Protectionism on the rise?

Real Time Economics draws attention to a World Bank report which claims that 17 of the G-20 countries have erected new trade restrictions over the past few months. It finds that developed countries have relied exclusively on subsidies, imposing 12 such measures, while nearly half of the 35 measures adopted by developing countries were tariffs. Subsidies to prop up the auto sector amount to $48 billion, with high-income countries accounting for $43 billion of that, including $17.4 billion in the U.S. alone.

Barry Eichengreen and Douglas Irwin draw on the experience of the Great Depression to argue that the only way for countries to avoid the spectre of protectionism is to co-ordinate their fiscal and monetary policies.

They write that monetary stimulus generally benefitted the initaiting country but had a negative impact on its trade partners, "The positive impact on its neighbours of the faster growth induced by the shift to 'cheap money' was dominated by the negative impact of the tendency for its currency to depreciate when it cut interest rates. Thus, stimulus in one country increased the pressure for its neighbours to respond in protectionist fashion."

As Paul Krugman said earlier, the problem with fiscal policies are that its positive policy externalities and attempts by countries to capture it locally, would lead to protectionist policies. The "Buy American" provision in the Obama administration's fiscal stimulus plan is only the most recent example. Eichengreen and Irwin write,

"Fiscal stimulus in one country benefits its neighbours as well. The direct impact through faster growth and more import demand is positive, while the indirect impact via upward pressure on world interest rates that crowd out investment at home and abroad is negligible under current conditions. When a country applies fiscal stimulus, other countries are able to export more to it, so they have no reason to respond in a protectionist fashion. The problem, to the contrary, is that the country applying the stimulus worries that benefits will spill out to its free-riding neighbours. Fiscal stimulus is not costless – it means incurring public debt that will have to be serviced by the children and grandchildren of the citizens of the country initiating the policy. Insofar as more spending includes more spending on imports, there is the temptation for that country to resort to 'Buy America' provisions and their foreign equivalents."

AIG story in graphics

AIG, in which the government has so far taken over 80% in stake, has moved from one bailout to another and there is no end in sight even after receiving capital infusion of $180 bn in four tranches - $90 bn in two loans, $40 billion purchase of preferred shares and $50 billion to soak up the company’s toxic assets (more here). A nice chronicle of the AIG crisis is available here.

NYT carries this excellent graphic outlining the story of AIG.



The bailout story is outlined below



And the controversy on bonus payouts is captured below



And the list of all its trading partners, who benefitted from the government bailout, is available here.

Update 1
And in response to the hugely unpopular $165 m bonus payout by AIG, the US House of Representatives passed a legislation imposing 90% tax on on bonuses paid this year to traders, executives and bankers of AIG and other firms that have accepted large amounts of federal bailout funds and who earn more than $250,000. The legislation would apply to bonuses paid to executives at companies holding at least $5 billion in bailout money and would essentially wipe out the phenomenal paydays that have been a tradition on Wall Street, at least until the firms reduce the amount they owe taxpayers to less than $5 billion.

Global development snapshot

(HT: Aid Watch)

The integrated global economy and the crisis

The last two decades have seen the build-up of global macro-economic and structural imbalances on a massive scale. The technology shares and then the real estate bubbles in the US generated a wave of "irrational exuberance" and a widely shared "wealth effect" that triggered off a massive consumption binge among American consumers. The former was fuelled by what Ben Bernanke called the "global savings glut" which had its origins in the emerging economies and was sustained by the loose monetary policy followed by Alan Greenspan.

Chastened by the bitter experience of the their crisis of 1997, the Central Banks of East Asia ran up massive foreign exchange surpluses, which, in the absence of sufficiently mature domestic financial markets, they invested in the safety and liquidity of the US Treasury Securities, despite their low yields. At its peak, these inflows were financing the US deficits at the stunning rate of $ 2 bn per day, and blowing up one bubble after another! The cheap capital in turn spawned a massive spurt in financial engineering and innovation, resulting in the proliferation of large number of complex financial instruments and products.

All this in turn generated a wealth effect that was encashed by the American consumers through a massive consumption binge, that was sustained to a large extent by borrowings. The cheap imports from the export hungry economies of East Asia in turn fed this consumption boom in the US besides keeping a tight lid on inflationary pressures.

In other words, there were a series of striking complementarities. One part of the world economy had huge capital surplus, which was readily absorbed by another part. One part provided cheap exports which were lapped up by consumers in another part. Cross-border capital flows found favorable investment climate among the emerging economies. Massive surpluses in one part sustained equally massive deficits in another part. Thrift and savings in one part of the world financed borrowings and consumption in another.

