Tuesday, February 2, 2010

More on the January 25 Hurriyet column

As I mentioned earlier, I exchanged emails with two readers on previous week's column. One of them was asking me why I was happy with the 5% growth rate, noting that Turkey's historical growth rate was around 4% for the past three decades. My response was the following:
Why would I be happy with this, given Turkey's historical growth performance? Here, it gets a bit tricky. You are obviously right that the 5% seems a bit too high when looked at the historical context. But, I have two important disclaimers: First, Turkey's problem, like many EM, is the variability of the growth rate, or quite a bit of "grey swans", to pay homage to Nassem Nicholas Taleb. In the attached graph, I counted 10 such episodes in the last 3 decades. Second, the Turkey of the 80s and 90s is structurally quite a bit different than the Turkey of the last decade (capital controls, customs union, you name it), so I am not sure historical growth rates tell us much.

Also, such a rule would have actually served Turkey well in the past few years, more or less imitating actual budget performance. Obviously, the IMF program ensured that the fiscal contraction turned out to be expansionary, but still as I outlined in the paper, a fiscal rule has similar credibility mechanisms set in place if done properly. I am also fully aware that such a counterfactual exercise does not make much sense, but I still feel the post-2001 crisis economy can hint us quite a lot. Moreover, most studies I am aware of place Turkey's potential growth rate at 5-6%; which would be child's play if Turkey did a few labor market reforms, which I am sure you know much better than me....

But I definitely see (and appreciate) your point, and I feel that playing with a fiscal rule after you enact it is much more dangerous than playing with an inflation target, so the government would have to get this right at the first attempt. But at the end of the day, equally important as the actual number will be the coefficients a and b, on which we (or at least I) know nothing about at this stage...
The Reader (I just can't help cheesy movie references all time), in response, made the following comments:
I agree with your argument about Turkey's potentials but my main point is that one has to be cautious. One shouldn't treat g* as a target growth rate or potential growth under ideal circumstances. The post-2001 performance was supported by the best world economic growth spurt in history. Hence it may not be representative of what is likely to be coming, since the world as a whole is expected to grow more slowly.

The objective of the fiscal rule is to bring debt back on a declining and sustainable path in a non-disruptive and gradual but sufficiently rapid manner. (Remember only a year and half ago the medium-term framework aimed to lower debt to 30 percent and suggested that was an appropriate target.) The purpose of the (g-g*) term is to allow for cyclical factors in fiscal decisions so that too much pro-cyclicality is avoided. But if g* is not chosen realistically then too many situations will be considered below-potential and there may not be enough fiscal adjustment. That is why g* = 5 percent may not be sufficiently cautious. You can see this best by doing some simulations yourself. Take some reasonable values for the parameters a and b like 1/3 or 1/4. Assume something like d* = 1 percent which is in the range analysts have talked about. You can then compare how debt behaves over time with different g*. This of course depends on how actual g turns out. Again to be on the cautious side assume actual growth is 4 percent over the medium term. You will see that debt will decline very slowly if, e.g. g=4 and g*=5.

Of course as you say Turkey may grow faster but then if that happens the rule may be adjusted. But to start with it is important to be cautious.
After thinking through, I noticed that (s)he had a point and I might indeed have been a bit optimistic:
Your arguments make perfect sense. In particular, I agree that the post-2001 Turkish growth miracle was aided by global conditions. In that respect, the Turkish economy got a double boost: The economy rebounded from a crisis + cheap money started to rush in- very useful for a capital flows-dependent economy... So you are right that the post-2001 era might be misleading. But that leaves us with no past to gouge on: As I mentioned before, 1980s and 1990s are not good guides, either.

I did a couple of very simple debt sustainability exercises before writing the column, but the lowest g I was assuming for good times was 5%. Now, after reading and thinking through your emails, I see I might have been a bit overoptimistic:(

I guess it all boils down to whether you are willing to put up with a type I or type II errors. And now when I think about it, I feel it is much better to err on the side of caution. It is probably much easier to relax to fiscal rule rather than tighten it after causing raising debt.... But the feedback Babacan got from the columnists is exactly the opposite. At least, that's the impression I got from reading their columns...

To sum up, I am leaning towards your arguments right now...
I am a rather conservative It's Mostly Fiscal type economist, so I am wondering what came over me. Maybe, since I was always being critical of the government, I felt compelled to be as positive as possible. Anyway, I thank my reader in waking me up. Because as I mentioned in the column, the cost of messing up the fiscal rule is likely to be very high.

BTW, the columnists Babacan talked to were mostly in favor of an even more relaxed fiscal rule (higher g). Lax fiscal rule, no to the IMF? And I tell to them, to quote Parker Selfridge: What have you guys been smoking?

No comments: