Project: FREE policy brief
Inflation Expectations and Probable Trap for Macro Stabilization
As of today, a majority of the negative consequences of the deep Belarusian currency crisis of 2011 seem to have been realized. Hence, the Belarusian economy is now ‘purified’ from main macroeconomic distortions and has a chance for sustainable long-term growth. Nevertheless, there are signals that some nominal and real inertia may generate new shocks for the national economy. From this view, the money market is of great concern, while interest rates signal maintained high inflation expectations. High and unstable expectations may entrap monetary policy and generate new shocks for the Belarusian economy. In this policy brief, we deal with a visualization of inflation expectations and argue for the necessity of a new nominal anchor in order to stabilize expectations for future periods.
In 2011, Belarus experienced its highest inflation and devaluation in modern history. These were consequences of the automatic macroeconomic adjustment determined by a number of both long- and short-term distortions in the national economy. Changes in prices and exchange rate adjusted real parameters towards their long-run equilibrium level. Hence, from a long-run perspective, one may interpret these adjustments as favorable since they ‘purified’ the economy from the macroeconomic imbalances that may have hampered growth. Furthermore, shifting from exchange-rate (XR) targeting to a managed float is another essential aftermath of the currency crisis. Economic authorities had to recognize that accommodative monetary policy (MP) was not compassable with XR targeting since it resulted in a considerable overvaluation of the real XR, and correspondingly, an incredibly large current account deficit. Thus, the new exchange rate regime may be argued to be a new automatic stabilizer for Belarus, providing the level of current account balance consistent with other macroeconomic fundamentals. Overall, the current stance of the national economy might be treated as a chance to “begin again from the ground up”. In this sense, the Belarusian economy as of today is sometimes compared to the Russian economy after its crisis in 1998, which then performed particularly high growth rates.
In our opinion, realizing the opportunity for a strengthening of long-term growth through structural changes undoubtedly should become a policy priority of Belarus in the near future. However, it should be emphasized that despite “purification” from major macroeconomic imbalances, there are still a long list of short-term challenges. In particular, one may stress the risks of expansionary policy revival; increasing external debt burden; growth in non-performing loans, which may undermine the solvency of the banking system; reduction of foreign demand due to shocks in global economy. These risks are more or less observable and may be monitored. Hence, the realization of one or the other shocks from this list might not come as a surprise, and economic authorities seem to at least realize this, and when possible, take prevention measures.
At the same time, another challenge seems to be more adverse and urgent; namely, the question of inflation and devaluation expectations. In economic theory, expectations play a crucial role in affecting behavior of economic agents. Recognition of the role of expectations at the money market determined intention to “subject” and stabilize these within modern monetary policy frameworks.
In Belarus, given the recent history of high inflation and devaluation, corresponding expectations of Belarusian economic agents are likely to be rather high. Moreover, shifting from XR targeting to a managed float has not yet resulted in provision of a new nominal anchor for the public.
For instance, disinflation was declared to be a priority goal, but there are no strict commitments on its numerical value, as well as in respect to procedures and mechanisms to provide disinflation trends. As of today, the Belarusian MP regime can hardly be classified as a standard regime. The MP Guidelines for 2012 assume indicative targets on international reserves, refinancing rate and the growth rate of banks’ claims on the economy. The latter witnesses the propensity to monetary targeting. However, the instable relationship between the monetary aggregate to be targeted and the ultimate goal (inflation), as well as the indicative nature of this commitment give rise to doubts in respect to treating it as monetary targeting. Furthermore, commitment on bank claims on the economy can hardly be treated as a nominal anchor for the public. According to the taxonomy of MP regimes by Stone (2004), Belarus is currently closer to the weak anchor regime, which assumes “no operative nominal anchor…and central bank reports a low degree of commitment… and high degree of discretion”.
Thus, our hypothesis assumes that there has been an adverse shock in inflation expectations due to weak nominal anchor and recent experience of huge inflation. If that is the case, this may be an additional source of shock for the money market, which may cause a new wave of macroeconomic instability. In order to make policy recommendations, this hypothesis needs empirical support. However, it is difficult to identify expectations in empirical analyses since this variable is typically unobservable and cannot be univocally measured. Instead, expectations are most often treated indirectly through other variables. Many central banks deal with the results of sociological polls on this issue, but these approaches may suffer from different economic meanings and measurements of inflation expectations by economic agents.
An alternative approach was proposed by St-Amant (1996) and extended by Gotschalk (2001), who base on famous Fischer equation representing current nominal interest rate as the sum of ex-ante real interest rate and expected inflation. Further, based on the approach by Blanchard and Quah (1989), structural vector autoregression (SVAR) between nominal and real interest rate is identified with a number of restrictions, which allows decomposing changes in the nominal rate to those associated with ex ante real rate and inflation expectations. The latter may be used as a measure of inflation expectations. Such a measure of inflation expectations assumes explicit economic meaning referring to the money market, i.e. the rate of future inflation, which will provide the, by economic agents, expected level of interest rate. Taking the data from statistics (not polls) and international comparability of such estimates are important advantages of this approach.
We applied this methodology to Belarusian data (nominal and real interest rate on ruble households’ deposits with a term more than a year). The obtained time series measure changes in inflation expectations in the current period for a period of the next 12 months. However, our goal is to visualize the level of inflation expectation and not changes in expectation. Therefore, we use the series in levels, choosing January 2003 as the base period (when National Bank of Belarus actually shifted to XR targeting regime), and assigned a zero level (as starting one) to it. The obtained series of inflation expectations is provided in Figure 1.
Figure 1. Inflation Expectations in Belarus
The estimated series of inflation expectations show a decrease in 2003 – mid 2005, which may be explained by the effectiveness of the new nominal anchor (XR), and correspondingly the expected disinflation. The expectation of reflation in late 2005 till late 2007 may be explained by the more expansionary policy and changes in Russian preferences that took place during this period. After that, there was a period of stable expectation, which is likely to be explained by the credibility of the nominal anchor (nevertheless, there was a shock in late 2008 that is associated with the impact of the global crisis).
The most considerable shock took place in the beginning of 2010, which has a lack of intuitive explanation and might be associated with a phase of radically expansionary policy.
Finally, a new significant shock took place in late 2010 – beginning 2011 which might be associated with the visualized problems at the currency market at that time.
Currently, there is a very high level of inflation expectations and its increased volatility in the second half of 2011 seem to be of a great importance. It signals that economic agents do not treat price shocks as a single-shot, but mostly tend to consider it as a long-lasting process. Hence, the absence of a nominal anchor and the fresh memory of huge inflation seem to be responsible for the current high and instable inflation expectations.
Maintenance of high inflation expectations is a dangerous threat for the money market. Propagating inflation through expectations may be considered as a separate channel within the monetary transmission mechanism (along with interest rate, exchange rate and bank-lending channels). In other words, even without additional fundamental preconditions for inflation, inflation expectations may become a self-fulfilling prophecy.
However, during the last two months (December 2011 and January 2012) this adverse effect seems to have been suppressed by monetary authorities, as the monthly inflation rate reduced radically in comparison to average rate in May-November 2011. This is likely to be the outcome of the significant monetary policy tightening that has resulted in a sharp increase in nominal interest rates by banks. On the one hand, such nominal interest rate complies with the shocks in inflation expectations and real ex ante interest rate (the latter grew as well at the background of the crisis). In other words, current level of nominal interest rates will equalize ex post real rate with ex ante real rate if the actual inflation rate has been as high as current inflation expectations. But on the other hand, if actual inflation had been much lower than expected one (and it tends to be so, in case of keeping on conservative MP), ex post real rate would be much higher than the ex-ante one. For instance, such a situation has already been peculiar during December and January: according to our estimations, ex ante real interest rate in December was about 3.6% in annual terms (preliminary data on January shows that it in this month it is rather similar), but annualized ex post real rate for these months is about 30%.
This suggests that there is a trap for the monetary authorities. If they keep high interest rates, based on the expected inflation, the impact of expectations on actual inflation will be mitigated, but the losses, say in terms of output, will be high because of the extremely high ex post real interest rates. If the monetary authorities facilitated the rapid reduction of nominal interest rates, current nominal rates would not guarantee ex ante real interest taking into consideration the high inflation expectations, which would then constitute a severe shock for the money market. Hence, the mechanism of self-fulfilling prophecy would work.
Furthermore, the increased ex ante real rate (and high probability of even higher ex post real rate in national currency) could give speculative incentives for a number of economic agents. For example, many agents could increase the share of national currency in their savings portfolio, either avoiding buying hard currency (which took place during the peak of the currency crisis) for new deposits, or changing the nomination of their deposits to the national currency (i.e. selling the hard one). In a sense, this trend may be interpreted as the compensation of losses on ruble deposits in the last year, which is needed to revive the demand for such deposits. But in any case, these internal processes (along with restricting money supply by the National bank) influence the domestic currency market. Through this, the supply and demand are formed not only due to current and financial international flows. Hence, due to these incentives for hard currency supply and demand, the current value of the nominal rate may substantially deviate from the equilibrium rate. The latter may be defined as in Kruk (2011): the one that may clear the market immediately (given short-term trends in current account flows at the background of medium-term values of other fundamentals).
Figure 2. Actual and Equilibrium Exchange Rate
Note: For 2010Q1-2011Q1 official rate of the National bank is taken as actual nominal rate, for 2011Q2 the exchange rate at the ‘black market’ (used by internet shops), and for 2011Q3 ‘black market’ and later the exchange rate of the additional BCSE session are taken.
The assessments of the equilibrium exchange rate based on this methodology (Kruk (2011)) show that in the third quarter, the actual rate almost equals the equilibrium rate. For 2011Q4, all necessary data is not available yet, but an approximate assessment correction of the equilibrium rate of the Q3 for average inflation between Q3 and Q4 may be used (i.e. in real terms the rate should not have changed in order to sustain equilibrium). Such an assessment indicates that the actual rate in the Q4 is again overestimated by roughly 5-10% in comparison to the equilibrium rate.
At a first look, such an ‘overhang’ at the domestic currency market seems to not be a great problem. But along with the trap stemmed from the high and unstable inflation, this may contribute and propagate possible shock at the money market. Furthermore, this ‘overhang’ is due to speculative incentives, which in turn, are due to high inflation expectations. Hence, high and unstable inflation expectations are a prime cause of this ‘overhang’.
Finally, we may argue that unfavorable inflation expectations is a multidimensional problem, which generates grounds for shocks at the money market and entraps monetary policy at the current stage. Therefore, restraining inflation expectations must currently be an absolute and unconditional priority of economic policy.
This gives rise to the issue of which policy tools that are needed for solving this problem. Tight monetary policy alone may not be enough and/or its losses in terms of output may be unacceptably high, especially taking into account that keeping the Belarusian economy depressed is likely to cause huge migration and thus reducing the prospects for long-term growth.
Our view on the problem of inflation expectations supposes that they stem both from recent experience of very high inflation and the absence of nominal anchor. Inflation memory cannot easily be removed, but introducing a new nominal anchor seems to be worthwhile. Among possible options, given the desire to preserve autonomous monetary policy in Belarus, the introduction of inflation targeting (IT) is seen as inevitable. A shift to this regime is associated with plenty of obstacles and might not be realized immediately (Kruk (2008)). A gradual shift to IT through its intermediary phases (so called IT Lite) is more expedient and complies more with the requirement of obtaining new powers and capacities at the National Bank of Belarus.
Taking on more and more strict commitments in terms of inflation and implementing mechanisms and procedures peculiar for IT (the latter is even more important than commitments themselves) will increase credibility and public trust for the National bank. The other side of the coin involves decreasing and less volatile inflation expectations, which do not challenge monetary policy and facilitate low and stable inflation. Another advantage of IT is the possibility to mitigate price shocks.
Our main policy recommendation is therefore that it is necessary to shift to an IT framework as soon as possible, starting from exploiting the forms of IT Lite. The advantages of this step overweigh all the obstacles, including those associated with the reluctance of economic authorities to change institutional preconditions.
