Monday, February 28, 2011

Jay Leno On Government Shutdown

A shutdown of the federal government in the United States (or actually only parts of it, since for example the military wouldn't be affected) seems to be averted for now, but is still possible later during March given the fact that House Republicans demand spending cuts that both Senate Democrats and President Obama say are out of the question, meaning that at least one side have to accept concessions that are humiliating for them and bad for the country in their mind to avoid shutdown. It might therefore be the case that a shutdown will take place.

What would happened if the federal government shutted down? Well, during the latest shutdown in 1995, Jay Leno in an appearance in Las Vegas described the effects this way:

Imagine what will happen when the federal government shuts down. Illegal immigrants could start pouring into our cities, drug use could sky rocket. In L.A. they'll think they can get away with murder [This was shortly after O.J. Simpson was acquited]. So what's different? No different really.

But then he corrected himself by saying that one thing would change:

Congress is being laid off too, and this effects the local economy here in Vegas too. Five brothels just went out of business, just like that.

Trade Deficits In Relation To Budget Deficits & Trade Policy

Sometimes I'm not as clear as I want to be because I assume that readers are as aware of certain complex truths that I'm aware of. For example here I mention that one way in which fiscal austeity will not reduce growth is because it will reduce the trade deficit.

This caused at least one reader to wonder whether this meant that I endorsed the theory that mercantilism can boost growth.

But that was not what was meant. First of all it needs to be remembered that a reduced trade deficit and a reduced net capital inflow are flip sides of the same thing. While the "trade deficit reducing" aspect of it raises output, the "capital inflow reducing" part lowers it because it raises interest rates. From a demand point of view, nothing happens to aggregate demand, it is the compostition that changes.

It must also be remembered that the main way in which the reduced demand from fiscal austerity is compensated is by lowering interest rates. However, if a reduction in the budget deficit reduces the trade deficit then net capital inflow decreases too which in turn means that interest rates may not fall so much. What this means is simply that the reduced demand from a reduction in the budget deficit is counteracted by a lower trade deficit rather than lower interest rates.

This however, doesn't mean that you can boost growth by erecting barriers for imports because this will also reduce capital inflows something which in turn will raise interest rates.

To use an analogy: assume that a company sells for a billion dollars, this could increase their cash assets (not necessarily notes and coins)accounts receivables by a billion dollars . But if some customers pay later then perhaps cash assets will increase by only $500 million while will increase $500 million. In this analogy accounts receivable are like a lower trade deficit and cash are like the interest rates, they are two forms of economic improvements resulting from deficit reduction and sales respectively.

This however doesn't mean import barriers would improve the economy, any more than refusal to accept cash payments would improve corporate profits, because the trade deficit reduction and accounts receivable increases would be counteracted at least fully by higher interest rates and less cash assets respectively. The fact that one thing (a sale or a budget deficit reduction) can have positive effects doesn't mean that a change in the composition of improvements is necessarily better because the necessary flip side of this change in composition is negative, something that cancels out the apparent improvemebt from more of the positive flip side of this change in composition.

Saturday, February 26, 2011

The GDP Accounting Identity & Causality

Catherine Rampell discusses yesterday's downward revision of fourth quarter 2010 U.S. GDP growth and notes that this was in part attributed to a downward revision of state and local government spending. This proves according to her that "smaller government can be a drag on growth".

The fallacy here is essentially the same as the fallacy of protectionists that notes that imports are a negative factor in GDP statistics and therefore concludes that limiting imports would boost GDP. The fallacy lies in thinking that a change in one of the components of the right side of the GDP accounting identity ( Y= C+I+G+X-IM, with Y being GDP, C being consumer spending, I being investments, G being government spending, X being exports and IM being imports) will necessarily cause an equal change in the left side of it.

But that need not be the case at all as it could just as well cause an opposite change in one of the other components in the right side of the equation. The theory that higher imports enables higher domestic demand and exports is just as consistent with the GDP accounting identity as the theory that higher imports causes a reduction in GDP. Similarly, the theory that lower government spending enables higher private demand and a lower trade deficit is just as consistent with the GDP accounting identity as the theory that lower government spending causes a reduction in GDP.

