Friday, November 14, 2014

What if… Gorbachev had succeeded?

On 7 October 1989 Mikhail Gorbachev visited Berlin for the celebration of the GDR 40th-anniversary, and said: “History punishes those who come too late” (Childs 2000): the statement criticised Honecker but was best suited as his own epitaph. 

But let’s try and imagine what might have happened if Gorbachev’s perestroika had actually succeeded.  Five years ago I wrote a paper developing this theme and presented it at a Conference in Warsaw. The paper illustrated how Gorbachev might have succeeded in achieving the radical reform of the Soviet political and economic system, the construction of market socialism, the re-structuring and acceleration (uskoreniye) of the Soviet economy, and the possible though unlikely continued existence of the USSR.

I should stress that this was not, or at least was not meant to be, an exercise in 20/20 hindsight. Alternative courses can be formulated without the possession of perfect foresight of the state of the world in 1985-1991.  Nor is a change in Gorbachev’s initial conditions required, of the kind “If only he had come to power in 1974, at the height of the fourfold rise in the oil price ...”. This exercise was meant as a genuine counterfactual alternative. Its purpose is that of damning Gorbachev’s disastrous economic strategy and showing that he and his economic policies, more than anybody else’s doings, are ultimately responsible for the collapse of  socialism in the Soviet Union, for the failure of an alternative design of market socialism, and for the immense human cost of post-socialist Transition.  A similar exercise, considering counter-factual alternatives to the actual course of Transition in Cental-Eastern Europe, is only outlined to suggest that Transition might have been handled at a lesser human cost. 

In order to succeed, Gorbachev would have had to act swiftly, instead of practically wasting his first two years in power (1985-87), and lay down sound economic foundations for perestroika: eliminate repressed inflation, preferably through a confiscatory currency conversion; break state monopoly of foreign trade, introduce rouble convertibility on current account, liberalise trade, foster competition. By 1991 he would have also legalised private ownership and enterprise, given state managers bonuses geared to market performance, implemented small privatisation, commercialised state enterprises, begun some privatisation of large enterprises and banks. On Christmas Day 1991, instead of resigning as President of the Union, he could have celebrated the victory of economic perestroika.

What next? There would have been still thorny choices and therefore possible mistakes to be made, before completing Transition and after. Gorbachev would have needed continued vigilance and sound economic advice, for instance to avoid too rapid dis-inflation at inordinately high real interest rates, as happened in 1994-95, and the consequent recession; to avoid an unsustainable combination of overvalued exchange rate, high interest rate to support it, and a public debt increasing as a result of high debt service, as happened in 1998 under the IMF’s watch; to avoid the unnecessary cost to the budget of switching the pension system from PAYG to a funded system.

As a result of the good economic foundations of economic perestroika, and the avoidance of these kinds of subsequent pitfalls, income losses from the Transition recession would have been lower, and growth would have accelerated earlier and faster than it actually was and did. The welfare of Russians would have improved significantly and continuously as a result. The same reasoning applies to all other Transition economies that to a greater or lesser extent followed stabilisation and Transition paths out of sequence or to excess. It is impossible to have unanimity about whether the measure taken were or were not mistakes, and how serious, let alone quantify the gains. But pretending that there were no serious unnecessary mistakes in the Transition is neither reasonable nor respectable. 

The improved economic performance would have generates political consensus, but not necessarily to the point of providing permanent democratic support for a political regime associated with significantly large state ownership and associated political values (of equality, solidarity, participation, etc.). In some Transition countries post-communist parties were returned to power in democratic elections (e.g. Poland, Hungary, Slovakia) after being defeated,  but only intermittently, not permanently; some party alternation in power is an integral part of democracy. But non-persistent, intermittent market socialism cannot deliver its expected economic and social advantages. When democratic support for an ecomic system is lacking or is not permanent, then its maintenance over time requires necessarily forms of political repression. There is a high political price to pay for an economically successful and persistent market socialism – as confirmed by "market socialist" countries such as China, Vietnam, Belarus, Uzbekistan. 

Would an economically successful Gorbachev have been able to hold together the Soviet Union? There would be economic advantages to be shared out, from holding it together.  A continued Union would maintain and promote intra-Union trade volumes thanks to the single currency, and sustain inter-republic imbalances through transfers within the All-Union budget and inter-republic credits.  An early initiative and widespread economic success, including internal and external convertibility of the rouble, would have lessened centrifugal forces. If some political and administrative autonomy was granted to the 15 republics as well, the chances of retaining the Union would have improved. But the Soviets had seldom solved ethnic conflicts, mostly they had only suppressed them (just as they had done with inflation). Independence aspirations would have made it difficult for Russia to retain close ties even with republics that economically had most to gain from continued integration, like Ukraine. The probability of holding together the Union would have been greater than zero, but not significantly greater. 

Would a successful market-socialist Russia have been able to hold together CMEA/Comecon? Arguments similar to those for holding together the Soviet Union would apply, but would be much weaker. The international socialist division of labour had a bad name, in spite of Soviet subsidisation of its Comecon partners since 1974, by supplying oil and raw materials at below world prices. Memories and accusations of earlier Soviet exploitation through trade were still deeply ingrained. In January 1990 Comecon partners de facto destroyed it by trading freely rather than continue the old trade arrangements, even at the cost of paying higher prices for oil and materials. By September 1991 Comecon was officially dissolved. Comecon Soviet trade partners were already negotiating European Association Agreements and aid programmes with the European Community (now the European Union).

