Archive for December 4th, 2008

Rate cut Thursday; Sweden tops at 175 bps cut!

December 4, 2008

So many Central banks met and cut rates today. Here is a list and the actions:

European Monetary Union to break-up or see additions?

December 4, 2008

The EU set up is quite complex. There are 27 economies which are members of the European Union but only 15 have adopted Euro as their currency (see the list here). These 15 have abandoned their monetary policy and have given the same to one Central Bank – ECB. These 15 are said to members of European Monetary Union (EMU)

The current set of events has put entire EU in an interesting (and dangerous) twist. All economies under EU have been caught under severe economic and financial stress. This has divided the members into 2 lists:

  • The members of EMU (15 economies) are feeling the pressure of staying in the EMU. They can neither use monetary policy  to stimulate their economies nor use fiscal policy and provide fiscal stimulus as they are under the Stability and Growth pact. Read the superb articles by Simon Johnson and Martin Feldstein for some clarity on the matter. The list of economies under this are:

Austria Italy
Belgium Luxembourg
Cyprus Malta
Finland Netherlands
France Portugal
Germany Slovenia
Greece Spain
  • The other set that are not members of EMU for different reasons. For instance UK, Denmark and Sweden can become members but have not chosen to. The others need to work on the conditions in the growth and stability pact before they can become members. This group is feeling pressure to join EMU more than ever before mainly to protect their falling currencies. Euro currency has taken a beating but has still been much better shaped than others. The list of economies under this are:
    Bulgaria Lithuania
    Czech Republic Poland
    Denmark Romania
    Estonia Slovakia
    Hungary Sweden
    Latvia United Kingdom

    This list of joining Euro currency also includes economies that are not yet members of EU like Iceland and Russia.

As Feldstein and Johnson point out, EU is going to face a real crisis going ahead. It is going to test its policymakers to the hilt and would have to ensure that it does not break-up.

ECB has just completed 10 years (it was established on 1 June 1998) and Euro will complete 10 years old on Jan 1 2009 (started on Jan 1, 1999). It hasn’t faced a crisis like this in past 10 years and even asking members to join in might have been a lot easier. European policymakers also take a lot of pride in ECB (read Trichet’s interview) and its policies. The path ahead will be very tricky and testing.


Barry Eichengreen provides his excellent insights as well.

Mumbai Terror Attacks and Guns vs Butter

December 4, 2008

I have been reading and seeing a lot of discussion and debate on Mumbai terror attack.  I have no clue on how the entire defence and security system works. However, I would like to give this an economic perspective.

The attacks take me back to basics of economics. In the first few pages of any introductory text-books is a concept called Production Possibility Frontier:

In economics, a production-possibility frontier (PPF) or “transformation curve” is a graph that shows the different rates of production of two goods that an economy (or agent) could efficiently produce with limited productive resources. Points along the curve describe the trade-off between the two goods, that is, the opportunity cost. Opportunity cost here measures how much an additional unit of one good costs in units forgone of the other good. The curve illustrates that increasing production of one good reduces maximum production of the other good as resources are transferred away from the other good.

Wikipedia link puts food and computers on y and x axis. In most text-books one finds guns and butter instead. Guns can be taken as the defence and security system of the country. There used to be always this debate earlier- whether a country should spend on guns or butter given its limited resources. India also has limited resource that needs to be spent across spectrum of public goods. There are 2 broad scenarios:

  • India is spending adequately on defence but it is not done very efficiently. Hence, in terms of PPF we are inside the curve and should try and reach the curve. The policy prescription would be to make the expenditure process more accountable and ensure money goes where it belongs.
  • India is not spending enough on defence. In terms of PPF we are at point C (or even farther to right) in graph 1 as shown in wikipedia (replace computers by guns/defence). Here, the policy prescription would be to devote more resources to guns/security and move towards point B (not at B, towards B).

So, where are we? In reality PPF is an abstract concept as there are multiple goods that are produced and one can’t analyse it via PPF as it allows only 2 goods. So, we can’t say which point on PPF are we on. However, what we can look at is how much we spend on defence vis-a-vis all other goods.

Here is a table which shows the govt expenditure on defence:

  Defence Expenditure Distribution (in %) Defence Expenditure
(% of GDP)
  Revenue Capital Revenue Capital Total
1990-91 70.5 29.5 1.9 0.8 2.7
1991-92 70.0 30.0 1.7 0.7 2.5
1992-93 68.9 31.1 1.6 0.7 2.3
1993-94 68.6 31.4 1.7 0.8 2.5
1994-95 70.7 29.3 1.6 0.7 2.3
1995-96 70.2 29.8 1.6 0.7 2.3
1996-97 71.2 28.8 1.5 0.6 2.1
1997-98 74.2 25.8 1.7 0.6 2.3
1998-99 74.8 25.2 1.7 0.6 2.3
1999-00 74.8 25.2 1.8 0.6 2.4
2000-01 75.0 25.0 1.8 0.6 2.4
2001-02 70.1 29.9 1.7 0.7 2.4
2002-03 73.1 26.9 1.7 0.6 2.3
2003-04 71.9 28.1 1.6 0.6 2.2
2004-05 57.8 42.2 1.4 1.0 2.4
2005-06 59.9 40.1 1.3 0.9 2.2
2006-07 60.4 39.6 1.2 0.8 2.1
2007-08 RE 59.2 40.8 1.2 0.8 2.0
2008-09 BE 54.5 45.5 1.1 0.9 2.1
  • The first 2 columns show how we spend on defence i.e. whether on salaries (revenue) or towards purchase of new arms, machines etc (capital). So, this answers part of the first scenario. In this we can see till 2003-04, 70% of defence expenditure was towards revenue items which is very high. This pattern changes in 2004-05 and now higher expenditure is beginning to show towards capital items. However, we don’t know how much is the ideal distribution but 70% towards revenues clearly looks excessive. This is changing but revenue still forms bulk of defence expenditure. The terror attacks points to the need to have better equipment and this would mean more expenditure is needed on capital goods. What could also be done is to cut revenue expenditure on subsidies and interest payments which comprise 40% of revenue expenditure.
  • The next three columns show how much we spend on defence with respect to other goods. This answers to second scenario. Beginning 1990s the ratio as a % of GDP declines from 2.7% in 1990-91 to 2.1% in 1996.97. This again increases and touches 2.4% in 2001-02 (perhaps in response to 1999 Kargil war) and then again declines to 2.0% in 2007-08 which is the lowest ratio in the time-series. 
  • The terrorist attack points to both- the need to increase capital expenditure and overall amount towards defence/security. How much should be enough? This would involve some international comparison to understand what is appropriate
  • As per this wikipedia list, India is 11th highest ranked in terms of military expenditure and spends about 2% of the world defence expenditure with US topping the list at 45%. The same link also shows the list of 16 top countries with highest defence expenditure as a % of their respective GDP. It shows North Korea at top with 23% of GDP and Maldives at bottom of the list at 5.50%. Israel whose security system is lauded spends about 7.30% of its GDP on defence.

I am no expert on how much is sufficient and the nitty-gritties of defence industry, but we need to think about economics while suggesting policies. If we spend more on defence, the resources would be spent less on others. Which others? Moreover, in recent Union Budget discussions, the focus has been on off-balance sheet items etc. But previously theer was focus on defence and people didn’t like if more was spent on defence. So, it is not as if it is an entirely new issue.

India is already facing severe pressures to devote its limited reources on nearly everything under the sun-  education, infrastructure (both hard and soft, each comprising 7-8 sub-sectors), agriculture development etc etc. And now on defence and security which can not be ignored anymore. In times of already high fiscal deficit (PM’s EAC says it could be above 7%), how do we finance so many activities? How do we allocate resources in best possible manner? These are crucial questions and unfortunately there are no easy answers.


1. Niranjan Rajadhyaksha has an excellent post on these issues – Understanding India’s Defence Spending Dilemmas

Terrorism and financial stabilty in the same boat of ignorance?

December 4, 2008

The Mumbai Terror attacks takes me back to a longish post I had written a while back. In that post I had said we should, take terrorism a lot seriously than we do. The knee-jerk reactions will not work as counter-terrorism policies need a overhaul of our security and defense systems.

In that post I had pointed out how financial stability and terrorism are in the same boat.

Copenhagen Consensus is a forum that started in 2002 and debates the top challenges facing the world. The challenges are presented as research papers on both sides- one defending the challenge, other nullifying it. The papers and findings are presented before a jury which then ranks the challenges based on evidence presented. There have been 2 forums so far one in 2004 and other in 2008. An analysis shows how both financial stability and terrorism are there in the same boat of ignorance.

In 2004 cited financial instability as one of the challenges but was not ranked as the panel noted it as complex and uncertain. It said:

Four proposals before the panel addressed the issue of international financial stability. The panel, noting the complexities and uncertainties in this area, chose not to come to a view about which, if any, of these proposals to recommend. They were therefore not ranked.

In 2008 CC didn’t mention financial stability as a challenge but had terrorism as a challenge.  Interestingly, it couldn’t come to any conclusion on terrorism either:

The panel chose not to include any of the proposed solutions to the challenge of terrorism in the overall ranking. Though the paper presented innovative and new work on the economic costs and benefit of terror prevention, the panel found that there was not sufficient evidence regarding the proposed options.

What is important is to discuss and act on these issues in good times. However, what we get to see is we forget these in good times and when they strike, we are clueless and don’t know how to act/react. Read the post for more details as have pointed to suggestions by Martin Feldstein and papers presented at the Copenhagen Consensus.

UK to support households directly

December 4, 2008

Last week, Fed took out a new program to support student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (The scheme was called TALF, my views on TALF are here).

Now UK has stepped in with a scheme called Homeowner Mortgage Support Scheme:

The new Homeowner Mortgage Support Scheme will enable households that experience a significant and temporary loss of income as a result of the economic downturn to defer a proportion of the interest payments on their mortgage for up to two years. The Government will guarantee the deferred interests payments in return for banks’ participation in the scheme.

The Government will work with lenders over the coming days to develop the scheme in detail, with a view to it being available to customers early in the New Year. The country’s eight largest banks have already pledged that they will work with the Government to develop the scheme.

This is pretty direct support to households. Which banks have joined?

The 8 largest lenders covering 70% of the mortgage market  – HBOS, Nationwide, Abbey, Lloyds TSB, Northern Rock, Barclays, RBS, HSBC – have agreed to support the new scheme. 

So, most banks have joined in. It is getting scary in UK.

Assorted Links

December 4, 2008

1. WSJ Blog points US economy is simply sinking

2. MR points economists have abandoned principle

3. Krugman on wages in great depression. Krugman actually answers this Mankiw post. It is getting interesting

4. Rodrik asks Does globalization erode social safety nets?

5. FIn Prof points stocks are yielding more than bonds for the first time in 50 years 

6. CTB points monetary policy i.e. low interest regime does lead to financial fragility

7. Econbrowser showshow bad thiings are with US auto industry

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