Turning the Russian petro-monetary transmission mechanism upside-down

Big news out of Moscow today – not about the renewed escalation of military fighting in Eastern Ukraine, but rather about Russian monetary policy. Hence, today the Russian central bank (CBR) under the leadership of  Elvira Nabiullina effectively let the ruble float freely.

The CBR has increasing allowed the ruble to float more and more freely since 2008-9 within a bigger and bigger trading range. The Ukrainian crisis, negative Emerging Markets sentiments and falling oil prices have put the ruble under significant weakening pressures most of the year and even though the CBR generally has allowed for a significant weakening of the Russian currency it has also tried to slow the ruble’s slide by hiking interest rates and by intervening in the FX market. However, it has increasingly become clear that cost of the “defense” of the ruble was not worth the fight. So today the CBR finally announced that it would effectively float the ruble.

It should be no surprise to anybody who is reading my blog that I generally think that freely floating exchange rates is preferable to fixed exchange rate regimes and I therefore certainly also welcome CBR’s decision to finally float the ruble and I think CBR governor Elvira Nabiullina deserves a lot of praise for having push this decision through (whether or not her hand was forced by market pressures or not). Anybody familiar with Russian economic-policy decision making will know that this decision has not been a straightforward decision to make.

Elvira has turned the petro-monetary transmission mechanism upside-down

The purpose of this blog post is not necessarily to specifically discuss the change in the monetary policy set-up, but rather to use these changes to discuss how such changes impact the monetary transmission mechanism and how it changes the causality between money, markets and the economy in general.

Lets first start out with how the transmission mechanism looks like in a commodity exporting economy like Russia with a fixed (or quasi fixed) exchange rate like in Russia prior to 2008-9.

When the Russian ruble was fixed against the US dollar changes in the oil price was completely central to the monetary transmission – and that is why I have earlier called it the petro-monetary transmission mechanism. I have earlier explained how this works:

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

This effectively means that in such a set-up the CBR will have given up monetary sovereignty and instead will “import” monetary policy via the oil price and the exchange rate. In reality this also means that the global monetary superpower (the Fed and PBoC) – which to a large extent determines the global demand for oil indirectly will determine Russian monetary conditions.

Lets take the case of the People’s Bank of China (PBoC). If the PBoC ease monetary policy – increase monetary supply growth – then it will increase Chinese demand for oil and push up oil prices. Higher oil prices will push up currency inflows into Russia and will cause appreciation pressure on the ruble. If the ruble is pegged then the CBR will have to intervene to keep the ruble from strengthening. Currency intervention of course is the same as sell ruble and buying foreign currency, which equals an increase in the Russian money base/supply. This will push up Russian nominal GDP growth.

Hence, causality runs from the monetary policy of the monetary superpowers – Fed and the PBoC – to Russian monetary policy as long as the CBR pegs or even quasi-peg the ruble. However, the story changes completely when the ruble is floated.

I have also discussed this before:

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

If today’s announced change in monetary policy set-up in Russia is taken to be credible (it is not necessary) then it would mean the completion of the transformation of the monetary transmission which essentially was started in 2008 – moving from a pegged exchange/manage float regime to a floating exchange rate.

This will also means that the CBR governor Elvira Nabiullina will have ensured full monetary sovereignty – so it will be her rather than the Federal Reserve and the People’s Bank of China, who determines monetary conditions in Russia.

Whether this will be good or bad of course fully dependent on whether Yellen or Nabiullina will conduct the best monetary policy for Russia.

One can of course be highly skeptical about the Russian central bank’s ability to conduct monetary policy in a way to ensure nominal stability – there is certainly not good track record, but given the volatility in oil prices it is in my view also hard believe that a fully pegged exchange rate would bring more nominal stability to the Russian economy than a floating exchange rate combined with a proper nominal target – either an inflation target or better a NGDP level target.

Today Elvira Nabiullina has (hopefully) finalized the gradual transformation from a pegged exchange to a floating exchange rate. It is good news for the Russian economy. It will not save the Russia from a lot of other economic headaches (and there are many!), but it will at least reduce the risk of monetary policy failure.

PS I still believe that the Russian economy is already in recession and will likely fall even deeper into recession in the coming quarters.

 

 

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Time for the Fed to introduce a forward-looking McCallum rule

Earlier this week Boston Fed chief Eric Rosengreen in an interview on CNBC said that the Federal Reserve could introduce a forth round of quantitative easing – QE4 – since the beginning of the crisis in 2008 if the outlook for the US economy worsens.

I have quite mixed emotions about Rosengreen’s comments. I would of course welcome an increase in money base growth – what the Fed and others like to call quantitative easing – if it is necessary to ensure nominal stability in the US economy.

However, the way Rosengreen and the Fed in general is framing the use of quantitative easing in my view is highly problematic.

First of all when the fed is talking about quantitative easing it is speaking of it as something “unconventional”. However, there is nothing unconventional about using money base control to conduct monetary policy. What is unconventional is actually to use the language of interest rate targeting as the primary monetary policy “instrument”.

Second, the Fed continues to conduct monetary policy in a quasi-discretionary fashion – acting as a fire fighter putting out financial and economic fires it helped start itself.

The solution: Use the money base as an instrument to hit a 4% NGDP level target

I have praised the Fed for having moved closer to a rule based monetary policy in recent years, but the recent escalating distress in the US financial markets and particularly the marked drop in US inflation expectations show that the present monetary policy framework is far from optimal. I realize that the root of the recent distress likely is European and Chinese rather than American, but the fact that US inflation expectations also have dropped shows that the present monetary policy framework in the US is not functioning well-enough.

I, however, think that the Fed could improve the policy framework dramatically with a few adjustments to its present policy.

First of all the Fed needs to completely stop thinking about and communicating about its monetary stance in terms of setting an interest rate target. Instead the Fed should only communicate in terms of money base control.

The most straightforward way to do that is that at each FOMC meeting a monthly growth rate for the money base is announced. The announced monthly growth rate can be increased or decreased at every FOMC-meeting if needed to hit the Fed’s ultimate policy target.

Using “the” interest rate as a policy “instrument” is not necessarily a major problem when the “natural interest rate” for example is 4 or 5%, but if the natural interest rate is for example 1 or 2% and there is major slack in the economy and quasi-deflationary expectations then you again and again will run into a problem that the Fed hits the Zero Lower Bound everything even a small shock hits the economy. That creates an unnecessary degree of uncertainly about the outlook for monetary policy and a natural deflationary bias to monetary policy.

I frankly speaking have a hard time understanding why central bankers are so obsessed about communicating about monetary policy in terms of interest rate targeting rather than money base control, but I can only think it is because their favourite Keynesian models – both ‘old’ and ‘new’ – are “moneyless”.

I have earlier argued that the Fed since the summer of 2009 effectively has target 4% nominal GDP growth (level targeting). One can obviously argue that that has been too tight a monetary policy stance, but we have now seen considerable real adjustments in the US economy so even if the US economy likely could benefit from higher NGDP growth for a couple of year I would pragmatically suggest that the time has come to let bygones-be-bygones and make a 4% NGDP level target an official Fed target.

Alternatively the Fed could once every year announce its NGDP target for the coming five years based on an estimate for potential real GDP growth and the Fed’s 2% inflation target. So if the Fed thinks potential real GDP growth in the US in the coming five years is 2% then it would target 4% NGDP growth. If it thinks potential RGDP growth is 1.5% then it would target 3.5% growth.

However, it is important that the Fed targets a path level rather than the growth rate. Therefore, if the Fed undershoots the targeted level one year it would have to bring the NGDP level back to the targeted level as fast as possible.

Finally it is important to realize that the Fed should not be targeting the present level of NGDP, but rather the future level of NGDP. Therefore, when the FOMC sets the monthly growth rate of the money base it needs to know whether NGDP is ‘on track’ or not. Therefore a forecast for future NGDP is needed.

The way I – pragmatically – would suggest the FOMC handled this is that the FOMC should publish three forecasts based on three different methods for NGDP two years ahead.

The first forecast should be a forecast prepared by the Fed’s own economists.

The second forecast should be a survey of professional forecasts.

And finally the third forecast should be a ‘market forecast’. Scott Sumner has of course suggested creating a NGDP future, which the Fed could target or use as a forecasting tool. This I believe would be the proper ‘market forecast’. However, I also believe that a ‘synthetic’ NGDP future can relatively easily be created with a bit of econometric work and the input from market inflation expectations, the US stock market, a dollar index and commodity prices. In fact it is odd no Fed district has not already undertaken this task.

An idealised policy process

To sum up how could the Fed change the policy process to dramatically improve nominal stability and reduce monetary policy discretion?

It would be a two-step procedure at each FOMC meeting.

First, the FOMC would look at the three different forecasts for the NGDP level two-years ahead. These forecasts would then be compared to the targeted level of NGDP in two year.

The FOMC statement after the policy decision the three forecast should be presented and it should be made clear whether they are above or below the NGDP target level. This would greatly increase policy-making discipline. The FOMC members would be more or less forced to follow the “policy recommendation” implied by the forecasts for the NGDP level.

Second, the FOMC would decide on the monthly money base growth rate and it is clear that it follows logically that if the NGDP forecasts are below (above) the NGDP level target then the money base growth rate would have to be increased (decreased).

It think the advantages of this policy process would be enormous compared to the present quasi-discretionary and eclectic process and it would greatly move the Fed towards a truly rule-based monetary policy.

Furthermore, the process would be easily understood by the markets and by commentators alike and it would in no way be in conflict with the Fed’s official dual mandate as I strongly believe that such a set-up would both ensure price stability – defined as 2% inflation over the cycle – and “maximum employment”.

And finally back to the headline – “Time for the Fed to introduce a forward McCallum rule”. What I essentially have suggested above is that the Fed should introduce a forward-looking version of the McCallum rule. Bennett McCallum obviously originally formulated his rule in backward-looking terms (and in growth terms rather than in level terms), but I am sure that Bennett will forgive me for trying to formulate his rule in forward-looking terms.

PS if the ECB followed the exactly same rule as I have suggested above then the euro crisis would come to an end more or less immediately.

 

 

Soon everybody will be scared about ‘currency war’ again – we should be celebrating

With the dollar continuing to strengthen and now the Japanese yen starting to take off as well central bankers in the US and Japan are likely increasingly becoming worried about the deflationary tendencies of stronger currencies and recent comments from both countries’ central banks indicate that they will not allow their currencies to strengthen dramatically if it where to become deflationary.

This has in recent days caused some to begin to talk about the “risk” of a new global “currency war” where central banks around the world compete to weaken their currencies. Most commentators seem to think this would be horrible, but I would instead argue – as I have often done in recent years – that a global race to ease monetary policy is exactly what we need in a deflationary world.

If we lived in the high-inflation days of the 1970s we should be very worried, but we live in deflationary times so global monetary easing should be welcome and unlike most commentators I believe a global currency war would be a positive sum game.

Over the last couple of years I have written a number of posts on the topic of currency war. The main conclusions are the following:

  1. Currency war is a GREAT THING and is VERY POSITIVE – if indeed we think of it as a global competition to print money. This is what we need in a deflationary world.
  2. As long as we are seeing commodity prices decline and inflation expectations we can’t really say that the currency war is on yet.
  3. Currency war is NOT a zero sum game. It is a positive sum game in a deflationary world.
  4. Don’t think of monetary easing/currency depreciation to primarily work through a “competitiveness channel”, but rather through a boost to domestic demand. Therefore, we are likely to actually see the trade balance WORSEN for countries, which undertakes aggressive monetary easing. The US in 1933 is a good example. So is Argentina in 2001-2 and Japan recently. Sweden versus Denmark since 2008.

I don’t have much time to write more on the topic this morning, but I am sure I will return to the topic soon again. Until then have a look at my previous posts on the topic (and related topics):

Bernanke knows why ‘currency war’ is good news – US lawmakers don’t

‘The Myth of Currency War’

Don’t tell me the ‘currency war’ is bad for European exports – the one graph version

The New York Times joins the ‘currency war worriers’ – that is a mistake

The exchange rate fallacy: Currency war or a race to save the global economy?

Is monetary easing (devaluation) a hostile act?

Fiscal devaluation – a terrible idea that will never work

Mises was clueless about the effects of devaluation

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

The luck of the ‘Scandies’

The Fed’s un-announced 4% NGDP target was introduced already in July 2009

Scott Sumner started his now famous blog TheMoneyIllusion in February 2009 it was among other things “to show that we have fundamentally misdiagnosed the nature of the recession, attributing to the banking crisis what is actually a failure of monetary policy”.

Said in another way the Federal Reserve was to blame for the Great Recession and there was only one way out and that was monetary easing within a regime of nominal GDP level targeting (NGDP targeting).

NGDP targeting is of course today synonymous Scott Sumner. He more or less single-handedly “re-invented” NGDP targeting and created an enormous interest in the topic among academics, bloggers, financial sector economists and even policy makers.

The general perception is that NGDP targeting and Market Monetarism got the real break-through in 2013 when the Federal Reserve introduced the so-called Evans rule in September 2012 (See for example Matt Yglesias’ tribute to Scott from September 2012).

This has also until a few days ago been my take on the story of the success of Scott’s (and other’s) advocacy of NGDP targeting. However, I have now come to realize that the story might be slightly different and that the Fed effectively has been “market monetarist” (in a very broad sense) since July 2009.

The Fed might not have followed the MM game plan, but the outcome has effectively been NGDP targeting

Originally Scott basically argued that the Fed needed to bring the level nominal GDP back to the pre-crisis 5% trend path in NGDP that we had known during the so-called Great Moderation from the mid-1980s and until 2007-8.

We all know that this never happened and as time has gone by the original arguments for returning to the “old” NGDP trend-level seem much less convincing as there has been considerable supply side adjustments in the US economy.

Therefore, as time has gone by it becomes less important what is the “starting point” for doing NGDP targeting. Therefore, if we forgive the Fed for not bringing NGDP back to the pre-crisis trend-level and instead focus on the Fed’s ability to keep NGDP on “a straight line” then what would we say about the Fed’s performance in recent years?

Take a look at graph below – I have used (Nominal) Private Consumption Expenditure (PCE) as a monthly proxy for NGDP.

PCE gap

If we use July 2009 – the month the 2008-9 recession officially ended according to NBER – as our starting point (rather than the pre-crisis trend) then it becomes clear that in past five years PCE (and NGDP) has closely tracked a 4% path. In fact at no month over the past five years have PCE diverged more than 1% from the 4% path. In that sense the degree of nominal stability in the US economy has been remarkable and one could easily argue that we have had higher nominal stability in this period than during the so-called Great Moderation.

In fact I am pretty sure that if somebody had told Scott in July 2009 that from now on the Fed will follow a 4% NGDP target starting at the then level of NGDP then Scott would have applauded it. He might have said that he would have preferred a 5% trend rather than a 4% trend, but overall I think Scott would have been very happy to see a 4% NGDP target as official Fed policy.

The paradox is that Scott has not sounded very happy about the Fed’s performance for most of this period and neither have I and other Market Monetarists. The reason for this is that while the actual outcome has looked like NGDP targeting the Fed’s implementation of monetary policy has certainly not followed the Market Monetarist game plan.

Hence, the Market Monetarist message has all along been that the Fed should clearly announce its target (a NGDP level target), do aggressive quantitative easing to bring NGDP growth “back on track”, stop focusing on interest rates as a policy instrument and target expected NGDP rather than present macroeconomic variables. Actual US monetary policy has gradually moved closer to this ideal on a number of these points – particularly with the so-called Evan rule introduced in September 2012, but we are still very far away from having a Market Monetarist Fed when it comes to policy implementation.

However, in the past five years the implementation of Fed policy has been one of trial-and-error – just think of QE1, QE2 and QE3, two times “Operation Twist” and all kinds of credit policies and a continued obsession with using interest rates rates as the primary policy “instrument”.

I believe we Market Monetarists rightly have been critical about the Fed’s muddling through and lack of commitment to transparent rules. However, I also think that we today have to acknowledge that this process of trail-and-error actually has served an important purpose and that is to have sent a very clear signal to the financial markets (and others for that matter) that the Fed is committed to re-establishing some kind of nominal stability and avoiding a deflationary depression. This of course is contrary to the much less clear commitment of the ECB.

The markets have understood it all along (and much better than the Fed)

Market Monetarists like to say that the markets are better at forecasting and the collective wisdom of the markets is bigger than that of individual market participants or policy makers and something could actually indicate that the markets from an early point understood that the Fed de facto would be keeping NGDP on a straight line.

An example is the US stock market bottomed out a few months before we started to establish the new 4% trend in US NGDP and the US stock markets have essentially been on an upward trend ever since, which is fully justified if you believe the Fed will keep this de facto NGDP target in place. Then we should basically be expecting US stock prices to increase more or less in line with NGDP (disregarding changes to interest rates).

Another and even more powerful example in my view is what the currency markets have been telling us. I  (and other Market Monetarists) have long argued that market expectations play a key role in the in the implementation of monetary policy and in the monetary policy transmission mechanism.

In a situation where the central bank’s NGDP level target is credible rational investors will be able to forecast changes in the monetary policy stance based on the actual level of NGDP relative to the targeted level of NGDP. Hence, if actual NGDP is above the targeted level then it is rational to expect that the central bank will tighten the monetary policy stance to bring NGDP back on track with the target. This obviously has implications for the financial markets.

If the Fed is for example targeting a 4% NGDP path and the actual NGDP level is above this target then investors should rationally expect the dollar to strengthen until NGDP is back at the targeted level.

And guess what this is exactly how the dollar has traded since July 2009. Just take a look at the graph below.

NGDP gap dollar index 2

We are looking at the period where I argue that the Fed effectively has targeted a 4% NGDP path. Again I use PCE as a monthly proxy for NGDP and again the gap is the gap between the actual and the “targeted” NGDP (PCE) level. Look at the extremely close correlation with the dollar – here measured as a broad nominal dollar-index. Note the dollar-index is on an inverse axis.

The graph is very clear. When the NGDP gap has been negative/low (below target) as in the summer of 2010 then the dollar has weakened (as it was the case from from the summer of 2010under spring/summer of 2011. And similarly when the NGDP gap has been positive (NGDP above target) then the dollar has tended to strengthen as we essentially has seen since the second half of 2011 and until today.

I am not arguing that the dollar-level is determining the NGDP gap, but I rather argue that the dollar index has been a pretty good indicator for the future changes in monetary policy stance and therefore in NGDP.

Furthermore, I would argue that the FX markets essentially has figured out that the Fed de facto is targeting a 4% NGDP path and that currency investors have acted accordingly.

It is time for the Fed to fully recognize the 4% NGDP level target

Just because there has a very clear correlation between the dollar and the NGDP gap in the past five years it is not given that that correlation will remain in the future. A key reason for this is – and this is a key weakness in present Fed policy – that the Fed has not fully recognize that it is de facto targeting a 4%. Therefore, there is nothing that stops the Fed from diverging from the NGDP rule in the future.

Recognizing a 4% NGDP level target from the present level of NGDP in my view should be rather uncontroversial as this de facto has been the policy the Fed has been following over the past five years anyway. Furthermore, it could easily be argued as compatible  with the Fed’s (quasi) official 2% inflation target (assuming potential real GDP growth is around 2%).

In my previous post I argued that the ECB should introduce a 4% NGDP target. The Fed already done that. Now it is just up to Fed Chair Janet Yellen to announce it officially. Janet what are you waiting for?

Is Karnit Flug jeopardizing Stan Fischer’s “straight line policy”? Not yet, but…

It is no secret that I think that Stanley Fischer did a good job as governor of the Bank of Israel from 2005 to 2013. He basically saved Israel from the Great Recession by essentially keeping Israeli nominal GDP “on a straight line”. During his time in office the Israeli NGDP level diverged no more than 1-1.5% from what we could call the Fischer-trend.

However, Fischer is no longer at the BoI. Instead former deputy governor Karnit Flug has taken over – effectively from July 2013 and officially from November 2013. The question then is has Mrs. Flug been able to maintain Fischer’s “straight line policy” in place? The graph below gives us the answer.

Karnit Flug NGDP

The picture is pretty clear – essentially coinciding with Flug taking over as BoI governor the slowdown in NGDP growth (already started in 2012) has accelerated and we have now dropped somewhat below the Fischer-trend. It would be foolish to say that this in any way is catastrophic, but the change is nonetheless visible and should give reason for serious concern if it is allowed to continue to “drift off”.

Are inflation expectations becoming un-anchored? 

I have earlier warned that there is a risk that we are seeing inflation expectations becoming un-anchored in for example the euro zone because policy makers are preoccupied with everything else than focusing on their nominal target (for example an inflation target).

On the other hand I have also praised the Bank of Israel for always communicating in terms of (market) inflation expectations relative to the BoI’s 1-3% inflation target (range). However, one could argue that the Bank of Israel is beginning to look more like the Swedish Riksbank (which is preoccupied with household debt and  property prices) or the ECB (which is preoccupied by “everything else”).

A look at inflation expectations can tell us whether these fears are justified or not.

Inflation expectations Israel

The graph shows five different measures of inflation expectations. The first four are inflation expectations based on financial market pricing (BoI’s calculations) and the last one is based on a survey of professional forecasters.

Most of the measures show that there has been a pretty consistent downtrend in most of the measures of inflation expectations for little more than a year. However, it is also notable that we are still within the BoI’s 1-3% inflation target range and 5-year and 10-year inflation expectations are still close to 2% and as remained fairly stable.

Therefore, it is too early to say that inflation expectations have become un-anchored, but it should also be noted that we might be risking a sneaking un-anchoring of inflation expectations if policy actions is not taken to avoid it.

Bringing us back on the “straight line”

The recent rate cuts from the Bank of Israel shows that the BoI is not completely ignorant to these risks and I believe that particularly the latest rate cut to 0.25% on August 25 is helping in curbing deflationary pressures. However, more could likely be done to insure against the deflationary risks.

So what should Karnit Flug and her colleagues at the Bank of Israel do to bring us back to the Fischer-trend and to avoid an un-anchoring inflation expectations?

I have three suggestions:

1) Avoid repeating the mistakes of the Riksbank. The Swedish Riksbank has consistenly for some time now undershoot its official inflation target and in my view this has very much been the result of a preoccupation with household debts and property prices. Historical the Bank of Israel has avoided making this mistake, but there are undoubtedly voices within the BoI that what monetary policy to be more dependent on the development household debt and property prices (these voices are within all central banks these days…)

That said, the Bank of Israel is far from being the Riksbank and so far the emphasis on property market developments in communication about monetary policy has not been overly problematic, but that could change in the future and if the BoI became more focused on these issues then I fear that that could led to a more fundamental un-anchoring of inflation expectations and therefore a more unstable economic development.

2) Avoid repeating the mistakes of the ECB. While the Riksbank has been preoccupied with property prices the ECB has been preoccupied with fiscal policy. There are some signs that the Bank of Israel is getting a bit too focused on fiscal policy rather than focusing on monetary policy. Hence, Mrs. Flug has recently been in a bit of war of words with Finance Minister Yair Lapid about the public budget deficit (see for example here).

While I have sympathy for Mrs. Flug’s fiscal conservatism it is not really the task of any central bank to have a view on fiscal policy other than just take fiscal policy as an exogenous factor when setting policy instruments to hit the central bank’s target. The Bank of Israel should make this completely clear so market participants do not come to think that the BoI will keep monetary policy overly tight (ECB fashion) to punish the Israeli government for overly easy fiscal policy.

3) Pre-announce what to at the Zero Lower Bound. With the BoI’s key policy rates at 0.25% we are effectively at the Zero Lower Bound (ZLB). It is no secret that (Market) Monetarists like myself don’t think that the ZLB is a binding constraint on the possibility for further easing monetary policy. However, the ZLB is often a mental constraint on monetary policy makers.

I think that most observers of the BoI knows that the BoI does not have major “mental” problem with using other instruments – than the interest rate – to ease monetary. Hence, the BoI has since 2008 both bond quantitative easing by buying government bonds and intervened in the currency market to weaken the Israeli shekel. It could easily do that again and I think most market participants full well knows this. Hence, in that sense Israel is in a much better than for example the euro zone.

However, instead of letting the market guessing what it might do in the future if necessary the BoI should already today announce what instrument it would be using to conduct monetary policy at the ZLB. Personally I think the most suitable “instrument” to use for small open economy is the exchange rate channel either in the way it has been done for years by the Monetary Authority of Singapore (MAS) or in recent years by the Swiss and Czech central banks.

I think the best option would simply be for the BoI to announce that it – if needed – could put a floor under USD/ILS and at the same time announce that it will keep the door open for moving up this floor until inflation expectations on all relevant time horizons are between 2 and 2.5%. That in my view would likely lead to a weakening of the shekel of a magnitude to bring inflation expectations immediately in line with this narrow “target” range.

Karnit Flug doesn’t have an easy job to do, but she has a solid foundation to build on

There is no doubt that there is a risk that Stan Fischer’s achievements as Bank of Israeli governor could be jeopardized. However, Karnit Flug has not failed yet and she still have the opportunity to continue the success of Stan Fischer.

But then this has to focus on bringing back the “straight line policy” and ensuring that inflation expectations do not become un-anchored. Hence, she needs to not allow herself to be distracted by the development in property prices and fiscal policy and instead focus on how to conduct monetary policy in a transparent and efficient way at the Zero Lower Bound.

PS I am well-aware that Stan Fischer no longer officially is a proponent of NGDP level targeting and that the BoI does not have an NGDP level target, but rather an inflation target. However, thing of a NGDP target as an intermediate target to implement the “ultimate” target – the inflation target. If the BoI for example keeps the NGDP level on a 5% path and we assume that potential real GDP growth is 2% then the outcome will be 2% over the cycle.

China might NEVER become the biggest economy in the world

It is often assumed that given China’s remarkable growth rates over the past three decades – around 10% real GDP per year – China is on the way to soon becoming the largest economy in the world. In fact earlier this year it got a lot of media attention that when the World Bank argued that China already had overtaken the US as the largest in economy in the world. However, the argument was completely bogus as it was based on Purchasing Power Parity (PPP) rather than on actual exchange rates (To be fair we should blame the media rather than the World Bank for this interpretation of the data).

PPP based measures of GDP (per capita) might make sense if we want to measure how much an average citizen can buy for given an average income, however, it does not make sense when we want to measure the size of the economy. There we have to use measures based on actual exchange rates and if we do that then it turns out that the Chinese economy is still significantly smaller than the US economy. Hence, total Chinese GDP today is around 10 trillion USD, while US GDP is around bn 17-18 trillion USD. Said in another way the US economy is still nearly double the size of the Chinese economy.

And what I will argue in this post is that China might never overtake the US as the biggest economy in the world.

Chinese growth set to slow dramatically in the coming decades

There is a broad consensus among long-term macroeconomic forecasters that the Chinese economy is likely to slow significantly in the coming quarters – starting today!

There are overall three reasons why this is the case:

1) The catching-up process means less and less: A very large part of China fantastic growth performance over the past three decades is due to a “natural” catching up process. When poor economies – like the Chinese economy three decades ago – is freed up a catching up process is started. This means a lot for low-income economies, but as income levels increase the catching up process slows down. This is already the case for China.

2) Investment growth is likely to slow significantly: Fixed investments as share of GDP in China is extremely high – well above 40% of GDP. This is at least 10-15 %-point more than in other countries with a similar GDP/capita level. This to some extent reflect capital misallocation in the Chinese economy as investment decision in the Chinese economy to a large extent still is a result of quasi-central planing. It is therefore natural to expect investment growth to slow quite significantly in the coming decades.

3) China is facing serious demographic challenges: You can blame the Communist Party’s one-child policy or come up with other explanations but the fact is that the Chinese labour force is now already in decline and the decline will continue in the coming decades and soon the Chinese population will be in outright decline.

So from a growth-accounting perspective we have it all – less Total Factor Productivity growth – as the catch-up process slows, a slower increase in the capital stock and finally a declining labour force.

It is therefore hardly surprising that most long-term forecasts made for the Chinese economy forecast a rather significant slowdown in Chinese growth in the coming decades (See for example here.)

Closing in on the US, but China might never make it

It is commonly argued that trend growth presently is around 7-7.5% in China, however, it is equally common to argue that we will see a slowdown in real GDP growth to an average of around 5-6% in the coming 10-15 years. But the real slowdown comes after 2030 where the Chinese economy is expected by most long-term forecasters to start to approaching Japanese style growth rates and outright negative trend-growth should not be ruled out in the 2050s based on reasonable expectations about demographics, the investment ratio and the catching-up process.

Obviously it is difficult to make any macroeconomic forecasts. However, I would actually argue that it in many ways it is easier to make forecast 10-20 years ahead than 1-2 years ahead. When we do short-term forecast the shocks will always mess up our forecasts, but over a 10-20 years horizon the positive and negative shocks tend to even out. Furthermore, in the long-run it is all about supply side factors and with the growth rate of the labour force being a major factor we already know quite a bit. Hence, we have a pretty good idea about the growth of the Chinese labour force in 15-20 years as the people entering the labour force as young adults in 15 or 20 years already have been born.

I have gone through a number of studies of the long-term growth perspectives for the Chinese economy and based on that we can make a simple “simulation” of how the level of Chinese real GDP will develop from now and until 2060. I should stress it is not a forecast as such and lets therefore just stick with the term “simulation” of future Chinese real GDP under reasonable assumptions about the development in technology and in productions factors.

The graph below illustrates my argument that China might never overtake the US as the largest economy in the world. Here is my assumptions (and they can certainly debated, but they are not much different from the “consensus” forecasts for long-term growth in China and the US). I assume that trend real GDP growth in China over the next 15 years will be 6% – slowing from presently 7.5% to 4.5% in 2030. Hereafter the negative demographics in China really kick in and as a result trend growth drops to an average of just 2% for the period 2030-2060.

I have indexed Chinese real GDP at 55 in 2014 – reflecting that Chinese GDP (in USD) is around 55% of US GDP. In my simulation I have assumed that US trend real GDP growth is 3%. This is probably slightly optimistic compared to the “consensus” among long-term forecasters, but it is basically the growth rate we rather consistently have seen in the US economy since the early 1960s. The American demographic challenges are somewhat smaller than is the case for China and I find it rather likely that the US gradually will adjust immigration policies so meet these challenges (I certainly hope so…)

It is important to stress that I here assume that the there is no real appreciation or depreciation in the USD/RMB exchange rate (no Balassa-Samuelson effect). Hence, the exchange rate development is determined by relative inflation in the US and China. This might twist the results slightly against China. On the other hand I have also assumed that the output gap is zero in both countries. In fact the output gap in the US is still negative, while the output gap in China likely is close to zero or even positive. This twists the results against the US. Lets just (completely unreasonably) say that these factors even out each other.

China will NEVER catch up

So there you go. You see under these – simplistic – assumptions the Chinese economy will continue to gain on the US economy over the next two decades. However, under these assumptions (and I again stress it is assumptions) it will be close (around 90%), but no cigar for the Chinese economy – the Chinese economy will never be the largest economy in the world – or at least not in my life time and I do plan to live to at least 2060.

Furthermore, starting around 2040 China will stop catching up and instead see its economy decline relative to the US and in 2060 we will be more or less back where we started with Chinese GDP being around 60% of US GDP.

Now you might say that these results are too negative in terms of China or too positive in terms of the US and that might very well be the case. However, I do think that my simulations illustrate that China is not automatically set for global economic and financial domination. So while China – for a period – might become a bigger economy than the US – if we for example assumption 2.5% US trend growth rather than 3% – the negative demographics will start to kick in soon and that will ensure that the US economy will remain the biggest economy in the world – also in 50 years. This also means that it is quite hard to imagine in my view that the “financial centre” of the world will move to China and I find it extremely hard to imagine that the Chinese renminbi will take over of the role as the leading reserve currency of the world from the US dollar.

But there is no reason to cry for the Chinese

So China might never become the biggest economy in the world. However, that should really not be important for the Chinese. It might be for Chinese policy makers, but the average Chinese should instead celebrate the fact that outlook for his/her income level remains very bright and income growth for the individual Chinese is likely to remain very high in the coming decades. So the discussion above should not really be seen as being “bearish” on China. In fact I am rather optimistic about the Chinese “miracle” continuing in the coming decades. We should celebrate that, but we might never be able to celebrate the day the Chinese economy overtakes the US in absolute size.

Something very clever Bryan Caplan wrote in 2007 on “Anti-Foreign Bias”

I must admit that I am somewhat depressed by the state of the world today. Deflationary monetary policies in Europe, increased protectionist tendencies and war and geopolitical tensions around the world. It is no secret that I think it is all connected.

But why do voters around the world rally behind the cries for closed borders and even more military build-ups? Why do policy makers – democratic and non-democratic – find it in their interest to stir up anti-immigrant sentiment, geopolitical tensions and to introduce protectionist measures?

Bryan Caplan might provide the answer – the “anti-foreign bias” of rationally irrational voters – this is from a piece Bryan wrote for Reason from 2007: 

A shrewd businessman I know has long thought that everything wrong in the American economy could be solved with two expedients: 1) a naval blockade of Japan, and 2) a Berlin Wall at the Mexican border.

Like most noneconomists, he suffers from anti-foreign bias, a tendency to underestimate the economic benefits of interaction with foreigners. Popular metaphors equate international trade with racing and warfare, so you might say that anti-foreign views are embedded in our language. Perhaps foreigners are sneakier, craftier, or greedier. Whatever the reason, they supposedly have a special power to exploit us.

There is probably no other popular opinion that economists have found so enduringly objectionable. In The Wealth of Nations, Adam Smith admonishes his countrymen: “What is prudence in the conduct of every private family, can scarce be folly in a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry.”

As far as his peers were concerned, Smith’s arguments won the day. More than a century later, Simon Newcomb could securely observe in the Quarterly Journal of Economics that “one of the most marked points of antagonism between the ideas of the economists since Adam Smith and those which governed the commercial policy of nations before his time is found in the case of foreign trade.” There was a little backsliding during the Great Depression, but economists’ pro-foreign views abide to this day.

Even theorists, such as Paul Krugman, who specialize in exceptions to the optimality of free trade frequently downplay their findings as abstract curiosities. As Krugman wrote in his 1996 book Pop Internationalism: “This innovative stuff is not a priority for today’s undergraduates. In the last decade of the 20th century, the essential things to teach students are still the insights of Hume and Ricardo. That is, we need to teach them that trade deficits are self-correcting and that the benefits of trade do not depend on a country having an absolute advantage over its rivals.”

Economics textbooks teach that total output increases if producers specialize and trade. On an individual level, who could deny it? Imagine how much time it would take to grow your own food, while a few hours’ wages spent at the grocery store can feed you for weeks. Analogies between individual and social behavior are at times misleading, but this is not one of those times. International trade is, as the economic writer Steven Landsburg explains in his 1993 book The Armchair Economist, a technology: “There are two technologies for producing automobiles in America. One is to manufacture them in Detroit, and the other is to grow them in Iowa. Everybody knows about the first technology; let me tell you about the second. First you plant seeds, which are the raw materials from which automobiles are constructed. You wait a few months until wheat appears. Then you harvest the wheat, load it onto ships, and sail the ships westward into the Pacific Ocean. After a few months, the ships reappear with Toyotas on them.”

How can anyone overlook trade’s remarkable benefits? Adam Smith, along with many 18th- and 19th-century economists, identifies the root error as misidentification of money and wealth: “A rich country, in the same manner as a rich man, is supposed to be a country abounding in money; and to heap up gold and silver in any country is supposed to be the best way to enrich it.” It follows that trade is zero sum, since the only way for a country to make its balance more favorable is to make another country’s balance less favorable.