Gorbachev's hypothetical successful perestroika would not have led to Comecon survival.  At most, perhaps, a couple of years earlier he might have been able to extract economic assistance from the West in exchange for his acquiescence to the re-unification of Germany – for which he got nothing at all – and for the Finlandisation of Eastern Europe – a prospect overtaken by events in 1989.   

What difference would Gorbachev’s hypothetical successful perestroika have made in Russia? Only an alleviation of the pains of Transition in the 1990s; there would have been not very much difference in the 2000s, considering that in his second presidential term Putin had already reversed enterprise ownership trends, re-acquiring greater state control in many sectors and a majority stake in energy (Hanson, 2008). By comparison with the sensitivity of Russian performance to the price of oil, probably Gorbachev’s success would have been equivalent to a ten-year-long rise of $10 on the price of a barrel. (According to the Bank of Finland Research Department a $10 permanent increase raises Russia’s growth rate by 1%). The recent implosion of the US and global financial system had a far greater effect on Russia’s prospects.

What difference would Gorbachev's hypothetical successful perestroika have made to modern geopolitics? An earlier economically stronger Russia would have probably contained USA bids for the "American Century", thus sparing them the humiliation of their century ending so soon after it had barely begun.  Certainly Georgia would not have responded to encouragement by George W. Bush and Dick Cheney to attack Russia. But the Twin Towers had nothing to do with Russia, and it is impossible to tell whether the major armed conflicts that followed their attack – in Afghanistan and Iraq – would have been prevented by an economically stronger Russia. Most probably not.

Gorbachev’s and the whole Transition’s economic débacle clearly reduced the demand for socialism on a world scale, but his success would have made no difference for European social-democracy, as it would not have prevented the disintegration of the Italian left or the degeneration of British Labour into New Labour, nor favoured Zapatero’s victory in Spain. Probably both the European Union and NATO would have been smaller than they are now.

A Russian economy made stronger by an efficient Transition would have been less vulnerable to the contagion of global financial turmoil, both in the South East Asian crisis of 1997 (that was an important factor in the Russian crisis of 1998), and today. But a stronger Russia would have neither prevented such global financial crises, nor contributed much to their resolution. 

We should leave the future to futurologists. In 1989 Fukuyama’s conjecture  about The End of History was falsified before the ink had dried. All we know for sure, whether Gorbachev had or had not been successful in implementing economic perestroika, is that – as prophesised by a wall graffiti in London in 1991: "The future is not what it used to be".   

Wednesday, July 16, 2014

Stuck In Transition

The EBRD Transition Report for 2013, published last November, was entitled Stuck in Transition? By the time of the EBRD Annual Meeting of 14-15 May 2014 the cosmetic question mark was no longer appropriate.

In 1991 the EBRD – European Bank for Reconstruction and Development – was set up in London in order to assist the post-socialist transition countries, and to promote their sustainable development as open market economies. Initially the EBRD operated in 28 countries: the 15 Republics from the Former Soviet Union, 6 countries from Central-Eastern Europe (Bulgaria, the Czech Republic, Hungary, Poland, Romania, Slovakia), 5 Republics from Former Yugoslavia, plus Albania and Mongolia.  Soon the Czech Republic was declared to have completed its transition and dropped out, but two additional members from the further split of Former Yugoslavia were added: Kosovo and Montenegro. Then 6 countries from Eastern and Southern Mediterranean were added, assimilated to transition economies because of similar problems of stabilization, re-structuring, and the change of their political and economic institutions: Cyprus; Turkey; Egypt, Jordan, Morocco, Tunisia. Today the EBRD has 35 countries of operation, and 66 shareholders. Next Libya is lined up for membership.

Since 1994 the EBRD has published in November every year a Transition Report, monitoring economic and institutional developments and constructing synthetic indices summarizing the progress of individual countries in various aspects of their transition process. In November 2013 their Transition Report was entitled: Stuck in Transition?, with a cosmetic question mark at the end. The Report acknowledged that since the mid-2000s the reform process seemed to have stagnated in transition countries, actually registering some reversals reflected in the “downgrading” of EBRD indices. The inflow of Foreign Direct Investment had slowed down and in some countries was reversed, also as a result of the end of US Monetary Easing pre-announced by Ben Bernanke. Economic growth, as a result of the 2008-2009 global crisis and the Eurozone Crisis of 2011-2012, had slowed down to well below pre-crisis levels: only 2% was expected in 2013. Productivity growth - under current policies and institutions – was going to be modest during the current decade and decline further in the next decade: therefore economic convergence with developed countries was at risk. Further economic reform meets social, political, human and capital constraints.

But for the EBRD Stuck In Transition? was only a rhetorical question. The preannounced end of US Monetary Easing did not materialise under Bernanke or his successor Janet Yellen. The Eurozone Crisis was countered by the ECB unorthodox new measures introduced by Mario Draghi. FDI was bound to resume its course. In November 2013 economic growth in the area was projected to accelerate to 2.7% in 2014. There was said to be a virtuous circle between democratization and institutional development, and between the progress of institutions and economic growth. For the EBRD all was well really in the Transition.

