Sunday, December 30, 2012

Australia's "Dutch Disease" in three graphics

As I blogged earlier, in recent years, on the back of the surging demand for ores and minerals, the Australian economy has been showing signatures of resource mis-allocation, popularly described as the "Dutch Disease".

The boom in commodity prices has resulted in the Australian dollar surging against the US dollar.

The country's terms of trade, the price of its exports relative to imports, have risen sharply. This has made its tradeable sector more attractive, since it fetches more domestic currency for the same volume of exports.

The strong exchange rate has boosted the commodities mining sector, but at the cost of non-mining tradeable sectors like tourism and manufacturing. Mining, though just 10% of the economy, is estimated to suck up nearly 70% of total capital expenditure across the economy. These trends are starkly reflected in the respective contributions of each to the national economic growth.

Saturday, December 29, 2012

Friday, December 28, 2012

Nudging to prevent losing your phone

The Ciago iAlert and Cobra Tag are Bluetooth keychain fobs that communicate with your iPhone or Android phone. Once you’re 30 feet away from the phone, the keychain starts beeping, as though to say, “You’re leaving your $200 phone behind, you idiot!” It works the other way, too; the phone beeps if you leave your keys behind.
(HT: Pogie Awards NYT)

Thursday, December 27, 2012

India's coal crisis is a political problem

MR points to this graphic which captures the widening demand-supply mismatch in coal availability for power generators.

This blog has been a strong advocate of electricity deficit being arguably India's biggest growth constraint. The widening mismatch, for whatever reasons, should be addressed with the highest priority. But that is easier said than done.

While the state-owned coal mining monopoly, Coal India Limited (CIL), should its share of the blame for the current crisis, the major problems lie beyond mining per se. The three most critical problems facing the sector are lack of rail transportation facilities, and difficulties in land acquisition and environmental clearance for expansions and new projects. We therefore have a situation where even the mined coal is stuck up at pithead for lack of adequate transportation facilities and capacity addition projects are delayed inordinately.

The conventional wisdom on addressing India's coal crisis is to open up coal mining for private exploitation. But this argument fails to appreciate the aforementioned underlying reasons. Though the private sector would be effective at mining coal, the problems of transportation, land acquisition and environmental approvals would remain.  Its resolution lies in the political and social realm.

Land acquisition and environmental clearances are essential for both laying rail transport lines and establishing new projects. In the prevailing social and political climate, where populist rhetoric and media trials shape the mainstream discourse, both these issues present extremely difficult, increasingly insurmountable, challenges.

The private sector will be even less capable of addressing these non-mining challenges. In fact, private involvement is likely to vitiate the environment and make its resolution even more difficult. It is no wonder that the coal blocks allocated for captive power generation remained mostly unexploited. Governments cannot afford to be seen to be supporting private participants in "dispossessing" poor people and "damaging the environment". Nor would the private sector agree to policies like provision of employment to land losers, long used by the CIL to buy-out local opposition to its projects.

All this means that India's coal crisis can be resolved only through a mature political process. A reasonably generous relief and rehabilitation (R&R) policy, which enjoys bipartisan political support, has to form the centerpiece of any such process. In its absence, no government - whether the Congress or BJP or a third front - will be able to effectively address the problem.

The million-dollar problem then is to achieve a political consensus on such policies. Coal mining is just one of the areas where bipartisan political support is sine-qua-non for any progress. Unfortunately, this looks likely to remain an elusive goal in the current political environment.

Monday, December 24, 2012

The global youth unemployment crisis

The co-existence of large youth unemployment rates and labor market shortages, symptomatic of labor markets across the world, is a classic market failure. Econ 101 teaches us that job seekers and education service providers would respond to the market signals generated by employers and acquire the skills required to clear the labor market. But in the real world, there is apparently a massive co-ordination failure between employers, education providers, and job-seeking youth.