We have different theories about whether a decrease in government spending will increase private sector GDP (private domestic demand and net exports) or whether it will reduce GDP or a combination of the two , but there is nothing in the GDP accounting identity that proves that lower government spending will reduce GDP.

But what about the fact that GDP and government spending were both downwardly revised? Doesn't that prove that lower government spending lowers GDP? No, it doesn't because this revision reflected an epistemological and not an ontological change. The revision reflected that more information about a past event was available, it wasn't that one revision necessarily caused the other.

Friday, February 25, 2011

Swedish Boom Isn't Due To Monetary Policy

Scott Sumner claims that Sweden's relative economic success is due to its monetary policy.

First of all, it is odd for someone that thinks that nominal GDP (NGDP) targeting to view Sweden's experience as a success. NGDP fell in Sweden between the third quarter of 2008 and the third quarter of 2009 by 4.7%, more than the 2.6% drop in the United States during the same time.

While Sweden avoided deflation at that time, the drop in real output was larger.

By contrast, between the third quarters of 2009 and 2010, NGDP growth at 8.1% in Sweden was much higher than what Sumner usually favors, while U.S. nominal GDP growth at 4.5% is much closer to what Sumner favors.

With NGDP falling much more during the recession than the supposedly failed U.S. policy while growing much more now, Swedish monetary policy has deviated much more both on the downside and the upside from Sumner's supposed "stablize NGDP growth" rule.

But aside from the fact that to the extent that Sweden has been successful, it contradicts Sumner's monetary policy rule, there is little reason to believe that Sweden's relative success in the form of a stronger recovery than most other countries is due to monetary policy.

If monetary policy was behind the recovery, we would have expected a particularly strong recovery in the cyclical manufacturing sector. But while Sweden, did have a higher than average growth in industrial production at 11.5% during the third quarter, it was lower than in many other EU countries including Estonia, Latvia, Poland and Slovakia.

The reason why Swedish growth was the highest in the EU was instead mainly because growth in the more labor intensive service sector was highest. That in turn was the result of the supply-side marginal tax rate and unemployment and sick leave benefits reduction implemented by the Swedish centre-right government. It is these policies, along with good growth in neighboring countries, that has caused the high growth rate during the latest year.

BTW, I see that Sumner in a later post partly acknowledge the role of good non-monetary policies, but claims that the good non-monetary policies was only possible because of NGDP targeting. But that is false for several reasons, including the aforementioned fact that NGDP has been more unstable in Sweden than elsewhere and that even when NGDP fell the most, the Swedish government continued its supply boosting strategy.

Estonian Industrial Orders More Than Double

The recovery in Estonia from its recent depression seems to accelerate more and more as industrial orders rose as much as 26.4% in December from the previous month, something that caused the annual rate of increase to increase from an already very high 59.3% to 114.8%.

While it is possible that some of this extraordinary increase reflects one time factors, and while the overall economy will grow a lot slower than the industrial sector as the service sector is less cyclical, this certainly suggests that Estonia's overall growth will accelerate further in the near future.

Thursday, February 24, 2011

Another Problem With Qadaffi

The main problem with Libya's dictator Muammar Qadaffi is of course that he is a murdering tyrant and an enemy to freedom in Libya and elsewhere. However, while that is of course trivial compared to the aforementioned key problem with Qadaffi is that no one knows how to spell his name, as there are no less than 12 different spellings of his name.

Here is BTW a classic scene from the 1988 movie Naked Gun, with a fictional meeting between Qadaffi and various other murdering tyrants including Yasser Arafat, Idi Amin, Fidel Castro, the ayatollah Khomeini and Mikhail Gorbachev (who was much more benign than the others). Qadaffi is the only one that is still in power, the others have either died or resigned. Let's hope that Qadaffi will be similarly finished soon.

Wednesday, February 23, 2011

About Libya

Unlike the revolts in Egypt and even more so Tunisia, the uprising in Libya is having a significant direct effect on the world economy. The reason is that Libya is a significant oil exports, and the disruptions caused by the uprising has already basically stopped Libyan oil exports, something which in turn has raised the price of that key commodity significantly.

Unlike the regimes in Tunisia and Egypt, the Qaddafi regime has proven itself to be able and willing to use brutal military force against protesters. Depite this, the opposition seems to have taken control over eastern Libya, while the Qaddafi regime seems to remain in control for now over the western parts , including the capital Tripoli.