The question mark may or may not have been justified in November 2013, but by the time of the EBRD Annual Meeting in Warsaw on 14-15 May 2014 it undoubtedly was no longer appropriate. The virtuous circle between institutional development and economic performance would turn into a vicious circle if exogenous shocks adversely affected either factor. In 15 of the EBRD countries of operation, as a result of the global crisis, public opinion had turned against market reforms, especially in the more democratic countries, thus breaking the link between democratization and the development of institutions. “Private capital flows to the transition region as a whole had remained relatively low and a continuation of cross-border deleveraging was delaying the resumption of credit growth” (EBRD, May 2014). Turkey took a turn for the worse, with widespread political unrest and its violent repression, and associated economic slowdown. There were adverse political developments and serious new economic problems in Egypt. And above all the confrontation between Russia and Ukraine caused a slowdown in Russia (with consequent rouble devaluation and stock exchange fall) and a recession in Ukraine, which adversely affected other Central European countries, especially the Baltics and Serbia. The end of recession in Slovenia is not enough of a compensatory factor.

The latest EBRD growth forecasts for 2014 in the transition area have been cut back from 2.7% to 1.4%, and an improvement to 1.9% in 2015 was regarded as possible but problematic. The EBRD most likely outcome is near zero growth in Russia this year and minimal growth in 2015, and in Ukraine a 7% decline this year and stagnation next year. But the EBRD worst-case scenario is extremely worrying: the implementation of threatened economic sanctions against Russia would immediately precipitate a Russian recession, and bring growth in the whole area to a complete halt, with serious contagion implications for the entire global economy.

On 26 July in Saint Petersburg Professor Ruslan Grinberg, Director of the Institute of Economics of the Russian Academy of Sciances, convened a Founding Conference with the purpose of setting up a new Centre for the Economic and Socio-Cultural Development of the CIS and Central-Eastern Europe.  Against the background illustrated above a renewed focus on these countries, with their distinctive features due to the common Soviet-type starting model, is undoubtedly most opportune, timely, indeed absolutely necessary.

In brief, the Agenda of such a Centre ought to include a re-consideration of alternative models of capitalism other than the hyper-liberal, crony [“oligarch” in Russian] capitalism that has prevailed in the transition; re-thinking the role of the State in the transition process, re-vamping its functions in market regulation and the very creation of market institutions, infrastructure investment, the financing of research and innovation, the alleviation of poverty and unemployment and the guarantee of social peace.  On this last point the EBRD 2013 Report rightly lays great emphasis on the need for “economic inclusion” for the success of any market economy. Inclusion is understood as broad access to economic opportunities regardless of gender, social class and urban/rural background, especially for young adults. 

More generally, intellectual inspiration could be drawn from the comparative analysis of transition experiences to-date but also from recent publications including for instance Thomas Piketty’s Capital in the Twenty-First Century (2013), Mariana Mazzucato’s The Entrepreneurial State (2011) and Grzegoz Kolodko’s monumental work on transition and on globalization. Inter-disciplinarity is essential. We wish Professor Grinberg every success with his new venture.

Friday, April 4, 2014


The word "Padre" is immediately and inexorably associated in my mind, due to my early Catholic indoctrination, with the utterance “forgive me for I have sinned”.  But these days PADRE is also the acronym for another kind of forgiveness, of part of public debt in Eurozone member countries.  Politically Acceptable Debt Restructuring in the Eurozone is a proposal put forward by Pierre Pâris (CEO and Founding Partner, Banque Paris Bertrand Sturdza, ex-Barings and ex-Morgan Stanley) and Charles Wyplosz (The Graduate Institute, Geneva, ICMB and CEPR), “To End the Eurozone Crisis, Bury the Debt Forever”, VoxEU, 6 August 2013, and in their fuller Special Report 3, Geneva Reports on the World Economy, ICMBS and CEPR, January 2014, launched by CEPR in London on 4 March).  See also Carlo Clericetti, 15 February 2014.

The PADRE scheme envisages the substantial reduction of Eurozone public debt, say on average by one half of its current level, through the retirement of government bonds by the European Central Bank, proportionally to individual country shareholdings in the ECB, financed through the securitization of shareholders’ entitlement to ECB seigniorage.

[Reminder: The Bank of Italy website defines Seigniorage as “the flow of interest from the assets held against notes in circulation (or, more in general, against the monetary base).” In the case of the Eurosystem, it is included in the definition of “monetary income” which according to Article 32.1 of the Statute of the ESCB and of the ECB is “The income accruing to the national central banks in the performance of the ESCB's monetary policy function. ” (ibidem). The legislation on how the “monetary income” of the national central banks of the participating member states is distributed can be consulted on the ECB website.]
Therefore by definition – by benefiting all members proportionally to their shares – PADRE would not imply any resource transfer from any country to another, nor any burden on “virtuous” countries to the advantage of allegedly profligate and undeserving other members (as it would happen by pooling public debt), or associated moral hazard: existing bonds would be replaced by bonds issued and serviced by the ECB on behalf of member countries mobilizing their shares of ECB seigniorage, at an interest rate estimated by Pâris and Wyplosz of the order of 3.5%, only marginally higher than the Bund rate of about 3.3%. This is why such a scheme should be “politically acceptable”, especially since a safeguard clause would stop undisciplined countries from resuming their earlier bad behaviour.  The debt/GDP ratio and the associated spread on public debt would be permanently and painlessly reduced at a stroke.

Pâris and Wyplosz estimate that as a result of this operation Italy’s Debt/GDP ratio would fall from 133% to 80.4%. Beside Italy, only Greece, Ireland and Cyprus would remain above the statutory 60% fixed by the Maastricht Treaty, while Estonia, Latvia, Slovakia and Luxemburg would end up with positive net public assets instead of public debt.  Interest payments would fall not only because of the fall of debt but also because of the lower interest rate charged on new issues. The Fiscal Compact, currently a Damocles’ Sword on many EU countries, would become manageable: in order to comply with it Italy for instance would need a primary surplus of just over 1% for twenty years instead of over 3.5% (one twentieth of the Debt/GDP ratio in excess of 60%).