The McKinsey and Company have a timely report (pdf here) on this issue, where they examined more than 100 education-to-employment initiatives in 25 countries and surveyed employers, youth, and education providers from nine countries, including India. It points to a twin global crisis - "high levels of youth unemployment and a shortage of people with critical job skills". It writes,
In the OECD countries, more than one in eight of all 15- to 24-year-olds are not in employment, education, or training (NEET). Around the world, the ILO estimates that 75 million young people are unemployed. Including estimates of underemployed youth would potentially triple this number... Across the nine countries, 43% of employers surveyed agreed that they could find enough skilled entry-level workers... The McKinsey Global Institute estimates that by 2020 there will be a global shortfall of 85 million high- and middle-skilled workers.

As the report points out, the massive pool of unemployed youth represents not just a gigantic pool of untapped talent; it is also a source of social unrest and individual despair. It writes,
If young people who have worked hard to graduate from school and university cannot secure  decent jobs and the sense of respect that comes with them, society will have to be prepared for outbreaks of anger or even violence. The evidence is in the protests that have recently occurred in Chile, Egypt, Greece, Italy, South Africa, Spain, and the United States (to name but a few countries). The gap between the haves and the have-nots in the OECD is at a 30-year high, with income among the top 10 percent nine times higher than that of the bottom 10 percent.
The report argues that the biggest problem with bridging the labor market mismatch is the lack of data on "the skills required for employment or on the performance of specific education providers in delivering those skills". It writes,

Clearly, employers need to work with education providers so that students learn the skills they need to succeed at work, and governments also have a crucial role to play. But there is little clarity on which practices and interventions work and which can be scaled up. Most skills initiatives today serve a few hundred or perhaps a few thousand young people; we must be thinking in terms of millions. Why don’t we know what works (and what does not) in moving young people from school to employment? Because there is little hard data on the issue... This deficiency makes it difficult to even begin to understand which skills are required for employment, what practices are the most promising in training youth to become productive citizens and employees, and how to identify the programs that do this best.

Building a reliable and upto date database is easier said that done, especially given the dynamic nature of the job skills requirements. However, any meaningful effort to address this has to involve greater co-ordination between employers and post-secondary education service providers. The market mechanism may ultimately respond by forcing employers who face severe labor shortages to work more closely with education providers. However, a more promising approach will be for governments to play an important role in bridging this information gap and become the market facilitator.

The survey finds that the best education-to-employment programs across the world are characterized by close relationship between employers and education providers - the former helps design the curricula and students spend nearly half their training on a job site. Further, employers commit to hire youth before they are enrolled in a program to build their skills.

Though the report briefly touches on the issue of employers uninterested in investing in skills development, except specialized skills, for not being able to capture its full value. They realize that employees would benefit more and trained employees are more likely to move elsewhere in search of better opportunities. In other words, the social value of the skills training exceeds its private value for the employer. In fact, the social gains go beyond even the private gains to the individual employee. It contributes towards mitigating labor market frictions which constrains investment and keeps large numbers of people unemployed.

This does give skills training the nature of a public good, as much as education in general. It is therefore appropriate that governments finance, atleast partially, the cost of such post-secondary education-to-employment training. Some state governments in India have tried to address this through placement-linked jobs training programs, whereby government pays private institutions for short-term skills development trainings to unemployed youth in return for guaranteeing them employment. However, in the absence of close relationship between the training agencies and employers these programs, which are mostly short-term and academic inputs focused, have been largely failures. But they provide important pointers on the way forward.

Saturday, December 22, 2012

Evidence-based policy making – Missing the woods for the trees?

There is no denying that evidence should inform public policy design. However, it may be a matter of debate as to what constitutes evidence and how it should inform the policy design process. There may also be a need to revisit the interpretation of “external validity” of research findings beyond its current locational - geographical, social, and cultural - context.

Conventional wisdom on evidence-based policy making predominantly views “evidence” as emerging from a process of scientific research. Even within research, in recent years there has been a trend to seek evidence from field experiments, preferably randomized control trials. This approach provides limited space for “priors”, especially those drawn from a source with “less than objective” underpinnings, in policy design. Indeed, in an ideal world the entire policy edifice should be constructed on the objectivity of experimentally exposed scientific wisdom.

