28 June 2008

Oil, Food and Economics - Sumita Kale

If the subprime crisis wasn’t bad enough, the oil price spike has unnerved the world this year. And with food and fuel prices soaring in all countries, the policy prescriptions are back to the standard myopic solutions of interest rate hikes, duty cuts, export curbs etc. But if we step back and try to see the larger picture to decipher what these prices are signalling, what do we find? One theory that has finally got the prominence it has deserved is the Peak Oil Theory. In fact, for Matt Simmons, energy investment banker and ‘Peak Oil’ theorist, the signs that crude was entering danger zones have been clear since 1989, but it was only post 2002 when China kick started its explosive growth that the situation became bleak. For most of the world though, peak oil has become a keyword only recently because of the rapid rise in the oil price this year. According to Simmons, it was the unplanned for growth from developing countries that has taken up 99 percent of spare capacity and which has continued despite a ten fold rise in prices. Of course, to a large extent consumers are insulated from international oil prices : Price increases from about the $60 level have not been passed on to consumers, especially in the developing countries. State revenues are being sacrificed and/or consumers are being insulated by subsidies. To begin with, the true extent of oil reserves in the world remains an unknown; the rising share of state-owned oil companies has led to secrecy on reserves data. Spare supply capacity is fuzzy and this explains the frenzied rise in prices currently as there is a paranoia that is gripping the market. In short, supply constraints are more than likely to stay, than disappear. There are also various industry issues such as aging oil wells, rising costs of extraction, chronic rig and skilled manpower shortages etc. – the list is long. 80% of oil infrastructure needs to be rebuilt; the fresh demand for steel will in turn impact inflation. Simmons who has been anticipating this for long now says that the world has to go on a ‘war footing’ now and force a change in consumption pattern – the current trend is just not sustainable. What about food prices? At a symposium convened in March by the Banque de France, Martin Redrado, Governor of the Central Bank of Argentina, was spot on when he said that the rising inflation is to a large extent due to the ‘convergence’ of consumption levels – the developing countries are catching up in consumption patterns (growth in auto demand etc.) and change in dietary habits at a time when there is a delicate balance between production and demand. Two unanticipated impacts on the already delicate balance between supply and demand have had an impact on prices. The first is climate change reducing global grain output (droughts in Australia and Ukraine etc.); and the second is the impact of high crude prices in diverting grain for bio-fuel production that has triggered off the rising prices in corn, soya, wheat etc. Since food contributes a significant portion of consumer budgets in emerging economies, this will show up in forthcoming wage revisions, putting more pressure on prices. Higher energy and food prices will impact growth via higher interest rates that are being forced upwards in an attempt to curb the price rises. Redrado’s paper has interesting policy implications as it throws a spotlight on the social and political tensions that will arise as countries are forced into a period of lower growth and higher inflation. Per capita consumption of food and crude oil is much lower in China and India, than in the US- to bet on a slowdown in these economies, therefore, has social ramifications as well. On the other side, high oil prices are causing prosperity in oil-rich countries, the recent debate over sovereign wealth funds is just one instance of the political implications of this growing wealth. Prices may settle this year or the next, already there is relief coming in on the wheat front with better output forecast in Australia this year. Relief on the oil front though at this point seems doubtful. But all these problems hitting the world today highlight one important signal : you ignore the environment and natural resources at your peril. Would this have been the case if economics didn’t try so hard to distance itself from geography, sociology and other ‘soft’ disciplines? Trying to go deeper into this, I came across this interesting piece on Ecological Economics by Robert Constanza from the University of Vermont. “Ecological economics is a transdisciplinary effort to link the natural and social sciences broadly, and especially ecology and economics (Costanza 1991). The goal is to develop a deeper scientific understanding of the complex linkages between human and natural systems, and to use that understanding to develop effective policies that will lead to a world which is ecologically sustainable, has a fair distribution of resources (both between groups and generations of humans and between humans and other species), and efficiently allocates scarce resources including “natural” and “social” capital. This requires new approaches that are comprehensive, adaptive, integrative, multiscale, pluralistic, evolutionary and which acknowledge the huge uncertainties involved. For example, if one's goals include ecological sustainability then one cannot rely on the principle of "consumer sovereignty" on which most conventional economic solutions are based, but must allow for co-evolving preferences, technology, and ecosystems (Norton et al. 1998). One of the basic organizing principles of ecological economics is thus a focus on this complex interrelationship between ecological sustainability (including system carrying capacity and resilience), social sustainability (including distribution of wealth and rights, social capital, and coevolving preferences) and economic sustainability (including allocative efficiency in the presence of highly incomplete and imperfect markets).” Sounds familiar to my previous post on Mukherjee’s ideas on what Economics should include. Clearly the need of the hour for us economists! Looking forward to a debate on this one! ********************** PS: This post includes valuable inputs from Suyodh Rao, (an economist based in Hyderabad, India)- thanks Suyodh, for all your mails about oil, food and water!

