Crisis Talk - The World Bank Group

The Ukrainian Tax Administration's Response to the Crisis

It is widely known in Ukraine that the performance of the State Tax Administration (STA) is assessed by the volume of collected tax revenues, which is tracked on a monthly and annual basis. It is these figures that matter, and not the level of taxpayer service or public opinion. A new year has just started and the STA is already asking the Government to reduce the targets on tax revenues for 2009, which are the same as last year for company profit tax and slightly higher for VAT.

The STA argues that the targets are unrealistic considering the general decline in production and trade, the reduction of exports, etc. The signal is clear – we should prepare for hard times and the STA doesn’t want to be a poor performer, with a culture that demands the set targets should be exceeded, a heritage coming from the Soviet past.

This last decade tax revenues have been growing from year to year, based on a natural tendency of inflation and GDP growth. 

Living in a Madoff World

Editor's Note: Arshad Sayed is World Bank Country Manager in Ulaanbaatar, Mongolia. 

Madoff made off with billions, Nassim Taleb kept sighting unseen Black Swans, and the global economy has been in a tailspin. Meanwhile, I have been ensconced on the Mongolian Steppe. It's so far from it all that the approaching recession looked impenetrable – until now.

The prices for Mongolia’s major export, copper, and the herder’s main sources of livelihood, cashmere and meat, are in free fall. Why?

What unleashed this financial maelstrom that threatens to besiege my neighbor’s lives seemingly so disconnected from those at the center of it on Wall Street? As I look for answers there is no shortage of raison d’êtres.

Aid to the Suffering World

William Easterly, of The White Man's Burden fame, has just started a blog on the market for development aid. His first entry discusses president Zoellick's recent proposal to have a small percentage of stimulus packages in the West be dedicated to aid for developing countries. Easterly argues that besides being unrealistic, this proposal does not offer any increased responsibility for how the money would be used. Read on.

Financial Sector Wages

There is a lot of irritation currently about salaries and bonuses in the financial sector, especially in light of recent bail-outs. Critics of the exuberance in the financial sector should not worry. According to a new working paper by Thomas Philippon and Ariell Reshef, we can expect a sharp decrease in financial sector salaries in the coming years. This prediction is based on an analysis of the wage and skill development in the U.S. financial sector from 1909 to 2006. Until 1933, the financial sector was a high-skill, high wage industry. After the Great Depression, the financial sector not only lost its high human capital, but also the wage premium compared to the rest of the private sector. It was not until the 1980s that the financial sector became yet again a high-skill and high-wage industry, driven by financial liberalization and innovation.

 

Both in the period from the mid-1920s to the mid-1930s and from the mid-1990s onwards, salaries in the financial sector were not consistent with education levels and employment risk, suggesting short-term rents for financial sector employees and an unsustainable labor market equilibrium. So, expect financial sector salaries to drop, although not immediately as the experience from the Great Depression shows, where it took several years for relative financial sector wages to drop. But given excess wages of 40%, expect big drops! These high excess wages might also explain regulatory failures in the run-up to the crisis; regulators could simply not attract sufficient talent given the high excess compensation in the private sector. So, the next question will be: what about the impact on MBA and Finance programs.

A Broken Record on East Asia

James Seward, a financial sector specialist working in East Asia and Pacific, admits that he is "beginning to sound like a broken record." Unfortunately, he has good reason. Most of the recent news coming out of East Asia does not sound good at all. Seward reports the following scary news on the East Asia and Pacific blog:

Banking problems are now increasingly expected to begin emerging across East Asia. Fitch just released a report that Chinese banks’ expected losses are mounting and projected that the loan losses would be 6 percent or more by end-2009. However, this was hedged by stating that “there are concerns with weaknesses in the banks' loan classification, the rise in hidden credit risk, and uncertainties about the reliability of collateral and guarantees, which may be contributing to widespread under-capturing of Chinese banks' credit risk exposure.” The Chairman of the banking regulator, the China Banking Regulatory Commission, stated that there will be a “reasonable tolerance” for rising bad loans in the banking system this year. Also, the various announcements by governments to push commercial banks into supportive lending may also result in additional problems.