However, one important clause should be emphasized. Shifting to IT (especially gradually through IT Lite) does not guarantee that current high inflation expectations will be reduced automatically and immediately. In other words, it does not guarantee that the cost of reducing inflation in terms of output will decrease (though for the present Belarusian situation there are grounds to suspect that it would facilitate). For instance, Mishkin (2001) shows that “there appears to have been little, if any reduction, in the output loss associated with disinflation, the sacrifice ratio, among countries adopting inflation targeting… The only way to achieve disinflation is the hard way: by inducing short-run losses in output and employment in order to achieve the longer-run economic benefits of price stability”. However, an introduction of IT assumes that new shocks in inflation expectations may be prevented, and due to it, low and stable inflation will be more likely.
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References
- Blanchard, O., Quah, D. (1989). The Dynamic Effects of Aggregate Demand and Supply Disturbances, American Economic Review, Vol. 79, No.4, pp.655-673.
- St-Amant, P. (1996). Decomposing US Nominal Interest Rate into Expected Inflation and Ex Ante Real Interest Rates Using Structural VAR Methodology, Bank of Canada, Working Paper No. 96-2.
- Gottschalk, J. (2001). Measuring Expected Inflation and the Ex Ante Real Interest Rate in the Euro Area Using Structural Vector Autoregressions, Kiek Institute of World Economics, Working Paper No.1067.
- Mishkin, F. (2001). From Monetary Targeting to Inflation Targeting: Lessons from Industrialized Countries, World Bank, Policy Research Working Paper No. 2684.
- Kruk, D. (2008). Optimal Instruments of Monetary Policy under the Regime of Inflation Targeting in Belarus, National Bank of Belarus, Materials of International Conference “Efficient Monetary Policy Options in Transition Economy”, pp. 305-322.
- Kruk, D. (2011). The Mechanism of Adjustment to Changes in Exchange Rate in Belarus and its Implications for Monetary Policy, Belarusian Economic Research and Outreach Center, Policy Paper No. 004.
Is Regional Policy Effective in the Long Run? Learning from Soviet History
Regional inequality has been a pressing issue in many countries, and also between the countries of the European Union. Unequal economic development, where some regions develop successfully and prosper while other regions stagnate, is often viewed as a source of social instability and economic inefficiency. Many kinds of regional policy have been proposed in order to mitigate such a situation by promoting growth in lagging regions. The policies range from subsidies and favorable tax policies for business investment to large-scale government investment projects. The ultimate goal of all regional policies is to create an environment for sustainable growth in regions that have fallen behind. In theory it might appear that a policy, which is implemented during a specific period of time, would be sufficient to achieve sustainable development: subsidies or creation of infrastructure would lure firms into a region and create a favorable environment for economic agents (both firms and people). The temporary policy would create agglomeration externalities that would ensure sustainable development even after the policy is discontinued.
However, are such regional policies in fact successful? Researchers often observe a short-run impact, but it is less clear whether regional policy can make a difference in the long run. From the literature on historical “natural experiments”, we know that spatial structures of economic activity are very resilient to temporary impact. For example, the wholesale destruction and loss of life in WWII seems to have had little or no effect on the regional shares of population and manufacturing in the long run. On the other hand, significant and permanent (or long-lasting) changes to market access, such as the division ofGermanyafter WWII, do reshape the spatial economy in the long run.
Our study looks at the long-run patterns of Soviet city growth in light of Stalin’s industrialization and WWII. The Soviet government’s investment decisions during that period were dictated to a large extent by military strategy and ideology. Massive relocation of productive resources from west to east before, during, and after WWII represents a unique natural experiment, in which production factors were destroyed in some parts of the USSR, while new production facilities and infrastructure were created in other regions of the country. Using a unique dataset, we test whether Gulag camps, wartime evacuation of industry, and location near the war front had a long-run effect on city size.
In the 1930s-1950s, Stalin’s system of penal labor camps (the Gulag) was widely used as a source of cheap labor, especially in remote locations where there was no other available labor force. Penal labor was used in a variety of sectors (logging, mining, manufacturing and construction). Presence of a camp near a city or town usually meant that this location was chosen by the Soviet government for an investment project. We trace the impact of having a camp nearby on city growth from 1930 to the present day.
Evacuation of enterprises from western to eastern regions of the USSR (to avoid their possible capture by the advancing German army) is traditionally named among factors that determined post-war growth of cities in the Urals andSiberia. Indeed, data show that the majority of evacuated enterprises never returned to their original location in the westernUSSR. Western cities that sent enterprises into evacuation often lost their significance in the immediate post-war period. We test whether evacuation affected the growth of cities in the longer run, ceteris paribus.
Unfortunately, no detailed data on deaths and destruction in Soviet cities during WWII are publicly available. We therefore measure the impact of wartime damage by constructing a set of indicators for cities that were occupied or were close to the front line during WWII.
The results show that (controlling for pre-war city size, rate of growth, and geographical location) occupation and location 30 km or 200 km from the front line do have a negative and statistically significant effect on city size by 1959. However, this effect disappears by 1970. This is consistent with findings forJapanandWestern Germany, where pre-war trajectories of city growth were restored after 25-30 years.
Surprisingly, the result is roughly the same for cities which hosted evacuated enterprises. Controlling for pre-war size and growth rate, geography and presence of Gulag camps, cities that received evacuated plants grow faster until 1959, but the difference is not statistically significant in 1970 and later. Thus, contrary to the commonly held belief, the effect of evacuation was only temporary.
By contrast, the presence of a Gulag camp increases city size in a long time horizon. Gulag cities grow faster not only in the 1930s-1950s when the Gulag system was operational, but also in the 1970s and 1980s. On average, the Gulag effect only disappears in the 1989 population census.
Specialization of the camp also makes a difference. Effect on city population from a camp where prisoners were involved in agriculture or logging is short-lived. Such camps were not used to build capital or infrastructure, so the nearby cities did not become more attractive for free labour. However, if a city had a camp where prisoners worked in manufacturing, mining, or construction of production facilities or housing, its population increased permanently. Compared with the best match from a control group (a city of similar characteristics, but without a Gulag camp), such a city accrued 50% more population, and this difference remains statistically significant even until the census of 2010.
Overall, the evidence on Soviet city growth supports the common finding: the direct effects of WWII were relatively short-lived. The experience of enterprise evacuation shows that one-shot relocation of production factors by the state also fails to produce robust changes in the geographical redistribution of economic activity in the long run. However, when the Soviet government established new industrial centers in the eastern parts of theUSSR, and made massive investments in production facilities and infrastructure using Gulag labor, it managed to permanently shift the geography of economic activity. This example illustrates the size and scope of impact that is required to affect economic geography in the long run.
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Who Needs a Safety Net?
One definition of safety net found on the internet is the following: “a net placed to catch an acrobat or similar performer in case of a fall”. This brings to my mind the thrilling performances I saw at the circus when I was a child and I have to admit in most cases there was a safety net. Only in some rare occasions it was removed and the increased tension became palpable. We knew that only the best acrobats could dare performing in those conditions since the slightest mistake or distraction could lead to disastrous consequences. Born in this context, the term safety net has soon been extended beyond circuses. The same internet source, right below the standard definition adds: “fig. a safeguard against possible hardship or adversity: a safety net for workers who lose their jobs”.
Imagine you are a European worker in a time of crisis. You are the only breadwinner in your family and you become unemployed. The situation of your family is going to worsen significantly, but you know that – at least for some time – you and your family will be able to survive thanks to your unemployment benefits and to other forms of social support. In the meantime, hopefully, you will be able to get a new job – maybe thanks to the help from a public employment agency – or will at least be admitted into some publicly sponsored training program increasing your probability to get a new job.
Imagine that, instead of being fired, you get sick. Luckily most of the costs for your care will be covered by the public healthcare system. You will continue receiving your salary (with a reduction as the length of the period of sickness goes beyond a certain number of days) for at least a few months, typically until you can go back to work. If your illness is really serious, at some point you will not receive compensation but you will keep your job unless you stay away from your workplace continuously for a very long period. Should you lose your job, you will still be able to rely for a while on unemployment benefits and on additional forms of social support. Your family will be suffering of course, but at least you will be able to “gain some time” to find a solution.
Now imagine a different scenario. You lose your job. You get one month severance pay but no unemployment benefits. The labor market is hardly creating new jobs, so you have a high probability of not finding a good job and will have either to accept to be unemployed for a long period of time or to work in badly paid temporary jobs, maybe in very dangerous working places (because nobody is in charge of checking working conditions). In case you choose not to risk and to try looking for safer jobs, most likely during your unemployment period you will not receive any training and certainly no support from (non-existing) public employment agencies.
Or, what if you are sick and all healthcare costs fall on you. If you have a private health insurance you get some assistance. If not, you have to dissave in order to get some treatment. You receive one month of salary, after which your employer is free to fire you without having to give you any compensation. So you suddenly find yourself sick and not only unable to help your family but being a burden for it, with no public support and no income. To be fair, you might receive some sort of assistance, after you have applied to the government for support as a needy household if your situation has deteriorated so much that you cannot ensure even your subsistence (maybe by selling assets). However, this support is typically not that high.
This second case is not that of a fictional country. It is a representation of the conditions of most workers in Georgia.
If you keep this in mind, you will not be surprised looking at the following pictures taken from the latest EBRD (European Bank for Reconstruction and Development) Transition Report, titled: “Crisis and Transition: the People’s Perspective”. The tables and pictures included in the report are based on a series of household surveys conducted by the EBRD in a number of transition countries plus a few selected countries of Western Europe. The aim of this study was to study how the crisis had affected household’s welfare in order to draw some conclusion about the potential vulnerability of countries and households to future crises.
Figure 1.
Source: EBRD Transition Report 2011
In this first picture Georgia (in red) stands out as very much above the regression line. It is what is defined as an “outlier”. In this case, being an outlier means exactly that Georgian households, despite having been themselves hit by a relative smaller number of negative events, appear to have suffered much more than households in similar situations in other countries. In other words, they were forced to cut their consumption much more than households in other countries.
The second picture (below) allows us to see where Georgian households had to cut their consumption. Of course, cutting the consumption of luxury goods is not the same as cutting the consumption of food or healthcare. Looking at the second picture, the situation in Georgia appears even worse. Most households have had to cut exactly where one would hope they had not to: staple food consumption and visits to doctors.
Neither of these cuts bode well for the future of Georgian households, as they are likely to have long lasting (negative) effects. Especially as a new world crisis seems approaching.
Figure 2.
Source: EBRD Transition Report 2011
Why this discussion about Georgia and safety nets? The reason is because for some time now Georgia has been presented consistently as a showcase country with an impressive reform track (including an extremely liberal labor market reform that has drastically reduced all forms of workers’ protection) and equally impressive growth rates.
Much less has been said about how Georgian people have been affected by these reforms. For sure the picture that emerges from the EBRD study is of a country where households are extremely vulnerable to any slowing down of the economy or worsening of the macroeconomic conditions, much more than in most other countries.
Again, looking at the EBRD study, we can see that this is related to at least two factors: on the one hand the extremely weak safety net provided by the state; on the other hand, the limited success (so far) in translating high growth rates into a substantial amount of new, “good quality” jobs. This is what led the EBRD, after presenting these results to suggest the following two key priorities for the Georgian government: “…to create a basis for export led growth… […] but also to establish an effective social safety net”.
I would like to conclude with my personal answer to the question: “who needs a safety net?” The answer is a lot of people, I would say, especially in times of crisis like the current. After all, not even the best acrobats would dare to perform all the time without it, especially when they are trying their most dangerous performances for the first time and when preconditions are less than perfect. Why? Because the cost of failure would be too high. Like in the case of acrobats – even more, as they are not risking their own lives – policy makers have the responsibility of taking into account in their evaluations what could go wrong and think of ways to minimize negative impacts on the population.
Most economists would agree that only a sustainable increase in the welfare of citizens (including the most vulnerable ones) is the true sign of development of a country in the long run. Assuring this, as someone sometimes seems to forget, requires also creating and maintaining – especially when markets are less than perfect, a solid social safety net.
