Development Bank Research Bulletin

Monetary policy simulation game

Do you want to test your skill as a central banker? The Swiss National Bank -- the central bank of Switzerland -- has created a monetary policy simulation game called MoPoS, and you can try your skills without doing too much damage to our economy.

The game program can be downloaded from here

And an instruction guidebook is also available in a pdf file.

MoPoS (short for: Monetary Policy Simulation Game) is a computer game which lets the player act out the role of a fictitious central bank by implementing monetary policy in a simple virtual economy. The purpose of the game is to give the player a feel for the options and limitations of monetary policy.

There is, however, no connection whatsoever between MoPoS and the monetary policy conducted by the Swiss National Bank.

On the one hand, no special background knowledge is necessary to play the game, which has been designed for interested lay persons as well as pupils and students. Since, on the other hand, it allows the model specifications (monetary policy regulation, parameter values, shock characteristics) to be altered at will, informed users will also find numerous forms of application. MoPoS was developed by former National Bank economist Yvan Lengwiler.

Czech Republic to overtake East Germany in seven years

What could explain why East Germany, with all the rule of law and administrative integrity in place, plus 1 trillion euro of subsidy, is soon going to be overtaken by Czech Repbulic (in gdp per captia) which is plagued by rampant "looting" and "no law and no finance"? Labor market inflexiblity is the key.

The economic transition in the East Bloc is always said to be a failure. Rapid convergence didn’t happen, income level stagnates, reforms and polices are wrong... Nevertheless, to give a fair judgment, we need to find a proper benchmark, because otherwise we don’t know how things otherwise would have evoled.

For Czech Republic, the perfect benchmark is East Germany. Before taken over by the communists, The Czech lands (Bohemia and Moravia) were at similar level of economic development as what later became Democratic Republic of Germany. Four decades later, at the time of communism’s collapse, Czech was poorer than East Germany. East Germany is bigger than Czech (population: 16 million vs. 10 million at the time of transition), but not much bigger. They are not only neighbors, share a lot of historic background, but also similar in industrial structure (as a result of Soviet planning) at the time of transition.

What did East Germany get afterward?  East Germany got pretty good institutions (legal system, political system, business environment) in place in short period of time, , rapid transfer of knowledge and know-how from fellow Germans from the West through training and transfer programs, efficient banking sector as a result of the direct takeover of East German Bank by more efficient Frankfurt banks, and on top of all these, one trillion Euro of fiscal transfer to finance massive public investment in equipment and infrastructure.

With all of these perfect advantage, East Germany was supposed to be converge to living standard in the West pretty soon and further widened the gap with its Easter neighbor the Czech Republic.

In the Czech Republic, in contrast, legal system is not functioning, “looting” was rampant among corporate managers in the midst of mass privatizations, business environment is plagued by corruption and bureaucracy red-tape, inflation was high and fiscal policy was not working for most of the 1990s, financial system was in bankruptcy until foreigners start to take over some of them......and not to forget, there is no "West Czech Republic" that can inject one trillion Euros.

All of these contracts will forecast East Germany’s rapid and certain dominance of Czech Republic in terms of economic growth and rising GDP per capita.

The results in hindsight however contract such predictions made back then. Yes, Now East Germany is still some 15% richer than Czech Republic (note that East Germany started richer), but the trend in the past seven years or so will project that with another seven years, the Czech Republic is going to take over East Germany in terms of GDP per capita, if Czech Republic continues to growth at 3.3% /year while East Germany at 1.0%/year.

The reason, as Professor Jennifer Hunt (McGill University) suspects is rooted in the labor market in East Germany.  East Germans are half as productive as their Western counterparts, but with the slogan “The same pay for the same work” they are demanding the same level of salary.  In 2003, although Eastern GDP per capita was only 67% of the western level, disposable income per capita was already 82% of the western level.  Western firms thus would rather expand their facilities in the West to serve the new consumer market in the East, instead of employ workers in the East.

