Constitutional political economy of foreign investment in the Philippines

Originally livestreamed on the Facebook page of The CoRRECT Movement on February 21, 2021 (the 35th anniversary of EDSA), this discussion with Orion Perez Dumdum covers the political economy of constitutional restrictions on foreign ownership in key sectors of the Philippines. CoRRECT stands for Constitutional Reform and Rectification for Economic Competitiveness and Transformation. It is a study group that espouses reforms in the Philippine Constitution of 1987.

The show notes used to structure the discussion are found here.

Dilawan: Rise and Fall of the EDSA Regime - Vision vs Reality

In this episode we are going to dissect the vision that Ninoy had offered for the Philippines, and delve more  deeply into the early days of the post-EDSA regime to see how this vision was corrupted by the yellow forces.

A plutarchy with populist tendencies

The title of this piece is inspired by Prof. Yuen Yuen Ang’s take on how China escaped the poverty trap. Ang argues that despite one party rule, China was able to forge merit-based mechanisms of accountability that led to its development. She describes it as an “autocracy with democratic characteristics”.

The Beijing Consensus refers to the political economy instituted by the People’s Republic under Deng Xiaoping, after Mao’s death in 1976. It is an alternate path to development, sitting in contrast to the failed Russian Soviet experiment with a command economy and all its inherent inefficiency, unwieldiness and poor incentives.

Under the China model, Beijing sets national economic policy through its five year plans. It then assigns to regional counterparts the task of meeting these targets through a “franchise-like” system. Each local government uses its own connections (“guanxi”) to attract investment to contribute to the the national goal under a process of “directed improvisation”.

Promotion within Communist party is based on performing well against official targets, relative to peers. Individuals rising to the highest policy-making body, the Politburo standing committee, prove themselves in towns and villages first, then at cities and regional levels.

The central government, in giving agency to regional executives, is able to keep its “distance” from local politics and avoid blame when their administration fails, due to ineptitude or corruption. It can overrule or interfere with local affairs, if public outcry reaches the capital. This is what gives the autocratic state some form of democratic accountability.

Beijing adapted local customs to mimic Western institutions that foster open competition within a marketplace of ideas. Instead of inter-party competition, the Chinese have created internal tournaments within the ruling party. They follow through on long-range plans, without disruption from corruptible, short-term election cycles that occur in developing states.

The Philippines has been characterised as a cacique democracy, from its inception in the 1890s with local and national politics dominated by a small set of wealthy, well-connected families. Even with American “tutelage” in democracy, participation in politics was largely confined to those with political pedigree and deep pockets.

A lack of policy consensus after independence from the 1950s to 1970s ensued leading to boom and bust cycles. Since EDSA ‘86, multiparty democracy is seen as chaotic, with limited participation and increasing concentration of power even within the partylist system.

But there has been considerable policy continuity in economic affairs since EDSA. This has led to increased rates of economic growth with greater capacity to handle internal contradictions of a market-based system, namely the disparity by which its spoils are shared.

Developmental spending enables political families to retain legitimacy. They are slowly moving away from direct forms of patronage to programmatic, institutional responses to poverty and other challenges. The evidence? … Free college, universal health care coverage and public school feeding programs, cash transfers to poor families, senior citizen benefits, among others.

Rivalry among political families has created conditions that mimic democratic accountability, stealing the thunder from progressive movements. Chief executives act as family figures making government seem near and personal.

Apo Marcos, Tita Cory, Steady Eddie, Pareng Erap, Ate Glo, PNoy and Tatay Digong were personages meant to instill a sense of filial piety in the nation through pakikisama and bayanihan, the illusion that we are all part of an “imagined community” despite our regional, ethnic differences.

The Philippines may thus be regarded as a plutarchy with populist tendencies. The adoption of democratic forms of governance without the institutions performing their function, has given rise to political dynasties. Through local customs, the Philippines has begun to develop a consensus for economic growth and development under a market-based system.

This has led to increased concentration of economic and political capital. To retain legitimacy, actors voluntarily initiate populist programs that increasingly rely on fiscal space afforded by growth to fund them, sustainably. This constitutes an alternate path to development, which might be dubbed the Manila Consensus. 