In addition to nascent banking problems, countries across the region are seeing painful declines in trade accompanied by hits to employment. Perhaps most telling, Seward reports that some 1/3rd of crains in Singapore are sitting idle. Trade statistics see a delay of some months - crains don't. As for rising unemployment, the lunar new year is not looking too bright:

...about 10 million migrant workers [in China] lost their jobs by November, and many migrant workers are returning home for the lunar new year on one-way tickets. To round out the bad news on China, in December housing prices dropped for the first time on record and construction is projected to shrink by 30% this year.

Governments across the region continue apace with fiscal stimulus plans. How much of this will take the form of increased spending and how much the form of tax cuts? Seward doesn't offer a breakdown, although the repeated use of the term "infrastructure" suggests that most if not all will be in the form of increased government spending. If this is the case, hopefully these countries won't run into the kind of problems of 'disappearing money' that Simeon Djankov warns about in Bulgaria.

Banking and the State

Ample empirical evidence shows that the state is often a poor banker, both in normal times and crises. This is particularly true in less developed countries. Yet, state ownership is mostly prevalent in those countries. This evidence can be easily forgotten as the crisis unfolds.

Financial crises tend to increase state involvement

The severity of the current financial crisis has raised doubts about market effectiveness. As Mr. Greenspan recently pointed out: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity are in a state of shocked disbelief.” States have intervened in unprecedented ways to address fears of insolvency, aimed at safeguarding stability and restarting lending. Direct interventions ranged from massive capital injections (e.g., in UK and US) to bank nationalizations (e.g., Fortis, Glitnir, B&B). Indeed, bank nationalizations are a common intervention tool: they occurred in 57 percent of recent financial crises and future state involvement can be persistent. For example, during the East Asia crisis, assets of Indonesian state banks jumped from 40 to 60 percent of total bank assets. Korea and Thailand experienced similar increases. In these countries, state involvement was still at elevated levels years after the crisis.

Dire Straits

Hopping into a taxi at Sofia airport, it is as if I go back to the mid-1980s: the radio is playing Pink Floyd's The Wall. I have long noticed a strange regularity about taxis in Bulgaria: they always play 1980s music: Pink Floyd, Scorpions, Queen, Dire Straits. During our latest trip last summer, my wife (an American) noticed this too. So it's not my imagination. I also see this pattern in other countries in Eastern Europe - for example, the Czech Republic, Poland, FYR Macedonia.
 
This is the music I grew up on, so I like it. But I struggle for an explanation. Surely there is some decent music that has come since. And one could go back to the Beatles, the Doors, etc. I can come up with two explanations: either the radio is controlled by people of my generation, who do it for fun; or there is a general sense of nostalgia towards the high years of socialism (before it started crumbling). For the mid-1980s was a fun time, at least in Bulgaria. Full employment, an overall sense of security, good education.
 
I was hoping that for the sake of the region, I would be increasingly limited to listening to The Wall at home. But the unfolding economic crisis may increase nostalgia for the "good old times" and it may be all Dire Straits in the next few months/years.
 
The signs are around. I spoke to a software producer who said that demand for his company's products is down 15% relative to January 2008, and that payments on finished work are down 60%. That is, clients are trying to stretch payments so accounts receivables are accumulating. Some of these presumably will not be paid as clients go out of business. And this is in a sector which is supposed to be among the most crisis-resistant. Imagine what is happening in construction.
 
Fortunately, the music of that age offers some good anti-crisis advice. See, for example, the refrain in Money for Nothing (Dire Straits, 1984):

We gotta install microwave ovens
Custom kitchen deliveries
We gotta move these refrigerators
We gotta move these colour tvs, lord

In other words, increase household consumption. The lyrics stop short of recommending tax vs fiscal stimulus. Unless they are really deep and the title "Money for Nothing" suggests fiscal expansion will be wasted.

When Will Stocks Rebound in Eastern Europe?

Editor's Note: The following is a joint contribution from Simeon Djankov and Facundo Martin. You can also download a PDF of When Will Stocks Rebound in Eastern Europe?