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The Distributional Impact of Austerity Measures in Latvia
For a country of its size, Latvia was mentioned in the last decade’s macroeconomic discourse remarkably often: first, for its exceptional growth up to 2007, then – for a dramatic GDP contraction in the aftermath of the 2008 financial crisis, and for the so-called “internal devaluation” policy that was the cornerstone of Latvia’s recovery strategy. Now, when GDP recovery is underway for 9 quarters, Latvia is held up as an example of a country that paved its way out of the crisis with decisive and timely budget austerity measures. The size of budget consolidation package was remarkable, reaching almost 17% of GDP in 2008-2011. Today, when there is so much talk about austerity in the context of the Eurozone debt crisis, Latvian consolidation experience is of particular interest. In this brief, we are looking at the distributional impact of selected implemented austerity measures, using a microsimulation tax-benefit model EUROMOD. Our results suggest that the impact of these measures is likely to have been progressive, meaning that rich population groups are bearing a larger part of the burden.
From Boom to Recession
The “Baltic Tigers” – a term coined to praise the Baltic countries for their dynamic development in the 2000s, especially after their accession to the EU in 2004. During 2004-2007, average annual GDP growth in the Baltics exceeded 8% (in Latvia average growth was 10%). The growth was to a large extent driven by an externally financed credit bubble, leading to overheating of the Baltic economies: inflation was skyrocketing, unemployment was at historically low levels, and current accounts posted double-digit deficits. Before the outbreak of the crisis, the Latvian economy was in the most vulnerable position: Estonia was better situated thanks to prudent fiscal policy implemented in the “good” times, whereas Lithuania was less exposed thanks to its private sector being relatively less indebted.
The growth slowdown in Latvia began in 2007 and was initially triggered by the government’s adopted “anti-inflation plan” and the two of the biggest banks’ actions aimed at restricting credit expansion. Altogether, this initiated a decline in real estate prices. By December 2007, the average price of a square metre in a standard-type apartment in Riga had fallen by 12% from its peak in July (Arco Real Estate, 2008). Construction, retail trade and industrial production growth slowed down in the second half of 2007. GDP quarter-on-quarter growth approached zero by end-2007 and turned negative in the 1st quarter of 2008. In August 2008, the second largest Latvian commercial bank, domestically owned Parex Bank, faced deposit run and was unable to finance its syndicated loans, and in November 2008, the Latvian government took the decision to nationalize the bank. By the 3rd quarter of 2008, GDP quarter-on-quarter contraction exceeded 6%. The budget revenues lagged behind the expenditures, resulting in a gradually growing budget deficit, which reached about 5.5% of GDP in the 3rd quarter of 2008 (see Figure 1).
Figure 1: Year-on-year growth of general government budget total revenues, tax revenues and expenditures, %; seasonally adjusted budget balance, % of GDP
Source: Eurostat, authors’ calculations
In circumstances where the fiscal position was quickly deteriorating but world financial markets were frozen, the Latvian government was forced to seek financial assistance from international lenders. After tough negotiations in November and December 2008, Latvia received a 7.5 billion euro (about 1/3 of GDP) bailout facility from the IMF, the European Commission, the World Bank and the Nordic countries. Latvia received the funding in a series of tranches, with the transfer of each tranche being subject to implementation of a strict reform package agreed with the lenders.Given that introduction of the euro in 2014 remained the Latvian government’s target, one of the key elements of the reform programme was maintaining the lat’s peg to the euro. Therefore, the Latvian government had to accept especially strict and wide-ranging budget consolidation measures.
Budget Consolidation
The total size of budget consolidation achieved in 2008-2011 was impressive: overall, the fiscal impact of the reforms is estimated at 16.6% of GDP (Ministry of Finance of Latvia, 2011). Under the pressure of international lenders, budget consolidation was front-loaded and was achieved astonishingly fast – the fiscal impact of the reforms implemented in 2009 reached almost 10% of GDP, whereas the impact of 2010 and 2011 year measures was much smaller – 4.1% and 2.6%, respectively (see Figure 2).
Figure 2: Size of the implemented consolidation measures and budget deficit outturn, % of GDP*
* Budget deficit in 2011 is the Bank of Latvia’s autumn forecast
Source: Ministry of Finance, Bank of Latvia, Eurostat
Yet the way the consolidation was done was rather chaotic. The 2009 consolidation was mainly implemented by expenditure cuts, including strong wage and employment reductions in the public sector (public pay and employment cuts were continued in the following years, wages were cut by 15-20% in each round and most bonuses were abolished). On the revenue side, the government stuck to the goal of shifting tax burden from labour to consumption, thus the consolidation was mainly achieved by raising indirect taxes, while the personal income tax was reduced. Another line followed by the government at the time was to strengthen support to those affected by the crisis, for example, the duration of unemployment benefits was increased.
Nevertheless, by the time preparation of the 2010 budget started, it became clear that in circumstances of continuing GDP fall and peaking unemployment (in 2009, GDP fell by 17.7%, and the rate of unemployment reached 17.1%), the reduction in labour taxes could not be sustained while the social budget could not bear the burden of growing expenditures. Consequently, the reduction in the personal income tax was reversed (the tax rate was raised even above the pre-crisis level). To consolidate the social budget, the government implemented an across the board cut by introducing ceilings on the size of many benefits. In 2011, the tax burden on labour was further increased by raising the rate of mandatory social security contributions.
Budget consolidation was done under the pressure of the crisis and the reform package was designed in a great rush. What also may not be disregarded, is that the three years – 2009, 2010 and 2011 – were election years in Latvia: in 2009, there were local government elections, in 2010 – parliamentary elections and in 2011 – parliamentary re-elections . Elections have arguably affected the composition of implemented austerity measures. Thus, in June 2009, just ten days after local government elections, amendments to the Law on State Pensions were passed, which stipulated that old-age pensions should be cut by 10%, but pensions to working pensioners should be cut by 70%. This decision caused a strongly negative public reaction and on December 21, 2009, the Constitutional Court ruled that the government’s decision was unconstitutional arguing that the state must guarantee peoples’ right to social security. In the following budget consolidation rounds, even in the face of convoluted IMF recommendations to find a constitutional way of ensuring sustainability of the pension system (IMF, 2010), the government remained strictly opposing any pension cuts.
The mix of implemented reforms is crucial not only because it determines the effectiveness with which the budget consolidation is achieved. What is equally important is that the mix of reforms affects the distribution of costs of the crisis and shapes the economic recovery path. The consequences of the crisis – the dramatic rise in unemployment and wage reductions in the private sector – had a strong impact on incomes, yet policy makers can do little to directly affect this process. On the other hand, policy makers can offset or aggravate those effects by implementing reforms, such as those that made up the austerity packages. In this brief, we assess the distributional impact of selected austerity measures, which were implemented in 2009 – 2011.
Modelling Approach and Limitations
We use the Latvian part of the tax-benefit microsimulation model EUROMOD and follow a similar approach as that taken by Callan et al (2011). We limit our analysis to reforms in direct taxes, social contributions, and cash benefits . In particular, the following austerity measures are included in the analysis:
- removal of income ceiling for obligatory social insurance contributions (in 2009);
- increase in the rate of social insurance contributions for employees, employers, and self-employed (June 30, 2011);
- reduction of tax exemptions (July 1, 2009);
- increase in the rate of personal income tax (2010);
- introduction of benefit ceiling for unemployment benefits (2010), maternity, paternity, and parental benefit (November 3, 2010);
- cuts in state family benefit (2010);
- cuts in child birth benefit (2010);
- reduction in the amount of parental benefit by limiting eligibility to non-working parents only (May 3, 2010);
- making stricter income assessment criteria for guaranteed minimum income (GMI) and reducing amount of the GMI benefit for some groups (2010).
We assess the distributional impact of these austerity measures by comparing two alternative scenarios:
- the baseline scenario – simulation of 2011 tax-benefit policy system (with austerity measures implemented), and
- the counter factual scenario – simulation of tax-benefit policy system that would have emerged in 2011 in the absence of austerity measures.
If a policy was changed as a part of the austerity package (e.g. income tax increase), we implement a pre-austerity policy (e.g., reduce the income tax to its pre-austerity level). However, if the changes in the policies were regular (e.g. an increase in minimum wage that was planned long before the discussion of austerity measures had started) or not related to austerity measures (e.g. increase in duration of unemployment benefit) we include them in the counterfactual scenario, as well as in the austerity package scenario. By defining the counterfactual scenario in this manner we focus on the impact of austerity measures only holding other things equal.
Despite Latvia is one of the countries where the size of the austerity package was especially large, the distributional effect of the implemented measures has not been analysed neither before nor after the policies had been implemented. Until recently Latvia didn’t have a national microsimulation model which could be used to assess the impact of taxes and benefits on household income. This paper is the first attempt to do this.
However, our analysis is subject to some drawbacks. First, EUROMOD’s input data is based on the European Union Statistics on Income and Living Conditions 2008 (with the income data referring to 2007). We adjust 2007 incomes up to 2011 using updating factors based on the aggregate evolution of such incomes according to national statistics. However, we do not adjust for the changes in the labour market that happened during this period. Therefore, we estimate the effect of austerity measures on data that represent the population with pre-crisis labour market characteristics (e.g. relatively low number of unemployed people).
Second, the analysis is limited to the direct impact of the implemented measures, disregarding the secondary effects such as e.g. behavioural responses of people on the implemented policies.
Results
The simulation results suggest that the impact of the analysed austerity measures was progressive with top income groups being the most affected (see Figure 3). The six countries considered in Callan et al (2011) show different degrees of progressivity: Greece demonstrated a clearly progressive impact, while Portugal was the only country where the effect was regressive. The result for Latvia is likely to be a consequence of introduced ceilings on contributory benefits, as well as the increases in income tax and social insurance contributions. While income tax in Latvia is flat (except for a relatively small untaxed personal allowance), the lowest income deciles contain proportionately more unemployed people and pensioners.
Figure 3: Percentage change in household disposable income due to austerity measures by income deciles
Source: based on own calculation using EUROMOD
Higher progressiveness was observed for households with children (see Figure 4), which is explained by the introduction of ceilings on child-related contributory benefits. At the same time, the impact on the households with elderly was more even.
Figure 4: Percentage change in household disposable income due to austerity measures for different types of households by income quintiles
Source: based on own calculation using EUROMOD
While the introduction of austerity measures made all income groups poorer, progressivity of the impact reduced income inequality. The Gini coefficient of the counter factual scenario is 1 percentage point higher than that of the base scenario. After implementation of the austerity measures, the poverty line decreases because the median income decreases. As a result, poverty rates using relative poverty lines decreased. The poverty rate of the elderly was affected the most, because pension income was not cut and pensioners became relatively better off as compared to other population groups. However, if measured against the fixed poverty threshold, the poverty rate increased in all population groups (see Table 1).
Table 1: Poverty rates and Gini coefficient before and after implemented austerity measures
Source: based on own calculation using EUROMOD
Concluding Remarks
The austerity measures analysed in this paper have had a progressive impact, with the richest population groups likely to be bearing most of the costs. This result should be interpreted with caution. It should be taken into account that we do not model all of the austerity measures that were implemented in 2009-2011. E.g., we do not model the impact of changes in VAT rates, which is likely to have been quite strong and regressive.
Latvia is a society with extremely high income inequality. For example, the income quintile share ratio calculated by the Eurostat (S80/S20), which measures income inequality, in 2009 was the second highest in the EU (6.9 as compared with an EU average of 4.9). It is unlikely that the progressive impact identified in this paper will significantly reduce income inequality gap in Latvia relative to other European countries.
References
- Arco Real Estate (2008). Real estate market overview (Sērijveida dzīvokļi, 2008. gada decembris)
- Callan, Tim, Chrysa Leventi, Horacio Levy, Manos Matsaganis, Alari Paulus & Holly Sutherland (2011). “The distributional effects of austerity measures : a comparison of six EU countries”, Social situation observatory, Research note 2/2011.
- International Monetary Fund (2010). Republic of Latvia: Second Review and Financing Assurances Review Under the Stand-By Arrangement, Request for Extension of the Arrangement and Rephasing of Purchases Under the Arrangement and Request for Waiver of Nonobservance and Applicability of Performance Criteria. IMF Country report No. 10/65, March 2010.
- Ministry of Finance of Latvia (2011). Budget consolidation in 2008-2011 (Veiktā budžeta konsolidācija laika posmā no 2008.-2011. gadam)
Can the Baby- and Woman-Friendly Maternity Wards Save Lives?