Towards a New Philippine Political Architecture

Tomorrow the Senate committees on electoral reforms and people's participation as well as constitutional amendments and revisions of codes will hold a hearing on political dynasties.

Senator Francis "Kiko" Pangilinan announced it on Twitter.

When there is a monopoly, chances are your development will not be sustainable because only a few are benefitting and that's why you have so much poverty.

Dahil dito, tayo'y magkakaroon ng pagdinig para sa mga batas laban sa political dynasties. Magkita-kita po tayo bukas 9 am. pic.twitter.com/m01HiEfNRT

— Kiko Pangilinan (@kikopangilinan) February 14, 2018

In 2013, at the height of the #ScrapPork protests, I wrote a policy brief on reforming Philippine political institutions and governance. Instituting either a ban or a cap on political dynasties needs to go hand in hand with electoral reforms that would strengthen political parties. The paper is found below and can be downloaded here. Could this be an idea whose time has come?

Lessons from Rwanda

Twenty years on since the Rwandan genocide how has the country transitioned into a more stable society and been able to punch above its weight in good governance and growth?

Landlocked, under-endowed, war-ravaged, Rwanda a nation of 10.5 million people has faced a number of disadvantages, not the least of which was the ethnic strife between the Hutus and Tutsis that has ravaged the country in the past. And yet it in spite of these setbacks, it has experienced very respectable growth figures (averaging 7.4 per cent per annum) and improving social indicators over the past decade.

Rwanda has undertaken significant efforts to reform its regulatory environment. Just consider the following:

• The World Bank ranks Rwanda the 4th best country in Africa to do business, after Mauritius, South Africa and Botswana.
• It only takes 3 days to set up a business, the 8th shortest time in the world.

• The country is in the 71 percentile rank with a score of 53/100 in Transparency International’s Corruption Perception Index, placing it in the same class as Malaysia and South Korea.

So how has a country which suffered many years of war and as much corruption as any other impoverished nation, managed to turn things around?

Well the short answer is they did this through an accommodative political settlement and the help of both conventional and unorthodox institutions and economic strategies.

Rwanda has had a long history of ethnic violence between the two main rival tribes.  From pre-colonial times up to 1959, the pastoralist Tutsis were the ascendant political class over the agriculturalist Hutus. Ethnic differences were exaggerated under colonial rule. In the lead up to independence in 1962, Belgian colonists transferred their support to Hutu elites. This led to mass killings of Tutsis many of whom fled the country.

Two Hutu regimes ruled the country from 1961-94. Having a single-party dominate politics for most of this period did not prevent the nation from succumbing to decentralised rent-seeking and clientelist behaviour. A group known as Akazu was at the apex of this system. It was related to but not controlled by the administration.

Tutsis sought to regain control of the country through an invading Rwanda Patriotic Army. This culminated in the genocide of 1994 by retreating Hutus. After consolidating their hold on the country, the Rwanda Patriotic Front (RPF) established a government of national unity incorporating moderate Hutus, one of whom led the country as its president.

Although a certain amount of political repression in the guise of preventing a return of “ethnic ideology” has occurred, the coalition governments comprised of all legal parties in parliament being proportionately represented in cabinet (the ruling RPF holds no more than fifty per cent of the portfolios) has succeeded in keeping the nation stable. This inclusiveness along with its program of restorative justice known as gacaca has fostered reconciliation and allowed the country to experience improvements in social and human development not seen previously.

The intrusive intervention of government in everyday life at times borders on social engineering as the government has sought to follow the Singaporean model in both economic and social policy implementation. President Paul Kagame (elected in 2003 and then again in 2010) has been labelled the global elite’s favourite strongman for improvements to public service delivery, particularly in health and education.

Departmental line agencies have been managed through an institution of performance contracts known as imhigo which Tim Kelsall describes as “modern performance agreements supported by a significant component of moral pressure and neo-traditional gloss.” This combination of formal scientific management theory and homegrown practices has permeated down to the grassroots by roping in local officials and civil servants.

On the economic front, Rwanda has applied a hybrid approach to investment promotion. On the one hand, it has adopted policies and institutional arrangements considered best practice by the World Bank’s Doing Business surveys. Responsibility for managing this has been assigned to the Rwanda Development Board (RDB). But this works in parallel with a more activist approach in industrial policy with the RPF’s holding company, Tri-Star Investments getting involved in joint ventures and start-up companies.

