China’s opposition is disappointing. It’s assumed to be linked to its low rating (and a general view that the Bank shouldn’t rank its members)–but they could have spun a positive story around their efforts towards a more market oriented economy and their improvement in the rankings–one would have thought that would be a good argument for them.  Another argument made against the report is its bias towards deregulation.  That’s fair, but the report positively weights certain regulation required for the proper functioning of markets and the rule of law.

My view is pretty simple:  the report has flaws, and certainly can be improved, but overall has been a significant force for better policies.  As a starting point for the discussion (a benchmark, not a final assessment), its data is informative and highlight important institutional features that matter for economic growth and poverty reduction.   As an incentive to liberalize, it works. It’s a public good that should be kept, and a healthy example of a multilateral institution candidly assessing country policies.  That’s why I was heartened to receive the email below from supporters of the Report.  They deserve our support.

________________________________

From:

Daron Acemoglu (Professor at the Massachusetts Institute of Technology),

Paul Collier (Professor at Oxford University, former Research Director at the World Bank),

Simon Johnson (Professor at the Massachusetts Institute of Technology and former IMF Chief Economist)

Michael Klein (former World Bank Group Vice-president and co-founder of Doing Business), and

Graeme Wheeler (former Managing Director of the World Bank and now Governor of the Reserve Bank of New Zealand)

We are writing to you about the World Bank’s Doing Business report.  Published since 2003 the report benchmarks 185 countries annually on key dimensions of the legal and regulatory environment for small businesses.  It has supported numerous reforms all over the world helping small businesses and employment.

There is currently a serious risk that the report may be abolished or severely curtailed as part of an ongoing review that will be finished in the next few weeks.  The report has always been subject to controversy as it highlights shortcomings that countries may not appreciate.  The World Bank’s President and its Board of Executive Directors will consider the future of the report in the next few months.

We would like to ask you to support an open letter to the World Bank’s President and its Executive Directors supporting the Doing Business project and recommending general directions for the future.  The letter (see below) is informed by our review of the arguments about Doing Business (attached).

This is our private initiative and without any institutional affiliation.

Please, reply by return email, if you agree to support the open letter. If you wish, indicate in which capacity you want to be mentioned.  If you want to forward this email to ask others also to support the letter, please, ask them to reply to this email address (helpdoingbusinessreport@gmail.com) so that we can keep an accurate record of support.

If you wish to refer to further information about the Doing Business report this link gets you to chapter of the report that describes it in detail:

http://www.doingbusiness.org/~/media/GIAWB/Doing%20Business/Documents/Annual-Reports/English/DB13-Chapters/About-Doing-Business.pdf

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Open letter to the President of the World Bank and its Executive Directors

The World Bank’s Doing Business Report benchmarks 185 countries on important aspects of the business environment for small and medium sized firms.  The spirit of Doing Business is to enable people everywhere to be successful on the basis of sensible rules, not on the basis of special connections or corruption. The data shed light on important institutional features that matter for economic growth and poverty reduction.

The data and the rankings provided by Doing Business make for helpful bench-marking tools.  They lead countries to consider and tackle important institutional challenges.  Precisely due to the power of the data criticism persists.

The report has, again, come under scrutiny at the time of its 10^th anniversary.  The World Bank President has appointed a special commission to review the report and make recommendations.  All options are on the table including, at the extreme, abolition of the report.  We are concerned about this.  We feel the arguments about the Doing Business Report are by now well known.  The report itself provides a model of transparency about data sources, methodology, uses of data and limitations of the data. The way forward is not to question the basics of the report, but to move ahead with further improvements and additions.

As an input for the deliberations by the World Bank’s Board of Directors and its President, we offer the following view on basic directions to take. The view is informed by the attached review of the Doing Business indicators.  The review was agreed by Daron Acemoglu (Professor at the Massachusetts Institute of Technology), Paul Collier (Professor at Oxford University, former Research Director at the World Bank), Simon Johnson (Professor at the Massachusetts Institute of Technology and former IMF Chief Economist), Michael Klein (former World Bank Group Vice-president and co-founder of Doing Business) and Graeme Wheeler (former Managing Director of the World Bank and now Governor of the Reserve Bank of New Zealand).

