was never questioned by prosecutors or in court, and has in fact denied knowledge of the alleged plot in his public comments.

The prosecutor offers no counter-evidence but sticks to his guns. The judge disregards the forensic reports produced by the defendant. He rejects the defendant’s request that the friend be heard in court. A trial that should have long ended in acquittal – followed by the filing of charges of prosecutorial misconduct – instead moves towards an almost certain conviction. The defendant’s lawyers walk out of the courtroom in disgust, which prompts the judge to file charges against them in turn.

It could be a movie, but it is not. It is the reality of the Sledgehammer trial in which more than 360 officers are accused of having plotted to overthrow the government back in 2003.

Never mind that there is no evidence for the coup plot beyond unsigned Word, Excel and PowerPoint documents full of inconsistencies. Never mind that these documents have never been authenticated or traced to real military computers. Never mind that the names on the digital documents would never stand in a proper court of law as evidence, as they could have been easily manipulated by anyone with a modicum of computer knowledge. Never mind that the documents contain hundred of anachronisms that leave no doubt they were not produced on the alleged dates by their alleged authors. Never mind the numerous forensic reports – including two from American experts – that expose the digital evidence and “hand-writing” as forgeries. Never mind the public comments of the military higher-ups that contradict prosecutors’ claims.

The Sledgehammer case’s absurdities are just the tip of the iceberg. Since 2007, Turkish prosecutors have launched a series of mass trials against alleged members of a terrorist organization, Ergenekon. The defendants – military officers, journalists, politicians, academics, lawyers -- are accused of plotting to destabilize the country and preparing a coup. Scores of defendants have been jailed for three years or more, yet the existence of Ergenekon has never been established. The prosecutors’ evidence ranges from the circumstantial to the fabricated, as in Sledgehammer.

Even worse, it is evident that it is the police who have been planting evidence and framing the defendants in at least some of these cases. One defendant was able to prove that police had downloaded contacts from a terrorism suspect onto his mobile phone to establish a link between the two. In a couple of instances, key incriminating documents turned out to have been in the possession of the police prior to the raids in which they were allegedly recovered from defendants’ premises. In one episode reminiscent of Keystone Kops, police searched the wrong house and still located evidence against the intended target.

What keeps the travesty going is the support it gets from the country’s two dominant political forces. On one side is the government of Recep Tayyip Erdogan, which through its control of judicial appointments ensures the Sledgehammer trial moves to its inevitable conclusion. Erdogan has adroitly exploited the case for maximum political advantage, using it to sideline and reshape the army.

On the other side is the Gulen movement, whose sympathizers in the police and judiciary bear primary responsibility for staging the Sledgehammer and Ergenekon trials. Gulenists have a history of peddling forged documents to frame military officers and other perceived opponents (1 and 2). The powerful Gulenist media have been the leading champion of the cases, publishing non-stop one-sided, often downright false accounts about the defendants and the evidence.

Then there are the country’s liberal intellectuals, who have embarrassed themselves by buying into the Erdogan-Gulenist line uncritically and failing to stand up for due process. It was a supposedly liberal paper, Taraf, that first published the bogus Sledgehammer documents without corroboration. (Taraf’s editor, Yasemin Congar, would later justify her decision by saying the plans were too detailed not to be real!) Adding insult to injury, the paper repeatedly, and falsely, reported that the documents carried the officers’ signatures.

Leading liberals such as Ahmet Altan, Etyen Mahcupyan, Hasan Cemal, and Alper Gormus have defended the authenticity of the coup plans, in total disregard of the facts of the case. Others who have become convinced of the forgery have preferred to maintain their silence in public. A common attitude is that the military must have been planning something, given its history of coups, even if the Sledgehammer plot is fabricated. Effectively, defenders of the trial have been saying: “Yes, the murder weapon may have been planted on the defendant, but no matter, he is not a nice guy anyhow.”

Predictably, cases against these prosecutions have been piling up at the European Court of Human Rights (ECHR). The ECHR, however, has limited room to issue judgment until all domestic legal avenues have been exhausted. In the meantime, the prosecutions’ fabrications are spilling over to the Turkish government’s filings before the Court. In one case, the Turkish government submitted a forged document attesting that a detainee did not need medical attention. In another, it reported falsely that explosives were found on the premises of a journalist.

The cost of all this to the future of Turkey’s democracy is incalculable. Erdogan and his supporters contend that he has restored the rule of law by vanquishing the military and civilianizing the political system. Every new political order needs a founding narrative, and that is Erdogan’s. Rarely, however, has the narrative been erected on such a patent forgery as Sledgehammer. As the case unravels, sooner or later, Erdogan and his successors will have to grapple with the unhappy consequences.

UPDATE (April 25, 2012): Today's New York Times has a long, and overdue, account of what the Gulen movement is up to in Turkey.