In order to obtain this result the ECB would have to buy €4,592 bn of bonds, on which it would pay €161 bn interest a year. The trouble is that the two economists estimate average yearly seigniorage revenue at only 1.1 bn, though rising at a steady rate over time. Pâris  and Wyplosz reckon that it would take 50 years before seigniorage could match interest costs. Still, the tangible immediate gains make the proposal a solution preferable to other alternatives considered and rejected by Pâris  and Wyplosz.

-      -- Consolidation through budget surpluses would take, from the peaks reached by the more highly indebted Eurozone countries, a time scale of twenty years, with front-loaded recessionary side effects.

-      -- The sale of public assets, totaling 37% of GDP in the Eurozone, often might be against national interest, would require a massive administrative effort “probably beyond reach”, more time than the two-three years available for it to be effective, and realization prices are bound to be disappointing especially in the recession.

-       --  Classic debt restructuring, deep enough to bring debt down to 60% of GDP would trigger off a bank crisis, for much indeed most of national debt has migrated to commercial banks, whose rescue would require government intervention and more debt; moreover bailouts are no longer available on an adequate scale and, even if they were they would simply add to public indebtedness and make the situation worse. 

-       -- Debt forgiveness would involve a transfer from better-off countries to crisis countries, politically and economically impossible other than perhaps for a single small country.

-       --  Finally, debt monetization in the Eurozone could only take the form of ECB purchases of government bonds, which run up against the same kind of objections as its Outright Monetary Transactions, and in any case leave governments with the burdens of both interest payments and repayment of principal at maturity.

The proposal put forward by Pâris and Wyplosz is a variation of debt monetization aimed at overcoming these drawbacks. I am strongly convinced that the PADRE proposal is excellent. Not least because, independently and contemporaneously, I made a nearly identical proposal in a post on this Blog, on 8 August 2013. 

In that post I took as starting point Willem Buiter’s estimate of the present value of ECB seigniorage, which he defines somewhat more broadly than the definition given above, as the profits obtained from monetary base issues, including the interest obtained from the investment of past issues, plus the anticipated inflation tax i.e. the loss in real value of the stock of monetary base caused by expected inflation, as well as the unanticipated inflation tax. 

This present value of course is not recorded in the ECB balance sheet, but is estimated by Willem Buiter to be of the order of €3.3 trillion (in The Debt of Nations Revisited: The Central Bank as a quasi-fiscal player: theory and applications  2011).  I wrote then “Its use to retire a sizeable part of Euroarea members’ debt in the same proportions in which they hold ECB shares would solve the Euro crisis without transforming the Eurozone into a “Transfer Union”, as it would not involve any redistribution across member states.  Potentially inflationary consequences of such an operation could be neutralized by reducing the size of the ECB balance sheet (selling assets and reducing loans), sterilizing monetary liabilities, raising obligatory reserves and raising the remuneration of excess reserves in order to induce banks to keep them inactive”. 

Indeed my own version of the PADRE proposal was put forward in an earlier post, and re-quoted in my post on The ECB firepower of 23 August 2012:

"Suppose the ECB bought a balanced packet of 100bn of EMU government bonds in the same proportions in which EMU countries hold shares."

"Roughly 30% of ECB shares are held by 10 EU members who are not EMU members (with the UK at 14.5%), the rest is divided among EMU members: Germany 18.9%, France 14.2%, Italy 12.5%, …, Spain 8.3%, Greece 2%, Portugal 1.75%, , Ireland 1.11%, … Malta 0.06%. Therefore the bond packet bought by the ECB would contain 100/70 or roughly 1.43 times each EMU member’s share in ECB capital, eg Spain €11.869 bn."

"Suppose that subsequently Spain defaults and its bonds lose 50% of their value. Germany [as ECB shareholder] loses 0.189*0.5*11.869bn euro, or €1.1216205 bn. An equivalent amount out of the €18.9bn outstanding German debt purchased by the ECB could be cancelled, and so on for all corresponding losses of other EMU members."

"Non-EMU-member Shareholders would have to be compensated by the ECB for 30% of the loss of value of Spanish bonds, i.e. would have to be paid dividends of 0.30*11.869 bn euro; all ECB outlays to come from ECB profits (including seigniorage if need be, in which case non-EMU members might not be entitled to compensation …)."

"In conclusion, EMU non-members would be compensated for their participation in the cost of Spain’s default with dividends, while EMU members would be compensated by the withdrawal of a corresponding value of their bonds (without prejudice for the present entitlement of non-EMU members to benefit or not to benefit from euro seigniorage)."

“So, there is no reason for peripheral (i.e. high spread) eurozone members to panic - yet. Where there is a will there is a way. And financial markets believe in the “Draghi rally”.”

The seed of such an idea came from an editorial comment in of 24/7/2012 (unsigned, perhaps by Wolfgang Munchau?), reporting on various proposals for the ECB to undertake Quantitative Easing like the Fed. The comment noted that a European QE is not against the EU Treaties, if the ECB would buy governments bonds from every Eurozone country [emphasis added]. All I did in my post The ECB firepower of 26/7/2012 (the day of the historical pronouncement by Mario Draghi committing the ECB to support the Euro) is to specify that government bonds from all Eurozone countries should be bought in the same proportions in which they are ECB shareholders, with dividend compensation paid out to other, non-Eurozone shareholders. In such a way there is no mismatch between the composition of ECB assets and liabilities due to Quantitative Easing, and no cross-country transfer is involved.