It is certainly a good and attractive slogan that everyone gets the same pay, but when you are not as good as others (at least at this moment before you go through some skill training), demanding the same level of wage as the smarter people are getting can only give you two results: (1) unemployment; why would employers (except the public sector) want to pay more to get less. (2)  lower paid and dirty jobs that people in the West don’t want to do; so you are segregating yourself by your own decision. As an old communist-era axiom in the Czech Repubic goes: "We pretend to work, and they pretend to pay us". True in East Germany now.

The whole plot was conspired by the labor unions in the West, which got higher wage pact for their comrades in the East. The true intention was to price out East German workers from the market, not to show solidarity!

Reference:

Jennifer Hunt: Is the transition in East  Germany as success?  (pdf file)

What do surveys tell us on how to win Latin America’s soul?

As the Economist magazine features in “The battle for Latin America's soul”, Latin American countries one by one is falling into hands of populists who oppose to economic reforms. It thus becomes an urgent question how market economy and economic reform can win Latin America’s soul again?

Ugo Panizza and Monica Yanez from the Inter-American Development Bank recently published a paper titled “Why are Latin Americans so unhappy about reforms?” in which they looked into the  Latinobarometro survey, which was conducted yearly in Latin American countries since 1996, for answers.

They use the opinion surveys to document discontent with the pro-market reforms. They explore  four possible sets of explanations for this discontent: (i) a general drift of the populace’s political views to the left; (ii) an increase in political activism by those who oppose reforms; (iii) a decline in the people’s trust of political actors; and (iv) the economic crisis.

What they find  is that the macroeconomic situation plays an important role in explaining the dissatisfaction with the reform process, while the other factors are not important. 

Detailed research of the survey data show that even if in 1997 100% of people belong to the center right, while in 2002 100% of them convert to extremist left, the support for reform will only go down by 9%. This means that even such an extreme assumption of drift to the left can only explain one third of the actual drop in support for reforms.

The survey results also show that increasing political activism of the leftists or decline in the trust of political actors cannot explain the drop in support for reforms

The single most important factor is the economy. Drop of GDP growth by one percentage point can reduce support for reforms by 1.1%. In the case of Argentina, growth rate dropped by 21 percentage points  between 1997 and 2002, which would predict a drop in support for privatization equivalent  to 23 percentage point.

In Latin America, countries experiencing crisis usually fall into vicious cycle.  When the economy performs badly or experiences a crisis, it becomes much easier for populists to get into power and halt economic reforms. Without reforms the country cannot gain real competiveness internationally, and the political situation becomes self-reinforcing as the economy deteriorate further (sometimes several years can be saved with high oil price, but then the pain will be felt harder when oil price drops).

Economic and employment growth is the only criteria voters use to evaluate reforms, and they usually don’t give you second chance. Reformists need to think more about the stability consequence of the reforms they propose, because “one strike, you are out”. Better do it slowly but safely.

Reference:

Why are Latin Americans unhappy about reforms?

When labor has a voice, everyone suffers! According to a new research

Michael Moore has long been fighting for workers’ rights to have a voice in managing corporations. “We can do it too!” he always argues.

Professors  Olubunmi Faleye, Vikas Mehrotra, and Randall Morck did a study on the consequence of labor control and paint a rather sad picture for us on what will happen.

They find that:
“Relative to other firms, labor-controlled publicly-traded firms deviate more from value maximization, invest less in long-term assets, take fewer risks, grow more slowly, create fewer new jobs, and exhibit lower labor and total factor productivity. We therefore propose that labor uses its corporate governance voice to maximize the combined value of its contractual and residual claims, and that this often pushes corporate policies away from, rather than towards, shareholder value maximization.”

When labor has a voice in corporate governance, a corporation actually creates fewer new jobs!

This is good for those already in the union shop as their jobs are secure and they don't care about other Americans. But this is absolutely bad and unfair for other hard-working Americans.

Think twice before buying into the idea that all workers are brothers for one another! For unionized workers, the size of the pie is fixed; they will be mad at you when you, a hardworking young worker more eager and better equiped for the job, wants to “steal” their lunch.