03 June 2008

Putting Short Term Stability Before Long Term Growth: Fifty Years Is Enough

by Ben Fine

This article has been published as a Policy Brief (No. 12) by the Intergovernmental Group of Twenty-Four on International Monetary Affairs and Development (G24). Blog authors are grateful to the G24 for allowing it to reproduce it; copyright remains with the G24.

It is fifty years since Jean-Jacques Polak published his classic article “Monetary Analysis of Income Formation and Payments Problems” in the IMF Staff Papers. This paper provided the theoretical basis for the IMF’s financial programming, and continues to do so today. This is remarkable in and of itself. The world economy has gone through major changes over this period, as have corresponding fashions within economic theory as triumphant Keynesianism gave way to varieties of monetarism in the wake of the collapse of the post-war boom.

We also have had fifty years of development economics, during which there have also been shifting and competing perspectives from modernization through the Washington consensus and beyond, to notions of the developmental state, as attempts have been made to understand why the success of East Asian NICs should contrast so much with achievement elsewhere. Is it credible that across this material and intellectual ferment, the “Polak Model” should remain sacrosanct?

To his credit, Polak’s initial contribution was extraordinarily modest and qualified in its aims. He made it crystal clear that the main problem addressed is a temporary balance of payments deficit in a developing country, this gap usually the result of excessive domestic credit to fill the gap arising out of a fiscal deficit. He presumed that the only reliable data available are those concerning monetary variables, and that the only corresponding policy variable is control of the domestic money supply.

The model only seeks to determine the level of nominal income, with its distribution between the output level and the price level to be determined by some other means. In this respect, in principle, the model is not monetarist since it must violate one or other of the assumptions that prices are fixed (at the world level) or that output is fixed (at full employment). In practice, not without justification, financial programming is heavily associated with the ideology of monetarism because of the pessimistic stance taken on productive potential.

It has targeted balance of payments and/or fiscal deficits with shifting instruments across countries and over time as fixed exchange rates have given way to floating exchange rates, and control of inflation and liberalization of money markets have been emphasized more or less to suit. Today, for example, the IMF is more likely to advise appreciation of the exchange rate to bring down inflation in middle-income countries than to address foreign or fiscal deficits, although these remain a priority for low-income countries, especially in Africa.

One criticism of Polak is his making virtue out of necessity. Even if monetary variables are the only ones that can be measured and controlled, they are not necessarily best for remedial action. A patient with a broken leg is not best treated with a thermometer to take temperature and aspirin to bring it down, even if these are all that is available in the hospital. This apart, Polak can be judged to have appropriately sought, but failed, to constrain the use of his model for purposes for which it was not designed.

He did, for example, refine the model, in a joint article in 1971, by adding extra variables and equations. But, as was explicitly recognized within this contribution, this was nothing more than an elaboration of the Hicksian IS-LM-BP model, standard across every undergraduate textbook.