Improving the health and well-being of mothers, infants and children has been an important public-health goal for many countries, which is reflected in the Millennium Development Goals (4 and 5), set by the United Nations. The well-being and health of mothers, infants and children determine future population health and thus public health challenges as well as economic development prospects. Although Ukraine and the other countries of the Former Soviet Union have fared well compared to the less developed countries of Asia, Africa and Latin America, their maternal and infant mortality and morbidity rates are 3 to 5 times higher than those in the European countries (including those of the Former Socialist block). There are many factors behind this situation. Nevertheless, a lot can be done to improve maternal and infant health by simply changing the way labor and delivery services are provided. New evidence-based medicine (EBM) standards introduced by the Mother and Infant Health Project (MIHP) are more baby- and woman-friendly and include: partner deliveries; avoidance of unnecessary C-sections, amniotomies and episiotomies; use of free position during delivery; immediate skin-to-skin contact; early breastfeeding; and the rooming-in of mothers and newborns. The impact of the Project culminates with 3 mothers’ and 11 newborns’ lives saved every two years in an average participating region.
Infant mortality/morbidity has often been a focus of health economics and medical research as a major indicator of a country’s well-being. In contrast, maternal health outcomes have been much less investigated. There are several potential reasons for such negligence. One is that the rates of maternal deaths are quite low in developed countries. The second is attributed to the difficulty of measuring maternal health outcomes in developing countries where the rates of maternal mortality are particularly high. Nevertheless, the issue of maternal health attracts considerable attention from society due to the fact that most of maternal deaths and health deteriorations are preventable. Moreover, recent evidence demonstrates that improvements in health outcomes for mothers and infants are not as much related to the availability of care (structural quality), as to the way this care is provided (process quality) (Barber and Gertler, 2002). Furthermore, some studies find that access to low quality providers in fact contribute to higher child morbidity and mortality (Sodemann et al., 1997).
Although the population health in Ukraine compares favorably to the situation in the developing world, it is still lagging far behind the developed countries in terms of maternal and infant mortality and morbidity. During the latest years, the level of anemia among pregnant women has increased 4.5 times, maladies of genital urinary system about 3 times, and diseases of blood circulation system 2 times. The average maternal mortality ratio fluctuates around 18-22 women per 100,000 live births, which is 3.5 times higher than in the EU. At the same time, infant mortality (9.5/1000) is two times higher than that in the EU, while the rate of stillbirth (16.89/1000) is four times higher. Additionally, the incidence of congenital anomalies of newborns has increased over time and reached the number of 2878 per 100,000, which is 77% higher than the EU average.
Another alarming problem related to maternal health is persistently high rate of abortions, which most likely originates from ignorance in modern family planning methods. In contemporary Ukraine, 71% of pregnancies end up in abortions. Although the number of abortions decreased twice between1991 and 2003 (from 1532/1000 live births to 728/1000 live births respectively), the incidence is still 3.5 times higher than that in the EU (Center of Medical Statistics of Ukraine 2007).
Mother and Infant Health Project Description
The Mother and Infant Health Project is an eight-year project advocating evidence-based medical practices aimed to improve women’s reproductive and newborns’ health. With funding from the USAID and private sources, and with the support from the Ministry of Health of Ukraine, the project has been implemented by the JSI Research and Training Institute. The first phase of the project was initiated in September 2002 in four regions of Ukraine, but the first four maternities joined the Project in mid-December 2003. By the end of 2006, the Project had expanded to 20 maternity hospitals in twelve pilot regions.
Following the Millennium Development Goals (MEU, 2005), the MIHP pioneers to introduce new evidence-based medicine (EBM) standards: partner deliveries; avoidance of unnecessary C-sections, amniotomies and episiotomies; use of free position during delivery; immediate skin-to-skin contact; early breastfeeding; and the rooming-in of mothers and newborns. In addition, the Project actively supports the provision of training on effective perinatal technologies for the staff of the MIHP maternities, development of “centers of excellence” that serve as models in training/education of medical practitioners of the corresponding oblast, and organizing a health awareness campaign on healthy lifestyles. The MIHP also aims to reinforce liaisons with local governmental institutions.
Furthermore, the Project works on integration of the EBM standards into a package of perinatal practices throughout Ukraine. It also targets revision of the current curricula for medical universities and colleges in order to increase the evidence base of educational programs for medical students and health care providers.
The MIHP in Ukraine belongs to a family of maternal and infant health improving initiatives throughout the world and builds upon their experience, JSI Mother Care (1998-2000) being the largest among them. However, the MIHP in Ukraine is unique both with respect to the institutional setting and to its scope and length, which allows for rigorous evaluation. Most of the earlier projects implemented by the JSI have mainly focused on specific issues (e.g. pregnancy of adolescent girls in Uganda and Zambia, anemia in Malawi) and have been short-term (the longest have been two-year projects in Egypt, Pakistan, and Zambia).
The Impact of the Mother and Infant Health Project
The evaluation of the impact of the first phase (2002-2006) of the Mother and Infant Health Project in Ukraine allows for an identification of improvements in the maternal and infant health outcomes due to enhancements in the quality of labor and delivery services. The identification of the quality improvement effect has been possible for two reasons. First, the basic perinatal and obstetrics care is universally available in Ukraine. Hence, the estimated impact of the small region participating in the MIHP can be attributed to the improvement in medical technologies rather than the availability of the services per se. Second, the variation in the project participation over time and across regions allows for control of the overall population health trend in the country.
Taking into account the effect of the other maternal health programs and personnel training outside the Project, Nizalova and Vyshnya (2010) find that the MIHP impact is in general health improving. Decreases in both maternal and infant mortality and morbidity in participating regions are more pronounced after the start of the Project. Among the infant health characteristics, the MIHP impact is observed for stillbirths and infant mortality and morbidity resulted from deviations in perinatal period and congenital anomalies.
Concerning maternal health, the MIHP is most effective in combating anemia, blood circulation, veins, and urinary-genital system complications, and late toxicosis. The analysis suggests that the effects are due to early attendance of antenatal clinics, lower share of C-sections, and greater share of normal deliveries.
For some outcomes (maternal mortality, normal deliveries, and anemia) there exists a significant effect of the MIHP trainings (without joining the Project), although it is about twice as small in magnitude for normal deliveries and anemia than the direct MIHP impact.
Cost-Benefit Considerations
A comprehensive cost-benefit analysis of the MIHP project is limited, since the majority of maternal and infant health indicators are hard to assess in monetary terms (e.g. increase in early neonatal visits of mothers; decrease in the number of cases of late toxicosis and complicated deliveries; decrease in infant morbidity due to various reasons etc.). Therefore, the focus is on the most “tangible” cost effectiveness indicators: (i) average annual per maternity cost of the Project and (ii) average annual per maternity “tangible” benefits.
The average annual per maternity cost is about 60,000 USD and it is calculated as an overall cost of the first phase of the project – 6 million USD – distributed over 20 treatment sites during 2002-2006, including the first year of the Project setup. Set of “tangible” benefits includes savings due to (i) a switch from C-sections to vaginal deliveries (cost savings of around USD 2,500 per maternity per year), (ii) a switch away from medicine-intensive ways of leading both C-sections and vaginal deliveries (around USD 65,000 per maternity per year), and (iii) saved lives of mothers and infants due to the implementation of the MIHP practices (around USD 5.8 million per maternity per year ).
Overall, the project cost to benefit ratio is 1 to 97 (60 to 5,847 thousand USD) if one takes into account the value of lives saved and it is 1 to 1.08 (60 to 65 thousand USD) if one considers only cost savings due to change in C-section and vaginal delivery practices and the switch away from C-sections to vaginal deliveries. The latter represents the lowest bound of the Project’s benefits since it does not take into account any health-improving impact of the MIHP. Although the range is quite wide and this preliminary calculation suffers from several limitations, it seems unlikely that given the estimated impact the true costs would exceed the true benefits.
References
- Barber, Sarah L and Paul J Gertler. 2002. “Child Health And The Quality of Medical Care.” University of California-Berkeley Working Paper .
- Giergiczny, Marek. 2008. “Value of a Statistical Lifethe Case of Poland.” Environmental and Resource Economics 41 (2).
- MEU. 2005. “Millennium Development Goals. Ukraine.” Ministry of Economy of Ukraine .
- Olena Y. Nizalova & Maria Vyshnya, 2010.”Evaluation of the impact of the Mother and Infant Health Project in Ukraine,” Health Economics, John Wiley & Sons, Ltd., vol. 19(S1): 107-125.
- Sodemann, M., M.S. Jakobson, I.C. Molbak, I.C. Alvarenga, and P. Aaby. 1997. “High mortality despite good care-seeking behavior: a community study of childhood deaths in Guinea-Bissau.” Bulletin of the World Health Organization 3 (75):205–12.
Russia and the WTO
Eighteen years after the start of the accession process, Russia is closer than ever to joining the World Trade Organization (WTO). The negotiations have been long and hard as Russia had to agree the accession terms with 57 out of the 153 WTO member countries which formed the working group. Moreover, the number of goods for which the extent and timeframe of the change of Russian tariffs were agreed exceeded 10,000. The negotiation team led by Maxim Medvedkov has done an immense amount of work and found compromises on sensitive issues such as pay for the flights of foreign planes over Siberia, compensating European producers for the discriminatory law on industrial assembly, the amount of support for the agricultural sector, access to the market of banking services, etc. Now, all these differences have been ironed out and the WTO has agreed with all the participants, and put on the table the final terms of Russia’s accession.
Terms of Accession
It has to be noted that the change of tariffs after Russia’s accession to the WTO will be insignificant. Average tariffs on goods after all the agreements have come into force will decrease to 7.8% from 10% in 2011.
The tariffs on agricultural goods will drop to 10.8% compared with the current level of 13.2%, and for manufactured goods from 9.5% to 7.3%. The duties on some goods will, however, drop significantly. For example, the tariff on new cars will be cut by half from 30% today to 15%. On the other hand, one has to bear in mind that the agreed decrease of all tariffs will not happen overnight after the Russian accession. It will rather take place gradually at a rate which has also been agreed on with the WTO members. The tariff for new cars will drop to 25% immediately after accession and will remain at that level for the next three years before the cuts resume at an annual rate of 2.5% over the following four years to reach the targeted level of 15%. Russia has no commitments to reduce tariffs any further. The tariffs on used cars up to 7 years old will be fixed at 25% at accession and will not change over the next five years before being cut to 20% over the following two years. Duties on cars older than 7 years will not change at all. On the whole, tariffs will be changed completely immediately upon accession only on one-third of the goods. For many goods the process will extend over three years, and for some over 8 years after accession.
Not only trade in goods, but also service and foreign direct investment spheres will be liberalized. One of the most difficult negotiation items was the banking sector, where some WTO member countries (notably the USA) demanded a total opening up of the Russian market of banking services to foreign financial and lending institutions. Moscow, for its part, insisted on preserving the current situation where only the subsidiaries and not branches of foreign banks operate in the Russian market. The difference between the former and the latter is that the activities of subsidiaries on Russian territory are regulated by the Russian Central Bank, while branches are regulated by the laws of the country of origin. The Russian position prevailed, which means that the situation for foreign banks will not change and the cost of entering the Russian market will remain at the current level. Accordingly, the cost of banking services for Russian clients will not change. This is not good news for Russian small and medium-sized enterprises which had hoped that a massive entry of foreign banks could help bring down the interest rates on loans.
Major changes may take place in the insurance market when Russia allows branches of foreign insurance companies. However, a nine-year transitional period appears to be enough for all the stakeholders to prepare themselves.
Assessment of the Consequences of Russia’s Accession to the WTO for the Economy
The question that is uppermost in the minds of all Russians is whether the economy stands to gain or lose as a result of WTO accession. On the one hand, opponents of accession point to the not very successful experience of accession to the WTO of some former Soviet republics. These opponents paint lurid pictures of the social consequences of the closure of a large number of Russian enterprises. By contrast, the advocates of accession cite the success of China whose export-led growth accelerated significantly after the country joined the WTO. Time will tell what the results of a WTO accession will be for Russia. The result will in many ways depend on well-thought-out and coordinated actions of the Russian federal and regional authorities. In the meantime, we can only talk about what we expect from accession and what its potential consequences may be. The Russian government and the World Bank have conducted several major studies, seeking to determine the economic consequences of a WTO accession. While there are some discrepancies in evaluating the quantitative changes in specific sectors and at the economy-wide level, researchers more or less agree in qualitative terms. The general consensus is that the changes in outputs, consumption, prices and welfare due to the new tariff agreements are likely to be fairly small. Because the overall reduction of import tariffs in Russia will be insignificant, one may expect that changes in specific sectors, too, will not be dramatic (within plus-minus 1-3% of the base level).