The issue of which side will prevail remains uncertain. However, regardless of who ultimately wins, the economic outcome for the outside world seems to be quite clear:

1) In the short-term, Libya's oil exports will be cut off, causing a short-term increase in the price of oil.
2) In the long-term, Libya's oil exports will likely resume, meaning that there won't be much long-term economic effects of this.

Monday, February 21, 2011

What's The Point Of Government Sector Unions?

While some conservatives claims that government workers are better paid than private sector workers, many left-liberals like Menzie Chinn claims that if you control for education levels and other relevant factors, government workers are actually lower paid than their private sector counterparts.

But if the largely unionized government workers are really underpaid compared to the mostly non-unionized private sector workers, then what is the point of having these unions? If they don't receive a higher pay or other privileges, then what's the point for government workers to be unionized?

Well, Paul Krugman answer to this question is: to ensure that some of the pay that the taxpayers send to government workers goes with the unions as middle men to Democratic election campaigns, or in other words to make governments subsidize the Democrats. Krugman of course expresses this very differently as he favors it, but that is in effect what he is saying, when he like Chinn says that unions haven't given government workers better pay and is instead meant to help counter the the power of the "oligarchy" (which Krugman claims is represented by Republicans like Wisconsin governor Scott Walker).

German Boom Accelerates

Though surveys of this kind should be taken with a grain of salt, the fact that both the IFO index and the PMI indicates the fastest rate of expansion for at least four years, indicates that growth in Europe in general and Germany in particular is accelarating.

Saturday, February 19, 2011

Fed Officials As "I Didn't Do It Kids"

In the Simpsons episode "Bart gets famous", Bart Simpson gets famous after having accidentally knocked down an entire stage in front of a studio audience, yet immediately exclaims "I didn't do it". The audience however thought his denial of something he obviously did was hiarious, and so did soon almost everyone else, and so Bart becomes famous for a short period as "the I didn't do it kid".

Now it is past and current Fed officials, including Alan Greenspan and Ben Bernanke that are acting as real life "I didn't do it kids". Despite the fact that it is obvious that they caused things like the housing bubble and the recent rally in food prices and other commodity prices, they seem to dedicate almost every public appearance to denying the obvious.

The only difference between Bart Simpson and Fed officials is that Bart didn't add semmingly sophisticated yet fallacious arguments with his denial which is why few simply laugh at the Fed officials. Fed officials are in other words no more credible, they're just more boring.

Friday, February 18, 2011

The Baltic Sea Boom

Of the 19 EU countries that have reported fourth quarter growth so far, the 5 highest growth rates were recorded in Estonia (6.6%), Finland (5.8%), Lithuania (4.4%), Germany (4.0%) and Latvia (3.7%).

What do these countries have in common? They are all located in northern Europe, more specifically by the Baltic sea. Also located by the Baltic sea are Demmark, Sweden and Poland, who haven't reported fourth quarter growth yet, but had high growth during the third quarter and are therefore likely to report high growth during the fourth quarter as well.

Why is growth so high in these particular countries? Well, there are particular factors driving growth in the individual countries, such as the supply-side reforms in Sweden, but in addition to them, the most important explanation is that growth is contagious.

When a neighboring economy is booming, this usually helps a country's economy as demand for your exports increase. And because the relative geographical proximity minimizes transportation costs, growth in neighboring countries will usually benefit your economy more than growth in countries that are farther away. This doesn't hold of course if there are legal or social barriers that prevents or minimizes trade, such as in the case of Cuba and the United States or the Arab countries and Israel, but that exception is fortunately not applicable to the countries around the Baltic sea.

Wednesday, February 16, 2011

Israeli Economy Growing Fast-But Average Income Doesn't Grow Quite As Fast

Israel's GDP in Q4 2010 grew by 1.9% (7.8% at an annualized rate) compared to the previous quarter and 5.6% compared to a year earlier.

This is very impressive considering that unlike most other rapidly growing economy Israel didn't experience a recession in 2009 (only a slowdown from previously high growth levels) and so its growth doesn't contain as big element of cyclical rebound as other economies with relatively high growth like Sweden, Estonia, Finland and Germany.

