Merry Christmas and Happy New Year!

Economics International Open Forum would like to wish you Merry Christmas and Happy New Year! We hope that you are now enjoying your time with families and friends. This year was a great success for Economics International: 373 visits, 208 visitors in only a couple of months after the Inaugauration in October (Source: official Google Analytics Data). The Economics International team is now working on restructuring the blog so that it is more interesting and entartaining. We are also working on making it more popular. We can assure you that on January the 1st you will see the first changes!

With kind regards,
Economics International

Dark Future for the World Economy?

Ernst & Young issued a report entitled: "Top 10 Risks for Business in 2008".

You may be thinking that credit crunch is the biggest risk... Unfortunately, you are grossly mistaken. Ernst & Young sees regulatory and compliance risk as the greatest danger:

As the greatest strategic challenge facing leading global businesses in 2008, the industry analysts we polled selected regulatory and compliance risk. This is being driven by an escalating regulatory burden in many markets, as well as numerous compliance challenges as companies extend their value chains well beyond Europe, North America, and the BRICs (Brazil, Russia, India and China). The possibility of regulatory intervention in sectors such as pharma, biotech, insurance, telecoms and utilities, is further elevating this risk. Such intervention could shape the competitive environment and drive fundamental change in business models.

But credit crunch is surely there - it is the second most important risk:

Our analysts acknowledged that few sectors would escape the impact of major global financial shocks. Biotech and utilities firms, for example, would have trouble raising capital; banking, asset management, and insurance companies would be likely to suffer direct losses from market movements; and after making high-cost exploration investments – oil & gas companies might suddenly find themselves facing low prices if the global economy moves into sudden recession.

Risk No.3 is aging workforce and consumers:

An increasing strategic risk for the majority of industries is the threat posed by workforce and consumer aging. Sectors such as asset management and insurance are experiencing dramatic shifts in demand and competitive battles are being fought for savings products that will appeal to the growing group of older consumers. Other firms, for example, those in the auto sector, are facing severe competitive challenges as a result of their aging workforces.

The whole report is available here.

“S” for Labor Supply

Our moderator, Jan Jablonski, seems to say: assumptions, stupid!

In international economics there is always a moment when we go into a murky waters of international comparison. There are several traps that we should be aware of. One of the greatest sins of an economist is to uncritically employ the analytical apparatus which was previously invented. In other words, there is a high probability of a mistake of some sort if one uncritically uses analytical tools developed for the US and applies them to i.e. Cambodia. What is the most fragile part? As usual it is assumptions. One needs to check if they hold to a reasonable extent. The problem seems to be vital especially in the field of international comparison, given the tremendous variety between economies around the world. This brings us to the actual topic of this short text which is the differences in labor supply among countries that find themselves in different stages of development.

Why labor supply? It is the area in which making a mistake in a simple copying market model with its usual parameters might bring a serious mistake. Usually labor market is assumed to work as any other market. A negative slope of a demand function does not need a particular explanation. Positive slope of a labour supply has its nice explanation. When wage raises the cost of not working also rises and substitution effect (being stronger than income effect) guarantees that the amount of hours of labour supplied rises. Alternatively, when wage falls there is less incentive to work (you don’t work if they pay you hardly anything) and labor supply falls. Thus we have a usual supply and demand cross on a diagram. There is a nuance often put in microeconomic textbooks, namely the backward sloping supply curve. From some high level of wage on, the income effect dominates the substitution effect and the amount of hours supplied to the market actually drops when wage rises. The story behind it is that if you are already rich (high wage) the additional increase in wage will remind you about the beautiful world outside your working place and you’ll decide to spend more time on leisure still enjoying a high wage.

On an aggregated level the labor supply curve often boils down to positively sloped straight line as only few people actually are “too rich for work”. This might well be good approximation for western economies in general. What happens if we travel with this framework to some developing country? Will it still be reasonable?

Let’s go down the wage axis and think what happens to the labor supply. If you earn only a little, let’s say enough to meet the subsistence level and suddenly your wage falls, there is a high chance you wish to continue your existence, so you supply more labor. By doing so you restore your income back to the subsistence level. Why wasn’t it a case in a previous setup? Well, the (usually implicit) assumption was that non-labor income guarantees subsistence level. It is a reasonable assumption in developed countries where non-labor income consists mainly of capital income, but also unemployment and other social benefits. It might be simply a mistake to assume the same for a developing country. Fristly, because of the low level of capital accumulation the capital income might be too low to guarantee a subsistence level. Secondly, a developing country might be simply too poor to maintain an extensive social security system.

What happens to our supply curve if we remove the assumption about the sufficient level of non labor income? Obviously it is getting a negative slope – lowering the hourly wage results in more labour supplied to the market. In this case the negative income effect dominates the substitution effect. What is important is that additional assumption might be very handy. If you have both supply and demand curves with a negative slope you might start worrying about stability of such model. It would be most embarrassing if, in the case of the excess of labour supply, the downward pressure on wages would bring even higher excess of labour supply. You need to assume that when wage falls, the amount of hours of labor demanded rises faster than the amount of hours of labor supplied to the market. In other words you need a slope of the supply curve to be higher (in absolute terms, as they are both negative) than the slope of a demand curve or alternatively: the supply curve needs to be steeper than a demand curve.