Many leading economists like Ken Rogoff had cautioned about the over heating global economic growth. The steep rise in foodgrain, energy and commodity prices in 2007-08 and the attendant global inflation scare was the first sign of an over heating global economy.

The sub-prime mortgage bubble is only a sub-set of this spectacular house of cards built up by these imbalances. In many ways, the much bigger bubble that has been pricked is the spectacular trilogy of unprecedented global economic growth, international trade in goods and services, and cross-border flows of capital. The financial market bubble was only the first to blow out, triggering off a cascading effect on the other two dimensions.

That the ongoing economic crisis had its origins largely in the sub-prime mortgage section of the American financial markets is now widely acknowledged. It is therefore surprising that it has had equally devastating effect on financial markets and economies elsewhere, both developed and emerging. There have been five major transmission mechanisms

1. De-leveraging from emerging economies
As the sub-prime mortgage bubble burst and the writedowns started mounting, the Wall Street firms started unwinding their positions in emerging economies to shore upt he balance sheets of their beleaguered parent firms in the US. There was a stampede towards the exit doors from emerging markets, sharply pulling down their equity markets.

The cascading effect of the de-leveraging and the wobbling global economy only added to the pressure on these foreign investors to repatriate their capital to the relative safety of US Treasuries. In fact, the first signs of appreciating dollar may itself have been a contributing factor towards investors exiting these economies.

The first half of the decade was the high noon of capital flows into the equity markets of the emerging economies. Private money invested in so-called emerging countries plunged from $928 billion in 2007 to $466 billion last year and is likely to fall to $165 billion this year, according to the Institute of International Finance.

2. Rising dollar
The de-leveraging saw American investors unwinding their foreign investment positions and bringing back the dollars home, thereby resulting in the appreciation of dollar. Apart from boosting the embattled balance sheets of their parent firms, these dollars have found a safe haven in the liquidity of American Government bonds. The emerging economy Central Banks too continue their investments in US Treasuries.

In 2008, the dollar rose 13% against major foreign currencies after adjusting for inflation, according to Federal Reserve data and foreign holdings of Treasury bills rose by $456 billion. Though this has been described as being similar to jumping into a house on fire, investors appear to believe that US Government will not default on its debt, re-affirming dollar's supremacy as the global reserve currency of choice.



This flight to dollar has had many effects. Primarily it has ensured that President Obama has enough funds (atleast until now) to finance the massive deficits to bailout the financial markets and stimulate the economy. It has hurt the US exports by reducing their competitiveness. However, it has contributed to keeping the price of oil down (oil prices are benchmarked to the dollar). Most importantly, it has had the effect of reversing the recently established pattern of capital flows from developed economies to emerging economies.

But unfortunatley, this default flight to dollar has the potential to build up another set of distortions and imbalances. It is seriously eroding the competitiveness of American exports, a major handicap at a time when America strices to lower its massive current account deficit. Further, as the Times writes, "A dollar invested by foreign central banks and investors in American government bonds is a dollar that is not available to Eastern European countries desperately seeking to refinance debt. It is a dollar that cannot reach Africa, where many countries are struggling with the loss of aid and foreign investment." Finally, the fact that American can still borrow at lower costs to finance its massive deficits is a strong dis-incentive for the US from making further structural adjustments on both spending and savings side.

3. The crisis in Eastern Europe - The last few years have also witnessed massive foreign currency borrowings, especially in Euros, by East European corporates (NYT has this story on the Russian oligarchs) to finance grandiose projects. As East European stock markets soared along with that of the remaining emerging economies and oil and commodity prices soared creating new billionaires in these parts, European banks cometed against each other in lending to these borrowers. There was a widespread belief that these borrowers, especially those from Russia, had implicit government backing and therefore the risk of default was minimal.

Now, with the global economy tethering on the precipice, these loans are already turning sour, as the borrowers struggle in the face of increased real debt burden and deteriorating balance sheets. The former is a consequence of the declining domestic currencies and the latter an inevitable accompaniment to the global economic slowdown. These defaults have the potential to trigger off major turmoil in Western European financial markets, and those loans could end up being Europe's equivalent of sub-prime bubble. In many respects, the sitaution in Eastern Europe looks similar to East Asia in the late nineties.

4. Falling exports
The heavy reliance of the East Asian economies on exports to drive economic growth has been exposed by the global economic slowdown. For far too long, the insatiable appetite of the American consumers for cheap imports of all kinds of goods had provided the perfect market for East Asian exporters. Now, as the American consumers have shut their doors tight, the exports have dried up dramatically. The knock-on effect of this external shock has been devastating on the economic growth of these economies, most of whom contracted in the last quarter of 2008.