Reference:
When Labor Has a Voice in Corporate Governance, (PDF file)  forthcoming in the Journal of Financial and Quantitative Analysis, alos covered by MIT Sloan Management Review

Does the new labor law really harm French youth? Who actually take to Paris streets? The truth is...

French are  taking to streets protesting. Why? They say they are protesting against a newly passed law that gives employers the right to fire workers under the age of 26 during their first two years on the job. They are outraged as it sounds that it gives the right to employers to fire people at their will. For them, it is like “What? You passed a law giving capitalists the right to kill people.....”

What does the law really do?

If I am an employer, and I am (under the old law) not given the right to fire a worker once I hire him; What will I do when making hiring decisions?  First, I am very reluctant to hire any one, as I fear that I may be burdened by him in case the demand for my products turns out lower than expected. Second, I will prefer hire an elder and more experienced worker, as I can know his quality from his previous career. As a result, under previous French labor law that making firing very difficult, unemployment is high and in particular for young people without any working experiences.

The new law is addressing exactly this problem. They give the right to employers to fire young workers under the age of 26 during their first two years on the job. Now I am more comfortable in hiring new and young workers. First, I can hire him when sales are rising and fire him when demands are low. (Note that previous I won’t hire this person in the first place); Second, I am willing to try out a young worker, because compared to an elder worker, it is easier for me to fire him if he turns out to be of low quality.  Thus the law will give many people the change of a first job. This is why the law is known as First Job Contract (The Contrat Premiere Embauche, or CPE)

Many workers are outraged by the word “fire”. But think about it: you can only be fired if you are hired in the first place. If you are unemployed, a law that protects you from being fired is meaningless.  Let me ask you: would it be a great thing if we pass a law permitting people to get anything from grocery stores for free? Isn’t it great? But in that case grocery shops will be empty and shopkeepers will move away and you would starve and cry outside the shops, and the law is meaningless for you. I don’t think I need to elaborate on another example such as passing a law exempting everyone from paying back credit card debts. Does it mean that then you will get unlimited credits from banks?

Why do they take to streets and who are they?!

Now you understand that the law actually helps unemployed young people? But why do they take to streets? French are smart people and they should have already figured out what I say. Yes, they do! And that’s exactly why they don’t take to streets. Ironically, It is another group of people that are protesting, those who are over 26, educated , or unionized. Hey, the “victims” are staying home, why are you instead in such a  hurry?!

As rightly pointed out by a BusinessWeek article,

“The students involved in the most recent demonstrations against the CPE are the ones least likely to be affected by it. That's because university students in France are often nearly 26 by the time they complete their studies. Relatively few would thus fall under the law's purview. Similarly, many of the trade unionists and civil servants protesting the CPE are also unlikely to ever be affected by it because they already have extremely strong job protection. Indeed, the French youth who might benefit the most from the CPE, the immigrant and first-generation youth that burned the suburbs of Paris last year, are rarely seen or heard from in the fevered demonstrations about CPE. "To a certain extent," notes Six, "It's the wrong kids marching in the street."

Now their motive is clear:  it is not about protecting the relatively unskilled young people, it is about protecting their own turf. Under the new law, unskilled young people will be given more chances by employers in trying their first jobs, threatening the job positions of elite college students and trade unionists. When the old law made firing workers very difficult, employers usually prefer experienced workers (who are already unionized) or college graduaes who demonstate their quality by being admitted into colleges and having managed through graduation. Under the new law, everyone is equal, and employers can check out who are of higher quality. Elite college students and unionists do not like this. It's that simple.

It is perfectly understandable that people protest against legislative changes that negatively affect their own interest. But by cheating? By claiming that you are protesting on behalf of those who you actually want to get rid of? Give me a break.

Is Stiglitz more moral than others? Are government interventions really better?