It is particularly the high tech sector that drives growth, with for example Intel investing and expanding their operations in Israel significantly.

However, though by any measure Israel's performance in recent years have been impressive, in part due to the free market reforms that have been implemented, it should be noted that average income grows slower than GDP due to Israel's high population growth.

As a result, while Israel's GDP growth during the latest year has been significantly higher than Germany's (5.6% versus 4%), its per capita growth has been somewhat lower because Israel's population grows by 1.8% per year while Germany's population is shrinking.

Tuesday, February 15, 2011

Higher Food Prices Good For U.S. Economy

Are higher prices good or bad? That depends on whether you are a buyer or a seller. It is good if you are a buyer and receives higher prices (though this of course assumes that the price increase isn't associated with a lower sales volume) and bad if you are a buyer.

That is why for example higher commodity prices are good for net exporters of commodities, such as Canada, Australia, Russia, Norway and Brazil while it is bad for net importers like the United States, China, Japan and Germany.

However, for the United States there are one group of commodities where it benefits from higher prices; namely food. As is hinted by the fact that agricultural exports are a separate category in the export price index but not in the import price index and as can be seen directly in trade statistics, the United States is a net exporter of agricultural products. This means that its terms of trade, and therefore also its real aggregate national income will increase whenever food prices rise.

Of course, most Americans lose from higher food prices, but for American farmers and others benefiting from agricultural production the recent increases in food prices are very good and their gains exceed in dollar terms the losses of American food consumers.

Mervyn King Is Stretching The Definition Of "Temporary"

U.K. inflation rose to 4% in January, meaning that it is now double the Bank of England's supposed 2% target.

Bank of England Governor Mervyn King tried to gloss over his failure by blaming it on the VAT increase and claim that it the increase is therefore just temporary, just like he blamed the 3.5% inflation rate in January 2010 on the reversal of the temporary 2009 VAT cut. Yet in January 2009, inflation was 3% despite that cut.

And indeed, with the price index being 116,9 with the 2005 average as the base of 100, the 5-year average of inflation is in fact about 3%. When the 5-year average exceeds the target by a full percentage point, you really can't blame it on "temporary factors".

Instead, as many people have said before "it was entirely the fault of Mervyn King" [and fellow Bank of England decision makers].

Monday, February 14, 2011

Has The Slump In Construction Been The Same As In Other Sectors?

Paul Krugman claims that the numbers shows that the increase in unemployment in the construction hasn't been greater than in other sectors. He does so by comparing the ratio of the number of unemployed in 2010 with the number of unemployed in 2007 for different sectors.

But this methodology is misleading for several reasons. First of all, if you double unemployment that is 3% initially the increase will be far smaller than if unemployment was 8% initially. In the first case, the more relevant increase in percentage points will be only 3 percentage point and in the second case the increase will be 8 percentage points. And the increase in the construction unemployment rate has been 13.2 percentage points, compared to 5 percentage points for the overall unemployment rate and just 2.8 percentage points for the sector education and health service.

And secondly, because some unemployed finds jobs in other sectors (thereby in many cases crowding out existing job seekers in that area and thereby increasing unemployment in that sector) or drop out of the work force. And with construction unemployment being higher than other sectors for a long time they are more likely to do so than workers in other sectors. Evidence of this can be found in employment statistics. While the number of formally unemployed that was previously construction workers rose 1.1 million, construction employment fell by 2 million (a 26.6% decline).

By contrast, while the number of formally unemployed that was previously working in the "Education and health services" rose by 668,000, the number of people employed in that sector rose by 1.2 million (a 6.5% increase).

In a related statistical note, the big decrease in construction employment means that the increase in the number of unemployed underestimate the increase in the unemployment rate.

When one sector has a 20.6% unemployment rate and another has a 5.8% unemployment rate and when even more astonishingly one sector see a 26.6% decline in employment and another see a 6.5% increase, there is clearly a strong element of structural change.

Saturday, February 12, 2011

Atlanta Fed President's Failed Attempt To Exonerate The Fed

Atlanta Fed president Dennis Lockhart argues that there is a distinction between "inflation" and "cost of living increases":

"Let's review what inflation is and is not. Inflation affects all prices. Inflation is not the rise of individual prices or the rise of categories of prices.