Even in Smith’s day, however, his story was probably too clever by half. The root error behind 18th-century mercantilism was an unreasonable distrust of foreigners. Otherwise, why would people focus on money draining out of “the nation” but not “the region,” “the city,” “the village,” or “the family”? Anyone who consistently equated money with wealth would fear all outflows of precious metals. In practice, human beings then and now commit the balance of trade fallacy only when other countries enter the picture. No one loses sleep about the trade balance between California and Nevada, or me and iTunes. The fallacy is not treating all purchases as a cost but treating foreign purchases as a cost.

Anti-foreign bias is easier to spot nowadays. To take one prominent example, immigration is far more of an issue now than it was in Smith’s time. Economists are predictably quick to see the benefits of immigration. Trade in labor is roughly the same as trade in goods. Specialization and exchange raise output—for instance, by letting skilled American moms return to work by hiring Mexican nannies.

In terms of the balance of payments, immigration is a nonissue. If an immigrant moves from Mexico City to New York and spends all his earnings in his new homeland, the balance of trade does not change. Yet the public still looks on immigration as a bald misfortune: jobs lost, wages reduced, public services consumed. Many in the general public see immigration as a distinct danger, independent of, and more frightening than, an unfavorable balance of trade. People feel all the more vulnerable when they reflect that these foreigners are not just selling us their products. They live among us.

It is misleading to think of “foreignness” as a simple either/or. From the viewpoint of the typical American, Canadians are less foreign than the British, who are in turn less foreign than the Japanese. From 1983 to 1987, 28 percent of Americans in the National Opinion Research Center’s General Social Survey admitted they disliked Japan, but only 8 percent disliked England, and a scant 3 percent disliked Canada.

Objective measures like the volume of trade or the trade deficit are often secondary to physical, linguistic, and cultural similarity. Trade with Canada or Great Britain generates only mild alarm compared to trade with Mexico or Japan. U.S. imports from and trade deficits with Canada exceeded those with Mexico every year from 1985 to 2004. During the anti-Japan hysteria of the 1980s, British foreign direct investment in the U.S. always exceeded that of the Japanese by at least 50 percent. Foreigners who look like us and speak English are hardly foreign at all.

Calm reflection on the international economy reveals much to be thankful for and little to fear. On this point, economists past and present agree. But an important proviso lurks beneath the surface. Yes, there is little to fear about the international economy itself. But modern researchers rarely mention that attitudes about the international economy are another story. Paul Krugman hits the nail on the head: “The conflict among nations that so many policy intellectuals imagine prevails is an illusion; but it is an illusion that can destroy the reality of mutual gains from trade.” We can see this today most vividly in the absurdly overblown political reactions to the immigration issue, from walls to forcing illegal workers currently in America to leave before they can begin an onerous procedure to gain paper legality.

 

 

Talk about being disappointed…By the Bundesbank

Take a look at this list of Bloomberg headlines coming out today:

*BUNDESBANK: INFLATION EXPECTATIONS NOTICEABLY BELOW ECB MANDATE

Wauw will the Bundesbank advocate monetary easing?

*BUNDESBANK DOESN’T SEE TURN IN GERMAN ECONOMIC FUNDAMENTALS

Yeah it sure looks like that!

*BUNDESBANK SAYS RUSSIA SANCTIONS LIKELY TO DAMP GERMAN EXPORTS

Yes, yes the Bundesbank is surely dovish

*BUNDESBANK SAYS GERMAN ECONOMIC OUTLOOK HAS CLOUDED

This gotta mean the Bundesbank will support QE

*BUNDESBANK SAYS DATA CAST DOUBT ON GERMAN 2H ECONOMIC REBOUND

Increadibly dovish Bundesbank…

*BUNDESBANK SAYS ECB PACKAGE ACCEPTABLE GIVEN LOW INFLATION

Yes, yes… have the market monetarists taken over in Frankfurt?

*BUNDESBANK SAYS EURO-AREA REBOUND TO BE WEAKER THAN EXPECTED

Yeah! Now the Bundesbank surely will endorse QE! No doubt!

*BUNDESBANK SAYS EXPANSIONARY POLICY MAY HARM REFORM EFFORTS

Or maybe not! Talk about being disappointed…

“If goods don’t cross borders, armies will” – the case of Russia

Recently I have been thinking quite a bit about the apparent rise of protectionism across the globe and in my quest to find data on the rise of protectionism I found some very interesting comments regarding the Global Trade Alert‘s annual report for 2013 (here reproduced from the Moscow Times January 11 2014):

Russia enacted more protectionist trade measures in 2013 than any other country, leaving it as the world leader in protectionism, according to a new study.

Furthermore, Russia and its partners in the Customs Union, Belarus and Kazakhstan, accounted for a third of all the world’s protectionist steps in 2013, said the study by Global Trade Alert, or GTA, a leading independent trade monitoring service.

A total of 78 trade restrictions, almost a third of all those enacted by Group of 20 countries, were imposed by Russian legislators last year, the study said.

With the new restrictions, Russia now has 331 protectionist measures in place, or a fifth of all protectionist policies registered worldwide .

Belarus is ranked second, with 162 measures.

The Russian-led Customs Union, which the Kremlin has presented as an alternative to the European Union, came under harsh criticism from the report’s authors.

“The Customs Union was responsible for 15 times as many protectionist measures as China while having only an eighth of the population,” said GTA coordinator Simon Evenett, in comments carried by Reuters.

He described Russia’s policy of economic restructuring as “nothing more than a potent mix of rampant subsidization and aggressive protectionism,” which contradicts the World Trade Organization’s principles.

Russia joined WTO in 2012.

The other members of the Customs Union, Kazakhstan and Belarus, are negotiating entry into the WTO.

Of Russia’s protectionist policies, 43.4 percent were targeted bailouts and direct subsidies for local companies, the report said. Tariff measures accounted for 15.5 percent, while anti-dumping, countervailing duty or safeguard provisions constituted almost 10 percent. Other steps included cuts in foreign worker quotas, export subsidies and restrictions, and sanitary measures

A surge in protectionism occurred around the world starting in 2012, the report said. The 2013 data indicate that the trend, which could slow down international economic growth in the next several years, is likely to continue.

Given recent events in Ukraine it is hard not to come to think of the old free trade slogan normally attributed to Frédéric Bastiat “If goods don’t cross borders, armies will”.

—–

PS if you want to think of a “model” of the recent rise in geopolitical tensions around the world then think of this causal relationship: Monetary policy failure => deflationary pressures => rising political populism and an increase in protectionist measures => increased geopolitical tensions. I will try to return to this topic in later posts as I increasingly think there is a relationship between monetary policy failure and increased political uncertainty and geopolitical tensions.

PPS 14 years ago I wrote a short article on the relationship between protectionism and war. You will find it here (page 25-26). It is unfortunately in Danish, but Google Translate might help you.

PPPS a couple of posts on monetary policy failure in Russia. See here, here, here and here.

Recommend reading:

Doug Irwin

 

 

Guest post: The Global Economic Impact of Open Borders (Nathan Smith)

On my blog I mostly writes about monetary policy issues. However, I from time to time I venture into other areas. Among the areas I would like to give more attention to is the economics of immigration. I used to teach immigration economics at the University of Copenhagen and have done research on the topic while working at the Ministry of Economic Affairs in Denmark 15 years ago. However, I have not worked professionally with immigrations economics for well over a decade and I have only followed the new research in this area from a bit of a distance.