Tri-Star helped the RPF raise funds during the Congo wars to overthrow Zairean dictator Mobutu Sese Seko through trading metals in international markets. The surplus achieved was then channeled towards domestic private sector development. The holding company has initiated many successful ventures with demonstration effects for the rest of the economy. Telecoms is one example. When Tri-Star sold part of its stake in Rwandatel in 2007, it got five to ten times its initial investment in the company.

Because profits from Tri-Star that are not ploughed back into its businesses revert to RPF, the party is financially independent. It uses this to fund its political campaigns without having to resort to political donors. Kelsall explains what this does:

The RPF’s financial solvency obviates the need for party officials to engage in election-related corruption, which in turn allows the party to take a very tough line on corruption among its leading supporters and in the bureaucracy.

Apart from Tri-Star the government has also orchestrated the formation of other funds, the Horizon Group belonging to the army, which undertakes socio-economic projects to produce productive enterprises, and the Rwanda Investment Group, a consortium led by domestic and diasporic elite.

The purpose of the second group is to raise capital other than through foreign borrowings to invest in projects of strategic national importance. Without such an interventionist approach, much of the agricultural and industrial transformations currently underway in different sectors of the economy simply would not be happening.

The case of Rwanda demonstrates many similar traits to that of the Northeast Asian developmental states. The RPF led government faced existential threats from the opposition in exile and from a potentially hostile ethnic majority at home just as the South Korean and Taiwanese states did from North Korea and from mainland China.

These threats have kept the ruling RPF focused on improving social and economic well-being for its citizens to maintain its legitimacy and hold on power. The regime has exercised a capacity for long-range vision and forward planning contained in its Vision 2020 roadmap, free from the influence of rent-seeking, private interests. It has ruthlessly pursued its policies at times through heavy-handed regulations and enforcement of rules.

The low crime, low corruption, low red-tape environment this has fostered was not enough. The RPF has used its clout to address market failures and encourage the adoption of productivity enhancing new technology. Through its holding company and other private-led investment groups that it has brought into being, jobs have been found for talented managers and skilled workers that might have otherwise gone overseas.

The Rwandan experience demonstrates the capacity of poor nations to bring about a system of governance that is relatively competent and free from corruption within a short span of time using home-grown institutions, resources and talent. The extremely harsh and disadvantageous position it faced did not become a hindrance, but rather provided greater incentive for it to go down the road it has followed. Surely, any emerging economy seeking to do the same should take heed the lessons from Rwanda.

Austerity and Trust

Image credit: marketjyotish.blogspot.com

As weekend voting in France and the collapse of the Dutch government signaled a backlash against austerity in Europe, analysts are wondering what its impact might be elsewhere.

Simon Johnson believes that the replacement of right of center governments with left of center ones won't change a thing as options are limited. The Austerity Has Just Begun is the way Johnson states their predicament.

Robert Reich draws lessons from Europe for the US as the presidential campaign season kicks off. For Reich it is not enough for the Democrats to say that "things would have been worse" under the Republicans. With trust in both their parties running low, neither camp has been able to establish a statistically significant lead over the other as the anemic economic recovery plods along. 

The UK budget recently passed by the Conservative-led coalition government might provide a few clues to US voters as to what life would be like under a Republican White House and Congress. Aside from effectively cutting entitlements to pensioners and reducing state spending at a rate unseen since the end of the second world war, the treasurer George Osborne eased taxes on the top marginal tax bracket by 5%. This has subsequently led to a precipitous fall in their polling.

Even in Australia, the debt and deficit debate is raging even as the government promises to deliver a surplus as it hands down its budget next month. Although it might be the sole advanced country that can afford at the moment to incur a deficit, the Labor government is being cornered into this box by the conservative opposition which promises to outdo them in reining in spending (despite the fact that they too have spending proposals of their own).

Psychological experiments involving groups and leaders have shown that when voters identify with their leader or consider him or her "one of them", they are more likely to accept withdrawal of resources (austerity) from that leader than if it were imposed by some outsider. When a leader who does not fit in with their group favors his own group with resources (tax cuts), they are also more likely to perceive this as unfair.

