Reagonomics – A Flashback

These days’ people are still thinking or hesitating to take some major economics steps like tapering, increasing interest rates etc… By seeing and analyzing the current scenario I remembered a strong head economist cum politician, former U.S. president, Mr. Ronald Reagan.

The economic policies which he used are popularly known as Reagonomics. He had a simple, but specific plan, of which he spoke often during the campaign: cut taxes, get control of government spending and get the government out of the way so that the entrepreneurial spirit of the American people could be unleashed. Some skeptics derisively called his plan “Reaganomics,” but President Reagan was undeterred.

Many economist and many leaders, across the globe, was amazed and surprised by the way he carried out the economic policies, administration and put U.S. economy on track in short span.

It was the most serious attempt in U.S. to change its economic policy of administration since the New Deal. "Only by reducing the growth of government," said Ronald Reagan, "can we increase the growth of the economy."

His program (in 1981) of Economic recovery had four major policy, they are

1. reduce the growth of government spending,
2. reduce the marginal tax rates on income from both labor and capital,
3.  reduce regulation, and
4.  reduce inflation by controlling the growth of the money supply.

He believed that this in turn will increase savings and investment, increase in economic growth, balance the budget, restore healthy financial markets, reduce inflation and also interest rates..

In August 1981, President Reagan signed the Economic Recovery Tax Act of 1981, which brought reductions in individual income tax rates, the expensing of depreciable property, incentives for small businesses and incentives for savings. So began the Reagan Recovery. A few years later, the Tax Reform Act of 1986 brought the lowest individual and corporate income tax rates of any major industrialized country in the world.

The numbers tell the story. Over the eight years of the Reagan Administration:

• 20 million new jobs were created
• Inflation dropped from 13.5% in 1980 to 4.1% by 1988
• Unemployment fell from 7.6% to 5.5%
• Net worth of families earning between $20,000 and $50,000 annually grew by 27%
•  Real gross national product rose 26%
•   The prime interest rate was slashed by more than half, from an unprecedented 21.5% in January 1981 to 10% in August 1988

During a G7 Economic Summit, the West German Chancellor asked him to “tell us about the American miracle” (Before two years, when he outlined his economic recovery plan these group of world leaders were unconvinced) As President Reagan observed with a wry smile, “I could tell our economic program was working when they stopped calling it Reaganomics”

Today many economist and politicians are more skeptics about taking some bold steps while economy is still quivering.  No doubt current scenario and situation may not be same; but taking decisions boldly can send a right signal to the economy to the take it to the next level.  This is where I admire Reaganomics.  Let us wait and watch how the policy makers do take decisions in coming days.

Sources: 

1. http://www.econlib.org/library/Enc1/Reaganomics.html
2. http://www.reaganfoundation.org/economic-policy.aspx

A Small Note on Fiscal Balance

What is fiscal Balance?  

           

The balance of a government's tax revenues (plus any proceeds from asset sales) minus government spending is called fiscal balance. This is also called as Government Budget Balance, Public budget balance, or Public fiscal balance (for convenient purpose let us keep as fiscal balance). When the balance is positive then the government has a fiscal surplus, if negative then fiscal deficit.

The fiscal balance is further classified into Primary balance and Structural Balance (also known as cyclically-adjusted balance).

What is Primary Balance?

The primary balance is government budget balance before interest payments. In simple terms fiscal balance minus interest payments gives us primary balance.

What is Structural Balance?

Structural balances are an extension of cyclically adjusted balances, correcting for a broader range of factors such as asset and commodity prices and output composition effects.

The need for calculation of structural balance: 

In order to assess the fiscal sustainability the adjustment of fiscal balances for the output cycle is really crucial and needed. There is no single method is considered as the appropriate adjustment method for adjusting fiscal balance. The appropriate adjustment method depends on country specific factors, data availability, fiscal regime and the economic structure of the country.

Source: IMF Fiscal Monitor, 2013.

Note: Interest rate as a percentage is difference between primary balance (which is not given in the above table) from overall balance. The Bolded numbers are Percent of GDP for Advanced Economies as a whole and EME’s as a whole             

If one read the table carefully, then one can see that emerging markets are doing better compared to developed economy (all data are for the year 2012).          