Eastern European stock markets had a traumatic 2008. In several countries, including Bulgaria, Lithuania, Romania and Ukraine, the market indices dropped 75%. In all other countries but Slovakia, stocks lost about half their value.

Will 2009 be different? Do investors have something to look forward to?

Stock market returns depend primarily on the underlying company profits. In emerging markets, these depend on the global economic outlook, as a large share of production goes to foreign buyers. So to know when stocks will rebound, you need to know two things: when the economic downturn will end (both at home and in major export markets), and whether stock prices turn up before or after economic activity picks up.

We study the latest economic forecast by the World Bank to answer the first question. We look at historical data in emerging markets and two developed economies (the United States and the United Kingdom) to answer the second question. In particular, we investigate the relationship between changes in industrial production and changes in stock market indices during previous downturns in six emerging markets (Indonesia, 1997-98; Korea, 1997-98, Thailand, 1997-99; Malaysia, 1997-98; Russia, 1998-99, and Argentina, 2001-02); and the United States (1980-81, 1982-83, 1990-91, and 2001-02) and the United Kingdom (1990-92 and 2001-03).

The Big Dig

Georgi Angelov (Open Society Institute, Bulgaria) alerted me to two interesting blog posts on the deficiencies of large fiscal expenditure projects. One is by Gary Becker (Chicago) and argues that "recessions are a good time to increase infrastructure spending only if these projects can mainly utilize unemployed resources. This does not seem to be the case in most of the so-called infrastructure spending proposed under various stimulus plans." The other post is on a paper by Linda Bilmes (Harvard) looking at the fiscal stimulus in light of Katrina, Iraq and the Big Dig (the largest US infrastructure project, in downtown Boston). The point here is that these projects took a long time to get off the ground, and lots of money was wasted.
 
Cheers to big spenders.

How Useful is Fiscal Spending Really?

If you hire your neighbor for $100 to dig a hole in your backyard and then fill it up, and he hires you to do the same in his yard, the government statisticians report that things are improving. The economy has created two jobs, and the GDP rises by $200. But it is unlikely that, having wasted all that time digging and filling, either of you is better off.

 

This is an example from a fun Gregory Mankiw article in the New York Times. Mankiw's main argument is that expanded government spending is less useful in crises than usually thought. The multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States' historical record, Professor Ramey estimates that each dollar of government spending increases GDP by only 1.4 dollars. So, by doing the math, we find that when the GDP expands, less than a third of the increase takes the form of private consumption and investment.

 

In contrast, a recent study by Christina D. Romer (the Obama appointee to head the Council of Economic Advisors) and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the GDP by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.

 

This is why tax stimulus is starting to be discussed more and more as a good crisis response. To see a recent calculation of how it can work, see my paper Tax Incentives as Crisis Response with Georgi Angelov.

Tomorrow's Trade

Editor's Note: Caroline Freund is a Senior Economist in the Research Department of the World Bank and runs a research project on the effects of the economic crisis on trade.

Tension is developing between trade and employment policies in some countries. The need to reduce costs and improve profits has pushed many companies to restructure production globally, with the result of increased foreign outsourcing. For example, Dell, the world's number two PC maker, recently announced plans to shift manufacturing from Ireland to Poland to cut costs. The monthly minimum wage is over $2,000 in Ireland, compared to $406 in Poland.

Other firms that are reportedly planning to expand outsourcing in emerging markets include: the major entertainment company Warner Brothers, Ireland's Wedgewood, and Japan's Renesas. Financial companies - which already account for about 25 percent of revenues of the large Indian service offshoring companies Infosys and Wipro - are also expected to increase outsourcing to cut costs. This fragmentation of production will help firms improve productivity, while softening the blow of the financial crisis on low and middle income countries, which gain both jobs and technology. The allocation of resources around the world will be improved, leading to gains from trade.

However, government policies are countering this force. The incoming U.S. administration has signaled an end to tax breaks for companies that outsource abroad and promised tax credits to companies that maintain or increase U.S. workers relative to those abroad. In France, state aid will not be offered to
auto companies that plan to shift jobs to lower wage countries. Lou Dobbs, among others, is calling for similar restrictions on a U.S. auto package.