Joseph Stiglitz argues in his book "Globalization and its discontents" that governments under some circumstances (i.e. in the presence of market failure) can improve economic outcome by well-chosen interventions. But how can you be so sure that governments will select “well-chosen” interventions, and who are going to be the judges on what are “well-chosen” and what are not. Theoretically Stiglitz is absolutely right (in that there are market failures), but in practices no one can agree on what are “well-chosen” unless there is an omnipotent angle who can plan our welfare benevelently (but we know that all government officials are human beings!).

In a book review of Stiglitz’s “Globalization and its discontents”, Harvard professor Benjamin M. Friedman very insightfully point out that the main flaws of Stiglitz’s accusation (of pro-market polices)  lie in his selective memory and his ignoring of counterfactuals. Basically, Stiglitz keeps on mentioning several successful cases of economic miracles where government interventions may play a helpful role, while remains outright silent on vast majority of other cases where government interventions created disasters. No one say that market economy is perfect. But as Churchill puts it, democracy is certainly not the best system, but it is at least not the worse. The same logic applies to market economy: when evaluating the outcome of a decision, you ought to assess it in relation to the plausible counterfactual alternatives, i.e. will things get worse or better under an alternative route. Otherwise you may reach a conclusion that all doctors are bad because their patients are all sick. I am sure the patients will not be sick unless they see doctors; they will simply die.

Let me cite some words from Professor Friedman’s book review article, which I like very much:

“A more fundamental problem, as Stiglitz readily acknowledges, is that we cannot reliably know whether the consequences of the IMF's policies were worse than whatever the alternative would have been. Many longtime observers of the developing world will notice that Stiglitz rarely mentions economic policy mistakes that poor countries make on their own initiative. Nor does he pay much attention to the large-scale corruption that is endemic in many developing economies—except in the case of corruption in Russia, where he argues that the privatization program pushed by the IMF opened the way for corruption on a historically unprecedented scale. He also never points out that the typical developing country spends far more on its military forces (to fight whom?) than it receives in foreign aid; yet it would seem necessary to take account of such wasteful expenditures, along with graft in all its forms, if one is to give a clear picture of why the non-developing economies are not succeeding.”

Stiglitz in his book also accuses that IMF officials are insensitive to poor people. He observes that IMF officials tend to meet only with finance ministers and central bank governors, as well as with bankers and investment bankers; they never meet with poor peasants or unemployed workers.

To answer him, let me quote Dr. Gregory House’s famous answer in the TV Series House M.D. , when asked why he never tries to meet and talk with patients (he only make diagnoses based on medical test results. )

He calmly addresses the question: Do you want a doctor who will hold your hands when you are dying, or a doctor who walk away from you when you are recovering?

To solve real problems, good intentions are not sufficient. In many cases, disaster are created by people with good intentions, as well as by hypocritical people who assume they command moral heights. We need someone who exhibit actions in helping poor people, instead of someone who repeats to you day by day how he cares about you and how others do not care about you.

Please also check out my previous commentary on Stiglitz's book review of Friedman's "Moral Consequences of of Economic Growth".

Chinese Dream: inequality of prosperity vs. equality of poverty

There are a lot of concerns about China’s income disparity between costal provinces and inland provinces. Let me show you why we shouldn’t worry TOO MUCH about it (we do need to worry about it though, and we definitely need to come up with solutions; but don’t’ worry too much or go against natural laws).

Some stylized facts for our readers:

50% of World's population and 67% of World's GDP are within 100 KM of an ocean or a river that is navigable as far as the sea. In Japan, 97% of population live within 100 KM of coast. In Europe, 89%, live within 100 KM of coast or ocean-navigable waterway. The ratio is 65% for the United States.

Thus it is natural that income disparity will always exist between costal region and inland of China, because you are naturally disadvantaged if you reside in inland areas.

You will certainly question me: why is the income disparity that huge in China then? Americans residing in inland are relatively poor but the gap is not as large as that is found in China.