CEFIR jointly with the Belgian TML Centre and the German ZEW with the support of the European Union Seventh Framework Programme, recently build a general equilibrium model of the Russian economy SUST-RUS (CEFIR 2011) which makes it possible to assess the effect of a Russian WTO accession on specific sectors. Several scenario calculations have been made to model the short term (one or two years after the reduction of all the tariffs) and long-term (five or six years after the reduction of all the tariffs) effects of a Russian WTO accession. The results of the scenario modeling should be seen as an indication of the direction of market processes caused solely by a WTO accession without taking into account any other possible changes in the economic environment (for example, a change of energy prices, the strengthening or weakening of the ruble against the leading world currencies, changes in the domestic market, etc.).
The short-term scenario assumes only a change of the tariff timetable. The long-term scenario has a further assumption concerning the return on foreign direct investments for the business service sector. Business services include banking insurance, financial services, transport services, wholesale trade, etc. Some terms of Russia’s WTO accession pertain to the business service sphere and envisage considerable liberalization of foreign companies’ access to these sectors. One can expect that lower barriers to entry would push down prices in these sectors and make them more accessible for Russian enterprises, which in turn would reduce their costs, boost production and create more jobs. The general equilibrium modeling of this mechanism assumes a conservative reduction of barriers for foreign investments of about 10% of the current level.
According to CEFIR’s results, the potential growth of welfare in the economy caused by a WTO accession in the short term will be 0.4% per year, and in the long term 1% per year. Budget revenues will fall due to diminished tariffs, and there may be a dip in the rate of GDP growth in the short term. Model calculations show a significant change of the trade balance, possibly a reduction of the trade surplus to 10%. At the sectorial level, a WTO accession will reduce domestic prices of timber and articles made from wood, foodstuffs, transport means, as well as equipment, clothes, chemicals and petrochemical products by 1.5-2.5% in the short term and by up to 3% in the long term. This will increase consumption by between 0.2% and 0.4% in the short term and up to 1.5% in the long term. It has to be noted that the liberalization of the service sphere is a very important assumption of these calculations as it accounts for half of the long-term gains for consumers.
The World Bank has also carried out a study of the consequences of a Russian accession to the WTO in 2004 (Jensen et al, 2004). That study put the net positive gain from liberalization of tariffs at 3.4% of the GDP. That analysis was based above all on the economic effect from a change in import tariffs. Trade liberalization is historically associated with lower tariffs. Most sectors stand to gain from accession. Because the authors identify two main causes of the gains from liberalization – easier access to foreign markets and cheapening of the ruble in proportion to the change of tariffs – the sectors that will benefit are those which has a high share of exports, and which have not been heavily protected by tariffs to begin with.
The biggest beneficiary will be metallurgy, with a 25% increase in output and employment in ferrous metallurgy and 15% in non-ferrous metallurgy. The growth in the chemical and petrochemical industries can be up to 10% and in coal mining up to 6%. The significant gains predicted by the World Bank study owe something to the optimistic view of the possible terms of Russia’s accession to the WTO. For example, it assumed that all the import tariffs would be cut by 50% and all (100%) of the administrative barriers to investment in business services would be removed. More modest assessments of the potential gains for Russia in other studies reflect the smaller Russian commitments to liberalization of import tariffs and the services sphere. For example, CEFIR’s results show that steel-making enterprises will not experience difficulties after a WTO accession and may grow by about 2% in the long term.
Along with the cut of import duties, Russian producers will face tougher competition on the part of foreign goods for which prices will be cut. Accordingly, Russian producers will also have to cut their prices to be competitive. This is good news for consumers. Not all domestic producers will be able to cut their prices. The enterprises whose production costs turn out to be higher than the new prices, and which fail to cut their costs, will be pushed out of the market. The sectors where one can expect a drop in production are above all those which have long been protected against international competition by high import duties. CEFIR’s study has shown that in the short term, negative consequences may ensue for the food industry, pharmaceutical companies and textile enterprises which may see their output drop by between 0.5% and 2%.
According to the World Bank study, the biggest decline in output and employment may occur in the machine-building sector (12%) and in the food and light industries as well as in the construction-material industry (up to 7%). The above figures of decrease or increase refer to the summary effect from liberalization accumulated over a period of 7-10 years after a Russian accession to the WTO. Several studies have been devoted to the consequences of a WTO accession for regional economies. For example, World Bank experts (Rutherford and Tarr, 2006) point to positive, but uneven consequences of a WTO accession for Russian regions. The biggest beneficiaries from lower tariffs are likely to be the Tyumen region, the North Western District as a whole, and in particular, St. Petersburg, where welfare may increase by 1%. Low growth or no growth may be expected in the Central District and in the Urals. These results tally with the assessments of the consequences of WTO accession for the Russian regions made by the Independent Social Policy Institute (ISPI 2004) which also included some regions of the Volga Federal District among the high-risk regions.
Results of studies of changes in the labor market in the wake of WTO accession, generally accord with the other findings. The International Labor Organization (ILO 2003) predicts an average loss of 6000 jobs in industry in the year following accession and up to 1000 jobs in seven or eight years’ time. The biggest number of jobs will be lost in the light-industry sector (up to 15,000 during the transitional period). Such a drop in employment will hardly make any difference to the unemployment situation in the country as whole, but may differ from one region to another.
Most studies agree that Russia may gain from easier access for Russian enterprises to foreign markets after a WTO accession, but that the gain will not be great compared to the potential gain from the liberalization of the service sphere. There are not many export-oriented enterprises in the country, but they exist. There are about 6,000 export-oriented enterprises in the processing industry. These enterprises include chemical, metallurgical and high-tech enterprises, and are the most efficient and competitive producers in the country. These enterprises may be expected to pick up the slack in the labor market due to redundancies in sectors that will be affected by a WTO accession. The coordinating role of the state is very important in creating conditions for movement of labor. The gradual reduction of tariffs may dampen the social consequences of Russia’s WTO accession. In the regions where some production facilities are “doomed”, programs for retraining of labor must be launched without delay, especially in information technologies, and the services and skills required for starting a new business. The aim of such retraining should be to enable those who lose their jobs to be employed in other spheres of the economy. It is equally important to develop new forms of financing migration of the population within the country. The solution of this task may become one more – and very important – result of the WTO accession for Russia.
References
- CEFIR. 2011. SUST-RUS project. www.sust-rus.org
- ILO. 2003. “Social consequences of Russia accession to WTO.” Moscow office of ILO (in Russian)
- ISPI. 2004. “Russia’s accession to WTO: real and imaginary social consequences.” (In Russian)
- Jensen, Rutherford, Tarr. 2004. “Economy-Wide and Sector Effects of Russia’s Accession to the WTO.” World Bank
- Rutherford, Tarr. 2006. “Regional Impacts of Russia’s Accession to the WTO.” The World Bank
Five Million Tourists in Georgia by 2015 – a Myth or a Nightmarish Reality?
Anybody traveling on the Georgian countryside will be astonished by the pace of development. Mestia, the capital of Svaneti, resembles one big construction site. The new concrete road from Zugdidi promises to shorten the travel time to 2 hours. A whole network of ski lifts is currently being planned, carrying a promise of turning Svaneti, a long-isolated region of Georgia, into the Switzerland of the Caucasus.
Mestia and Svaneti are representative of a broader effort by the Georgian government, assisted by international financial institutions, to develop the Georgian tourism sector. This has mainly involved infrastructure projects and tax breaks to encourage private investment in the tourism industry. A very partial list of touristic destinations that have received or are receiving a major facelift includes Old Tbilisi, Mtskheta, Signagi, Kutaisi, Gudauri, Mestia, Batumi, Kobuleti and Anaklia.
Tourism is one of Georgia’s main exporting sectors and earns hard currency and helps to reduce the current account deficit. As a labor intensive industry, it helps to create a lot of formal and informal jobs (particularly in the periphery where they are most needed). The growth in tourism also spurs business development in many related sectors of the economy – agriculture, transportation services, arts and crafts to name just a few.
Georgia is not the only country in the world riding on the wave of tourism expansion. Tourism is currently the fastest growing sector in the global economy, particularly important for developing countries. According to UNWTO tourism barometer, the flow of foreign tourists into developing countries increased by 4.5% in 2011 compared to the previous year. The rate of increase stands at 9% for Central and Eastern European countries.
For Georgia, however, the growth of tourism has been truly spectacular. According to the Georgian Border Security statistics, the number of foreigners visiting Georgia during the first 10 months in 2011 increased by 42% compared to the same period last year. While not reflecting the actual number of tourists (as opposed to foreigners working in Georgia and buyers of re-exported cars), these data illustrate a steep upward trend. Even under most conservative assumptions, the total number of border crossings by foreigners will reach about 2.6 million by the end of 2011, which is 28% above the 2010 level.
Since 2004, incoming tourism has expanded at an impressive average rate of 32% per year, nearly doubling every three years. A simple (simplistic) extrapolation suggests that in four more years, by 2015, Georgia may be receiving more than 5million tourists a year. Is this a realistic estimate? Would it be a blessing or a curse?
What the border crossings statistics conceal is that Georgia remains a very expensive destination, especially during the short high season. According to Travel and Tourism Competitiveness Index for 2011, Georgia is ranked 73rd among 139 countries, the same ranking as in 2009. In particular, Georgia ranked 82nd on information and communication technologies, 105th on air transportation infrastructure and 94th on general infrastructure. Overall, Georgia does better than its South Caucasus neighbors Armenia (100th) and Azerbaijan (87th) but worse than Russia (53rd) and Turkey (50th).
At present, tourists are willing to pay a significant premium to satisfy their curiosity for this Eastern outpost of Western civilization. Despite high prices and mediocre quality of services, Georgia has so far been able to maintain its attraction as an island of democracy; exotic, underexplored and yet secure location with good food and wine. However, as the country enters a period of two closely watched elections in 2012 and 2013, what will be at stake, among other things, is Georgia’s status as a destination of choice for investors, donors, and tourists. As far as mass tourism is concerned, a setback in the global public relations battle could bring into play the “value for money“ factor, making further expansion in the sector more tightly related to infrastructure and service improvements.
Slower growth in tourism may be a blessing in disguise. From the purely economic point of view one has to consider the impact of tourism on long-term economic growth. Unfortunately, tourism – like many other labor intensive service industries – has little potential for substantial productivity growth: it takes about the same amount of labor to cook one khachapuri today as it did in the 19th century. As wages are typically tied to productivity this means that tourism has little potential for long-term income growth. Wages in tourism may eventually increase – a phenomenon known to economists as “Baumol’s cost disease” – when other sectors improve their productivity and start competing for workers with the tourism industry.
Thus, the Georgian government should be advised to worry, not about the sheer number of tourists, but rather the amount of money the tourists spend in the country. According to this view, Georgia should strive to increase the share of relatively wealthy tourists from Western Europe and North America. These tourists account for a meager 3.6% of total border crossings by foreigners in the first 10 months of 2011. A closely related goal should be to smooth the sharp seasonal fluctuations currently plaguing the industry. High season tourism (mainly from the CIS) at “peak load” prices has been growing so far, but there is ultimately a limit to how many tourists Batumi, Kobuleti and Anaklia can absorb in July and August. After all, there are cheaper and better mass-tourism alternatives on the Turkish side of the border. Conversely, increasing offseason tourism would help attract additional investment in human and physical capital and raise the quality of services to a level appropriate for high-end tourism.
Along with the economic pitfalls outlined above, the danger associated with becoming just another “Disneyland” of mass tourism is in losing the very reason why people would want to come to Georgia, as well as losing a part of the national identity. The magnificence of Georgian landscapes is in the wild, untamed nature of their beauty. It is also one of the very few places in Europe where one can still witness and appreciate the tenacity and courage of people who do not merely survive, but “live with” the land, with the nature that is both generous and unforgiving.