If elections are to be framed as a contest of who voters trust more in handling the economy, the likelihood is that conservatives will have an edge (as in the case of the UK where tories still poll better than Labor in terms of economic management).

If elections are fought over which party voters are more likely to trust to scale back entitlements in a socially responsible manner, the party associated with the broad middle and lower income classes is more likely to pull ahead. Likeability and trust is perhaps what it all boils down to.

Oh, what a difference

Back in 2005, Germany had the highest unemployement rate among the major economies of the EU (of the big four including France, UK, Italy and the PIGS economies of Portugal, Ireland, Greece and Spain). Ireland had the lowest. Today, as Moody's downgrades the credit rating of six European countries, Germany has the lowest unemployment among them all. How fortunes have changed in such a short span of time. It should be noted that the Deutschland during the global financial crisis went alone in not stimulating its economy.

Could this be a case of free-loading? Stimulus only works when everyone does it, otherwise some of the fiscal spending leaks out through imports of foreign made goods, not benefiting the local economy. Germany, having benefited from the stimulus spending of its neighbors during the GFC, does not relish its present role in bailing out its ailing neighbors. A classic case of "no free lunch."

Obama Seeks to Curb Outsourcing

With 2012 being an election year, President Obama set out to frame his re-election bid in November around the economy. Having cited employment and productivity gains of late, he then targeted his ire on tax incentives offered to multinational companies for outsourcing business activities overseas.

The following is an excerpt from his State of the Union Address:

If you’re a business that wants to outsource jobs, you shouldn’t get a tax deduction for doing it. That money should be used to cover moving expenses for companies...that decide to bring jobs home.
Second, no American company should be able to avoid paying its fair share of taxes by moving jobs and profits overseas. From now on, every multinational company should have to pay a basic minimum tax. And every penny should go toward lowering taxes for companies that choose to stay here and hire here.
Third, if you’re an American manufacturer, you should get a bigger tax cut. If you’re a high-tech manufacturer, we should double the tax deduction you get for making products here. And if you want to relocate in a community that was hit hard when a factory left town, you should get help financing a new plant, equipment, or training for new workers.
It’s time to stop rewarding businesses that ship jobs overseas, and start rewarding companies that create jobs right here in America. Send me these tax reforms, and I’ll sign them right away.

 Just as he decried the uneven playing field that countries like China have created by undervaluing their currency, he advocated the use of the tax system to provide credits and government subsidies to industries (particularly in the clean energy and advanced technology sectors) as a way of ensuring that America was "built to last". All this was part of the solution in addressing what he called "the defining issue" of his presidency--keeping the American dream alive.

Well, well, well, it seems that Washington is no longer enamored with the Washington Consensus. As it pushes for free trade agreements across the globe to lower trade barriers for its products and to enforce the intellectual property rights of its companies, it is clear that the administration has no qualms about engaging in market interventions at home to boost the competitiveness of its local industries.

China's Hard Landing: Is it around the bend?

Last June, I speculated that a hard landing in China might be around the bend. That was even before the US downgrade and EU debt crisis unfolded. Now it seems the events of 2007 culminating in the collapse of Lehman the following year and the global stimulus in response to the North Atlantic crisis that followed may have returned to bite the People's Republic.

Reports of China's heavy handed treatment of foreign companies, defaults on loans and a slowing property market are developing into a credible narrative. Doomsayers like Rhoubini and Chanos have spoken. They predict the hard landing is on its way. Meanwhile confidence in China still remains strong with the EU looking east for help in financing its stability fund and Australia still expecting to profit from this Asian economy's thirst for iron ore and other mineral deposits as it did during the last global downturn.

What happens next depends on the ability of China's authorities to handle the current softening of global demand for its exports. Back in 2008, it engaged in a massive fiscal stimulus program. The unwinding of that stimulus is what gives the impression to many that it was headed for a soft landing. It can very easily turn the tap back on if the situation deteriorates. Their effectiveness at reading the situation will determine whether it has a soft or hard landing.

The glorious revolution

In my title, I am of course referring to the event in England in 1688 which unintentionally led to the Bill of Rights, rule of law, and Western capitalism as we know it. As background for those unfamiliar with it, there are two short clips at the end of this piece worth viewing.