It is true that the ECB has a capital of only €6bn in the process of doubling over 5 years, but - even setting aside Paul de Grauwe’s powerful argument that a Central Bank does not need equity capital at all - the off-balance-sheet resources corresponding to the present value of the ECB seigniorage are undoubtedly large enough to save the euro without invoking Eurozone or EU solidarity.

The existence of such formidable weapon in the ECB armoury does not indicate whether and when it will be used. But the very fact that it might – Willem Buiter always had indicated “quasi-fiscal abuse of the Central Bank” as a likely resolution of the Euro crisis – ought to set a limit to the downwards spiral of credit ratings and the escalation of spreads. 

The only difference between my proposal and the PADRE proposal by Pâris and Wyplosz is minor technicality: in their scheme the ECB buys bonds of a country, then it exchanges them against a perpetual, interest-free loan of equivalent face value, which remains indefinitely as an asset in the books of the ECB but will never be paid back (unless the ECB is liquidated); the counterpart of this operation will appear on the liability side of the ECB’s balance sheet as an equivalent in the monetary base. Pâris and Wyplosz also regard this as non-inflationary in the present conditions of near zero money multiplier, and otherwise envisage that the ECB could raise reserve requirements or sterilize the bond purchase programme by issueing its own debt instruments.

Great minds think alike, pity that nobody listens. Which is why, after describing the equivalent of PADRE, I wrote “However this kind of operation would go against the grain of German and other Nordic members’ monetary conservatism and is unlikely to be undertaken.”   The Karlsruhe German Constitutional Court decision of 14 March, asserting the legality of the European Stability Mechanism against the challenge of 37,000 German claimants, does not yet change the perspective of opposition to any such scheme by the Bundesbank, by its President Jens Weidmann and other German conservative circles. Pâris and Wyplosz seem to be more optimistic. I wish them good luck, wholeheartedly.

UPDATE (05/04/14)
I sent a preview of this post to Charles Wyplosz, Professor of International Economics and Direcctor of the Geneva
International Center of Monetary and Banking Studies, and an old friend. He wrote me a kind and generous e-mail acknowledging our independent development of the same idea, which they intend to mention in their subsequent work on PADRE.

Apparently they now have a forthcoming variant of their scheme that leaves the ECB out of the picture, to assuage German and other Nordic opposition. In that scheme, an agency does the buying, borrowing and swapping in perpetuities while the governments request that ECB sends its seigniorage income to the agency until the costs have been fully absorbed.

There are still a number of loopholes left, of course. “Some are legal but others are economic, including a sharp financial gap in the early decades. The kiss of near-death, though, is that governments must give up seigniorage for decades and, as we all know, governments can renege. We try to stack the cards against that but we will never satisfy those that require a 100% guarantee that it will never happen. “

Charles and Pierre now have some doubt about whether PADRE is indeed politically acceptable. They are “on the road, trying to sell it to officials and central bankers, even including a Bundesbank seminar in May.” Charles believes that there is interest, with strong support in highly indebted countries and no rejection yet in the virtuous countries. At this stage the main problem is that politicians believe that the crisis is over and have zero appetite for solutions to a problem that no longer interests them. Charles tried to place this kind of comment on my Blog but for some reason did not succeed, I am delighted to do it at his suggestion.

Tuesday, March 18, 2014


One of the factors that have slowed down Italian growth in the current crisis, even relatively to a sluggish Eurozone, is undoubtedly the endemic accumulation of large scale arrears in Public Administration payments to enterprises for their supply of goods and services to central and local government. True, the very expectation of payment delays tends to be built into enterprise costs and therefore inflate the volume of public expenditure, but even so the build-up of arrears remains a sick anomaly in any market economy, which especially in a tight credit market such as at present can drive even healthy, successful enterprises to lay-offs and bankruptcy.
The very scale of such public arrears is uncertain, which makes it worse. A year ago the Bank of Italy estimated the commercial debt of the Public Administration to be of the order of €90 bn at the end of 2012.  Since then €24 bn have been paid off, but there have been new gross additions to the total. A conservative estimate of current arrears is above €80 bn (La Repubblica, Economia e Finanza, 10 March 2014, p.2) while estimates by the Confederation of Italian Industry put them at as much as €120 bn. Many of the arrears involve off-budget, non-certified expenditures.
The idiosyncracy, not to say the idiocy of the “internal” Growth and Stability Pact constraints, translating Maastricht macroeconomic constraints into local authorities’ microeconomics, often prevents payments even when expenditures are properly budgeted for and finance is available. Anal retention on the part of high officials of the Ministry of the Economy and Finance, also in order to avoid possible accusations of payments breaking European constraints, is an additional factor. But an accounting convention that wholly or partly reckons expenditures and revenues on a cash basis (“bilancio di cassa) rather than on accrual (i.e. including also receivables and payables, as in the “bilancio di competenza”) actually provides an incentive for the Public Administration to obtain, as it were, free credit from enterprises in a way that does not affect adversely its financial performance, regardless of the massive costs inflicted as a result on the economy and its viability and growth.