5. Global deflation
The other major worry for the world economy is the strong possibility of a deflationary spiral gripping it, with clear trends of rapidly falling inflation in both developed and developing economies. If this trend continues, the world economy would be staring at what Nouriel Roubini has already predicted as the "stag-deflation", a devastating cocktail of growth recession and deflation. And the low interest rates across the world, kissing the zero-bound in most of the developed economies and close to the same elsewhere, makes the situation even more depressing as it forecloses the many of the conventional monetary policy responses to stimulating growth.

The major exporting economies of Europe, mainly Germany and France, too have been badly hit by the steep decline in global demand. It is one of the great ironies of the times and a testimony to how intimately linked are the fortunes of the economies of the world, that even those relatively healthy and fundamentally strong economies of the world like Germany and many of the East Asian economies, have been devastated by a crisis that had its origins in a sliver of the American financial markets.

The biggest cause for concern is that unlike in the previous crises, this time every major economy - developed and developing - and every sector - services and manufacturing - is badly affected, thereby leaving the global economy with no anchor to pull itself out. Previous crises were confined to a few economies or sectors, who could then rely on the others to bail them out and export their way out of the crises. The East Asian economies and Japan could rely on the massive demand from American consumers to export their way out of trouble. Similarly, the American financial markets found willing collaborators in the Asian and East European Central Banks and Sovereign Wealth Funds (SWFs) to keep up a strong flow of credit and calm the markets after the collpase of the equity markets in the aftermath of the bursting of the bubble in technology stocks.

We have the first truly global economic crisis. It cannot be denied that the chickens of globalization have now come home to roost. The two critical touchstones of globalization - trade in goods and services, and cross-border capital flows - are in retreat, and with some vengeance. A new World Bank report has predicted that the global economy would shrink in 2009 for the first time in more than half a century and forecast that global trade would decline for the first time since the early 1980s.

Debate on quantitative easing

An interesting debate is on about the utility of monetary policy during recessions, especially when interest rates are touching the zero-bound.

It has long been argued in the neo-Wicksellian paradigm that as part of stimulative monetary policy, Central Banks should lower their very short term interest rates, thereby reducing both bond yields and longer term rates, and boosting aggregate demand, future growth and inflation. But when short term interest rates are zero, expectations of future inflation and growth are not well-anchored, and central banks consider operating on longer term rates, this paradigm looks incomplete. In such circumstances, it would appear that monetary loosening by Central Banks should aim at increasing bond yields, since it would signal higher expected growth in real output and attendant inflation, which would in turn increase long term interest rates.

It is in this context that Nick Rowe points to a question raised by David Altig of the Atlanta Fed in Novemeber 2008,

So, if stimulative monetary policy is what we are after, should we be looking for lower long-term rates or higher long-term rates?

With the interest rates touching the zero-bound, rendering conventional interest rate driven monetary policy responses to the banking crisis superfluous, Central Banks across the world (and here) have been toying with unconventional responses like buying private sector assets by issuing Treasury Bills and "quantitative easing" (QE) techniques. Under QE, the Central Bank will buy government securities and private assets like commpercial paper (CP), using its own money, either newly printed or from available stocks, thereby effectively adding to the monetary base.

By resorting to QE, specifically by purchasing long term government securities, the Central Bank is hoping that its purchases would push up the bond prices, and hence lower bond yields, and lower longer term interest rates. It is then hoped that this would set in motion a cycle of expectations about future economic prospects that would boost investment, increase real output, boost consumption, increase inflationary expectations and hence lead to higher interest rates.

In other words, the success or otherwise of QE would depend on the relative effects of the purchase of securities and the impact on expectations about the future growth prospects. The need of the hour being expectations of higher growth and resultant future inflation, which would force up interest rates, it is important that QE too achieve the same result. This can be achieved only if the effect of expectations about future growth exceeds and dominates the effect of purchase of securities.

In normal times, nominal short term interest rates can be effective in driving long term expectations. However, when interest rates are touching the zero-bound, Nick Rowe argues that "a permanent increase in the money supply (or one that is expected to be permanent) will have a different, and bigger, effect today than a temporary increase in the money supply (or one that is expected to be temporary)".

About its transmission down the economy, Rowe writes, "The objective of monetary policy, in a recession, is to create an excess supply of money. People accept money in exchange for whatever they sell to the central bank, because money by definition is a medium of exchange. But they don't want to hold all that money. Or rather, the objective of the central bank is to buy so much stuff that people don't want to hold the money they temporarily accept in exchange. An excess supply of money is a hot potato, passing from hand to hand. It does not disappear when it is spent. It spills over into other markets, creating an excess demand for goods and assets in those other markets, increasing quantities and prices in those other markets. And it goes on increasing quantities and prices until quantities and prices increase enough that people do want to hold the extra stock of money."