Even without restrictions, industrial subsidies are a threat to trade. They are contagious, and could result in a subsidy war that would leave everyone worse off. (See, for example, a recent article from Jagdish Bhagwati in the Financial Times on this type of scenario.) In addition, they pull resources away from more productive uses. It's not just the industrial countries at fault. Recent trade policy reversals in the developing and emerging markets are also of concern. At least 15 (including Brazil, China, India and Russia) have plans to expand protection in some sectors.

Yes, creating jobs and maintaining income during the downturn is crucial. But this is a global recession. World leaders should choose policies that stimulate domestic demand, without inflicting pain on others.

30 Wise Men

The Group of 30 (a club of top-flight financial thinkers and doers) just released a report called A Framework for Financial Stability that details recommendations on what regulatory and "industrial organization" reforms may be needed. It is a dry read, but has many good ideas. As it is still early days, many ideas are still not detailed enough.

I have been thinking about one issue in particular - why the credit ratings agencies failed so miserably. The Group of 30 says that a new "payment model" should be constructed. In other words, the credit agencies should not depend fully on being paid by the people they evaluate. That sounds right, but an alternative model is not that obvious.

There has been considerable noise about introducing more competition in the sector. The merits of this argument are not that clear, as many of the first victims of the crisis in the US were companies or products which were rated by all 3 agencies. Presumably, these agencies did not collude in producing their ratings, so there was some competition.

The real issue is that this market has not been high-margin, so competition from entry is not present. This is what Andrei Shleifer (Harvard) suggested during a recent visit. In fact, the big 3 credit rating agencies have more or less the whole market and have had it for years. For this to change, other players may need bigger incentives. The crisis may provide just that.

No Trust Left

While most economists are busy discussing the origins of the current crisis, a few are looking ahead. One nice think-piece is by Daron Acemoglu, of MIT, which draws three lessons. I like the third lesson the most:

The third notion that has also been destroyed by recent events is at first less obvious. It is also one that I strongly believed in. Our logic and models suggested that even if we could not trust individuals, particularly when information was imperfect and regulation lacklustre, we could trust the long-lived large firms - companies such as the Enron's, the Bear Stearn's, the Merrill Lynch's, and the Lehman Brothers's of this world - to monitor themselves and their own because they had accumulated sufficient reputation capital. Our faith in long-lived large organisations was shaken but still standing after the accounting scandals in Enron and other giants of the early 2000s. It may now have suffered the death blow.

If right, Acemoglu is onto something big. Trust is essential to business activity, and losing it may result in bigger cataclysms down the road. For those interested in how trust develops, read Trust in Large Organizations, by my co-authors Andrei Shleifer, Rafael La Porta and Florencio Lopez-de-Silanes.

Sustainable Solutions to the Crises in Ukraine

Ukraine has suffered through so many crises lately – political, financial, gas. Where should we be on the lookout for the next one, and how can we work to mitigate it? The financial crisis provides a window of opportunity to consider new possibilities. What kind of solutions will not only get us out of this mess but will prove sustainable well into the future?

One prime candidate for a solution is the energy sector. Simply put, municipal heating in Ukraine is a centralized system that relies on natural gas, whereby hot water is transported long distances through pipelines to apartment blocks. This is a system that is highly costly for many reasons – expensive fuel, huge losses of heat, centralized control, etc.

Although the common thinking is that reforming the existing system is a challenging task for the state in the near or distant future, some forward-looking businessmen have seen it differently. They set up autonomous heating systems for newly built cottages and apartment blocks. Those with the longest-term thinking have already devised ways to offer alternative energy, mainly windmills and solar panels, on the assumption that sooner or later clients won’t be willing to remain dependent on ever-more-expensive natural gas.

Latvia Cuts the Income Tax by 2 Percentage Points

In yesterday's post, we presented a new paper arguing the merits of tax reform as part of the crisis response. An interesting (and sobering) document to read in this regard in Latvia's stand-by agreement with the IMF. Among other crisis measures, Latvia will reduce the personal income tax by 2 percentage points, from 25 to 23% (this is described on page 67).
 