Interestingly the cases discussed previously are not exclusive. Putting all the pieces together we get a labor supply curve (Ls on the graph) which has something like an S-shape. The part between point A and B on a graph is a standard representation of a labor supply curve. The part above the point B represents the discouraging effects of a rising wage on hours of labor supplied. The part below point A would represent the increase in hours of labor supplied due to decrease in income below the subsistence level. Which part of the supply curve is applicable to a particular case is a matter of assumptions you can allow.

A real life example often brought forward is the case of female labor force participation. The data investigation for Mexico confirmed a negative relationship between wages and labor supply for this group on low levels of income. The relationship turns positive when the income rises.

What might be the general conclusion? It is trivial, but also crucial: to be aware of assumptions that are required in order to proceed with the analysis. Otherwise one might arrive with conclusions very far from reality.

Author: Jan Jablonski

Literature:

Licona Gonzalo Hernández Reshaping the Labor Supply Curve for the Poor, LACEA Annual Meeting, Rio de Janeiro, Brazil, 2000, lacea.org.

Krueger Anne O., The Implications of a Backward Bending Labor Supply Curve, The Review of Economic Studies, Vol. 29, No. 4. (Oct., 1962), pp. 327-328.

Dessing Maryke, Labor supply, the family and poverty: the S-shaped labor supply curve, Journal of Economic Behavior & Organization, Vol. 49 (2002) 433–458.

Paying Taxes

PricewaterhouseCoopers and World Bank have just published a new report on corporate taxation, "Paying Taxes 2008":

"Paying Taxes 2008" offers data on total tax rates, payment frequency, and the time needed to comply with tax regulations in 178 economies. This year's report finds that business taxation goes well beyond corporate income taxes. It identifies five types of taxes that firms pay: profit, social, property, turnover, and other taxes, such as municipal fees and fuel taxes. The number of steps, time requirements, and various cost indicators are used to determine the overall burden of paying taxes.

You are probably wondering who is No. 1? Ireland? Honkkong? Or
maybe some Central - Eastern European country, e.g. Estonia? No.

One more surprise: it is Maldives.

RIO'S VOICE: Growth and development styles?

From the WSJ "Brazil Says ‘Não Obrigado’ to China-Style Growth Rates":

At the International Monetary Fund meetings, most ministers points to the 10% growth rate of China with a mixture of envy and awe. But Brazil’s finance minister Guido Mantega says 5% will do just fine. “I don’t know if it’s desirable to grow more than 5%,” he said in an interview. “We prefer to grow at a medium rate.”

My first reaction was to wonder who could possibly believe that. I couldn't, and I'm Brazilian! If Mr. Mantega's claim were true, we would be willing to forego half of the income per period we could have if growth rates were equivalent to Chinese ones. Keeping the pace, Chinese will double their GDP in 7 to 8 years, while it will take us around 15 years to double ours. Everything else equal, that roughly translates into twice as much time to double our standards of living, and why would anyone go for that?

According to the WSJ article, it seems as if Mr. Mantega is concerned about inflation, which is easier to keep under control when growing moderately because of lower demand pressures, and about being able to lower interest rates:

At mid-level growth rates, he said, it was easier to keep inflation under control – and provide additional incentive for Brazil’s central bank to lower the country’s sky high interest rates. The Brazilian benchmark Selic is now 11.25%, down from 19.75% in Sept. 2005.

“The conditions are there so that interest rates can head toward levels in civilized nations,” said Mr. Guido, by which he said he meant a nominal rate of 7% to 8%

But wouldn’t that ignite inflation?

I'll ignore the contradiction this time. Important to note now, however, is that China's 10-year high inflation is well within Brazil's target of 4.5% ± 2 p.p. It is possible to grow fast while maintaining prices under control, as long as the economy is not growing beyond it's potential rate. [For those thinking of accelerating inflation in China, remember growth was also accelerating past 10% a year.]

Funny enough, the other day I ran into China Daily's op-ed "China is on the right path to development". From what I wrote above, one could think I would agree with it, and that was my impression at first too, however the title of the article is rather misleading. Instead of focusing on the policies and institutions allowing for Chinese growth, the author in fact discusses the responsibilities that come along with the country's rise.

He declares that "the current international economic order and rules, which were mostly formulated by Western powers to reflect their interests, do not work well for the realization of China's long-term and strategic interests", and goes on to essentially state that China ought to abide by its own commitments, but shouldn't give in to "ceaseless demands from Western powers for further opening and reform".

Unfortunately reality is not so easy to deal with. Policies that benefit a country at the expense of its trading partners will certainly lead to retaliation, as history has shown over and over. The US Congress has already indicated it will pass a bill raising tariffs if the Chinese don't revalue the Yuan, recent events also indicate China's beggar-thy-neighbor policies are irritating the Europeans. Soon, Brazil and other nations will follow. The China Daily's article seems to ignore how others interested parties react to China, and it would be wise to remember these words from the World Economic Outlook of April 2006:

Even as linkages between economies grow, far too many governments are putting the slightest domestic constraint above any international interest. Others are reviving beggar-thy-neighbor policies, except they are now on the capital account—shielding large swathes of their own economy from corporate takeovers while encouraging their own companies to take advantage of the continued openness of others.

This is dangerous, short-sighted and sub-optimal. As Raghuram Rajan (Economic Counsellor and Director, Research Department, IMF), "I hope good sense will prevail".

And what about Brazil? Well, one can debate all day which development style to use. The most serious problem with our minister's statement is that we cannot talk about a style of growth when there is no growth to begin with! I have a feeling we will come back to this some time soon...