External validity of experimental research is generally viewed in terms of its replicability in “other environments”. Critics of experimental research view this as its Achilles heel. But even before we come to other environments, there are concerns about its replicability within the same environment, when scaled up.

Can we afford the “luxury” of an ideal policy design, informed by rigorous experimental evidence? Is there no rigorous and objective enough process of consolidating “priors” in development research? More importantly, are “research findings” any more unbiased and objective than other sources of similar knowledge? Are the findings of a field experiment readily amenable to being scaled up, even in the same environment, without considerable dilution of its final effect?
Specifically, I have two important points for consideration. One, the process of experimental research driven evidence discovery overlooks the, often equally rigorous, evidential value of institutional knowledge latent in communities and public systems. Two, such research findings, especially experimental results, present sanitized outcomes, whose replication when scaled-up under less-sanitized, real-world conditions are questionable. Let me illuminate both these in some more detail.

The vast body of mightily impressive experimental research from the past two decades reveals several important insights, statistically rigorously validated, about the development process. But there is little by way of knowledge or insights that were not already available as institutional wisdom. Therefore, and especially given the huge amount of money and effort that has gone into obtaining this knowledge through experimental research, it is appropriate that we question as to whether the same could have been learnt in a more cost-effective manner from the latent institutional wisdom.

I see several benefits from a process of discovering institutional wisdom. One, it is likely to shorten the knowledge discovery cycle, besides lowering its cost. Second, unlike the fragmented nature of knowledge that emerges from the inherently restrictive, mostly single-issue based experimental research, a knowledge discovery process is more likely to reveal a more comprehensive and organic understanding of the underlying problem. Third, it is also likely to reconcile the dissonance between logical and theoretical consistency and implementational difficulties which characterize a large body of experimental research.

Fourth, the discovery of latent institutional knowledge through a consultative process would, by keeping the stakeholders involved, increase the likelihood of it being willingly embraced by them. This stands in contrast to the obvious disconnect between experimental research and its audience within public systems, which prevents its ready adoption. Fifth, this strategy is likely to create a body of replicable heuristics which can be used to reveal latent knowledge in different socio-economic settings. This becomes especially important given the highly context-specific nature of policy and implementation framework design, a reason that weakens the external validity of any experimental finding.

Sixth, the internal dynamics generated by such a process is itself likely to lay the “environmental” foundation for a successful scale-up. A social consultative process of unraveling latent knowledge typically generates unintended positive spill-overs that can potentially both weaken change opposing factors and strengthen administrative capability. Finally, an experimental research based knowledge discovery, which limits “priors”, opens up too many policy threads and becomes an exercise in the search for the ideal policy design. In contrast, a knowledge discovery process helps finalize a robust enough second-best policy framework design and leaves open those still uncertain threads to be identified or validated by experimental research.

The absence of any discussion about such a latent knowledge discovery process is surprising since deep-dive problem-solving through interviews, focus group discussions, observations, surveys, and so on, is the staple of modern consulting industry. If such evidence is rigorous enough for businesses before they undertake make-or-break investment decisions involving billions of dollars, why would they be any different for governments? And businesses use such evidence to decide on decisions involving human preferences and in aligning human incentives to their commercial interests.

How would the process of arriving at a strategy to sell cheap shampoo satchets to poor people be dramatically different from one for selling mosquito nets or chlorine tablets to the same category of people? Is the process of devising a strategy by private financial institutions to attract deposits of low income people any different from that aimed at increasing savings among the same people? For that matter, is there any radical difference between a commercial strategy to induce positive responses from the market at the “bottom of the pyramid” and one that seeks to get the same target group to respond to similar incentives for their own welfare?

This brings to my second concern about the extant methodology of experimental research. My concern arises from three directions. One, there is a big difference between implementing a program on a pilot basis for an experimental study and implementing the same on scale. In the former, the concentrated effort and scrutiny of the research team, the unwitting greater over-sight by the official bureaucracy, and the assured expectation, among its audience, that it would be only a temporary diversion, contributes to increasing the effectiveness of implementation. Two, is the administrative system capable of implementing the program so designed, on scale? Finally, there is the strong possibility that we will end up implementing a program or intervention that is qualitatively different from that conceived experimentally. 