                              

Note:  In many European countries, they have set an independent body to carry out the study of fiscal balance and they are called Fiscal councils. In India it is not easy to calculate the structural balance due to multiple factors mentioned above.

Is Subsidies are Bad?

We all come across the term subsidies more often. I would like to pen down here about the basic things about subsidies.

1.  What is Subsidy? What are the main Objectives of Subsidies?

Answer: The most general definition – It is an assistance to an economic sector or any business for producers. Subsidies lead to changes in demand/ supply decisions by means of creating a wedge between consumer prices and producer costs.

Many of these subsides are set in place by the Government for producers or distributed as subventions in an industry in order to prevent decline of that particular industry or for an increase in prices of its products or simply to encourage it to hire more labour (as in the case of wage subsidy)

These are often aimed at:

1. Inducing higher consumption/ production
2. Offsetting market imperfections including internalisation of externalities;
3. Achievement of social policy objectives including redistribution of income, population control, etc.

2.  What are the Economics effects of Subsidies?

Answer:  Economic effects of subsidies can be broadly grouped into

1. Allocative effects: these relate to the sectoral allocation of resources. Subsidies help draw more resources towards the subsidised sector
2. Redistributive effects: these generally depend upon the elasticities of demands of the relevant groups for the subsidised good as well as the elasticity of supply of the same good and the mode of administering the subsidy.
3. Fiscal effects: subsidies have obvious fiscal effects since a large part of subsidies emanate from the budget. They directly increase fiscal deficits. Subsidies may also indirectly affect the budget adversely by drawing resources away from tax-yielding sectors towards sectors that may have a low tax-revenue potential.
4. Trade effects: a regulated price, which is substantially lower than the market clearing price, may reduce domestic supply and lead to an increase in imports. On the other hand, subsidies to domestic producers may enable them to offer internationally competitive prices, reducing imports or raising exports.

            Source: Wikipedia

Now comes one of the important question

3. Whether Subsidies are really bad? 

Answer: If you ask an economist then he would answer Yes Subsidies are bad. I would like to quote here from an article by Kenneth P. Green on energy policy. It explains why subsidy in any form is bad policy.

First, subsidies breed corruption. They don’t create incentives for honest people that already have a market-worthy product — such people can already sell their goods into the market easily.

Rather, subsidies create a fertile garden for rent seekers who are unable to sell their goods competitively in a free-market, and prefer to tap the coercive and redistributionist force of government to lever their uncompetitive good into the market at the public’s expense.

Rather than contribute to overall social welfare by giving consumers the best goods at the least cost, or even maximizing the efficient use of people’s taxes, rent-seekers undermine social welfare by foisting inferior or over-priced goods onto the market while taking money from people that could be used for other important purposes.

This is a particular problem in countries with relatively weak property rights regimes, and countries with legal institutions insufficient to prevent it.

He further states that,

Subsidies subvert the efficient functioning of the market, which is our only effective mechanism for matching supply with demand. Free trade of a given good is, as economics tells us, the only way to determine efficiently how much of that good is desirable at a given price.

                    Source: http://www.american.com/archive/2012/august/subsidy-powered-vehicles

In 2011, Delivering the P N Haksar Memorial lecture here, Subbarao, Governor of RBI, said, "In charting a roadmap for fiscal consolidation, we need to be mindful of the quality of fiscal adjustment-- which is to weed out unproductive expenditure and protect growth promoting expenditure," he said.

Sharing his thoughts on subsidies in his address on 'rejigging the Elephant Dance: Challenges to Sustaining the India Growth Story, Subbarao said, "There are bad subsidies and there are good subsidies".

"Bad subsidies like fuel subsidy, subsidy on LPG may be Rs 300 but every time you buy LPG you are getting subsidy to the extent of Rs 300. Not only you, Mr Birla, Mr Ambani, every time they buy a cylinder, they will also get subsidy," he said.

"Then there is fertiliser subsidy...soil degradation happens because of fertiliser subsidy and thereafter irrigation subsidy," he said.