The rationale is to leave more money in the hands of consumers, who will be weathering various hits, including a 25% cut in public wages.
 
As we argued in Tax Stimulus as Crisis Response, a temporary tax cut is a faster and less-prone-to-corruption measure to stave off the crisis than most fiscal expansion projects. The Latvians get this.

Tax Stimulus as Crisis Response

A new paper from Simeon Djankov, a regular contributor to Crisis Talk, and Georgi Angelov, a Senior Economist at the Open Society Institute, argues for the merits of tax incentives in dealing with the crisis. From the abstract: 

Many countries are contemplating stimulus packages as a response to the deepening economic crisis. This paper discusses the benefits of tax reform as a crisis-response measure. It provides a calculation of the benefits of such reform, taking as an example the reduction of payroll taxes in Bulgaria. We also estimate the costs in terms of foregone revenue. We find that a reform to reduce the payroll tax by 7.5 percentage points, from 31.3% to 23.8%, would result in 130,000 jobs being created or saved, and a 0.5% increase in annual GDP growth. Taking the static and dynamic effects of such reform into account, the cost would amount to 0.63% of GDP. The reform has three additional benefits. First, it is not subject to corruption: the government is not in a position to distribute largesse as under a fiscal expansion program. Second, it works as a direct stimulus - every business and worker in the formal economy gets the benefit. Third, tax reform is quick to implement and can have immediate effects.

>> Download Tax Stimulus as Crisis Response

Germany's Crisis Response

In terms of originality, Germany's crisis response package beats everyone else to date. One item is giving 2,500 euros to anyone who is willing to scrap any car that is 9-years old (or more) and buy a new one. This is both good for the economy and for the environment. Another item - my favorite - is reducing the payroll tax. The whole program, worth 50 billion euro, is described in this article from the BBC.
 
I spent some time trying to figure out whether the Germans have gone protectionist, and whether the subsidy only applies to German-made cars. The answer is 'No'. Any make will do. Perhaps implicitly the government knows no German would be caught buying a Renault. Germans like their cars to be of good quality.
 
A similar plan probably wouldn't work in the US to save the Big 3. It may increase sales for their rivals instead.

Calvin and Hobbes Called It

Check out this Calvin and Hobbes cartoon - and no, it's not recent. It looks like comic strip author Bill Watterson called the current economic crisis 15 years ago.

(Hat tip: Simeon Djankov)

East Asia Feels the Pain

Who said this is a US crisis? East Asian countries are among the first to report trade statistics, and the numbers for November/December are eye-catching. According to analysis by Caroline Freund, the World Bank's top trade economist, Taiwan (China)'s exports in December fell 41% relative to December 2007. You read it right: 41%. In comparison, South Korea's exports fell a paltry 17%.

Other countries are reporting December numbers early next week.

One explanation for the rapid fall is that East Asia primarily exports to the United States, where demand is sagging. If so, Mexico is in trouble. Indeed, its November exports fell by 16% relative to 2007. Germany's November exports fell by 24%, perhaps for the same reason. And this means that in addition to part-nationalizing some banks like Kommerzbank, the German government may need to consider some boosters for the export sector. Did someone say tax cuts?

The Best Stimulus?

Ed Glaeser, a Harvard professor and a fellow co-author of The New Comparative Economics, recently wrote an opinion piece comparing the various scenarios a stimulus package can take. (Click here to read "Who should get the federal stimulus funds.") The main point, and one I have started advocating, is that cutting taxes, especially payroll taxes, is a better stimulus than spending heavily on infrastructure. As Glaeser argues:

Perhaps the best way to avoid this problem [the risk of a financial fiasco] is to target tax cuts toward lower-income Americans who are most likely to spend anything they get. The bulk of the fiscal stimulus could be used to radically reduce the Social Security and Medicare taxes paid by lower- and middle-income Americans over the next 18 months. A payroll tax cut should boost the economy by getting money in the hands of people who will spend it. The tax cut would also make work pay more for poorer Americans, and that should increase employment. Even if the tax cut doesn't end the recession, it would at least ease the downturn's burden on poorer Americans.