It is one thing to find considerable increases in teacher attendance due to the use of time-stamped photographs or rise in safe water consumption from the use of water chlorination ampules when both are implemented over a short time horizon, in microscopic scale, and under the careful guidance and monitoring of smart, dispassionate, and committed research assistants. I am inclined to believe that it may be an altogether different experience when the same is scaled up over an entire region or country over long periods of time and with the “business as usual” minimal administrative guidance and monitoring. And all this is leaving aside its unanticipated secondary effects. In fact, far from implementing an intervention which is tailored based on rigorous scientific evidence, we may actually end up implementing a mutilated version which may bear little resemblance to the original plan when rolled out at the last mile. 

I believe that evidence-based research has a critical role to play in development policy design. But it should complement a process of discovering latent institutional knowledge, through something resembling a scientific problem- solving approach. Experimental research should be used to tie-up the loose ends that arise from the former exercise. A marriage of the two should be the way forward in evidence-based policy design. 

Tuesday, December 18, 2012

The new North-South divide - Water?

I am struck by the remarkably neat north-south stratification in this map of global water demand and availability, both in terms of physical supply and access to populations. The entire southern hemisphere is water stressed, in sharp contrast to the entire north which has enough to meet its demand.

In much of Africa and Latin America, and parts of India and China, though availability may not be a problem, access remains poor. But it is in North Africa, Middle East, and Central Asia, where availability is itself a problem, conflicts centering around water bodies are most likely. Already, water sharing from the Nile, Tigris-Euphrates-Jordan Rivers, and Aral Sea are the source of geo-political tensions.

However, there may be another reason why water may be an important source of geo-political conflicts. It is not that people will be fighting for drinking water. In fact, as this latest OECD forecasts indicate, domestic consumption will be dwarfed by other industrial uses of water. Even the demand for agricultural consumption is estimated to decline. But demand from manufacturing sector and power generation (especially from water intensive renewable solar and thermal generators) is estimated to form nearly half the global demand for water by 2050.

Since a large share of this demand is going to come from the Northern hemisphere, the sharp geographical water-divide will invariably suck in the richer nations too.

Thursday, December 13, 2012

The revolving door and business-politics links

The conventional wisdom on business interests influencing policy making has been one of purchasing such influence through lobbying or outright bribery. However, there is growing evidence, from across the world, that business interests may be more directly integrated into the decision making process by a revolving door between business and politics.

Businessmen enter politics either by contesting elections, made easier by the fact that modern elections are extremely expensive, or be appointed to important posts. While the former may be the more commonplace way in developing countries, the latter may be the more likely entry point in developed countries.

In an excellent recently released study, Simon Luechinger and Christoph Moser use both quantitative and qualitative data to examine Senate-confirmed US Defense Department appointments of six Presidential administrations. Specifically, they observed the effect of these appointments on the stock market prices of the companies which were linked to the appointees. Given the importance of such connections in defense department, where procurements are important, they find,
According to the results, investors clearly expect firms to profit from their political connections. The one- and two-day average cumulative abnormal returns amount to 0.82% and 0.84%. These estimates are not driven by important observations, volatile stocks, or industry-wide developments, and placebo events yield no effects. Effects are larger for top government positions and less anticipated announcements, i.e., announcements for which the actual nominee was not rumoured to be the main candidate. Figure below displays the baseline results and the results for the less anticipated events together with the temporal pattern of average cumulative abnormal returns for the four trading weeks prior to and after the announcement day.

In India, links between business and politics has been more direct, with a large number of businessmen entering politics through elections and backdoor, through the Rajya Sabha. However, the trend of businessmen being appointed to important nominated posts are very small. It is just as well. The example of KV Kamath, who was once being considered for the post of RBI Governor, and who has since been continuously demanding lowering interest rates despite the embedded inflationary expectations, clearly revealing his entrenched preferences, does little to inspire any confidence.

