Risks in the Global Economy

Finn E. Kydland University of California

Santa Barbara

ASSAL 2012San Jose, Costa Rica

• Outline of Theme

Predictability of economies varies considerably across nations or regions of the world. Major reasons:

1.Growth-promoting decisions, such as capital formation, innovation, including development of new products and production processes, are forward-looking and require a view of the future policy environment

a) Consistently poor policy is being pursued in that nation

2. Finding from economic theory: optimal government policy is inconsistent over time. Examples of bad implications in practice:

b) Apparent good policy is being pursued, but there is considerable uncertainty as to whether this policy will change in the future, with adverse implications for the investment environment, currently and in the future

A deep understanding of the interaction of points 1 and 2 above will aid one in forming expectations about the future, depending upon the region or nation within that region.

Talk about Latin America, the United States, Canada, the EU and Euro Zone (also touching upon Norway, not a member), China, Kazakhstan, Azerbaijan, and Sub-Saharan Africa

Real GDP per capita Real GDP per capita

• Elementary background

Aggregate production function

GDPt = ZtF(Kt,Lt)

Technology for converting inputs of capitaland labour into output of goods and services

Technological progress

• Main driving force for economic growth:

Innovation and technological change(Z in the production function).

They lead to future productivity growth.

• But, to take advantage of technological change:

Need investment in new capital, physical(structures and equipment) and human Government policy may be a crucial factor, positive or negative, for growth

Examples: Argentina in 1990s and early 2000s (negative)Ireland in 1990s and early 2000s (positive)

• Examples of policy (theme: significant stimulus for the economy?)

Fiscal policy: Stimulus through temporary tax rebates – little effect on consumer spending (and investment)

Stimulus spending? Infrastructure, education, research, if future productivity improves significantly, can justify the additional debt to pay for it. Otherwise, may be a bad idea, especially for a nation with budget problems.

• Perspective from theory of a benevolent government:

Suppose the government has an unchanging objective, say, to maximize some measure of the present value of citizens’ welfare over time

Theoretical implication: The resulting optimal government policy is inconsistent over time; it requires a commitment mechanism in order to be implemented. Otherwise, there’s a strong temptation to change policy in the future. Rules rather than Discretion.

• Where is that temptation theoretically the greatest?

Increase tax on physical and human capital(especially relevant in the current situationwith large and growing debt/GDP ratios)

Partially renege (default) on government debt, say, through surprise inflation

Examples of mechanisms used in practice by governments to tie their own hands (not always successfully!)

(i) Gold Standard

(ii) Currency Board

(iii) Independent Central Banks

• Commitment mechanisms (cont’d)

These examples apply to monetary policy. Not obvious how to commit to good fiscal policy.

• Probable main explanation

Time-inconsistency “disease” due topast hyperinflations, devaluations,deposit freezes and defaults ongovernment obligations, resulting inlack of credibility among investors

Real GDP per capita Real GDP per capita

Real GDP per capita Real GDP per capita

So far, no evidence that the “new trend” is moving any closer the old

If anything, it’s diverging, with recent growth rates lower than the average for the 1947-2007trend

Growth rate of real GDP so far in 2012 under 2%. Last reported, for July-Sept., 2%.

• But, as the example of China demonstrates:

Consistent policy not sufficient

• Summary Remarks

Significant risks exist for the continuationof low growth in many important nations

Major cause: Uncertainty about futuregovernment policy

We need ways to avoid the “time-inconsistency disease”

Designing policy for the Longer Run much more important than short run

Enough uncertainty in the world as is;extra government uncertainty is bad

Opportunity for nations with credibility to narrow gap to the high-income-per-capita countries

• Copenhagen Consensus Center’s Consulta de San Jose

Question: If Latin America were willing to spend, say, $10 billion more over the next five years on improving welfare, which projects would have the greatest benefits (benefit/cost ratios)?

Areas: democracy; education; employment/ social security; environment; fiscal problems;health, infrastructure; poverty/inequality;public administration and institutions; crime and violence

Copenhagen Consensus Priorities for Latin America

1) Early childhood development programs

2) Fiscal rules 3) Increased investment in infrastructure, including maintenance

4) Policy and program evaluation agencies

5) Conditional cash transfer programs

• Interesting proposed solution

Increase the level of political partyand party system institutionalization