"I want to contrast inflation to the cost of living. In casual language, we often interpret a rise in the cost of living as inflation. They are not the same thing. Cost-of-living increases are a result of increases in individual prices relative to other prices and especially relative to income. These relative price movements reflect supply and demand conditions and idiosyncratic influences in the various markets for goods and services. If some component of a household's cost-of-living basket goes up in price, the higher cost of living is not ipso facto inflation."

So what he is saying is that only when all prices rise is there inflation. But even in the 1970s there were some prices that fell, so this means that ccording to Lockhart, there were no inflation in the 1970s.

Indeed, it is only in countries with hyperinflation like Germany in 1923 and Zimbabwe more recently that all prices rise, so what Lockhart is really in effect saying is that only when there is hyperinflation can you say that there is inflation!

There are more strange aspects of Lockhart's speech:

The Fed, like every other central bank, is powerless to prevent fluctuations in the cost of living and increases of individual prices. We do not produce oil. Nor do we grow food. Or provide healthcare. We cannot prevent the next oil shock, or drought, or a strike somewhere—events that cause prices of certain goods to rise and change your cost of living.

"So monetary policy is not about preventing relative price adjustments dictated by market forces. It is about controlling the broad direction and pace of change of all prices across the economy.

But except for hyperinflation there is never any "broad direction of all prices", there are always some prices that rise and some prices that fall. And taking supply factors that raise certain prices as an excuse for the price increases overlooks that there are supply factors that reduce prices, for example, technical progress in the computer industry that teduces computer prices or other forms of productivity increases or increases in labor supply.

You can't use negative supply shocks to rationalize some price increases while overlooking how positive supply shocks limits or prevents other price increases or lower prices-at least not if you want to be intellectually honest. And as long as there is positive growth, the positive supply factors are greater than the negative.

Lockhart does have a point though in the sense that when you judge central bank action by other factors beyond their control. But since non-monetary factors usually lowers prices, a focus on monetary inflation usually put the central bank in an even worse light.

The Broken Window Fallacy Of The EPA

In response to Republicans who points out that its new rules limiting carbon dioxide emissions, the Environmental Protection Agency (EPA) claims that it will create new jobs by compelling companies to invest in reducing emissions.

This is essentially the same logic as those that claims that if a boy throws a stone into a window breaking it this will create new jobs when the window needs to be replaced. And the fallacy is the same as in the classic tale: just as the expense for the window means that the business owned can't afford to buy other things, so will the cost of complying with the new regulation mean that businesses can't afford to invest in other things.

Meanwhile, the extra cost of doing business will reduce the incentive for taking the risks associated with business activity, causing a reduction in the total number of jobs.

Friday, February 11, 2011

More On Baltic Boom

As a follow-up to the last post, a preliminary estimate of GDP for Estnia during the fourth quarter suggests that it increased 2.3% compared to the previous quarter (that's 9.5% at an annualized rate) amd 6.6% compared to the previous year.

That is the highest growth number in the EU except for probably (the numbers haven't been released yet) Sweden.

The two other Baltic countries also gre strongly compared to the previous quarter, but not quite as much as Estonia. Latvia's GDP grew by 3.7% compared to last year while Lithuania's grew by 4.6%

Wednesday, February 09, 2011

Estonian Exports Increase 67%

After suffering through a depression, Estonia is recovering fast, led by an extraordinary export boom. In December 2010, exports increased as much as 67% (while imports increased 44%).

Other indicators also suggest a vigorous recover, as factory orders increase 59.2% in November and industrial production increase 38.5% in December.

Monday, February 07, 2011

Is China Or America Biggest Manufacturing Nation?

Mark Perry, Scott Sumner and some other economists have recently linked to this article by Boston Globe columnist Jeff Jacoby, where he claims that a UN database shows that the value of U.S. manufacturing is still (or more correctly was still in 2009) larger than the value of manufacturing in China.

This would strike you as odd, considering that you can for example see news of how China is the by far biggest consumer of copper and other industrial metals as well as oil and coal and how Chinese car sales and sales of other durable consumer goods as well as Chinese goods exports are greater than in the United States.

And if you look at the U.N. statistics page, you can see that at current exchange rates, the value of manufacturing in China was $2.05 trillion, more than the $1.78 trillion value of U.S. manufacturing.