Friday, December 7, 2012

Gift giving to influence decision making

Ulrike Malmendier and Klaus Schmidt have a very appropriate working paper on the corrosive effects of official gift transactions. They outline the problem,
In a typical scenario, a procurement manager receives gifts (ranging from small “tokens of appreciation” such as pens or coffee mugs to precious bottles of wine or event tickets) from a supplier, who hopes to get favorable treatment relative to his competitors, even if his competitors offer better or cheaper products. Similarly, politicians and regulators receive gifts or campaign contributions from lobbyists trying to affect their decisions in favor of special interest groups. In both examples the recipient of the gift makes a decision on behalf of a “client” who is often anonymous: the shareholders of the procurement manager and the general public... a physician may prescribe more drugs of a pharmaceutical company after attending a conference sponsored by that company because he wants to get more sponsoring in the future or because of scientific information provided at the conference... Such practices have raised concerns – and stirred a regulatory debate – about the influence of gifts. Gift giving has been blamed as a major contributor to weak corporate governance, to the dramatic rise of health care costs, and to wasteful pork barrel politics.
And they find that even small gifts have outsized negative externalities,
In a series of experiments, we show that, even without incentive or informational effects, small gifts strongly influence the recipient’s behavior in favor of the gift giver, in particular when a third party bears the cost. Subjects are well aware that the gift is given to influence their behavior but reciprocate nevertheless. Withholding the gift triggers a strong negative response... We also show that disclosure and size limits are not effective in reducing the effect of gifts, consistent with our model... The main contribution of our paper is to show that there is an additional  and powerful effect of the gift per se. Subjects reciprocate to (small) gifts even if there are no monetary incentives for doing so and if the gift does not convey positive information about the product. The laboratory setting allows us to exclude future interaction, informational content, or any (other) monetary incentives as explanations for such a response. We show a significant effect even for small-scale gifts that amount to little compared to the income of the recipient. We also find that the effect is significantly stronger when it comes at the expense of a third party, compared to the classic gift exchange situation with two parties.
Their central finding is simple, "If a gift is given the decision maker tends to favor the gift giver; if no gift is given the decision maker tends to discriminate against him, both at the expense of the third party". The most pernicious effect of this practice comes in gifts given to public officials and health care professionals. The former comes at the cost of the public resources while the latter at the cost of the patients undergoing treatment. Such practices are widespread and not confined to just developing countries.

The close links between public officials and corporate interests is in no small measure underpinned by the psychological bonds established through gift-giving. As I have blogged earlier, human beings form rational expectations based on the social environment in which they work. Public officials, new to a particular office, internalize the expectation of being offered gifts either from the precedents of gift-giving established in that office or from observing their peer group elsewhere.

Furthermore, these expectations form a slippery slope that leads straight down the path to outright corruption. What starts off with accepting routine and small gifts, soon snowballs into accepting expensive gifts and demanding gratification in return for a favor. This process is furthered by the gift-giver who immediately capitalizes on the expectations formed within the official and fulfills his urges. A Mont Blanc pen soon gives way to a family holiday at an exotic foreign location or new year jewelry gifts for the family. With time, even this gives way to offers to finance the child's higher education at a foreign university or an apartment at a prime location. The noose tightens and the public official soon gets anchored within the cross-hairs of the corporate interest.

There are no easy solutions. Banning all gifts is not practical given the difficulty of its enforcement. Moral suasion and the creation of an environment that discourages, even stigmatizes, such gift taking is the only sustainable way to address it.

Wednesday, December 5, 2012

Sunk cost effect and the politics of large military projects

The Times has a nice story that captures the troubles facing the F-35 Joint Strike Fighter plane, being developed for the Pentagon by Lockheed Martin since late 2001. The article describes growing frustration in Pentagon about perceived delaying tactics of the contractor and persistent technological flaws, including limited range. The plane, which was thought to become the Chevrolet of the skies, was to have 70-80% common parts and be used by all the three wings of the military.