Clearly from a substantive viewpoint it makes no difference whether the Public Administration owns given arrears to enterprises, or borrows from banks or the financial markets an equivalent amount to pay them off, in which case it does not augment its debt but simply transfers it from the enterprises to new creditors. Financial markets are most unlikely to respond adversely to the Public Administration reducing payments arrears through additional borrowing. But with cash accounting the arrears are not counted as part of expenditure or as a component of debt, whereas the equivalent borrowing does in its entirety. Hence the incentive to let arrears grow.

The popularity of cash accounting belongs to a past in which the control of the  money supply in order to control inflation was a paramount preoccupation at all costs, even if the accumulation of Public Administration arrears towards enterprises involved the collapse of the real economy.

This accounting convention has already made immense damage in the course of post-socialist transition in the early 1990s, when the International Monetary Fund made monthly disbursements to Russia conditional on its respect of cash limits to the state budget deficits, thus encouraging the explosion of arrears owed to enterprises. or owed to state employees, or even to old age pensioners. As the Russians used to say, “Pay As You Go” then meant: First you pay, then you go. Italian so called “esodati”, whose entitlement to pension matured through early retirement was vanified by the sudden rise of pensionable age decreed by the indefensible, unconscionable Minister of Labour Elsa Fornero of the Monti government, could choose this as their motto.

Such an obtuse and nonsensical policy fostered by the IMF in Russia in the early 1990s, in addition to an interest rate positive and large in real terms up to usury levels, and an associated overvalued exchange rate, led to mass unemployment and the parallel accumulation of inter-enterprise debt of the order of 40% of manufacturing enterprises turnover. This de-monetisation of the economy was one of the most important factors in the transformation recession of Russia in the 1990s, which destroyed more than one third of Russian GDP. By the same token the build-up of arrears is one of the factors that took current Italian recession above the European and Eurozone average.

Moreover, accounting conventions differ in Italy and Europe, and for different items of expenditure. Capital account expenditures (perhaps 20% of total arrears, though the precise proportions are also unknown) are always accounted for on a cash basis, both in Europe and in the “internal” so-called Growth and Stability Pact. Current account expenditures (the remaining roughly 80% of arrears), on the contrary, are accounted for on an accrual basis by Europe, and on a cash basis according to the “internal” Pact. Thus past current account expenditures, already accounted by Europe on accrual, can be paid without impacting the European 3% deficit ceiling in the payment year, having been accounted for already in the deficits of past years; whereas capital account payments in 2014 count against the deficit ceiling in that same year.

Franco Bassanini (President of the Cassa Deposity e Prestiti, CDDPP, a public agency managing postal savings, funding infrastructure and public enterprises) and Marcello Messori (Rome LUISS University) worked out for the ASTRID Foundation a clever and simple method for getting rid of all Public Administration payment arrears, both on capital and current account, without infringing expenditure and deficit (and therefore debt) ceilings.

Namely, Public Administrations would be asked to verify, and either challenge or certify within a period of 2-3 months, any claims of payment arrears by commercial suppliers. Certified credits would be guaranteed by the state (guarantees being a contingent quasi-fiscal liability of the state, not accounted for as expenditure) and could therefore be discounted by banks at a small premium (of 1%-2%, and anyway under 2% for the credit to continue to enjoy the state guarantee).  Banks would have an incentive to accept them because they could always use them as collateral with the ECB to obtain liquidity, and moreover would improve the position of Public Administrations towards the banks themselves. Beneficiary enterprises could in turn reduce their liabilities towards suppliers, invest and hire new employees. VAT owed on unpaid arrears and currently suspended would also be paid, providing additional government revenue. J.P. Morgan calculated that in Spain, which was suffering from a similar predicament and paid off about €30 bn of Public Administration commercial debts, GDP grew by 1.2% as a result; in Italy the impact on growth could be greater. (See the interview with Franco Bassanini in La Repubblica, 10 March).

On 18 March 2013 EU Vice-Presidents Antonio Tajani and Olli Rehn had already accepted that “attenuating factors could be applied to the liquidation of commercial arrears” from the view point of the Growth and Stability Pact, but the principle was implemented only partially, thus involving the Ministry of the Economy and Finance in complex intermediation to establish eligibility and priorities, that slowed down the reduction of arrears. And last summer amendments removing state guarantees and establishing undetermined ceilings to arrears reduction stopped payments altogether under Enrico Letta’s government.

In a recent TV programme Franco Bassanini declared that current account arrears (which he put at between €20 bn and €100 bn) could be specifically removed from the “internal” Growth and Stability Pact, having been already included in past deficits, and paid by next June, while capital account arrears (of between €5bn and €10 bn) could be paid by 21 September as announced by the new Premier Matteo Renzi. Public Administrations without the necessary funds could take a 5-year loan guaranteed by the state, which in case of insolvency would be acquired by the CDDPP, on a longer maturity basis of the order of 15 years. More power to his elbow.

Wednesday, March 5, 2014

Kornai: Shortage versus Surplus Economies

The eminent Hungarian economist Janos Kornai successfully characterized the Soviet-type, centrally planned socialist economy as The Shortage Economy (2 Vols, 1980). Whether money prices were stable, rising or falling, those economies were characterized by large-scale, endemic excess demand at prices below the market-clearing level, with associated re-trading (whenever feasible) at higher black market prices.
Kornai attributed shortages primarily to soft budget constraints, i.e. the ability of state enterprises to replenish their liquid resources through budget subsidies or credit (by banks or suppliers) whenever money prices were raised in order to reduce shortages. However, soft budgets can explain open inflation but are neither necessary nor sufficient to explain repressed inflation, which requires simply administered prices consistently lower than market-clearing: socialist planners could not eliminate inflation, so they simply pretended they had, and repressed it.  