Paul Krugman though disagrees and feels that once short-term interest rate become zero, "money becomes a perfect substitute for short-term debt", and "any further increase in the money supply therefore displaces an equal amount of debt". He feels that QE techniques like buying long-term debt or risky assets, will have an effect not by increasing money supply, but by the central bank taking some risk off the private sector’s hands, with all its attendant consequences.

Update 1
William Buiter makes the distinction between QE (expanding the monetary base), credit easing (outright purchases of private securities by central banks), and enhanced credit support (provide collateralised loans on demand at maturities up to a year at the official policy rate). He argues that all these measures worl when the credit markets face liquidity crisis, but not when the problem is a solvency crisis.

Free power and market distortions

That there are no free lunches is a widely acknowledged tenet of the dismal science. It is therefore understandable that free power provided to farmers in many Indian states come with substantial costs, more medium and long term, on a number of other sectors. Here is a laundry list of possible incentive distortions and negative externalities imposed by free power to farmers.

1. Most obviously, in the absence of any price signal, there will be an inevitable over-use of electricity.
2. Since electricity availability also determines the ability to access water sources, free power will also lead to over-exploitaiton of water resources.
3. With water availability no longer a constraint, farmers will be inclined to over-exploit both surface and ground water sources. They are likely to grow more water intensive crops and go in for multiple croppings. Attendant environmental damage arising from chemicals run off and salinization are inevitable.
4. With the constraints on water availability reduced, farmers lose the incentive to optimize on their water usage. The crop patterns tend to get skewed towards more water intensive commodities and farmers have no incentive to improve their productivity (by minimizing the usage of scarce water resources).
5. Farmers will be incentivized to make one-time investments in higher than required capacity of motors and pumps to extract (and thereby over-exploit) ground water. Ground water levels will decline with calamitous impact on drinking water sources, salinization (especially in coastal belts), deforestation, and exacerbating the inequity in access to water sources (falling water table makes the water more inaccessible to poorer farmers who cannot afford the larger capacity motor pumps).
6. With no incentive to optimize usage of electricity, farmers will end up purchasing poor quality motors (with low power factors and high power consumption) which sell cheaper in the market. These poor quality motors will end up "crowding out" the good quality motors.
7. In the context of substantial power deficits, over-use of electricity by farmers will result in scarcity elsewhere - residential, commercial and industrial consumers. Industrial and commercial activity will be adversely affected. The marginal costs imposed by scarcer electricity for the later is much larger than the marginal benefits accruing to farmers from free power.
8. In the absence of any returns from distributing power to farmers, the power distribution utilities will have no incentive in ensuring quality power supply or making additional investments in delivering power to these rural areas.
9. The inability of governments to fully reimburse the distribution and transmission utilities the cost of the free power delivered (a fait accompli given the precarious fiscal situation in many states) very adversely affects their operational viability and commercial profitability. The long term costs imposed on these utilites are considerable.
10. In order to restrict agriculture supply to the promised number of hours only, distribution utilities have made massive investments in segregation of rural and agricultural feeders (Gujarat), re-configuring feeder networks to enable single phase supply (1/3 arrangements in Andhra Pradesh), or load management units. By limiting three phase supply, these initiatives go against the professed objective of promoting non-farm sector growth in rural areas. It hinders the setting up of cold storages and food processing units, besides small scale manufacturing industries. Such sectors face high up-front investment costs in dedicated three phase lines, besides suffering from poor quality of supply.

Free market in water and the regulatory challenge

During the high noon of free-market capitalism in the aftermath of the collapse of the Soviet Union, it was thought that unrestrained free market capitalism could provide solutions for any public policy challenge. It was thought that these markets are best suited to optimally and efficiently allocate scarce resources among competing claims to those with the highest economic use, minimize transaction costs, and have within themselves the mechanisms to make course corrections and remedy distortions. As part of this trend, privatization of public service utilities had become the norm.

More than three decades after the experiment with market mechanism for delivering public utility services was was launched in Chile, the poster child of privatization, NYT has this report card. Starting from 1981, Chile had conferred private property rights on water, a public resource elsewhere, and permitted buying and selling of water like other commodities, with little government oversight or safeguards for the environment.