In particular, we believe that

-   the indicators provide informative measures about institutional arrangements that are useful for the development of all countries,

- the indicators are a step forward in the development of measures of institutions

-  the summary measures, whether the sub-indicators or the overall “ease of doing business” measure, are useful benchmarking tools

- policy-makers have typically used the indicators well

Going forward, the World Bank should

-     continue to maintain, update and publish all the existing Doing Business indicators including aggregate ranking

-     continue to improve the indicators and their collection

-     continue to explain both the uses and the limitations of the indicators

-  ensure that policy analysis places the indicators in the relevant country context drawing on complementary data sets

-  make proposals for further indicators that shed light on important institutional arrangements underpinning economic development

• Growth matters.  Today’s Eurozone GDP numbers remind us that Europe remains in a grinding recession; a second-half recovery now looks to be a long shot at best.  The only bright spot comes elsewhere, with news of  a German labor deal that will raise engineering wages by nearly 6 percent over the next 20 months (rebalancing European demand and stimulating German consumption needs more of this).  Some of the decline in the Pew numbers likely is cyclical, as declining confidence in their own economic prospects seems to spill over to other issues.  Notably, the need for jobs dominates other issues on the economic agenda.  The mood is particularly bleak in the periphery, reflecting those countries’ economic troubles. This is consistent with the idea the recession and diminishing expectations for the recovery are weighing materially on public opinion.

• A disillusioned France should matter to markets.  The sharpest decline in sentiment in the survey–both for their own economic prospects and for the EU project–is in France.  This coincides with other reporting suggesting declining confidence in the government’s ability to put the economy on the right track.  In this regard, markets could be sensitive to a rise in opposition to the European project in France.  The right-wing National Front (FN) party headed by Marine Le Pen has announced that it will run in next May’s EU parliamentary elections on a platform calling for an referendum on the euro.  How would markets react if–fueled by disillusionment with the government’s economic program–the FN was the first past the post in those elections?

• Will a single chart damage Europe’s efforts to resolve the crisis?  I missed this when it first came out, but it’s still worth a look.  Last month, the ECB’s Eurosystem Household Finance and Consumption Survey presented estimates, for households, of median net wealth and the median value of their main residence.  The interesting datapoint:  Germany is at the bottom.  Belgium, Spain and Italy (and, yes, Cyprus) all have household wealth several times German levels.

When this was released last month, the German press had a field day with the message that Germany shouldn’t bail out rich southern Europeans.  There was pushback:  it was noted that if means rather than medians were used, Germany would be in the middle of the pack (reflecting a more skewed German income distribution).  Further, the high proportion of renting rather than buying homes in Germany means more housing wealth is off the household balance sheet.  Broader measures of national wealth, including capital, restore Germany to the top ranks in terms of income.

The Pew survey (taken before the release of the chart), conversely shows Germans still support the European project, and are willing to pay to support it.  (By 52 percent to 45 percent, Germans support bailouts for countries in crisis, compared to 40 percent in favor in France.)  It remains to be seen, though, whether the chart below and the pessimism reflected in the Pew Survey resonates with less affluent German voters already suffering from bailout fatigue.

The unexplained fall in labor force participation

Their first chart shows the decline in labor force participation since 2007, both in absolute terms and relative to a Bureau of Labor Statistics (BLS) forecast for the future path of the participation rate made in 2007.  It suggests that the sharp drop in the participation rate since 2007 was unexpected and hard to explain by the structural factors that affected participation in the past such as the aging of the population, or shifts in specific groups such as female or youth workers.  This means that the gap between the two lines, the “participation gap,” must be cyclical–the result of the great recession–or because of some new structural factors that the BLS didn’t anticipate.

The structural argument deserves some elaboration.  Recall that labor force participation actually peaked around 2000 and was on a downtrend even before the great recession (see next chart). One view is that this means there are even more “missing workers” put out of jobs, involuntarily, by the weak recovery of 2000-07.  I think a better explanation is that there were already structural changes underway in the workforce that are not captured by the BLS forecast.  From this perspective, the great recession is an accelerant that forces change (eg, in terms of labor-saving by firms, changes in long-term competitiveness, or changes demand for skills) that had been building already.  Whether you want to describe this as cyclical or structural, these workers may not be easily brought back into the labor force through expansionary macro policies.