Of course, we almost always accept as inevitable the sacrifice of “tradition” for “progress”. Most of the time, it is difficult to tell whether the changes we are going through are for the better or for the worse. In particular, it may depend on what people perceive to be the “core” of their identity. Our feeling is that Georgians as a people have been formed to a great extent by the freedom, the wilderness, and the power of their mountains. Any successful and smart approach to developing the tourism industry would take into consideration these important cultural aspects as well.
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Development Programs and Security in Afghanistan
This policy brief summarizes the results of recent research which studies the effect of a development program in Afghanistan on the security situation there. We use a large-scale randomized field experiment to examine the effect of the largest development program in Afghanistan on the economic wellbeing of villagers and their attitudes toward the government and the security situation. We find that implementation of the program leads to significant improvement in villagers’ economic wellbeing as well as in their attitudes towards the government. The program also leads to an improved security situation in the long run. However, these positive effects on attitudes and security are not observed in districts with high levels of initial violence.
Development programs have long been used to promote economic and political development. In recent years, however, they have assumed yet another role: they have been used to promote security in countries fighting fierce insurgencies, such as Afghanistan and Iraq. The approach contends that such projects, which are commonly used by the domestic government and allied entities to provide basic services and infrastructure, improve economic outcomes, build support for the government, and ultimately reduce violence as sympathy of the population for the insurgency wanes. The idea of using development projects as a counter-insurgency strategy is becoming more and more influential and now constitutes a major component of the new U.S. counterinsurgency doctrine (U.S. Army/Marine Corps, 2006).
The study tests whether this approach works in the context of the National Solidarity Program (NSP) in Afghanistan. NSP is the largest development program in the country and has already brought almost $1 billion in aid to more than 26,000 Afghan communities. Under the supervision of the program communities elect a council, which assumes responsibility for implementing infrastructure projects (e.g. building wells or repairing roads) that are chosen by the villagers and are funded by block grants from the NSP.
To measure the effects of the program, the study uses a field experiment conducted in 500 villages across 10 Afghan districts spanning all parts of the country except for the southern provinces, where security levels were insufficient for the study to be carried out. The experiment divided the villages randomly into two groups of the same size, one of which received the program in autumn 2007, while the other group was to receive the program four years later. Before the start of the program the villages in these two groups were virtually identical, so their comparison over the course of these years shows the effect of the program on the life of village communities. The study uses the results of the extensive survey conducted in these villages two years after the start of the program as well as military information on security incidents around the villages during this period.
Our findings indicate that NSP has a strong positive effect on people’s economic wellbeing and on their attitudes towards the Afghan government (both at the central and local level). NSP also appears to improve attitudes toward NGOs and, to some extent, coalition forces on the ground. Respondents in NSP villages have significantly more positive attitudes toward government figures at almost all levels, including district and provincial governors, central government officials, the President of Afghanistan, Members of Parliament and government judges. Magnitude of effects varies from between 8 percentage points for Members of Parliament to 4 percentage points for the national police. NSP also has a positive effect on the attitudes of villagers toward NGOs and soldiers of the International Security Assistance Force (ISAF). The results for the summary measure indicate that NSPs improve villagers’ attitudes by 13 percent of a standard deviation. However, results for the two eastern districts, which experienced high initial levels of violence, are completely different. There is no positive effect of NSP on attitudes toward any government bodies, ISAF soldiers, or NGOs, and the effect on attitudes towards many figures is, in fact, significantly negative.
The results also indicate that villagers have more positive perceptions about security in NSP villages. There is no evidence, however, that the program affects the number of security incidents around villages recorded by NATO coalition forces (ISAF) in the short run (the first 15 months after the start of the program) or the number of security incidents reported by villagers in the survey. However, NSP does reduce the probability of security incidents in the long-run. The probability that a security incident will occur in one- and ten-kilometer radius around a village is smaller in treatment villages by 2 and 4 percentage points, respectively. For a three-kilometer radius, the probability is lower by 2 percentage points, but not statistically significant. In the two eastern districts, the short-run effect is similar to the average effect, but there are no statistically significant differences between treatment and control villages in long-run effects.
Overall, the empirical evidence suggests that strategies for winning the “hearts and minds” through the provision of development projects are working, but only in relatively secure regions. The development program improves the attitudes of the civilian population toward the government and makes them more likely to think that the government is working in their best interest, which in turn makes them less likely to support the insurgents. The fact that we observe the effect on security only in the long run suggests that support for the government reduces violence mainly by reducing the number of people willing to join the insurgents, rather than by increasing the population’s willingness to share information with the government. The results also suggest that development programs can prevent the spread of violence in relatively secure regions, but they are not effective in reducing violence in regions that are already experiencing significant security problems.
Overall, the results suggest that the benefits of development programs are not limited to the provision of direct economic and social benefits. They can also contribute to long-term sustained development by preventing the spread of violent internal conflicts, which are the core problem in many developing countries.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
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Are Natural Resources Good or Bad for Development?
Natural resources undoubtedly play an important role in the economy of many countries. Whether their contribution to development is positive or negative is, however, a contested and difficult question. Arguably countries like Australia, Botswana and Norway have gained enormously over long periods from their natural resources, others like Azerbaijan, Kazakhstan and Russia have gained in economic growth terms but maybe at the expense of institutional development, while in some countries, such as Angola and Sierra Leone, natural resources have been at the heart of violent conflicts with devastating effects for society. With many developing countries being highly resource-dependent a deeper understanding of the sources and solutions to the potential problem of natural resources is highly relevant. This brief reviews the main issues and points to key policy challenges for turning resource rents into driver rather than a detriment for development.
Is it good for a country to be rich in natural resources? Superficially, the answer to this question would obviously seem to be “yes”. How could it ever be negative to have something in addition to labor and produced capital? How could it be negative to have something valuable “for free”? Yet, the answer is far from that simple and one can relatively quickly come up with counterarguments: “Having natural resources takes away incentives to develop other areas of the economy which are potentially more important for long-run growth”; “Natural resource-income can cause corruption or be a source of conflict”, etc.
Looking at some of the starkest cases, the “benefits” of resources can indeed be questioned. Take the Democratic Republic of Congo for example. It is the world’s largest producer of cobalt (49% of the world’s production in 2009) and of industrial diamonds (30%). It is also a large producer of gemstone diamonds (6%), it has around 2/3 of the world’s deposits of coltan and significant deposits of copper and tin. At the same time, it has the world’s worst growth rate and the 8th lowest GDP per capita over the last 40 years.[1] The picture for Sierra Leone and Liberia is very similar – they possess immense natural wealth, yet they are found among the worst performers both in terms of economic growth and GDP per capita. While the experiences of countries such as Bolivia and Venezuela are not as extreme their resource wealth in terms of natural gas and oil respectively seem to have brought serious problems in terms of low growth, increased inequality and corruption. When one, on top of this, adds that some of the world’s fastest-growing economies over the past decades – such as Hong Kong, South Korea and Singapore – have no natural wealth the picture that emerges is that resources seem to be negative for development.
These are not isolated examples. By now, it is a well-established fact that there is a robust negative relationship between a country’s share of primary exports in GDP and its subsequent economic growth. This relationship, first established in the seminal paper by Sachs & Warner (1995) is the basis for what is often referred to as the resource curse, that is, the idea that resource dependence undermines long-run economic performance.[2]
Based on the World Development Indicators database (World Bank). Primary exports consist of agricultural raw materials exports, fuel exports, ores and metals, and food exports.
At the same time, there are numerous countries that provide counterexamples to this idea. Being the second largest exporter of natural gas and the fifth largest of oil, Norway is one of the richest world economies. Botswana produces 29% of the world’s gemstone diamonds and has been one of the fastest-growing countries over the last 40 years. Australia, Chile, and Malaysia are other examples of countries that have performed well, not just despite their resource wealth, but, to a large extent, due to it.
Given these examples the relevant question becomes not “Are resources good or bad for development?” but rather “Under what circumstances are resources good and when are they bad for development?. As Rick van der Ploeg (2011) puts it in a recent overview: “the interesting question is why some resource-rich economies [.] are successful while others [.] perform badly despite their immense natural wealth”. To begin to answer this question it is useful to first review some of the many theoretical explanations that have been suggested and to see what empirical support they have received. Clearly, our overview is far from complete but we think it gives a fair picture of how we have arrived at our current stage of knowledge.[3]
Theories and Evidence
The most well-known economic explanation of the resources curse suggests that a resource windfall generates additional wealth, which raises the prices of non-tradable goods, such as services. This, in turn, leads to real exchange rate appreciation and higher wages in the service sector. The resulting reallocation of capital and labor to the non-tradable sector and to the resource sector causes the manufacturing sector to contract (so-called “de-industrialization”). This mechanism is usually referred to as “Dutch disease” due to the real exchange rate appreciation and decrease in manufacturing exports observed in the Netherlands following the discovery of North Sea gas in the late 1950s. Of course, the contraction of the manufacturing sector is not necessarily harmful per se, but if manufacturing has a higher impact on human capital development, product quality improvements and on the development of new products, this development lowers long-run growth.[4] Other theories have focused on the problems related to the increased volatility that comes with high resource dependence. In particular, it has been suggested that irreversible and long-term investments such as education decrease as volatility goes up. If human capital accumulation is important for long-run growth this is yet another potential problem of resource wealth.
The empirical support for the Dutch disease and related mechanisms is mixed. Some authors find that a resource boom causes a decline in manufacturing exports and an expansion of the service sector (e.g. Harding and Venables (2010)), others do not (e.g. Sala-i-Martin and Subramanian (2003)). But even the studies that do find evidence of the Dutch disease mechanism, usually do not analyze its effect on the growth rates. In principle, Dutch disease could be at work without this hurting growth. Another problem is that the Dutch disease theory suggests that natural resources are equally bad for development across countries. This means that the theories cannot account for the great heterogeneity of observed outcomes, that is, they cannot explain why some countries fail and others succeed at a given level of resource dependence. The same goes for the possibility that natural resources create disincentives for education. Gylfason 2001, Stijns (2006) and Suslova and Volchkova (2007) find evidence of lower human capital investment in resource-rich countries but the theory cannot explain differences across (equally) resource-rich countries.
As a result, greater attention has been devoted to the political-economic explanations of the resource curse. The main idea in recent work is that the impact of resources on development is heavily dependent on the institutional environment. If the institutions provide good protection of property rights and are favourable to productive and entrepreneurial activities, natural resources are likely to benefit the economy by being a source of income, new investment opportunities, and of potential positive spillovers to the rest of the economy. However, if property rights are insecure and institutions are “grabber-friendly”, the resource windfall instead gives rise to rent-seeking, corruption and conflict, which have a negative effect on the country’s development and growth. In short, resources have different effects depending on the institutional environment. If institutions are good enough resources have a positive effect on economic outcomes, if institutions are bad, so are resources for development.
Mehlum, Moene and Torvik (2006) develop a theoretical model for this effect and also find empirical support for the idea. In resource-rich countries with bad institutions incentives become geared towards “grabbing resource rents” while in countries where institutions render such activities difficult resources contribute positively to growth. Boschini, Pettersson and Roine (2007) provide a similar explanation but also stress the importance of the type of resources that dominate. They show that if a country’s institutions are bad, “appropriable” resources (i.e., resources that are more valuable, more concentrated geographically, easier to transport etc. – such as gold or diamonds) are more “dangerous” for economic growth. The effect is reversed for good institutions – gold and diamonds do more good than less appropriable resources. In turn, better institutions are more important in avoiding the resource curse with precious metals and diamonds than with mineral production. The following graph illustrates their result by showing the marginal effects of different resources on growth for varying institutional quality. Distinguishing the growth contribution of mineral production in countries with good institutions with the effect in countries with bad institutions, the left panel shows a positive effect in the former and a negative one in the latter case. The right-hand panel illustrates the corresponding, steeper effects when isolating only precious metals and diamond production.