In its 12th year of development, the badly delayed stealth technology based fighter jet which is supposed to replace the workhorse F-16, is already the most expensive military weapons system in history. With full production not expected till atleast 2019, the plane is estimated to cost the Pentagon a whopping $396 bn if the Pentagon sticks to its original plans to build 2443 jets by late 2030s. That would be four times as much as any other weapons system and with operational maintenance it is estimated to cost another $1.1 trillion. The cost of one plane has doubled from $69 million in 2001 to $137 now.

The program was pushed through in a hurry, despite widespread cautionary advise, in the aftermath of the September 2001 attacks. Now, with the rising costs and inordinate delays, questions are naturally being raised about the program. The Times points to two interesting reasons why the size of the program may have created a dynamics that makes it virtually impossible to limit, leave alone junk, the program. It writes
Todd Harrison, an analyst at the Center for Strategic and Budgetary Assessments, a research group in Washington, said Pentagon officials had little choice but to push ahead, especially after already spending $65 billion on the fighter. “It is simultaneously too big to fail and too big to succeed,” he said. “The bottom line here is that they’ve crammed too much into the program. They were asking one fighter to do three different jobs, and they basically ended up with three different fighters.”
Further, the production of the fighter plane was rushed through in 2007 even before flight tests had begun, forcing a leading Pentagon official to describe this as an "acquisition malpractice". Further, the military's own scientific experts were kept away from the development process, giving Lockheed a freehand with the technology development. As subsequent events have shown, the technological flaws have proven difficult to fix. The Times reports about the politics behind this move,

The willingness to “roll the dice” reflected the peculiar incentives at the Pentagon, where rushing into production creates jobs and locks in political support, even if it allows programs to drift into trouble. Lockheed and its suppliers on the F-35 employ 35,000 workers, with some in nearly every Congressional district.
The Pentagon clearly faces a big challenge with the management of the project. It now realizes that even if the contractor reneges on future deadlines, as is most likely to happen, it can do precious little to force them to comply. The sunk cost effect, whereby billions have already been spent, will deter the Pentagon from limiting the scope of the program. Both parties also realize that starting a new weapons system program now will take decades and unrealistic, especially given that the existing fighters are close to being grounded. Both parties also realize that given the large numbers of jobs created in its development, any effort to prune it down will raise strong political opposition. Further, cutting high-profile military programs will always raise the bogey of compromising national security. In any case, the biggest winner is Lockheed Martin, which has found an excellent opportunity to bleed the American tax payer for atleast the next three decades.  
The Times article is not clear on who is to blame for this misadventure, nor does it try to explore the motivations behind these apparently questionable decisions. It is naive to expect that these decisions were taken purely with good intentions and in the haste to get the new fighter jet flying. Such stories are commonplace in weapons market, especially in many developing countries. However, in all these places, the shadow of corruption and rent-seeking would loom large with all such deals. It will be surprising if the same were not true with F-35 fighter jet.    

Sunday, December 2, 2012

Analyzing the Turkish Economy

Turkey has been one of the most impressive economic growth stories outside India and China over the last decade. But, like all others, it too could not avoid the contagion effects of the Great Recession, suffering a sharp economic contraction in 2009. However, it recovered spectacularly in the aftermath of the Great Recession, growing at 9.2% and 8.5% in 2010 and 2011 respectively. The flip side of this impressive growth has been a build-up of dangerous signals elsewhere in the economy. As The Economist warned in mid-2011, signatures of overheating were evident everywhere in the Turkish economy.

As indicated in the IMF 2011 Consultation Paper, the external and internal balances have been casualties of the recovery. Its rapid growth concealed disturbing structural imbalances which had crept into the economy during the period of sustained growth. The rapid economic growth was built on the foundations of spurt in private investment, household consumption and imports. This graphic constructed from Eurostat indicates the surge in private investment and imports in the 2010-11 period.