However, since I started my blog I have had a tradition for inviting economic scholars and others to write guest posts on my blog. I am now continuing the tradition as I have invited Nathan Smith to write a guest post on a very interesting paper that he has been working on.

Nathan in his paper is trying to give an assessment of the Global Economic Impact of Open Borders. His results are extremely interesting and in my view illustrates just how big the economic potential benefits are if we moved towards a world of free movement of labour across borders.

This obvious is a very controversial topic so it is very welcomed that professional economists are contributing to a better understanding the topic. It is certainly about time that we start basing immigration policy around on a sound economic understanding of the topic rather than on emotions and populist rhetoric. I am therefore tremendously happy that Nathan has accepted my invitation to contribute to my blog on this very important topic.

Nathan would like to use this opportunity to welcome comments on his ideas and his paper. I would very much suggest that everybody interested in Nathan’s work and the economic of immigration in general leave comments here at the blog or drop Nathan a mail (see e-mail address below). You are obviously also welcome to drop me a mail (lacsen@gmail.com). It would be great if we could make this an example on a ‘real-time peer review’ of an academic paper.

- Lars Christensen

Guest post: The Global Economic Impact of Open Borders

by Nathan Smith (nathan_smith@ksg03.harvard.edu)

First, a little about me. I’ve been an open borders advocate for nine years now, first publishing in an online journal call Tech Central Station (see here, here, here, here, here, here, here, here, and here), then in my 2010 book, Principles of a Free Society, and most recently at the blog Open Borders: The Case and The Freeman. My work experience includes the Cato Institute and the World Bank. My education includes a Masters in International Development from the Kennedy School of Government at Harvard (2003), and a PhD in economics from George Mason (2011). Now, I teach economics (macro, public finance, investments, international trade, research methods) at Fresno Pacific University, a small Christian college in California. The website Open Borders: The Case was founded by Vipul Naik and is dedicated to describing and developing the case for open borders in a rational and balanced way.

Open borders is a question both of ethics and of positive economics. There are non-utilitarian arguments that deportation of illegal immigrants, exclusion of peaceful migrants, forcible separation of families, or other aspects of border enforcement violate human rights, are morally impermissible, and must cease regardless of the consequences. But even those who accept these arguments will be curious about what the consequences of doing our moral duty are likely to be. For utilitarians, the whole question will turn on what would happen under open borders. Others may accept that there are such things as rights, and that they may forbid some policies that would be adopted on the basis of a merely utilitarian calculus, but think that a substantial amount of migration restriction is consistent with rights. Open borders would then be evaluated on the basis of its consequences. So, putting my knowledge of development economics to work, I’ve just finished a draft of a paper, “The Global Economic Consequences of Open Borders,” in which I’ve been trying to guess what would happen if all migration restrictions were abolished. Lars was kind enough to offer me the chance to give a glimpse of my methods and results here.

Under the status quo, markets for labor and human capital clear at the national level. Under open borders, they would clear at the global level. At any rate, that is how I model the main difference between the status quo and open borders. Everything else, initially, is either held constant—total factor productivity (TFP), country risk premia on investment capital, the total world population, the total world human capital stock—or changes because of the way global labor and human capital markets clear—the population and GDP of different countries, the global stock of physical capital, the wages of raw capital and the premium paid to human capital around the world. But before solving for a new global equilibrium in the labor and human capital markets, I had to develop a description of the world under the status quo. That is, I had to develop a stylized description of the current world economy, which was consistent with a theoretical model that could subsequently be solved for a new, open borders equilibrium, and which, at the same time, fit tolerably well with the data.

At the heart of my description of the status quo are the factors of production. I follow Mankiw, Romer, and Weil (1992) in explaining international income differences primarily by differences in physical and human capital per worker. TFP still plays an indispensable role, but it varies across countries much less than does average human capital. It is indispensable because—as was pointed out by critics of Mankiw, Romer, and Weil (1992) such as Paul Romer—to explain international income differences entirely by international differences in physical and human capital per worker, requires one to claim that these differences are very large, with counter-factual implications for the marginal product, and therefore the price, of these factors of production across countries. As Lucas (1990) observed, if international income differences depended on physical capital alone, the marginal product and price of physical capital would be orders of magnitude higher in poor countries vis-à-vis rich ones, and if capital is internationally mobile, all new investment would occur in poor countries.

If international income differences depended on human capital alone, then human capital ought to have a higher marginal product and earn more where it was scarce, and we should see mass emigration of smart college grads from the US to India, rather than the other way around. But fairly small differences in TFP—say, a factor of three between the most and least productive countries—suffices to reconcile a factor endowments explanation of most international income differences, with plausible factor prices. Table 1 shows, for selected countries: average human capital and the country risk premium on investment capital, as imputed on the basis of data; TFP, a residual used to reconcile GDP per capita with average human capital and the risk premium; and the “wage of raw labor” and “human capital premium,” as predicted when national labor and human capital markets are solved for equilibrium.

table 1 Nathan Smith

Table 1 features very large differences in average human capital across countries. Some of the world’s least developed countries have less than 5% of the human capital of the average American. Average human capital was imputed on the basis of the UN’s Human Development Index (HDI), but the HDI was interpreted as (linearly related to) the log of average human capital. A possibly surprising, but on reflection plausible, feature of the status quo world as described in Table 1 and the underlying model, is that the wages of raw labor differ enormously across countries, but the human capital premium, though it, too, tends to be positively correlated with human capital, differs much less.

Lastly, it must be mentioned that there is a spatial model at work here. Working in Stata, I generate a data set of two million “settlements,” meant to fit major stylized facts about how the human population is distributed among cities, towns, and villages. I imputed TFP at the settlement level. I won’t try to describe the spatial model in detail here, but I do want to mention why it matters. A general problem for open borders models is that it’s hard to give strictly economic reasons why anyone would want to stay in unproductive places when they could move to productive ones.

To address this question, I start by noting that some domestic locations seem more productive than others, and asking why some people live in, say, Elko, NV, instead of New York. My spatial model is based on (a) increasing returns, (b) congestion disutilities, and (c) differences in local TFP. So, Elko, NV has lower TFP than New York, and ends up with fewer people and less physical and human capital per worker, but people still live there for the cheap land and lack of congestion. By the same token, why would anyone stay in Mexico, Indonesia, or Malawi under open borders, when they could live in the USA? Because the best city sites in the USA will get congested, and some places in Mexico, Indonesia, and Malawi may be better than some places in the USA.

So, what are my results? First, let me stress that these are preliminary. After some very helpful real-time peer review from my colleagues at Open Borders: The Case, I plan to refine the spatial model, and somehow I need to come up with better ways to deal with anomalies in imputed TFP, mostly arising from natural resource wealth. The paper describes two scenarios, “Scenario 1” which implements the model in the most literal fashion, and “Scenario 2,” in which I add in some other adjustments, such as human capital growth in response to the new incentives and opportunities of a world with open borders, falling country risk premia due to remittances and generally movements of people facilitating movements of money, and TFP adjustments due to cultural/institutional influences, positive and negative, and to the fact that TFP partly reflects congestible public goods.