The reason is population density. Starting more than 1,000 years ago, Chinese migrated westward and southward for new lands, and eventually the population density in these new-found lands becomes as high as where Chinese were originated. So long as the population density in inland region is higher than what its geography can support, you will have lower standard of living there; At least you have to try much harder.  American inland income level will go down substantially too if Mountains states have to support the same level of population density as in New England. There can only be several Las Vegas.

The only solution to this is migration of labor, as well as increase of accommodation capacity in already densely-populated costal area through better planning.  In Japan, the government does manage to increase population density in Tokyo bay area without compromising too much in environmental protections.

For the past twenty years, high geographic and social mobility in China has been a great weapon in combating poverty and social unrest. 

Believe it or not, most of China’s middle class and new rich were born in inland countryside. They left their stifling hometown and headed for costal cities.  There are few opportunities in inland usually not because of high transport costs. It is more a culture thing, that inland people are relatively isolated and have less exchange with outsiders, as a result, through generation after generation’s cultural reinforcement, they become  less open-minded and less flexible, which is very bad in today’s commercial world.  Many inland Chinese who get successful in cities are unwilling to return because they really hate the gossiping and equalitarian culture back in their hometowns. Such culture really kills talented people.

Some leave by attending colleges in cities, thanks to the standardized college entrance exam which is probably the last area of the system that is not yet corrupted. Even the most totalitarian emperors in Chinese history dared not to abort or corrupt the exam system, because by doing so you are closing the route of social mobility and you are calling for grassroots uprisings.

Those who are less intelligent usually start  as laborers in construction sites in big cites, save some money, start small businesses, grow bigger. They are advantaged because they are more hard-working than those born in cities, and can take any pains in the process (what kind of pains and humiliations can be greater than returning to their hometowns without getting rich)

Whichever routes they take, they settle in cities, and within one generation of sacrifice they place their children on the same starting point as those who were born in cities. We talk about American dream, and this is Chinese dream!

We rarely notice such high social mobility in China because once these country folks settle in cities they blend with the other people and most of them are unwilling to reveal their original roots. Most of them deep down still feel inferior. 

This doesn’t matter though, so long as the system has provided paths for inland people to step up the social ladder.  It is the fact that most senior officials in all levels of government and businessmen in the Forbes list of richest Chinese were born in countryside.

World Bank’s “ World Development Report 2006: Equity and Development” calls for equality, but isn’t inequality of wealth through personal hardworking more beautiful than equality of poverty through government intervention.

World Bank president Jim Wolfonson realizes this too, and write down some important caveats in the introduction page in case the message of the book get mis-interpreted.

"The history of the twentieth century is littered with examples of disastrous policies which were promoted in the name of equity or equality, and the results of which were ruinous. No policy that pursues equity without respecting market-based individual incentives for prosperity is likely to succeed. The joint pursuit of equity and prosperity must therefore be cognizant of the primacy of individual freedoms, and of the role of markets in allocating resources"

What determine turnovers of China’s provincial bosses? Evidence from historical data

It is widely believed that personnel decisions within China’s bureaucracy system are all based on connections, office politics, and dirty techniques. Serious examination of historic data reveals that the system is more sophisticated and meritocratic than it seems to be.

Professors Hongbin Li and Li-An Zhou at the Chinese University of Hong Kong study turnover data of top provincial chief in China between 1979 and 1996, and find that the likelihood of promotion of provincial leaders increases with their economic performance, while the likelihood of termination decreases with their economic performance.

Obviously, the central government uses such institutionalized rule to promote desirable local economic outcomes. They also find that the central government always evaluates the average performance over the provincial boss’s whole tenure rather than the performance in the year when the decisions were made.

GDP-based promotions have the negative side. The fastest way to push up GDP is through public investment, while the last thing you need to care is pollution. This is exactly why the central government is recently emphasizing the so-called "Green GDP".

They published the findings in the Journal of Public Economics, a top journal in the field.