This prompts three observations. First and foremost, such a model was constructed in the context of developed countries, raising doubts over applicability to developing countries. Second, as has remained the case throughout the life of financial programming, the model cannot address issues of development as its scope is confined to the so-called short run, over which everything to do with development is taken as fixed. Third, it is ironic that the Polak model began to embrace Keynesianism explicitly just as the approach was falling into disrepute with the stagflation of the 1970s.

Significantly, in the second half of the 1980s, the IMF did seek theoretically to reconcile growth or development objectives with short-run macroeconomic adjustment in proposing a marriage between its Polak model and the World Bank’s growth model. Three further observations follow.

First, the model was fundamentally flawed, bound by export pessimism (as if the world economy did not grow) and leading to declining levels of productivity increase over time. In other words, it remained heavily bound to the short run, and essentially to zero per capita growth in the long run. Second, ironically, this was when new growth theory had begun to flourish, suggesting how productivity increase could be generated over time, but the marriage model was bound to old growth theory in which productivity increase is exogenously determined. And, third, Polak reacted strongly against any attempt to forge a marriage between financial programming (confined and only appropriate to the short run) and growth theory. Indeed, in a personal communication commenting on the marriage model, Polak suggests:

My view is that it is not a worthwhile project, and each subject should be approached on its own, provided the practitioners are fully aware of any recommended policies on the other objective (which to be sure has not always been the case between the Fund and the Bank). A possible simile, somewhat limping of course: the jobs of a schoolteacher and a paediatrician are both to do good to a child, and each should be aware of the other … but the professions should remain specialised for greatest efficiency in each field.

This is well and good as far as it goes, but it neatly sidesteps what has been a major criticism of the stabilization policies of the IMF and the structural adjustment policies of the World Bank, the negative impact of what is adopted in the short run on longer run performance. The latter is better seen as attached to an evolving economy over time, rather than as some given equilibrium around which appropriate policies are targeted. Polak, and his model, simply do not address this issue as he is only too aware.

The recent turn to poverty reduction has intensified the failure to observe the reservations that Polak has expressed over the use of his model. The first, and, for some time, the only model underpinning PRSPs uses financial programming as its organizing framework. It does so while assuming that there is a single labour market and full employment, thereby, for the convenience of the model, abolishing the major sources of poverty – unemployment and low wages -- in one stroke. This is even justified on the grounds that the model is universally and conveniently applicable across all countries.

It is certainly not the case that the Polak model for financial programming determines IMF policy. Indeed, it allows for considerable discretion. But it does set a framework within which policy is discussed, one which prioritizes the short term over the long run, and financial functioning and targets over the traditional concerns of development. It is time for a fundamental rethink and a new framework – one both recognizing, rather than subordinating itself to, increasing financial volatility, and genuinely engaging adjustment with developmental goals, with poverty alleviation and growth as starting points, rather than add-ons.

For a fuller discussion, see Ben Fine, "Financial Programming and the IMF", in B. Fine and K.S. Jomo (eds), The New Development Economics: After the Washington Consensus, Dehli: Tulika and London: Zed Press

Ben Fine is Professor of Economics at the School of Oriental and African Studies, University of London, and Director of the Centre for Economic Policy for Southern Africa at SOAS. Recent books include “Social Capital versus Social Theory: Political Economy and Social Science at the Turn of the Millennium” (2001); “Development Policy in the Twenty-First Century: Beyond the Post-Washington Consensus” (2001); “The World of Consumption: The Material and Cultural Revisited” (2002); “Marx's Capital” fourth edition (2004); and “The New Development Economics: A Critical Introduction” (2006). His research interests include "economic imperialism" or the relationship between economics and other social sciences, especially social capital; the material and cultural determinants of consumption, particularly food; privatisation and industrial policy; and development theory and policy.