Civilian Labor Force Participation Rate, 16 and older

Source: BLS

This next chart from Erceg and Levin shows that the participation gap (derived from the first chart)– the orange dotted line–now exceeds the gap between current unemployment and the long-run unemployment rate (the purple line).  It shows that the participation rate adjusts more slowly than the unemployment rate.  It also highlights the amount of slack that needs to be absorbed is potentially much larger than suggested by the unemployment rate alone.

The bulk of the Erceg and Levin paper then addresses two critical questions:  Is this structural or cyclical? And will it persist as the economy recovers (and the unemployment rate drops)?  On the question of cyclicality, the paper looks at a cross-section of state participation rates during the recession (see below).  States with the deepest recessions had the sharpest fall in unemployment, which they argue suggests it’s weak demand that is driving much of the recent decline in participation.  State data has been criticized in the past as subject to noise and error, and others suggest that looking at flows into and out of the labor force is more consistent with a structural explanation.  In any event, this result is central to the debate over whether ‘this time is different’ because the post-war experience has been that participation is largely non-cyclical.

The Fed’s employment mandate

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” (Federal Reserve Act, 1977)

The Fed is unusual among central banks in having a statutory dual mandate to ensure both maximum employment and stable prices.  The Fed has long stressed that in most circumstances these two objectives are consistent, and further that it looks at a wide array of indicators in fulfilling its mandate.  However, much economic theory, and the Fed itself, have put the spotlight on the unemployment rate (and its relationship to the longer run, normal rate of unemployment) as the most important single metric of labor conditions.  This focus has intensified since the Fed, in December 2012, announced that an unemployment rate of 6.5 percent would serve as a threshold (not a trigger) for tightening policy from the current near-zero levels.

The dilemma for the FOMC is how to react if the unemployment rate declines to below 6.5 percent while the participation rate remains low.  Should we look at the sum of the unemployment and participation gaps as the measure Fed policy must address?  In assessing this argument, the Fed will have to answer three questions in particular:

• How low can the unemployment rate go before inflationary pressures emerge? The Fed’s estimates of the central tendency for the longer-run, normal unemployment rate, at 5.2-6 percent, is substantially higher than they forecast several years ago, reminding us of the inherent uncertainty in these traditional macro relationships.
• Does a high participation gap put downward pressure on inflation?  Certainly inflationary pressures remain muted, even too low (recent work by Lars Svensson and others suggest inflation below 1 percent can be distortionary and undermine a credible central bank’s policy).  But the great recession also has undermined notions of a tight relationship between slack in the economy and inflation (inflationary expectations haven’t moved very much with the recession) suggesting the need for caution during the upturn as well.  Does the existence of a pool of workers that have left the workforce, for example to retire or to go to school because there are limited job opportunities, put downward pressure on the wages of those who have jobs?
• Is monetary policy the right tool to address the participation gap? Recent research on long-term unemployment suggests that, once workers are unemployed more than six months, their connection to the work force become tenuous.  In such cases, even if their exit was the result of a demand shock, at some point they lose the skills, the connectivity, and the resume to reenter easily. What starts as cyclical becomes structural.  Monetary policy may be a blunt tool for addressing the participation gap, suggesting targeted fiscal policies (e.g., job retraining and employment subsidies) may be more effective tools.  The monetary policy dove will argue that absent fiscal policy, monetary policy is the best tool in the toolbox, while critics will weigh these potentially modest benefits against the cost of an even larger balance sheet.

None of these questions have easy answers. Erceg and Levin are careful to emphasize the limits of their analysis.  But their work, and the notion that the Fed needs to target policy to reduce this gap, may be front and center at future FOMC meetings.