But Kornai is certainly right in emphasizing the negative implications of shortages: labour over-full employment was associated with consumers’ frustration at their inability to secure goods and services at official prices, and with production inefficiencies, and vanified any attempt to establish forms of market socialism. 

In his latest book, Dynamism, Rivalry and the Surplus Economy (OUP 2013), Janos Kornai characterizes capitalism on the contrary as the economy of surplus, of excess supply and labour unemployment – not cyclical a’ la Keynes but endemic. 

The novel aspect of this characterization is its positive assessment as an environment favourable to dynamism, entrepreneurship and technical progress, innovation and structural change, while central planning, together with the failure to allow experimentation, reward the successful inventor and innovator, and to make available resources outside a rigid central plan, was ultimately responsible for systemic stagnation. Both systems have merits and drawbacks that Kornai regards as inseparable and genetically implanted in the two systems. His personal preference goes to the surplus economy, although he recognizes the evil of unemployment associated with it.

Kornai supports these provocative propositions with a mass of data on technical inventions and their diffusion in the two systems. Nevertheless, some reservations are in order.

First, the contribution of the state to technical progress is under-estimated by the acknowledged exclusion of military and space expenditure and generally the non-profit sector, without which we would not have had most IT progress including Internet. Conversely, the negative implications of capitalist protection of intellectual property have been overlooked.

Second, is shortage a necessary feature of socialism, i.e. is China a shortage economy?

Finally, the glorification of the surplus economy seems to have been somewhat mis-timed, considering both the large-scale costs of the “transformation recession” (Kornai’s label) of transition economies in the 1990s, and the persistence and severity of the current global crisis that began in 2007 and is still rampaging. Austerity has raised the surplus features of capitalism far beyond what may be regarded as necessary to enhance entrepreneurship and technical dynamism. 

(A session on Kornai' s latest book will be held at WINIR - World Interdisciplinary Network for Institutional Research - Conference on “Institutions that change the World”, Greenwich, London, 11-14 September 2014).

Tuesday, November 19, 2013

Germany: Too Much Virtue Is A Sin

On 30 October the Office of International Affairs of the US Treasury issued its customary semi-annual Report to Congress on “International Economic and Exchange Rate Policies”, in consultation with the Fed’s Board of Governors and IMF management and staff. The Report usually concentrates on China bashing for the undervaluation of the renmimbi, and this time is no exception: “The RMB is appreciating on a trade-weighted basis [by 6.6% on a real effective basis], but not as fast or by as much as is needed [an additional 5-10%]”. But the Report in addition vigorously criticizes Germany for its record trade surplus, which is regarded as a brake on the recovery of the Eurozone countries that experience a corresponding trade deficit and on global growth.
Among the Report’s Key Findings (p.3):
“Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand growth and shrink their surpluses. Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy.”
The main text of the report develops this proposition further: much of the decline in global current account imbalances that occurred in recent years reflects a demand contraction in deficit countries rather than strong domestic demand growth in current account surplus countries. Germany in particular has continued to run a very large and persistent surplus, raising the eurozone's overall current account, which was close to balance in 2009-2011, to a surplus of 2.3 percent of GDP in the first half of 2013. “Germany’s current account surplus rose above 7 percent in the first half of 2013, while the current account surplus for the Netherlands was almost 10 percent. Ireland, Italy, Portugal and Spain are all now running current account surpluses as import demand in those economies has declined. Thus, the burden of adjustment is being disproportionately placed on peripheral European countries, exacerbating extremely high unemployment, especially among youth in these countries, while Europe’s overall adjustment is essentially premised on demand emanating from outside of Europe rather than addressing the shortfalls in demand that exist within Europe.”
The section on the Euroarea emphasises the point: “Expansion was supported by domestic demand growth in Germany - though growth in Germany still continues to rely on positive net exports, which continues to delay the euro area’s external adjustment process – and on domestic demand in France.”
Nobody can argue with such propositions, which are based on a correct interpretation of well established facts, and are not at all new. The adoption by Germany of more expansionary policies has been advocated by many economists, from Martin Wolf (FT) to Paul Krugman (Those Depressing Germans, NYT 3 November 2013), from Jean Pisani-Ferry (Bruegel) to Mario Seminerio (La Cura Letale, Rome, 2012), to the IMF Managing Director Christine Lagarde as well as several IMF documents. What is extraordinary is that the criticism should come from the US government and from research circles before it is raised by the European Commission. 
EC practice suffers from a totally arbitrary and unwarranted asymmetry in treating surpluses and deficit countries: a current account deficit of 4% of GDP triggers off a disciplinary procedure for the offending country, while a 6% surplus averaged over three years is necessary before the EC takes any notice of that imbalance, and even then only perfunctorily. In 2012 Germany recorded a 7% record surplus but the three year average was just under 6% and nothing was said.
This is a general problem that Maynard Keynes had tried to address at the Bretton Woods Conference (1944). His Plan assigned to every country a “bancor” maximum overdraft facility equal to its average trade over five years; a penalty interest rate of 10% would apply to deficit countries above that limit, as well as to surplus countries on anything over and above any surplus exceeding the size of the permitted overdraft by more than a half, forcing compensatory exchange rate adjustments or capital flows, and subject to confiscation of residual excess reserves above the permitted surplus at the end of the year. “Nothing so imaginative and so ambitious had ever been discussed", commented Lionel Robbins. But the US was then the world’s biggest creditor and the Plan by the US representative Harry Webster White was preferred by the 42 countries attending the Conference. The burden of balancing trade was placed on deficit countries and no limit was set on surplus countries, thus necessarily impressing a deflationary bias on the nature of trade adjustments. The replication of this approach by the European Union is one of the many EU original sins. 
There is a well known tenet of Keynesian economics, resulting from national income accounting and not at all dependent on the validity of Keynesian fiscal policies, and therefore unchallenged: the excess of exports X over imports M, plus the excess of government expenditure E over taxation T, plus the excess of private investment I over savings S, must necessarily add up to zero. Thus a country experiencing a trade deficit must necessarily run a government deficit and/or a compensatory excess of investment over savings, hard to accomplish in the face of an otherwise shrinking demand. In other words, the German trade surplus makes it all that much harder for its deficit trade partners to balance their public accounts.
On 2 November the Economist’s Charlemagne column Fawlty Europe commented on “Germany’s obsession with competitiveness”… “For Germany booming exports are the measure of economic virility.” It is true that Germany is reaping the benefits of wage and price reductions (the internal devaluation) undertaken before the crisis; in the middle of the crisis any country adopting the same policy would pay the price of worsening that crisis. Germany also benefits from earlier structural reforms politically hard to replicate, and from the relatively price-inelastic demand for its high technology exports. But surplus countries like Germany, the Netherland and Austria are also benefiting from an artificially low exchange rate, with respect to the increasingly stronger exchange rate that would prevail if those countries were using their own currency instead of the euro. And, be that as it may, by holding down wages and failing to promote investment and growth they make trade adjustment in Italy, Spain, Ireland, Portugal and Greece – which has occurred – deflationary. Debtor nations were forced, mostly under German pressure, into austerity eliminating trade deficits at the cost of perversely rising debt/GDP ratios (see our earlier post on the subject), while German surpluses persisted and their failure to adjust magnified the costs of austerity and contributed to keep the world economy depressed.
Charlemagne notes that Germany has also benefited from straight protectionism, having failed to liberalise its construction and services.  While these sectors are not a significant share of German exports, a recent OECD study stresses that in general services have a much bigger impact on trade and trade competitiveness if we look at their inputs actually embodied in exports, i.e. adopting a Value Added approach to trade accounting. Charlemagne also recommends too that Germany could do more to invest in education and infrastructure, and make child care available for working women. 