Jacoby seems to have gotten his numbers by looking at the alternative indicator of "constant 2005 U.S. dollars". But the problem with using this indicator is that it overlooks the massive real appreciation of the Chinese yuan during this period, especially with regard to the manufacturing sector. And as I pointed out a few days ago, when comparing economic might, it is the value at current exchange rates which is relevant.

And if you were to look at [domestic] purchasing power adjusted numbers in a consistent way, China's superiority would be even greater because the general price level in China is still much lower than in the U.S.

The indicator "constant 2005 U.S. dollars" makes no sense at all in this context since it by using a past real exchange rate will neither reflect domestic purchasing power nor economic might (international purchasing power).

While the overall GDP of the U.S. remains higher than in China, and probably will continue to do so for about a decade, because its service sector is much greater than China's, China has in fact surpassed the United States in manufacturing. Jacoby's use of an irrelevant indicator could perhaps be excused by the fact that he isn't an economist (though that would raise the question of why he writes about economic issues), but Perry and others don't have that excuse.

Saturday, February 05, 2011

How Wage Increases Can Sometimes Increase Employment

A New York Times article claims that as unemployment in Germany has reached the lowest level since 1992, it now suffers from the opposite problem of labor shortages.

But first of all, at 7.4%, unemployment is still significantly above the level of unavoidable frictional unemployment. Labor markets have functioned with unemployment rates more than 5 percentage points lower, so there is no general labor shortage yet.

It could however be the case that a few sectors suffer from a shortage of workers with the right skills, even as unemployment is high in other sectors. The best solution to this is to educate the unemployed in other sectors so that they can work in the sectors which suffers from shortages. Encouraging older workers in the sectors with shortages to stay on the job longer and removing restrictions for foreign workers with the right skills in those sectors would also work.

Amazingly, the article overlooks the most obvious and effective solution to labor shortages, which as it happens would help (that of course, doesn't mean that one can't use other ways to achieve these solutions) with regard to all the three solutions discussed  the previous paragraph: higher wages.

As in any market, a shortage is a sign that the price, in this case the wage level, is too low. Raising pay in sectors with shortages would encourage people to get the needed education to work there, it would encourage older workers to stay on longer and it would encourage foreign workers with the right skills to move to Germany (though in most cases they would have to educate themselves too, only in this case in the German language).

But some employers in the sectors might object by saying that they can't afford to raise wages. But if they can't pay enough to get workers, then their business isn't efficient and shouldn't survive. In that case it is better if other employers, whether in Germany or elsewhere take over production.

Remember, a higher price doesn't just help achieve equilibrium by increasing supply, but also by reducing demand, in this case the demand for workers from inefficient employers.

I have frequently argued that wage cuts will reduce unemployment, but it is just as true that wage increases will reduce labor shortages and therefore increase employment. Thus if employers in some German sectors can't find the right workers then it should be clear that they should offer workers better pay. And if they can't afford it or pass on these increases to their customers, then they aren't efficient enough.

Friday, February 04, 2011

U.S. Employment Report Confirms Weak Recovery

Today's U.S. employment report confirms that the U.S. economy is recovering-but only at a slow pace and with different trends in different sectors.

The household survey showed a drop in the unemployment rate from 9.2% to 9%-but that mostly reflected a drop in the labor force participation rate which fell to a new multi decade low (as well as a downward revision of population). Actual employment rose ony 117,000, only barely enough to keep up with the population growth rate.

The payroll survey showed an increase in employment of only 39,000 with the private sector adding 50,000 jobs. Job growth is especially strong in manufacturing while construction continued to losejobs, confirming the sectoral trends discussed earlier this week.

Meanwhile, average hourly earnings rose unusually much, 0.35%, but as the average work week fell by 0.3%, average weekly earnings barely rose at all in nominal terms.

By contrast, the northern neighbor of the United States published a quite strong employment report, with employment increasing the equivalent of nearly 600,000 in the U.S. The increase was disproportionately in part-time jobs, but even full-time employment increased significantly.

Thursday, February 03, 2011

GDP Comparisons-Current Exchange Rates Or PPP?

I have recently pointed out that Egypt's GDP is smaller than that of Israel and Finland-which is anything but impressive given the fact that its population is more than 10 times bigger than Israel's and nearly 15 times bigger than Finland's.