The now classic essay by Douglass North and Barry Weingast investigates the institutional innovations that accompanied the resolution of this conflict and relate them to developments in public finance. Their thesis is that without such constitutional and political underpinnings, England would not have achieved global success both militarily and commercially in the following century.

They purposely side-step the religious element that is often cited. Greater importance was placed on the dispute that had been brewing since early in the 17th C between the Crown and Parliament. Many of the same issues in this dispute hound developing and transitional economies today.

At the core of this was the structuring of incentives to control the coercive powers of the state. Previously the divine right of kings was invoked to justify the arbitrary use of such powers resulting in the expropriation of property from the wealthy who were represented in Parliament. Despite objections, the king continued to wield his prerogative by forcing loan contracts on the elite and reneging on the debts.

This unpredictability meant that the Crown was unable to tap private credit markets. Following the revolution, the new monarch acceded to the rights of Parliament over such contractual obligations. As a sweetener, the confidence this engendered opened unprecedented access to capital at more affordable rates. This allowed England to achieve military superiority while maintaining fiscal liquidity and provided the conditions needed for the Industrial Revolution.

It is in keeping with this seminal work that much discussion circles today around the enforcement of property rights and the rule of law in developing and transitional economies. At the heart of the debate is the question whether Western notions of governance particularly legal institutions should be transplanted elsewhere. The differential experiences found in China and East Asia cast doubts on whether a "one size fits all" approach is appropriate.

The Philippines is an example of a developing country that went through a "peaceful revolution" to topple a dictator in 1986, but which is still mired in corruption and political instability. It has enshrined "people power" in its constitution as a vehicle for removing tyrannical rulers. The vibrant NGO and activist business community have proven since then how potent a threat this institution can be.

But the high transactions costs entailed in mobilising popular uprisings has taken its toll. As a result of experiments over the last decade, there is a growing demand for the rule of law in the form of restraint on the part of both the central government and civil society in expropriating public and private wealth from one another. Should a government be formed that addresses this demand, it might pave the way for greater investments in productive sectors, the same way that mutual checks in England between the Crown and Parliament did.

Revenue Write-Down: Deal or No Deal

The shifting of the Federal Labor Government position from conservative fiscal stewards to that of aggressive deficit hawks bears striking resemblance to the behaviour of contestants on the popular game show, Deal or No Deal.

The way in which the Rudd Government has framed its first and second budgets is characterised by what decision theorists would regard as an inconsistent set of risk preferences. Prospect theory, as developed by Daniel Kahneman (Nobel Prize in Economics, 2002) and Amos Tversky provides a good explanation of the way it has behaved. In short, when faced with gains, a decision-maker (i.e. the government) tends to be risk-averse; when confronted with losses, she becomes much more risk-seeking.

The theory is responsible for adjusting the standard expected utility model of decision-making under risk. As it turns out context determines whether standard models work and when they don’t, as explained by scholars Rose McDermott, James Fowler and Oleg Smirnov:

It may be that standard models work well when environmental conditions are characterized by abundance. However, when the external situation changes and individuals or groups begin to face real or perceived threats to survival, preferences will change in the predictable way.

This type of predictable behaviour has been seen in Deal or No Deal contestants when they start to lose the possibility of winning the larger cash prizes (see here for an explanation of how the game is played). Instead of taking deals equal to the average of possible cash prizes remaining, they often play on hoping to score the remaining higher amount.

Let’s play

In the first round of his fiscal budget cycle, Treasurer Wayne Swan was dealt a winning hand: a fiscal position in surplus, a smoothly running economy, strong property and commodity markets, healthy business and consumer confidence, trade surpluses as far as the eye could see (this was Treasury’s flawed assumption) and historically low unemployment. In fact, the only dark cloud on the horison was inflation, which was driven in large part by high oil prices.

So, in keeping with Labor’s election promise of delivering sound economic management, he brought down a budget that was conservative: no major spending (which would put upward pressure on inflation), a continuation of the tax cuts that the previous government had enacted, a few minor tweaks around the education revolution, but very little in terms of rocking the boat. A very respectable 2% of GDP in surplus was maintained.