Corporate tax reform (and its possible link to the debt limit) will be in the spotlight this week as the Joint Committee on Taxation today is expected to release recommendations compiled by 11 House Ways & Means working groups. Jaret Seiberg at Guggenheim highlights the possiblity of market-relevant headlines on the mortgage interest deduction, the corporate debt deduction, the tax treatment for REITs and master limited partnerships (MLPs), and overall corporate tax rates.  Meanwhile, the House likely will pass a bill this week calling on the U.S. Treasury to prioritize payments, an authority many believe that they already have (and which the Senate will not move on).  As we move forward, these two issues will be increasingly linked.

Better-than-expected fiscal numbers, and the prospect of a one-time transfer from the government sponsored enterprises (GSEs), have pushed back the date when the debt limit (to be reset to the level of indebtedness on May 19) is expected to bite starting in July/August until the fall.  The deficit now is running at a 4.5 percent of GDP pace, well down from 10.1 percent in fiscal year 2010.  With the effects of the sequester beginning to build, this dramatic fiscal tightening looks to subtract around 2 percent of GDP from growth this year.  Too much, too fast from a macroeconomic perspective, but good news on the debt-limit front.

Does this possible link of corporate-tax reform to the debt ceiling materially increase the prospect of new legislation in the near term?  Certainly the committee chairs are motivated and have laid out their core reform principles.

I remain skeptical that we can have a grand bargain that overcomes the vast differences between the positions of the two sides (e.g., different stances on top rates, revenue, and treatment of foreign source income).  This proposal, if implemented, would likely lead to gridlock in committee once each house has passed a bill.  But the advantage of linking debt-ceiling increases to corporate tax reform would be that even if the process ultimately fails to deliver, it could still push the debt limit past the midterm elections.  That’s a very small prize, but perhaps the best alternative to another cliff showdown, as there is little evidence of a plan B both sides could sign on to.

The implications are not only domestic. As Richard Haass notes in Foreign Policy Begins at Home: The Case for Putting America’s House in Order, putting our own house in order is essential to an effective foreign policy as well.

R&R’s comments on European debt also deserve note: “For Europe, in particular, any reasonable endgame will require a large transfer from Germany to the periphery. The sooner this implicit transfer becomes explicit, the sooner Europe will be able to find its way towards a stable growth path.”  Those who read this blog know I agree strongly with this statement, and believe that we have a model already in place–the Paris Club–that provides a way forward.  Perhaps after the German elections we will get an open discussion of the need for official debt relief before another crisis hits, but I’m not optimistic.

A few points:

1.   Markets now expect a rate cut, at a minimum.  A majority of economists surveyed by Bloomberg expect the ECB to cut the benchmark refinancing rate to 0.50 percent from 0.75 percent. Weak April data, signals from the ECB that it is increasingly concerned about the downside risks, and a soft inflation outlook for the eurozone as a whole have moved expectations. (The ECB sees euro inflation at 1.6 percent this year and 1.3 percent in 2014, and that was before the latest soft price data.)  In addition, credit data continues to disappoint.

Source: Eurostat

2.  Measures to ease credit conditions for SMEs may be close.  A trial balloon last week from Executive Board Member Yves Mersch suggested the ECB could provide liquidity support for the development of securitized pools of small business loans made by development banks. This is one of a number of ideas for spurring small and medium-sized enterprise (SME) lending in the periphery.  The Bank of England’s (BoE’s) Funding for Lending scheme is another possible model (though there isn’t convincing evidence so far that the BoE scheme has worked). It’s unclear any of these initiatives are ready to go forward, though.

Below is a nice chart from Morgan Stanley pointing out the importance of SME lending for periphery growth. (It shows that countries with the highest SME lending rates have the highest SME share in gross value added, or GVA.)

3.  But the case for a rate cut has its critics… My colleagues Benn Steil and Dinah Walker summarize the case for caution.  The broken transmission mechanism could mean that those southern European countries with deflation and negative growth may see little direct benefit from a rate cut, while the north already has inflation close to or above the ECB’s target.   The counter argument, which I find compelling, is that the first-order effect of the rate cut is to reduce funding costs of those banks (notably Italian banks) that rely on funding from the ECB.  I do believe that, with demand faltering across the eurozone and overall inflation below target and expected to fall, the risks to price stability in the north are very limited.  Further, over the longer term, these types of inflation differentials also contribute to the needed rebalancing of demand.