In Scenario 1, over 5 billion people migrate, and the world economy comes to be dominated by a few “Countries of Reinforced Dominance” and “New Settler Societies,” while the largest western European countries become “Corridor Countries,” which see much of their native human capital emigrate as they absorb a flood of less-skilled immigrants, and most developing countries become “Countries of Emigration,” losing much to most of their populations to emigration, or “Ghost Nations,” in which less than 2% of the native population stays. While I actually find these large patterns somewhat plausible, the “Countries of Reinforced Dominance” and “New Settler Societies” include too many resource-rich countries like Qatar, East Timor, and Botswana. Since everything else is mobile, high TFP outliers have an outsized impact on global outcomes.

So, I’ll reserve judgment until I come up with a better way to get at “essential” GDP, reflecting the inherent productivity of a place’s institutions, deducting natural resource windfalls. For the record, unskilled workers’ living standards under Scenario 1 converge to 23% of the current US level; the human capital premium rises almost everywhere, converging to $66,535 per annum; average (but not necessarily median) incomes rise for natives of every country in the world; the global capital stock rises more than 100%; and world GDP rises by 80%.

As I say, TFP anomalies are the Achilles heel of the model, and I like Scenario 2 better in part because it deals with them, albeit in a somewhat rough and ad hoc fashion. In Scenario 2, immigrants from low TFP places to high TFP places raise TFP in the places they come from, and reduce it in the places they go to. This is less about negative congestion externalities, which the spatial model has already tried to take into account, as it is about social norms and institutions. Take littering. Citizens of developed countries tend to have a “no littering” norm pretty firmly imprinted in their minds. Citizens of many developing countries do not. So, immigrants from developing countries would probably make litter more common in developed countries, since at least some of them would bring their bad habits with them.

At the same time, the social disapproval and legal penalties they would face for littering in the West would change the habits of some of them, and return migration and letters home would facilitate the spread of a “no littering” norm back to migrants’ countries of origin. The same would apply to many other useful protocols and practices of developed countries, from tipping to not stealing napkins from food courts to not paying bribes to democratic tolerance to culturally valuing literacy and book learning, which open borders could be expected both to dilute at home, and to spread abroad. As it happens, these plausible assumptions about institutional transmission also tame the implausible ascent of high TFP outliers. Since “founder effects” are important, however, I give natives five times the weight of immigrants in determining the TFP, under open borders, of a country of (net) immigration, while emigrants have only one-fifth the weight of those who stay home, in determining the TFP, under open borders, of a country of (net) emigration.

Scenario 2 represents, for the moment, represents my “best guess” of what a world of open borders would “really” look like. Even then, a strange qualifier must be added: I am holding things like world population and TFP constant even as I project the end-point of a transition that would take decades to play out, so the results must be interpreted as if the transition dynamics to open borders are “fast-forwarded” while other changes underway in the world economy are frozen in place. Total migration under Scenario 2 is a little over 3 billion, about 44% of mankind. Interestingly, international geographic mobility under open borders would look similar to interstate mobility in the USA today.

The global human capital stock would rise by 50%, world GDP by 69%, and the global stock of physical capital by 88%. Most developed countries would turn into “host nations,” seeing immigrants from developing countries swell their populations, while most developing countries would see a large fraction of their populations emigrate. However, under Scenario 2, there would be no “ghost nations”: the worst-off countries would be “rescued” by the benign effects of their diasporas, and would see institutions improve, average human capital rise, and investment capital become more available. Some high TFP outliers would turn into “new settler societies,” but (setting to one side the special experience of the USA) these countries would end up with only about 10% of world population. The aggregate experiences of major geographic-cultural regions, shown in Table 2, give a pretty good description of how open borders would change the world under Scenario 2.

Table 2 Nathan Smith

 

The most striking feature of Table 2 is the dramatic rise of the West, defined as the EU plus the English-speaking USA, Canada, Australia, and New Zealand. The West’s population would soar to over 3 billion. It would be home to 43% of the world’s population, but about two-thirds of physical and human capital, and it would generate two-thirds of world GDP. Of course, the West might become less Western as it absorbed billions of immigrants, mostly from East and South Asia, so some might see this as, not the rise, but the end of the West. But polities that represent rival civilizations, such as India and China, would certainly see their relative power decline.

More important, though, is the impact on individuals. And it is here that the strength of the case for open borders really shines through. “The Global Economic Impact of Open Borders” is meant as a contribution to positive, not normative economics. Evaluative judgments are included to keep the prose from being too dry, but are not what the paper is really about. Yet for anyone who cares about the welfare of the foreign-born, Table 3 cannot but be a powerful moral argument. For under Scenario 2, it is precisely the world’s poorest who would benefit most from open borders. Natives of the benighted Democratic Republic of the Congo would see their labor incomes rise, on average, by +1801%. Natives of Ethiopia, Burma, Tanzania, Kenya, and many other very poor countries, would see their incomes rise several-fold, partly because tens of millions of them would emigrate, partly because human and physical capital would become more abundant, partly because the diaspora’s influence would improve institutions. Natives of middle-income countries would see smaller, but still substantial, gains.

Table 3 Nathan Smith

Natives of developed countries would have a more ambiguous experience. There, the wage of raw labor would fall. The living standards of unskilled workers worldwide would converge to 44% of the US level. The human capital premium would rise in most places, even in the West, but in the USA, it would actually fall. This would occur because (a) the USA would be such a powerful magnet for skilled workers that average human capital, already high under the status quo, would actually rise slightly, and (b) TFP would fall by about 9%. In the large countries of Western Europe, natives would become minorities in the countries where they were born, but their average labor incomes would actually rise, thanks to gains from trade with immigrants, even as national TFP fell. But the median worker, having below average human capital, would probably earn less than under the status quo, and earnings would become more unequal. But the USA, where even the average worker would earn less than under the status quo, provides an especially good test case for the status quo.

Whether Americans would really be worse off under Scenario 2 is tricky. Their labor incomes would fall, but those who own land—and most Americans are homeowners—would see its value rise more than three-fold. Also, the US government would enjoy a far larger tax base, which it might use to hold natives harmless in the midst of enormous changes. But if we think of open borders as a sacrifice by Americans for the benefit of the foreign-born, it has the merit of being enormously effective on a per dollar basis. Global open borders would reduce Americans’ labor incomes by 10%, while increasing by multiples the welfare of billions of the poorest among our fellow human beings around the world.

While these results are not, in my view, rigged to favor open borders, they are of course highly contestable at the level of positive economics, as well as open, if accepted, to many normative appraisals. Yet I hope they will nonetheless help to dispel the notion that open borders are a “utopian” proposal. Open borders would not free mankind from work, or death, or turn the sea into lemonade, as one early utopian socialist dreamed. There would be major changes, and winners and losers, but on balance the changes would be positive, as well as highly egalitarian. Open borders is probably best compared to the abolition of slavery: a radical but not revolutionary reform, which seems quixotic, but which reason shows is attainable, and which will harm certain powerful vested interests, but benefit most of mankind, especially the worst-off, while expanding human freedom and reducing the amount of violence and coercion in the world.

At any rate, that’s my best guess as to what would happen. But my results are preliminary, and I will be grateful for feedback and criticism.

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