The same principle works in developing countries. In fact, it works even better in developing countries. Why? Because in addition to the arguments Glaeser puts forward there is a bigger argument: avoiding corruption. Large infrastucture spending in developing countries generally carries with it fears of corruption. In fighting the economic downturn, one may end up funneling money to a few people's bank accounts. That's what Glaeser would call a super financial fiasco.

The Sacred Cows of Capitalism, Alive and Kicking

Wounded perhaps, but the sacred cows of capitalism are alive and kicking, according to a new World Bank working paper by Asli Demirguc-Kunt and Luis Serven. The authors of Are All the Sacred Cows Dead? argue that "the 'sacred cows' of financial and macro policies are very much alive...the on-going crisis does not simply reflect a failure of free markets, but a reaction of market participants to distorted incentives."

Demirguc-Kunt and Serven, however, aren't just adding another paper to the now large pile that do a post-mortem on the origins of the financial crisis. The approach is much more prospective than that. How are regulators and central bankers in emerging markets to deal with banking systems and financial markets facing severe stress? It's more of this type of analysis that's needed right at the moment.

On blanket guarantees (compare this to a recent post from Thorsten Beck):

It must be recognized that the short-term benefits of guarantees will vary with the fiscal strength of the guaranteeing government. To hasten the end of an insolvency driven banking crisis and to constrain the spread of insolvencies in the short term, the government must manifest a substantial capacity for absorbing losses. This is not a luxury most countries can afford since most governments do not have the required fiscal capacity. Depending on the depth of the systemic insolvency such support may not even halt the spread of crisis and delay healthy adjustments.

On government ownership of banks:

Given the extent to which lending policies are politicized, it is not surprising that state ownership appears to heighten the risk of crises instead of reducing it. If anything, research suggests that greater state ownership is associated with various measures of financial instability, including a greater probability of banking crises.

On market discipline and Basel II:

Many interpreted the crisis as a vivid example of market failure, evidence that there is no such thing as market discipline, reinforcing calls for stronger regulations through improvements in Basel II accord. But the crisis also spawned a growing argument about the role Basel I accord may have played in causing the crisis. Indeed, it is no secret that Basel I contributed to the growth in securitization by assigning lower capital charges and thus giving incentives to institutions to move their assets into off balance-sheet securitization vehicles. While advocates claimed that Basel II, had it been implemented earlier, could have lessened or prevented the turmoil, critics of the Basel approach to capital regulation pointed out that the crisis has simply reconfirmed fundamental flaws that have been evident in this approach.

>> Download a PDF of Are All the Sacred Cows Dead?

Is Deposit Insurance Really the Solution to Depositors’ Worries?

Deposit insurance is an attractive tool for politicians, especially in crises such as this one. Announcing (unlimited) coverage of deposits in the banking system can prevent depositors from bank runs. And as long as the authorities do not have to make good on their promise, it is also a cheap tool. By now, however, most economists are well aware of the moral hazard effects of generous deposit insurance, a product of reduced market discipline. The result? Aggressive and imprudent risk taking. But considering recent events in Russia, one should be careful about believing blindly in the confidence-creating effect of deposit insurance either.

Some months ago, a small Russian bank called Capital Credit simply refused routine withdrawals by their customers, thus clearly signaling its illiquidity (which normally comes after insolvency!). But the Central Bank of Russia (which is also responsible for bank supervision) did not take any action for several weeks despite heavy protests by depositors. Only when depositors threatened to demonstrate in front of the Central Bank did bank supervisors finally withdrew Capital Credit’s license, thus allowing depositors to start the process of recovering at least part of their savings from the deposit insurance.

The result: despite an explicit deposit insurance scheme and despite the government’s assurance that all deposits would be secure, a loss of trust and confidence in the banking system occurred. As long as bank supervisors are not strong enough to intervene into failing banks, deposit insurance schemes cannot help conserve or restore confidence in the banking system.