4.  Quantitative easing as the endgame?  Gavin Davies’s summary of the options for the ECB gets to the same bottom line that I have.  An easing of collateral requirements can have a meaningful impact, but ultimately the ECB may need to consider a full-out quantitative easing if it is to meaningfully boost the size of its balance sheet.  As Steve Englander among others has highlighted (chart below), the relative size of the balance sheet is a good indicator of exchange rate moves.  It’s hard to see a return to growth in the periphery without some contribution from external demand.

Some progressive critics of austerity will argue that when an economy is at or near the zero lower bound, the effectiveness of monetary policy is diminished and more of the burden needs to be carried by fiscal policy.  My problem with that line of argument is two fold: first, in Europe at least, politics as well as the reality of unsustainable periphery debt and finances limit the amount of fiscal easing that is possible; and second, the ECB hasn’t done all it can do–far from it.

How does the attack on the two academic’s work change the landscape for macro policy, if at all?

The recent challenge to a key finding of Carmen Reinhart and Ken Rogoff’s This Time Is Different (R&R) has roiled the academic world.  But it’s far less clear that it meaningfully changes the politics and economics of deficit reduction.  My takeaways:

1.  One less cliff.  One of R&R’s results, which they and supporters promoted aggressively, was of a “cliff” at around 90 percent of GDP above which growth drops precipitously across countries.  We now know that a coding error and missing data contaminated that result.  They have also been criticized, I think unfairly, for how they weighted countries with long episodes of high debt (see recent sympathetic analyisis by Jim Hamilton).  Fix the errors and change the weights, and their cliff goes away, weakening the urgency of fiscal consolidation as debt nears 90 percent.

2.  But debt still matters.  Cliff or no cliff, higher debt is associated with lower growth in theory and in the data. R&R’s work contains a number of critical and still-valid findings, including the sluggish nature of the recovery that often follows financial and debt crises (going into the recent crisis, most economists expected a v-shaped recovery).  The critical level of debt above which growth suffers, perhaps even falls sharply, will vary across countries, being higher in the major economies than in the developing world or the periphery of Europe.  The causality can run the other way: low growth, especially when not expected, leads to higher sovereign debt as revenue falls below expectation, safety net spending increases, and governments adopt expansionary policies to spur growth.

3.  It doesn’t solve U.S. debt worries.  My belief that the United States is consolidating too quickly doesn’t subtract from the critical longer-term fiscal challenge we face, which will eventually cause a crisis if unaddressed.  But the existence of high debt remains an overwhelming political impediment to a more balanced approach today, even as the costs of funding today’s deficits remain low. Further, the dispute over the cliff, if anything, looks to deepen the divide between parties.  While the leadership on both sides say they don’t want a crisis over the debt limit, for example, the exit strategy from a showdown this fall remains unclear.

4.  The reduction in austerity in Europe is less than the talk suggests.  We are seeing in Europe a move to push back dates when deficit targets are reached.  Mostly, that reflects the reality of weak fiscal performance in a no-growth environment.  It’s reflected in an IMF forecast that has the pace of fiscal consolidation slowing as output falls.  It may be that the attack on the “Austerians” has increased the pressure on Germany in particular to acknowledge these adjustments, but it’s hard to argue that the end result is much different.

5.  Less austerity is a great idea for the European periphery…but who pays?  The periphery is where increased aggregate demand is most needed, but they have limited ability to finance an easing of fiscal policy without a counterproductive loss of confidence.  Sustainable levels of debt, including a realistic assessment of contingent banking sector liabilities, remain low there.  The IMF rightly argues that those countries that do have fiscal space (read Germany) should loosen policy to offset the contractionary forces at work in the periphery, but that argument found little traction at the recent IMF meetings. And we are years away from a meaningful fiscal union.  So, even if we discard the R&R cliff, there is little room for periphery policies to change.

In sum, the recent controversy over R&R’s results forces us to look again at what we know about debt sustainability, but it’s unlikely to lead to any immediate change in policy.  Perhaps if growth continues to disappoint we will need to reassess.  But for now, our fiscal debates remain as dysfunctional as before.