Capital inflows from the core economies of Europe increased, encouraged by the strong economic growth signals coming from the country. The IMF’s Consultation Paper writes,
Loans to the private sector grew by around 40 percent y-on-y during Q4 2010 to Q2 2011, to reach 48 percent of GDP. This reflected the historically-low interest rate environment and banks’ intense competition for market share. Lending was especially rapid to households (for general purpose and housing loans) and to small- and medium-sized firms due to strong demand and higher profit margins on these loans. With the increase in resident’s deposits - previously banks’ main funding source - falling far short of the increase in lending, banks’ average loan-to-deposit ratio jumped from 76 percent at end 2009 to near 95 percent in mid-2011. To expand loans, during the first nine months of 2011, banks relied on financing sourced from abroad to the same extent as residents’ deposit growth. 
As credit growth boomed, inflationary pressures became unhinged. Unemployment rate declined and the labor market tightened. Wages have risen sharply over the past three years. The rise in wages has also adversely affected the country’s external economic competitiveness. This has adversely affected exports, as reflected in the slowdown in exports, despite increased economic activity.

Business inventories have been rising and capacity utilization has been rising across the private sector. These headline inflationary pressures have been integrated into the broader economy, as reflected in the rising core inflation. Inflationary pressures have been boosted by the cumulative 30% nominal depreciation the Turkish lira has undergone since November 2010.

The central bank’s pro-cyclical policies too may have contributed to the inflationary pressures getting unhinged. Once Turkey opened its dialogue with European Union for membership in early 2005, investors formed expectations of its eventual entry into the Union and the implicit European guarantees that come with membership. Turkish government bond yields fell and capital inflows surged. The Turkish central bank has amplified this trend by embracing an extended period of monetary accommodation, and has kept its repo rates at record low rates.

This trend is similar to that with the case of the peripheral European economies in mid-nineties after the decision to join thesingle currency was announced. As happened there, capital inflows into the Turkish economy, to finance consumption and investment has surged. The rising wages and resultant decline in Turkish external competitiveness has the trademark signature of what happened to the peripheral European economies like Greece and Portugal.   

In many respects, Turkey’s macroeconomic situation is typical of developing countries which experience such positive shocks. Access to cheap capital often tends to increase credit growth, boost consumption, raise imports, and spur investment activity. All these make the non-tradeable sector more attractive, raising investment and supply. This often comes at the expense of the tradeable sector. As the economic growth exceeds its potential output, inflationary pressures get unleashed.  

In the Salter Swan model of macroeconomic balance, the Turkish economy stands at the point indicated by B. In the aftermath of the 2008-09 crisis, the economy recovered smartly on the back of a mixture of public spending, public consumption, and private investment. External capital inflows contributed significantly to this financing this trade. However, all of these policies and resultant effects pushed the economy from A to B, causing both external and internal imbalances. The internal imbalance is reflected in the overheating economy. The external imbalance is manifested in the rising and unsustainable current account deficit.

In order to re-balance its economy, Turkey needs to immediately address its twin imbalances. As the Salter-Swan model indicates, the economy needs to get back to A. This has to be achieved by re-balancing the internal sector, by cooling down economic growth and rectifying the resource mis-allocation away from the non-tradeable sector. This can be done by the central bank reversing its accommodatory policies and raising interest rates. This will slow down credit growth and thereby lower consumption and investment.

More fundamentally, the increasing prices for the non-tradeables (as reflected in the inflationary pressures) will dampen demand and contribute towards shifting economic activity away from non-tradeables. The higher Pn, ratio of price of non-tradeable and tradeable goods, will boost export activity. The economy will move up in the Salter-Swan model from B to C. If the central bank allows the Turkish lira to depreciate further, it will contribute towards raising Turkey’s external competitiveness.

The devaluation will help restore the economy’s external balance, over time, through three effects. First, the higher exchange rate will increase the competitiveness of Turkish exports and boost it. Second, the real balance sheet effect will contribute towards reducing imports. Third, in the absence of exchange rate stabilization policies and sterilization, the monetary approach to balance of payments effect tells us that the economy will re-balance by lowering the money supply. The LM curve in the IS-LM model will be pushed back to its long-run equilibrium. This corresponds to the movement from C to A in the Salter –Swan model.

It is imperative that Turkey address its internal and external imbalance problems at the earliest, failing which there could be the possibility of it slipping down the same path as Greece.