Moreover German energy-intensive producers are benefiting from an implicit subsidy on their electricity consumption, through exemption from the expensive surcharge used to finance Energiewende, the accelerated introduction of renewable energy scheduled to reach 35% by 2020 and 80% by 2050. Earlier this year European Energy Commissioner Günther Oettinger told a group of industry leaders that the price concessions for energy-intensive companies in Germany clearly amount to “inadmissible” subsidy levels. German business are concerned that they might have to repay hundreds of millions of euros to the German government.
Only on 13 November did Jose’ Manuel Barroso, the EU President, announce an “in depth analysis on the high German trade surplus”, with a view to understand whether Germany can make a larger contribution to the re-balancing of the European economy”. There is the prospect of a continued trade surplus of 7% in 2013, and the upwards revision of the 2012 trade surplus brings already the three year average above 6% in 2010-2012. Indeed “Following statistical revisions, the indicator has exceeded the threshold each year since 2007” and “the surplus is expected to remain above the indicative threshold over the forecast horizon, thus suggesting that it is not a short lived cyclical phenomenon” (EC 2013). German savings exceed investment, and despite boasting the second lowest share of private sector debt in GDP (firms and households) and low interest rates, private sector de-leveraging has continued, failing to boost demand; capital formation has declined last year. This calls for some action, not least to reduce the pressure for euro revaluation. But the bottom line of the EC document is simply that “Overall, the Commission finds it useful to conduct an in-depth analysis with a view to assessing whether imbalances exist” (italics in the original). This is a grotesque existential problem: what additional evidence is needed to establish that an imbalance exists, other than the imbalance itself?

German press and politicians have reacted to the US Treasury accusations and to the EC initiative with a combination of denials, hubris and cries of victimisation. The German Economics Ministry issued a strongly worded statement, saying that Germany's surplus is "a sign of the competitiveness of the German economy and global demand for quality products from Germany." It dismissed the accusations as “incomprehensible” and challenged the US to "analyze its own economic situation."
A memo to finance minister Schäuble reads: "The German current account surplus offers no reason for concern for Germany, the euro zone or the world economy"; Berlin is pursuing a course of "growth-friendly consolidation," and there are no imbalances "that would require a correction of our economic and fiscal policy." See also “Complaints about German Exports Unfounded”, by Jung-Reiermann-Schmitz, 5 November, and “Raw Nerve: Germany Seethes at US Economic Criticism” by Alessi, 31 October.

It has been pointed out that the prospective new grand coalition between the CDU, its Bavarian sister party, the Christian Social Union (CSU), and the Social Democratic Party (SPD) has already agreed to increase government investment and the minimum wage, both of which should stimulate domestic demand.  But the formation of that government – let alone its programme – is still under negotiation.
The real issue is an EU governance deficit. The worst thing that could happen to Germany as a result of an adverse “in depth analysis” by the Commission is a reprimand by Marco Buti's Directorate-General for Economic and Financial Affairs. No comment seems necessary.