Even if these papers provide important insights and allow for the possibility of similar resource endowments having variable effects depending on the institutional setting, two major problems still remain. First, the measures of “institutional quality” are broad averages of institutional outcomes (rather than rules).[5] Even if Boschini et al. (2007), and in particular Boschini, Pettersson and Roine (2011) test the robustness of the interaction result using alternative institutional measures (including the Polity IV measure of the degree of democracy) it remains an important issue to understand more precisely which aspects of institutions that matter. An attempt at studying a particular aspect of this question is the paper by Andersen and Aslaksen (2008), which shows that presidential democracies are subject to the resource curse, while it is not present in parliamentary democracies. They argue that this result is due to higher accountability and better representation of the parliamentary regimes.
A second remaining issue is that even if one concludes that the impact of natural resources differs across institutional environments it is an obvious possibility that natural resources have an impact on the chosen policies and institutional arrangements. For example, access to resource rents may provide additional incentives for the current ruler to stay in power and to block institutional reforms that threaten his power, such as democratization. In a well-known paper with the catchy title “Does oil hinder democracy?” Ross (2001) uses pooled cross-country data to establish a negative correlation between resource dependence and democracy.
However, one needs to be careful in distinguishing such a correlation from a causal effect. There are at least two issues that can affect the interpretation: First, there could be an omitted variable bias, that is, the natural resource dependence and institutional environment can be influenced by an unobserved country-specific variable, such as historically given institutions (which in turn could be the result of unobserved effects of resources in previous periods), culture, etc. For the same reason, cross-country comparisons may also be misleading. One way of dealing with this problem is to use fixed-effect panel regressions to eliminate the effect of the country-specific unobserved characteristics. This approach produces mixed empirical results: in the analysis of Haber and Menaldo (2011) the effect of resources on democracy disappears, while Aslaksen (2010) and Andersen and Ross (2011) find support for a political resource curse.
Second, the measures of natural resource wealth may be endogenous to institutions and, in particular, its level of democracy. For example, the level of oil production and even the efforts put into oil discovery can be affected by the decisions of (and constraints on) those in power. Thereby one would need to find instrumental variables that influence the level of democracy only through the resource measures.[6] Tsui (2011) investigates the causal relationship between democracy and resources by looking at the impact of oil discovery event(s) on a cross-country sample. His identification strategy is based on using the exogenous variation in oil endowments (an estimate of the total amount of oil initially in place) to instrument for the amount of total discovered oil to date. The idea is that, while the amount of oil discovered could well be influenced by the institutional environment, the size of the oil endowment is determined only by nature. Tsui’s findings also support the political resource curse story.
There are also numerous studies about the effect of resources on particular institutional aspects and policies. For example, Beck and Laeven (2006) find that resource wealth delayed reform in Eastern Europe and the CIS, Desai, Olofsgård and Yousef (2009) point to natural resource income as central for the possibilities of autocratic governments to remain in power through buying support, Egorov et. al. (2009) show that there is fewer media freedom in oil-rich economies, with the effect being the strongest for the autocratic regimes. Andersen and Aslaksen (2011) find that natural resource wealth only affects leadership duration in non-democratic regimes. Moreover, in these countries, less appropriable resources extend the term in power (in line with the ruler incentive argument above), while more appropriable resources, such as diamonds, shorten political survival (perhaps, due to increased competition for power). Several papers show that in a bad institutional environment natural resources increase corruption (e.g., Bhattacharyya and Hodler (2010) or Vincente (2010)), and reduce corporate transparency (Durnev and Guriev (2011)).
Implications for Policy
Overall the literature points to potential economic as well as political problems connected to natural resources. Even if some issues remain contested it seems clear that many of the economic problems are solvable with appropriate policy measures and in general that natural resources can have positive effects on economic development given the right institutional setting. However, it seems equally clear that natural resource wealth, especially in initially weak institutional settings, tends to delay diversification and reforms, and also increases incentives to engage in various types of rent-seeking. In autocratic settings, resource incomes can also be used by the elite to strengthen their hold on power.
Successful examples of managing resource wealth, such as the establishment of sovereign wealth funds that can both reduce the volatility and create transparency and also smooth the use of resource incomes over time, are not always optimal or easily implementable. Using the money for large investments could be perfectly legitimate and consumption should be skewed toward the present in a capital-scarce developing setting (as shown by van der Ploeg and Venables, 2011). But no matter what we think we know about the optimal policy it still has to be implemented and if the institutional setting is weak the problems are very real. This is just because of potentially corrupt governments but also due to the difficulty to make credible commitments even for perfectly benevolent politicians (see e.g. Desai, Olofgård and Yousef, 2009).
Many political leaders in resource-rich countries have pointed to the hopelessness of their situation and have expressed a wish to rather be without their natural wealth. Such conclusions are unnecessarily pessimistic. Even if it is true that the policy implications from the literature more or less boil down to a catch-22 combination of 1) “Resources are bad (only) if you have poor institutions, so make sure you develop good institutions if you have resource wealth” and 2) “Natural resources have a tendency to impede good institutional development”, there are possibilities. Some countries have succeeded in using their resource wealth to develop and arguably strengthen their institutions. Even if it is often noted that Botswana had relatively good institutions already at the time of independence, it was still a poor country with no democratic history facing the challenge of developing a country more or less from scratch. And at the time of independence, they also discovered and started mining diamonds which have since been an important source both of growth and government revenue. This development has to a large part been due to good, prudent policy.
There is nothing inevitable about the adverse effects of natural resources but resource-rich developing countries must face the challenges that come with having such wealth and use it wisely. The first step is surely to understand the potential problems and to be explicit and transparent about how one intends to deal with them.
References
- Andersen, J. J. and Aslaksen, S., 2008. “Constitutions and the resource curse.” Journal of Development Economics, Volume 87, Issue 2.
- Andersen, J. J. and Aslaksen, S., 2011. “Oil and political survival.” mimeo.
- Andersen, J. J. and Ross, M., 2011, “Making the Resource Curse Disappear: A re-examination of Haber and Menaldo’s: “Do Natural Resources Fuel Authoritarianism?”.” mimeo.
- Aslaksen, S., 2010. “Oil and Democracy – More than a Cross-Country Correlation?,” Journal of Peace Research, vol. 47(4).
- Beck, T., and Laeven, L., 2006. “Institution Building and Growth in Transition Economies.” CEPR Discussion Paper 5718, Centre for Economic Policy Research:London.
- Bhattacharyya, S., and Hodler, R., 2010. “Natural resources, democracy and corruption” European Economic Review, Elsevier, vol. 54(4).
- Boschini, A.D., Pettersson, J. and Roine, J., 2007. “Resource curse or not: a question of appropriability” Scandinavian Journal of Economics, 109.
- Boschini, A.D., Pettersson, J. and Roine, J., 2011. “Unbundling the resource curse” mimeo.
- David, P. A., and Wright, G.. 1997. “The Genesis of American Resource Abundance” Industrial and Corporate Change 6.
- Desai, R. M., Olofsgård, A. and Yousef, T., 2009. “The Logic of Authoritarian Bargains” Economics & Politics, Vol. 21, Issue 1.
- Durnev, A. and Guriev, S. M., 2011. ”Expropriation Risk and Firm Growth: A Corporate Transparency Channel.”, mimeo
- Egorov, G., Guriev, S. M. and Sonin, K., 2009. “Why Resource-Poor Dictators Allow Freer Media: A Theory and Evidence from Panel Data.” American Political Science Review, Vol. 103, No. 4.
- Gylfason, T., 2001. “Nature, Power, and Growth” Scottish Journal of Political Economy, Scottish Economic Society, vol. 48(5).
- Gylfason, T., Herbertsson, T. T., and Zoega, G., 1999. “A mixed blessing” Macroeconomic Dynamics, 3.
- Findlay, R. and Lundahl M., 1999. “Resource-Led Growth: A Long-Term Perspective.” Helsinki: World Institute for Development Economics Research.
- Frankel, J. A., 2010 “The Natural Resource Curse: A Survey.” HKS Working Paper No. RWP10-005.
- Haber, S. H. and Menaldo, V. A., 2011. “Do Natural Resources Fuel Authoritarianism? A Reappraisal of the Resource Curse.” American Political Science Review, Vol. 105, No. 1.
- Harding, T. and Venables, A.J., 2011. “Exports, imports and foreign exchange windfalls.” mimeo.
- Hausmann R., Hwang J. and Rodrik, D., 2007. “What you export matters.” Journal of Economic Growth, Springer, vol. 12(1).
- Leite, C. A. and Weidmann, J., 1999. “Does Mother Nature Corrupt? Natural Resources, Corruption, and Economic Growth.” IMF Working Paper No. 99/85.
- Mehlum, H., Moene, K. and Torvik, R., 2006. ”Institutions and the resource curse.” Economic Journal, 116.
- Montague, D., 2002. “Stolen Goods: Coltan and Conflict in the Democratic Republic of Congo.” SAISReview – Volume 22, Number 1, Winter-Spring, pp. 103-118
- van der Ploeg, F., 2011. “Natural Resources: Curse or Blessing?.” Journal of Economic Literature, American Economic Association, vol. 49(2).
- van der Ploeg, F. and Venables, A. J., 2011. “Harnessing Windfall Revenues: Optimal Policies for Resource-Rich Developing Economies.” Economic Journal, Royal Economic Society, vol. 121(551).
- Ross, M.L., 2001. “Does Oil Hinder Democracy?” World Politics, 53(3).
- Sachs, J. D. and Warner, A. M., 1995. “Natural Resource Abundance and Economic Growth.” NBER Working Papers 5398, National Bureau of Economic Research, Inc.
- Sala-I-Martin, X., Doppelhofer, G. and Miller, R. I., 2004. “Determinants of Long-Term Growth: A Bayesian Averaging of Classical Estimates (BACE) Approach.” American Economic Review, American Economic Association, vol. 94(4).
- Sala-I-Martin, X., and Subramanian, A., 2003. “Addressing the Natural Resource Curse: An Illustration from Nigeria.” NBER Working Paper 9804.
- Stijns, J.-P., 2006. “Natural resource abundance and human capital accumulation.” World Development, Elsevier, vol. 34(6).
- Suslova, E. and Volchkova, N., 2007. “Human Capital, Industrial Growth and Resource Curse.” Working Papers WP13_2007_11, Laboratory for Macroeconomic Analysis, HSE.
- Torvik, R., 2009. “Why do some resource-abundant countries succeed while others do not?”, Oxford Review of Economic Policy, vol. 25(2).
- Tsui, K. K., 2011. “More Oil, Less Democracy: Evidence from Worldwide Crude Oil Discoveries.” The Economic Journal, 121.
- Vincente, P., 2010. “Does Oil Corrupt? Evidence from a Natural Experiment in West Africa,” Journal of Development Economics, 92(1).
- Wright, G., 1990. “The Origins of American Industrial Success, 1879-1940.” American Economic Review 80.
Footnotes
[1] Based on World Development Indicators database (World Bank).
[2] Its robustness has been confirmed in, for example, Gylfason, Herbertsson and Zoega (1999), Leite and Weidmann (1999), Sachs and Warner (2001) and Sala-i-Martin and Subramanian (2003). Doppelhoefer, Miller and Sala-i-Martin (2004) find that the negative relation between the fraction of primary exports in total exports and growth is one of 11 variables which is robust when estimates are constructed as weighted averages of basically every possible combination of included variables.
[3] The interested reader should consult more extensive overviews such as Torvik (2009), Frankel (2010) or van der Ploeg (2011).
[4] This assumption has been criticized by, for example, Wright (1990), David and Wright (1997), and Findlay and Lundahl (1999) who all point to historical examples where resource extraction has been a driver for the development of new technology. On the other hand others, e.g. Hausmann, Hwang and Rodrik (2007), provide evidence that export product sophistication predicts higher growth.
[5] The distinction between using institutional outcomes rather than institutional rules has been much debated in the literature on the importance of institutions in general. It is, for example, possible for a dictator to choose to enforce good property rights protection even if this is something typically associated with democracy.
[6] The studies by Boschini, Pettersson and Roine (2007) and (2011) also use instrumental variables to try to account for the potential endogeneity problems. The results are in line with the OLS results but instruments are weak in this setting.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
Whither Legal Turkey?
With the ascent to power of the AKP and its political victory against the secular elite and as the country is about to draft its first civilian constitution, the party’s leadership faces a daunting challenge to transform the country into a real democracy for minorities as well as majorities. The legacy of the party’s leadership will not be determined by its win against a system rigged against them, but how they transform an authoritarian and arbitrary legal system into extended rights for, amongst others, the country’s ethnic Kurds, women, and political rivals. This requires more than a new constitution and will be the real test of whether Turkey can serve as a model for the region or not.