Yet estimates of purchasing power parity (PPP) adjusted per capita income "only" shows that Israel's per capita income is 4 to 5 times higher and Finland's 5 to 6 times higher (as estimates of the PPP of currencies differs, estimates of PPP-adjusted per capita income also differs).

The explanation for this divergence is the co-called Penn effect or Balassa-Samuelsson effect, which means that the general price level is higher in high income countries, meaning that the difference in PPP-adjusted income tends to be lower than income differences using current exchange rates.

But what is most relevant-income differences at current exchange rates or income differences adjusted for PPP?

That depends on the context. In the context that I discussed, namely the effects of the unrest in Egypt on the world economy, than current exchange rates should be used. The reason is that when dealing with the outside world, income in Egyptian pounds can only buy things using current exchange rates. It doesn't really matter whether or not domestic purchasing power is higher or lower, it only matters what purchasing power in foreign transactions it has. Which is why Egypt's direct importance in the world economy is smaller than Israel's or Finland's.

However, in other contexts, such as discussions of differences in living standards, it is the PPP-adjusted values that are more relevant. If you for example donät have to pay much rent and if food and other stuff you buy is cheap, then you will have a much higher standard of living than someone with the same income who has to pay a high rent and pay high prices for food and other things that person buys. That is why PPP-adjustment is in principle (In practice, the fact that estimates vary however means that you should analyze them with an extra grain of salt) better in the context of analyzing living standards and poverty. And that is why Egyptians aren't 15 times poorer than Finns.

Note that the latter doesn't just apply to analysis of different countries, it also applies when analyzing income differencies between different regions and localities within a country. One example of this that I recently discussed was the cases of California and Texas.

No PPP-estimates for American states exists as far as I know, but it seems very likely that the seemingly somewhat higher average income in California  reflects entirely or more a higher cost of living in general and a higher cost of housing in particular, rather than a higher real income of Californians compared to Texans.

Wednesday, February 02, 2011

Evaluating The Results Of An Experiment Before It Takes Place

Dean Baker argues that the "Great British austerity experiment" has failed based on the weak British GDP number published last week.

The problem is that a "experiment" by definition is supposed to be an empirical test, and the results of an empirical tests can't be evaluated until the test has been made and the results are known.

And the British austerity plan (or actually just the first phase of it) wasn't implemented until after the period described by the GDP numbers in question.

It may perhaps be the case that for example the VAT increase will have a contractionary effect on the U.K. economy and it may perhaps be the case that because of this and other factors, there might be negative growth during at least parts of this year. But the GDP number published last week doesn't prove or disprove this because it describes a period before the implementation of the VAT increase.

"Premature" is almost an understatement regarding Baker's analysis. 

A Moderate & Mixed U.S. Recovery

As people cheered the stronger than expected ISM manufacturing index, they seems to have missed that another important economic report was released that was much weaker than expected: namely construction spending which fell by 2.5% in December compared to the previous month and 6.4% compared to December 2009. All categories of construction, government construction, private residential and private non-residential fell.

All in all, recent economic reports suggests that the U.S. economy continues its recovery, but at a relatively slow pace and in a very uneven way. Manufacturing seems to have a fairly strong recovery, while growth is much slower in services and with the construction sector still being in a recession.

Tuesday, February 01, 2011

Protests Not Good For The Economy

Just as strikes helped cause the contraction in the Greek economy, the current protests in Egypt is now causing a "near paralysis" in the Egyptian economy as stores and factories are closed and tourists are evacuated.  The effects in Egypt seems to be much bigger than in Greece.

While Egypt has a large population, its economy isn't that big, so the global effects won't be significant.

These protests won't last forever so the effects of them will mostly be temporary. The long term effects depends on who wins the power struggle. If Mubarak or some of his cronies manage to stay in power or if some relatively secular opposition group takes over, then there won't be any significant long term effects.

If however the Islamic hardliners in the Muslim Brotherhood takes over, then it will be a lot more troublesome. The tourism sector will suffer as Islamic hardliners are unlikely to accept scantily clad Western women or alcohol .

More troublesome for the outside world is how many in the Muslim Brotherhood advocate war against Israel, something which create a regional conflict with a heavy human and economic price.