Then the GFC broke. Within weeks, the official pronouncements were that a severe financial cyclone was headed our way with a ferocity that had not been witnessed in a generation. Two rounds of fiscal stimulus were announced in quick succession leaving the coffers with a surplus of merely 1% of GDP (what they were unwilling to say then was that effectively with an expected slowdown, revenue write-downs of more than 1% were inevitable, so the government had already slipped into deficit at that point, but nevermind they thought, the stimulus might actually work).

Then the second round of the budget took place. This time the government literally was willing to bet the house. It went all-in. No such thing as cutting your losses, when the prospects were looking grimmer by the day. It took them a few days to acknowledge that the nation was as a result of its budget staring down a net debt worth a whopping 13.8% of GDP. It had changed its tack from being risk averse, economic conservatives to risk-seeking big-spenders, all in 18 months. Yet, despite all the recriminations it received for trying to spin the deficit negatives into a positive, Rudd and co were merely reacting based on nature’s inbred survival instinct.

The remaining hand

Ironically, political considerations had held them back from considering the full-on risk-seeking decision of cancelling tax cuts to address the structural imbalances in the budget that had crept in as a result of overconfidence on the part of the Federal Treasury in the commodities trade boom. Again from McDermott et al a lesson in economic reform:

An important topic…is the decision by some leaders to implement radical economic reform…(f)rom Latin America to Eastern Europe, leaders like Alberto Fujimori in Peru institute bold economic reforms with severe costs for the population and, surprisingly, receive widespread support for such action. Similarly, leaders such as Boris Yeltsin in Russia and Vaclav Klaus in the Czech Republic were re-elected despite instituting costly economic adjustment plans (emphasis added).

By not addressing the fiscal imbalances in the present budget, the Feds have had to assume a V-shaped recovery; and yet, notwithstanding their optimism it will take no less than 13 years for the “temporary” debt to be erased. With the current talk of long-term bond spreads widening and credit downgrades over the horison (which will lead to higher debt servicing costs), time will tell if this act of hesitance towards reform in the wake of aggressive yet popular spending leads the government and the electorate down the track to a no deal situation.

Discounting Human Nature

Why governments and voters in resource rich countries fail to horde boomtime windfalls for future economic contingencies and what to do about it.

"Australia's net debt will be the lowest of any major advanced economy in the world for the next decade. It is responsible for us to have embraced such a strategy to deal with the challenges presented to us and other economies with the global recession, and to do so within that responsible framework."

-Wayne Swan as quoted in The Australian, 9 May 2009.

“Young people have got to know this; that they have been put into hock for a very long period of time by this government and they’ll be paying for it through their taxes probably for generations.”

- Peter Costello as quoted in The Australian, 13 May, 2009

Governments today wish they had the equivalent of a Joseph, the biblical hero, appointed to Pharaoh’s court whose prudent advice spared the land of Egypt from hunger during seven years of severe famine. The thing is: there were josephs in our midst; they are known as economists who predicted the current crisis and the severity of its impact (Nouriel Roubini being one of them).

Apart from Norway and Chile, a country long considered a model of policymaking no other country seems to have taken the lesson of this biblical story to heart. Regarding Chile, The Economist reports

As a small, open economy it (Chile) is uncomfortably exposed to the world recession—the price of copper, its main export, has fallen by almost two-thirds since mid-2008 … The government forecasts this year’s fiscal deficit at 2.9% of GDP, but it can easily afford this. That is because it has stuck to a rigorous fiscal rule … requiring it to save much of the revenue gained when the copper price rises. Not only is public debt minimal (4% of GDP in December), but the government has also piled up $20.3 billion (about 12% of GDP) in a sovereign wealth fund which it can now spend.

Why aren’t other countries, particularly resource rich ones in the developed world, following the Chilean countercyclical example? Well, the answer depends on whom you consult, for example:

Political economists will point to the “Dutch disease” phenomenon that afflicts resource rich countries. During boomtimes, GDP accelerates past the long-run steady state of the economy. This windfall tempts governments of the day to increase spending on social services (as in the case of Holland in the 1980s) or reduce taxes or a combination of both (as in the case of Australia). When the boom ends, growth moves below the steady state, making the contraction all the more painful as social services are cut, taxes raised, etc. In fact, Jeffrey Sachs has built a general equilibrium model that mimics this phenomonen in action in the Venezuelan economy.