The result of this unfettered play of markets has been a system that promotes speculation, endangers the environment and allows smaller interests to be muscled out by powerful forces, like Chile’s mining industry. It writes, "Private ownership is so concentrated in some areas that a single electricity company from Spain, Endesa, has bought up 80% of the water rights in a huge region in the south, causing an uproar. In the north, agricultural producers are competing with mining companies to siphon off rivers and tap scarce water supplies, leaving many towns bone dry and withering."

Market based allocation and unbridled trading, coupled with a two-year drought, has created numerous anchronisms like in Atacama desert city of Copiapó, where "there are many more water rights for the river than water that arrives from the river". The absence of adequate environmental regulations have left ground water sources and rivers and lakes, contaminated by mining companies, whose heavy metals and other substances associated with mineral processing are found in these water sources.

The NYT article traces the fate of the town on Quillagua, which is in Guinness World Records as the "driest place" for 37 years, but had prospered off the Loa River, reaching a population of 800 by the 1940s, "A long-haul train stopped here — today the station is abandoned — and the town’s school was near its 120-student capacity. Today there are 16 students... without suitable water to raise crops, many residents saw no reason to continue resisting outside offers to buy the water rights in their town. One mining company, Soquimich, or S.Q.M., ended up buying about 75 percent of the rights in Quillagua. Most residents moved away; those who remain average around 50 years old... In 2007, the national water agency started investigating claims that Soquimich was extracting even more water from the Loa River than it was due. The inquiry is still pending."

In another recent development, the state of California declared a state of water emergency, because of three years of below-average rain and snowfall, a step that urges urban water agencies to reduce water use by 20% or face mandatory rationing if situation worsens.

This report card on the Chilean experiment and the California's problems provide excellent contextual settings for analyzing Prof. Robert Stavins' ineresting blog posts on the misconceptions about water pricing and the advocacy that price signals are the most effective mechanism for efficiently managing water demand(research article here). Prof. Stavins argues, highlighting the difference between the costs of a price of a can of soda and equal quantity of water, that water is heavily under-priced in the US, therefore eliminating all incentives to conserve scarce supplies.

While Prof Stavins is spot on in claiming that "efficient use of water will take place only when the price reflects the actual additional cost of making that water available", it is far too simple to assume that price mechanims can allocate water most efficiently and fairly. He is also right in analysing the fact that only a very small (estimated to be no more than 5% in the US) proportion of water is actually used for essential activities like drinking and cooking, thereby leaving enough room for price signal to effectively allocate the resource. (though here too, when coupled with bathroom, toilets and other essential activities, the share would go beyond 50%) His arguement about "seasonal pricing" of water, to take account of the reduced supply conditions during summer is also well founded. Further, the use of a system of "life-line prices" or provision of a minimum quantity free of charge, and focussing on price signals at higher consumption levels makes eminent sense.

However, especially in view of the Chilean and other experiences from across the world, any market based allocatory mechanism has to be under-pinned by and effective and enabling regulatory framework that will police the expected market failures. For a start, given the essential nature of water use and competing claims with industries and other uses, market based allocation should have clear and unambiguous first charge on water resources for domestic use. Among domestic users, it is possible for price signals, "life-line prices", and increasing block tariff (IBT) based approaches, to allocate water in a fair and efficient manner. Further, at the upstream, it is important that water extraction be subjected to all the required environmental safeguards so as to ensure that the negative pollution related externalities of industrial water extraction and use are left to be incurred by the society.

Of equal importance are issues related to riparian, especially lower, rights which are vital to ensuring that local communities are not denied their traditional right of water usage for their domestic and livelihood (agriculture and animal husbandry) purposes. It is easy to get carried away by the logic of property rights and price signals and construct market mechanisms that effectively overlooks these traditional claims and excludes (or prices out) all such categories. Needless to say, all such arrangements are unsustainable and recipes for disaster.

Further, the effectiveness of market-based systems, especially to manage the upstream supply-side of water, by using property rights and trading meachnisms may be of questionable value. Such arrangements presupposes the presence of a competitive market, with enough depth and breadth in traders and quantity supplied/traded. However, from countless experinces across the world, it has been found that three issues come in the way of such arrangements - consumption demand varies across seasons; supply is subject to vagaries of the weather; and supply generally declines with each passing year as the scarce available resource invariably gets allocated among an increasing number of users, each of whose demand in turn keeps growing.

It is for the same reason that un-bundling of water supply systems, similar to the example of electricity sector, and as suggested by Prof Stavins, may be counter-productive. As the experience of California with electricity suggests, the un-bundling of water systems and embracing of market based mechanisms, are no guarantee to ensuring that supply of water to bulk users like municipal suppliers can be made competitive.