Political Turnover and Economic Performance: The Incentive Role of Personnel Control in China
Abstract: In this paper, we provide empirical evidence on the incentive role of personnel control in post-reform China. Employing the turnover data of top provincial leaders in China between 1979 and 1995, we find that the likelihood of promotion of provincial leaders increases with their economic performance, while the likelihood of termination decreases with their economic performance. This finding is robust to various sensitivity tests. We also find that the turnover of provincial leaders is more sensitive to their average performance over their tenure than to their annual performance. We interpret these empirical findings as evidence that China uses personnel control to induce desirable economic outcomes. Our study adds some basic evidence to a growing theoretical literature emphasizing the role of political incentives of government officials in promoting local economic growth.

Indian state-owned banks introduce performance-linked incentive packages for employees: the true story

According to a report in today’s Business Standard, India’s finance ministry decided on a reform plan to improve efficiency in state-owned banking sector. In the plan, not only the chairmen and executive directors but also ordinary employees are entitled to  performance-linked incentive packages.

“Heads of 29 public sector banks are set to get a performance-linked annual incentive package. Besides, all of them will get a lumpsum ex-gratia payment on retirement, depending on the number of years they put in as directors on bank boards.  Down the line, close to 800,000 employees in the public sector banking industry, too, will get incentives, based on their performance in five key areas.”

Five parameters are considered to determine the size of annual bonus,  which includes “credit growth, deposit mobilization, quality of assets, and recovery of non-performing assets.” (The report mentions only four parameters though).

I don’t think such design can help achieve the efficiency goal.

First of all, credit growth and deposit mobilization has nothing to do with efficiency; to the contrary, for India, faster credit growth and deposit mobilization  in state-owned banks actually reduce financial stability and crowd out efficient investment (as state-owned banks typically use the deposits to purchase government bonds instead of to invest in good projects).

Secondly, the “incentive” package is not linked to individuals’ performance but the performance of the whole bank. No employees will work hard to improve quality of assets or to recover non-performing loans, because (1) if he works hard, his colleagues in all branches across India can free-ride on the results as well (2) if he doesn’t work hard, he can still receive bonus pay so long as his colleagues work hard (3) knowing this, no one work hard.

There are restrictions on the total size of the incentive package: “The maximum amount a bank can pay to employees through this route will be capped at 1 per cent of a bank’s profit after tax (PAT).”  Nevertheless, no details are given regarding what fractions of this 1 per cent will be allocated to ordinary employees. Theoretically, all of them may be allocated to the CEO, which did happen in many corrupted countries when they introduced so-called “employee” incentive package. As a matter of fact, I also notice that: “Financial incentives given to chairmen and executive directors will be outside the cap (1 per cent of PAT) applicable to bank employees.”  Ha, I caught you!

I speculate that the plan is drawn up simply for the purpose of legally tunneling money from the state treasury to chairmen and executive directors of state-owned banks.

No regulations are unbeatable, not even China’s one-child policy

Economists have long told us that people respond to incentives! Given proper incentives, you will be amazed by the kind of genius solutions people can come up with. No regulations are unbeatable, because the people and businesses you are regulating are always more-motivated than employees in regulatory agencies, and they will always be able to find some ways to avoid the regulations. Sometimes, it takes the form of bribery, in the others genius and absolutely legal solutions.

China: Drug bid to beat child ban
SHANGHAI, China (AP) -- More Chinese women are exploiting easy access to fertility treatments to skirt China's one-child limit, leading to a boom in numbers of multiple births, an official newspaper reported Monday. The main pediatric hospital in the eastern city of Nanjing recorded 90 births of twins or triplets last year, up from an average of 20 in past years, the China Daily said.

Genius solution notwithstanding, Isn’t it better for people to spend their time and talent in more productive activities (well, certainly having more children is also a “productive” activities) than in avoiding regulations.

Wherever there is a regulation, there is always some way to circumvent it, and this is how tax codes in the United States accumulate to thousands of pages of long, and Americans wastes tens of billon of dollars just to avoid them. By some estimation, it is actually better off for the society if American tax officers are corrupted because you may spend less money bribing them than hiring tax advisors, and in both cases American government won't recieve your money anyway.