A Sick Man No More
Turkey was once referred to as the ‘Sick Man of Europe’, plagued by financial turmoil, erratic growth, and territorial contraction. Today, it is among the twenty largest countries in the world both economically as well as population-wise, and remains one of few Muslim democracies. While Europe has been undergoing a financial crisis, Turkey has been growing at an unprecedented rate, leading the Economist to label it as ‘The China of Europe’.
Among the Arab countries, Turkey is also increasingly seen as a viable model of combining Islam and democracy, and many have lauded the government for its assertion of civilian control over state institutions. A recent triumphant tour of Egypt and Libya by Turkey’s Prime Minister blurred the distinction between official state visit and celebrity tour.
Yet Turkey’s leaders need all the political capital they can acquire, as steep challenges remain domestically. Whether Turkey can be a model for the rest of the Muslim world will be determined by whether its leadership can solve the remaining political and social injustices. Currently, these are exasperated by an outdated and authoritarian legal system and arbitrary enforcement of existing laws.
From White to Black
During the last two decades, Turkey has experienced something very rare. Historically, power emanated primarily from the country’s security establishment – the judiciary and the military – educated in the country’s elite schools and trained in a Kemalist creed where religious and non-Turkish identities had no place in the public sphere (that is, unless they were secular and Turkish). In the media, this group is often referred to as the ‘White Turks’.
The constitution set up in 1982, following a military coup two years earlier, put security and stability ahead of individual rights and cemented institutions with limited accountability to the public. The need to preserve the state’s security interests allowed for heavily regulated political participation among those deemed threatening to the state, be it Islamists, leftists, or those seeking increased Kurdish autonomy.
Weak coalition governments changed with the season, the debate captured by leaders powerful enough to hinder political rivals from affecting real policy while powerless or unwilling to do so themselves. Human rights abuses, especially in Eastern Turkey provided ample fuel for critics of Turkey’s prospects for EU membership.
Today, the ‘White Turks’ are nearly gone − a democratically elected majority government, made up largely of pious Muslims from the periphery of Turkey, is in power. The President, Abdullah Gül, is from Kayseri, the birthplace of the ‘Anatolian tigers’, a group of successful and piously Muslim entrepreneurs. The Prime Minister, Recep Tayyip Erdoğan, stems from (what was) one of the poorer neighborhoods in Istanbul, and spent time in jail for reciting what the judiciary deemed to be an inflammatory poem. Both men have wives wearing the headscarf, which for the secular elite is what a red rag is to a bull.
After a decade-long conflict between the moderately Islamist Justice and Development Party (AKP) and the secular elite, the former seems to have come out on top. Earlier this year the top brass of Turkey’s military corps resigned en masse following unprecedented arrests of senior military officers related to allegations of plotting a military coup. A constitutional amendment passed last year now allows military personnel, including those involved in the 1980 coup, to be tried in civilian courts and has revamped the appointment procedure of parts of the judiciary. A significant portion of all Turkish officers is currently in jail for conspiring against the AKP government.
With power consolidated behind them, the AKP leadership has their work cut out. While the Turkish model is already being lauded as a role model for the Arab spring countries, within the country significant challenges and injustices remain. Deep institutional reform is required to accommodate a people more than deserving of an open and free society. Full political and economic rights need to be further extended to women, religious minorities, as well as the country’s large Kurdish population. The justice system, especially the Turkish Penal Code needs to be altered to rid it of remnants of the authoritarian system that the AKP government claims to be dismantling. A new constitution is needed in which the state serves the people and not the other way around. Finally, Turkey needs more than new laws; it needs enforcement of, and compliance with, the rule of law in what would be an institutional change not seen since the birth of the republic.
In the name of terrorism…
In a recent survey of anti-terror convictions by the Associated Press in more than 100 countries, Turkey accounted for a third of all convictions. The Turkish state has long been at odds with a large Kurdish minority seeking greater autonomy and has been engaged in a war with the Kurdistan’s Worker’s Party (PKK) since the late 1980s.
The political system is currently rigged against Kurdish political representation, largely because of an extreme rule requiring any party to win at least 10 percent of the national vote to receive any parliamentary seats at all. Kurdish candidates not banned before elections regularly are afterwards and many end up in jail.
Despite the AKP’s attempt at a Kurdish Opening, and the sizeable Kurdish representation within the party, results have come up below expectations and large-scale protests remain commonplace in the region. Due to the Turkish Penal Code allowing anti-terror laws to govern the legal cases of protesters, this creates a source of regular condemnation from human rights organizations.
For example, not only can protesters sympathetic to Kurdish rights be prosecuted for spreading propaganda for a terrorist organization (Article 7/2, Anti-Terror Law), but also many are deemed to be “committing crimes on behalf of the PKK without being a member of that organization” (Article 220/6, Turkish Penal Codes). Consequently, demonstrators for Kurdish rights can be prosecuted as if they were actually fighting the government as armed members of the PKK (Article 314/2, TPC). When added to charges from the Law on Demonstrations and Public Assemblies, this could mean sentences of up to thirty years in jail. Child protesters usually receive much shorter sentences, often between four to five years.
Laws like these have profound effects on press freedom. According to a report by the Organisation for Security and Co-operation in Europe, Turkey has the dubious honor of being the world leader in imprisoned journalists. The report estimated somewhere between 700 and 1,000 ongoing proceedings that could lead to imprisonment of journalists. The length of sentences are occasionally astronomical; Vedat Kurşun and Emine Demir of the Azadiya Welat newspaper were sentenced to 166 and 138 years respectively in prison, while Bayram Namaz and Ibrahim Çiçek of the Atilim newspaper each face up to 3,000 years in prison. Some journalists, such as Halit Güdenoğlu of Halit Yürüyüş magazine, currently face 150 court cases.
At the same time, after 10 years of failing to reach convictions of leading members of the notorious Turkish Hizbullah, an Islamist militant group (unrelated to its Lebanese namesake), several of its leading members were released from custody earlier this year. The organization is thought to be responsible for the deaths of hundreds of people during the mid-1990s during the worst years of the conflict between the PKK and the Turkish state. Evidence suggesting covert state backing for the group’s fight and tactics against the PKK has not led to any serious consequences. The suspects were released in compliance with a new law restricting the amount of time suspects can be held while waiting for the final verdict in their cases to 10 years.
As if this was not ironic enough, the ten years of detainment without trial is now being used against the secular elite; officers, academics, journalists, former police chiefs, public prosecutors, and theologians alike. In two of the most controversial legal cases in Turkish history, around 500 individuals have been detained. Prosecutors in the Ergenekon investigation accuse detainees with membership of what is described as a clandestine terrorist organization seeking to destabilize the country’s Islamist-leaning government. In the Sledgehammer investigation, high-ranking members of the military stand accused of plotting a coup in 2003. Explained by the government as instrumental to the dismantling of the so-called “deep state”, the cases are increasingly criticized for the flawed, if not fabricated, evidence put forward by the prosecutors.
As noted by many observers, the detainees seem to have nothing in common except their opposition to the AKP government, as well as a social movement referred to as the Gülen movement. The actions of the prosecution approached that of a farce when earlier this year police raided the prospective publisher of a book about the the Gülen movement, written by detained journalist Ahmed Sik, and proceeded to delete every digital copy of the manuscript. The 12th Court for Serious Crimes described the draft as an “illegal organizational document” and ruled anyone refusing to hand in a possessed copy would be accused of “aiding a criminal organization.” Weeks later, seven theologians were arrested, and computers and documents were confiscated. The sole similarity between the theologians seems to have been their questioning of Gülen’s credentials as a theologian.
The independence of the judiciary is also under pressure. In 2007, a regional public prosecutor, Ilhan Cihaner, had started investigating links between Islamist organizations and the fixing of state contracts. After refusing to drop his investigations in late 2009 after pressure from the government, Cihaner was removed from his position and on February 17 2010 he was arrested and charged with membership of Ergenekon.
The Elephant in the Room: Women’s rights
Several of Turkey’s laws are also simply not enforced. Examples of this are laws regulating women’s rights. Despite a “Law 4320 on the Protection of the Family”, women’s de facto situation remains highly vulnerable – “enforcement officers, judges, and prosecutors neglect their duties, often due to lack of expertise or will to deal with cases of violence against women and girls”.
A recent survey by Hacettepe University reported that around 42 percent of all women older than 15 in Turkey—approximately eleven million women in total—have experienced physical or sexual violence at the hands of a husband or partner at some point in their lives.
Women who want to report abuse are turned away, and in some cases have been murdered despite having obtained protection orders. The law requires women’s shelters in every settlement above 50,000 inhabitants yet more than a hundred are still missing.
In the 2010 Gender Gap Report from the World Economic Forum, Turkey scored a rank of 126 out of 134 countries surveyed, behind its neighbors Iran, Syria, and Egypt. There are two main components that drove this abysmal performance in gender equality. The first is labor force participation; according to World Bank female labor force participation was a meager 24 percent in 2009 (on par with Saudi Arabia, Syria, and Egypt and below the rate found in Iran).
The second component is upper secondary education (high school), since this is where the combination of voluntary participation and the headscarf ban keeps many conservative families from sending their daughters to school. Almost a hundred years after Ataturk imposed a reform making primary education mandatory for women, gender inequality in education and labor remains one of the more serious impediments to Turkey’s future economic development.
The ban on the headscarf, especially in universities, a remnant of an increasingly archaic ideology, stands out as the unequivocal symbol of gender inequality. However, improving women’s rights and economic opportunities is about more than the headscarf – for example, making upper secondary education mandatory would be another less politically charged road ahead. But in order to further women’s participation in public institutions such as the labor force, education, and politics, political leaders need a pragmatic approach in outmaneuvering a deeper resistance to female emancipation.
Turkey needs more than a new constitution…
One of the AKP’s campaign promises of the recent June elections was the drafting of a new constitution. The political capital gained by the AKP in its fight with the military as well as its role as a model in the Muslim world, provides a unique opportunity to, for the first time, set up a civilian constitution that does away with many of the autocratic elements of the 1982 constitution.
A formal document with principals such as asserting the primacy of individual rights over the state is much needed. But without deeper reforms that seep into the justice system and the security establishment, this will simply become another superficial reform without real implications.
As long as the Turkish Penal Code and the anti-terror laws can be used in an arbitrary manner to pursue political opponents; be it Islamists, secular elites, or Kurds; constitutional reform will fail to bring about real change. Until real independence from political pressure is granted to judges and journalists alike, Turkey will not know freedom of expression. And without real change in female participation in markets and institutions, Turkey will not know gender equality. An age-old saying in Turkish goes “Happy is he who can call himself a Turk.” If only it was that easy.
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Further Reading
- Acemoglu, Daron, Simon Johnson, and James Robinson, 2005, “Institutions as the Fundamental Cause of Long-Run Growth”, Handbook of Economic Growth, Elsevier, edition 1, Vol. 1, No. 1.
- Duflo, Esther, 2005, “Gender Equality in Development”, BREAD Policy Paper.
- Jenkins, Gareth, 2009, “Between Fact and Fantasy: Turkey’s Ergenekon Investigation”, Silk Road Paper
- Hacettepe University Institute of Population Studies, ICON-Institute Public Sector GmbH, and BNB Consulting, “National Research on Domestic Violence against Women in Turkey 2008”, January 2009, http://www.ksgm.gov.tr//tdvaw/doc/Mainreport.pdf
- Human Rights Watch, “Protesting as a Terrorist Offense – The Arbitrary Use of Terrorism Laws to Prosecute and Incarcerate Demonstrators in Turkey”, Human Rights Watch Report, November 1st 2010, http://www.hrw.org/reports/2010/11/01/protesting-terrorist-offense-0
- Human Rights Watch, “He Loves You, He Beats You – Family Violence in Turkey and Access to Protection”, Human Rights Watch Report, May 4 2011, http://www.hrw.org/en/reports/2011/05/04/he-loves-you-he-beats-you-0
- World Economic Forum, The Gender Gap Report 2010, http://www3.weforum.org/docs/WEF_GenderGap_Report_2010.pdf