Subbarao said there were good subsidies as well, like giving cycles to girls to come to school and constructing toilets for girls in schools located in villages. "These are good subsidies," he asserted.

Source: http://ww.inwdianexpress.com/news/subsidies-are-bad-d-subbarao/880519

So there are few subsidies which are good, but, most of the subsidies are bad may be due to ineffective management and political reasons.

Currency War – A Small Note

If any one who is following the Exchange Market news closely then those people would have come across this term “Currency War”.  Many news targets on China while US, Japan, UK themselves are also involved in the war silently.  I would like to put few links here which talks about the present currency wars:

1. Why China fears currency wars

2. Central Banks Pause, but 'Currency War' Not Over

3. Currency Wars 2013: China Takes Aggressive Stance On Currency Tension With Japan, As Yen Sinks To New Low Against The US Dollar

4. Currency Wars Have Begun: Central Banks in Denial or Worse

5. China warns over fresh currency tensions

Now back to the topic. Here I am going to start with the basics and then going to give some historical facts

What is currency War?

The Currency war is nothing but Competitive Devaluation.   The Competitive devaluation is a situation in International Affairs where countries compete with each other in order to achieve relatively low exchange rate for their currency.

Who Coined the Term Currency War?

The term “Currency Wars” was coined by Brazils Finance Minister Guido Mantega in 2010 in order to describe how Federal Reserve’s Quantitative easing was pushing up other countries currencies. He also pointed out the effort made by the United States and China to keep their currencies at the lowest value.

What is devaluation? What is the difference between devaluation and Depreciation?

When a government or its central bank deliberately make downward adjustments to its currency in foreign exchange market then it is known as devaluation. This largely happens in fixed exchange rate regime. Depreciation occurs when a currency loses its value due to market forces.

Why one should care or worry about devaluation (or Currency War)

The Currency War will lead to instability. Nations who succeed in devaluation often experience inflation, especially, when they are dependent on imports. While those nations which do not involve in currency war will experience higher unemployment since their export sectors will lose competitiveness (read above article no. 5 for more info). 

Some Historical facts

When one look at the history then the popular method of devaluation was reducing the intrinsic value of precious metals content in minted coinage; example the Roman Empire faced constant threats from barbarians, but they lacked finance to defend themselves, so successive emperors reduced the silver and copper contents in coins.

When Fiat Money came into existence (where the value is purely based on laws rather than intrinsic value of the content) government started simply print bank notes in large quantities. After the First World War Wiemar Germany went to print huge volumes of German Mark in order to cover its expenses which resulted to hyperinflation on a massive scale.

This is a small note on Currency Wars which may lead to serious economic crisis across the globe. 

Some Basic Economics Lessons - Fiscal Deficit

      The Standard & Poors (S&P’s) had recently downgraded U.S. in their credit rating from AAA to AA+. After a week of the downgrade, Deven Sharma, then the president of S&P’s, got fired from the post (even though many newspapers quoted that he had step down) .
         

    The S&P’s report stated that “We have lowered our long-term sovereign credit rating on the United States of America to 'AA+' from 'AAA' and affirmed the 'A-1+' short-term rating.” It also stated further that “ The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.”
                

     Many people criticised the downgrade of the U.S. credit rating and few people supported the downgrade of U.S. credit rating with statement that it is due to growing fiscal deficit in U.S.. Of course, it will be a very interesting topic do an analysis on the latter part and one can write a good article on it. But, that's not going to be done here now.

      Now let's go to the basic lesson and see what does fiscal deficit means, its components and what does it indicate to us?

    Fiscal deficit is an economic phenomenon, when Governments total expenditure exceeds its revenue. In simple terms, it is the difference between government's total receipts (excluding borrowing) and total expenditure. There are two primary component of Fiscal Deficit; they are Revenue Deficit & Capital Expenditure.