Institutionalists will identify the agency costs associated with the exercise of control over windfall profits. Especially in developing economies with weak judicial systems and endemic corruption, decision-making with regards to such wealth becomes diabolically problematic.

Behaviouralists will point to the lack of rationality and self-control that creates perceptual biases that prevent a proper assessment of the risks involved by not saving. Planners could suffer from optimistic or hindsight bias as a result.

A rational observer might comment that these explanations aren’t good enough. Anyone with common sense would intuitively sense that “all good things eventually come to an end” and see the wisdom in “saving for a rainy day”. As it turns out, neuroscience is helping to uncover the reason for this irrational behaviour.

Any standard economic model would use exponential discounting to determine the optimal amount of consumption and saving a household or government should engage in. This only works when temporal or time preferences are consistent. If humans were completely rational, they would follow this mode. It now appears that our preferences for rewards change depending on the length of time being considered. This has led to the method of hyperbolic discounting which takes into account our being “present-biased”.

So it would seem that when faced with two options of having a reduction of taxes in the long-run through savings made in the short-run versus receiving a short-term benefit in the form of a one-off payment/increased social services paid for by higher taxes in the future, that taxpayers will by and large opt for the latter even if in the long-run, they would benefit more from the former. This is by the way the reason why households over-consume and over-borrow. Given that their governments suffer from the same imperfection in judgement, it is not surprising that they would give in to this populist urge.

On the other hand, a paternalistic State such as Chile, would recognise that given our flawed judgement, the necessity of enactomg legislation that automatically sets aside above average fiscal benefits in the short run to smooth over shortfalls in the long-run. This would reduce the need to go into debt when markets head south and unburden future generations from interest payments. This, to me, seems the only sensible way to go about discounting our very nature.

Opposite Poles

Two eminent economists, Meltzer and Krugman, dispute the issue of whether inflation or deflation will be the next great challenge facing the US (and world) economy. A lot depends on which period of history is used as an analogue for this one.

Allan H. Meltzer is a professor of political economy at Carnegie Mellon University. He has authored the book “A History of the Federal Reserve.” He believes that the US is headed for “severe inflation”. In an op-ed piece for the NY Times, he points out that

the interest rate the Fed controls is nearly zero; and the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain (Inflation Nation, 3 May 2009).

He pins the blame on both political and monetary authorities, in particular

the (doubtful) commitment of the administration and the (lack of) autonomy of the Federal Reserve ... under Mr. Bernanke, the Fed has sacrificed its independence and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages.…
It doesn’t help that the administration’s stimulus program is an obstacle to sound policy. It will create jobs at the cost of an enormous increase in the government debt that has to be financed. And it does very little to increase productivity, which is the main engine of economic growth.

Meltzer recounts the Fed under Paul Volcker (who is presently advising the Obama administration) which tamed spiralling inflation following the Oil Shock of the 1970s. As some have argued, the present crisis could have been instigated and deepened by the Oil Shock of 2007. Meltzer further points to one indicator that inflation is already here; he argues

(S)ome of my fellow economists, including many at the Fed … point to the less than 1 percent decline in the consumer price index for the year ending in March as evidence that deflation is a threat. But this statistic is misleading: unstable food and energy prices may lower the price index for a few months, but deflation (or inflation) refers to the sustained rate of change of prices, not the price level (emphasis mine). We should look instead at a less volatile price index, the gross domestic product deflator. In this year’s first quarter, it rose 2.9 percent — a sure sign of inflation.

Quoting the father of monetarism, he says

Milton Friedman often said that “inflation was always and everywhere a monetary phenomenon.” The members of the Federal Reserve seem to dismiss this theory because they concentrate excessively on the near term and almost never discuss the medium- and long-term consequences of their actions.

Paul Krugman is on the opposing side of the debate. He teaches at Princeton University and has made a living out of studying economic crises. His latest book is entitled “The Return of Depression Economics.” He counters Meltzer in his blog with a graph that depicts the “lost decade” in Japan in the 1990s where the growth of money supply, high deficits coincided with deflation. Krugman’s attention is devoted to avoiding wage deflation, as he writes in his column for the NY Times that

…according to the Bureau of Labor Statistics, the average cost of employing workers in the private sector rose only two-tenths of a percent in the first quarter of this year — the lowest increase on record. Since the job market is still getting worse, it wouldn’t be at all surprising if overall wages started falling later this year (Falling Wage Syndrome, 3 May 2009).

His view is that wage deflation is a symptom of a deeper problem in the economy. And his prescription is for “more stimulus, more decisive action on the banks, more job creation”. Quoting the father of stimulus economics, he argues that

(T)hings get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: “The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period.” And a rise in the effective interest rate is the last thing this economy needs.

So there you have it: two renowned experts fighting over the appropriate fiscal and monetary measures to take in this crisis. Both use staitstics and history to bolster their arguments. The disagreement ultimately comes from which previous recession is deemed relevant for this present crisis – whether the Great Depression of the 1920s and lost decade in Japan of the 1990s or the post-Oil Shock era of the 1970s.

Krugman and Bernanke, the deficit hawks, believe that constricting growth particularly at this moment could hamper economic recovery, while Meltzer, the institutionalist, believes that protecting growth at all costs has consequences far greater than we imagine.

The Calculus of Dissent

The opposition of conservatives in both Australia and the US to proposed stimulus bills despite the popularity of such measures and their endorsement by the IMF is (let’s call it for what it is) a form of political gamesmanship that could potentially pay dividends in a few years’ time depending on the extent of recessions in both countries.

Yes, there were ideological (some prefer the term philosophical) reasons for opposing them: too much wasteful pork was inserted, not enough tax breaks, a wasted opportunity to reduce taxes on labour seen as the most distortionary, and the tendency for cash handouts to be tucked away in savings because of the lump sums being handed out.

All of these plausible and valid reasons aside, the lack of political incentive to engage in deficit spending can be seen as the main reason for their opposition and should have been pinpointed early on by those advising both the Rudd and Obama administrations. The narrative being woven of the crucial and historic moment requiring bipartisanship fell on deaf ears from those across the aisle.

In the US Congress, not one Republican from the House voted for that chamber’s version. At the Senate, three moderate conservatives came on board, in exchange for reductions in the the total size of the package (by about 100 billion US dollars) and an increased share for tax cuts. This high price for such a feeble form of bipartisanship has frustrated Keynesian “Depression” economist Paul Krugman. He looks at the gap between potential and actual gross domestic product and concludes that the size of the now stimulus law is not large enough.

The title of this article (I should say) is inspired by the Nobel Laureate James Buchanan, the leading economist of the “Virginia School” of public finance. His book co-authored with Gordon Tullock, the Calculus of Consent, is an exposition of the “politics of exchange”. It demonstrates how, logrolling (a.k.a “you scratch my back, I’ll scratch yours) under majority voting rules leads to unchecked growth in the size of the public sector.

Buchannan and Tullock’s approach could be considered an economic rationalist approach to politics in a democratic system. In the crafting of the spending bill, the brazen pork barreling engaged in by US congressmen at the lower house seems to support this view. In terms of the rejection of these packages, the conservatives seem to take a stance that behavioural economists and game theorists regard as “retaliation”.

In bargaining games, two players are asked to split a cash pot. The first player is told he can propose the share splitting ratios. The second player can either take it or leave it. If he rejects the split then no deal takes place. First movers are instructed to propose a lopsided split, say 90-10. Knowing that he can either settle for 10 percent or nothing, the rational person would be expected to accept. In such experiments, it has been observed that second movers often turn the proposition down even if it is against his interests to do so.

The fact that in the US, Democrats had the majority and could still pass legislation without any support of other players possibly emboldened some to push the envelope. Staring at potential failure of these measures and a mid-term election in less than two years forced Obama to seek some modicum of co-ownership with Republicans to insulate him from criticism down the track. This effort failed, and as a result, his fate rests with the success of the stimulus.

In Australia, the story was a little different. A lack of majority in the Senate and the presence of a few Greens and independents meant that this was a multiplayer “game” with more than two players. The outcome was predictable: the bill was passed with concessions made to parochial interests. The outcome for the global economy though is less predictable. Only time will tell whether the calculus of dissent was right.