    Revenue deficit is defined as the actual net amount received (i.e. revenue minus expenditure) fails to meet the projected (or predicted) net amount to be received. In other words, when the actual amount of revenue received and/or the actual amount of expenditures do not tally with the projected revenue and expenditure figures. Capital Expenditure is famously known as CAPEX. It is the expenditure incurred for creating future benefits. In simple terms, the expenditure incurred to create physical assets like buildings, machineries, equipment’s, property etc.... A capital expenditure is incurred when the money is spent on either to buy fixed assets or to add to the value of an existing fixed asset.

    Fiscal deficit is an indicator to the government, about the total borrowing requirements from all sources.

Fiscal Deficit in India:

       In India, the fiscal deficit is financed by obtaining funds (money) from Reserve Bank of India (this is also called as deficit financing). The fiscal deficit is also financed by obtaining funds from the money market (primarily from banks). As per RBI Annual Report, the Fiscal Deficit for the year 2010-11 (Revised Estimates) is 7.7% (combined – Centre (5.1) and State (2.6)); whereas the Budget Estimates for 2011-12 is expected to be 6.8% (Centre - 4.6% & State - 2.2%)  

    

    

Quantitative easing - An Historical Perspective

Earlier I had already provided definition of Quantitative Easing (QE) (see October 11, 2010 post). Here I would like to share some historical background of Quantitative Easing. When we look wikipedia about QE it describes that "The original Japanese expression for "quantitative easing" , was used for the first time by a Central Bank in the Bank of Japan’s publications. The Bank of Japan has claimed that the central bank adopted a policy with this name on 19 March 2001."  I became puzzled to see that  how can a concept like QE can be a new thing.

After some research on the topic, found the Truth the quantitative easing is not a new concept or evolution of any concept. CPS (Centre for Policy Studies, UK), has published a Paper on QE by George Trefgarne.  In that paper George Trefgarne says that QE  "QE is not a new idea. It was originally pioneered in this country by a Tory administration over 200 years ago, which in response to a banking crisis, flooded the system with funds, by printing money. QE is merely a fancy expression to describe the modern, technical aspects of that process."

I am also puzzled to see the wikipedia definition of QE as a recent one, despite the fact that QE is also used during Great Depression of 1930's. Richard G. Anderson in his paper (published in Monetary Trends) said that  "During 1932, with congressional support, the Fed purchased approximately $1 billion in Treasury securities (half, however, was offset by a decrease in Treasury bills discounted at the Reserve Banks). At the end of 1932, short-term market rates hovered at 50 basis points or less. Quantitative easing continued during 1933-36. "

You can give a new term for a concept, but, concept like QE cannot be new at all. These are some historical Fact which I came to know on the road of unearthing QE.

What is a Currency War?

Recently in many newspaper/ channels we would have come across the term Currency War. What (exactly) is a Currency War? It is a writers term (Currency war),  for economist it is well known as competitive devaluation. It  is a condition in international market's where countries compete against each other in order to achieve a relatively low exchange rate for their home currency, which will help their domestic industry to perish.

Normally at a certain period or given time, any given currency exists in a global markets is determined by supply (how much of a currency exists) and demand (how much investors want to buy goods and assets denominated in that currency).  A country can make its goods and services more "cheaper" (some may say more competitive, because its cheaper) in the global market by devaluing its currency. 


The devaluation of a currency can be made in number of ways, say, from Quantitative Easing (QE) (printing more money - by doing so there will be greater the supply of its own currency, which, would result in the less value it tends to be) to Buying of another Country's Debt (more the demand for another country's currency, the more valuable it tends to be).

QE is a practice, when a central bank tries to mitigate a potential or actual recession by creating money and injecting it into the domestic economy (so that they can avoid inflation once the economy improves). 

QE to devalue a country's currency indirectly in two ways. First, it will encourage the speculators to bet that the currency will decline in value. Secondly, the large increase in the domestic money supply will lower the domestic interest rates, which will become much lower than the prevailing interest rates compared to the countries which are not practicing quantitative easing.

When a country's currency falls in value, its exports usually grow, because its goods and services becomes much cheaper on the global market. Which will benefit the export of the country and boost the domestic as well as the global market and thus achieving economic stability.

(For More info:  click here and for History of Currency War)

(Refernces: Wikipedia and Investopedia)