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					Topics in Development and Transition


             Handout 3
      The Economics of some
   “Alternative” Methods of Fiscal
               Finance




           Macro Topics in Development   1
               and Transition 2007
                        Objectives

This topic connects the earlier discussion about the constraints on
fiscal financing with some formal consideration of the multiplicity of
“hidden” taxes that are encountered in developing and transition
countries.

Helpful papers are by P-R Agenor (IMF Staff Papers 1990 and
1992) and Brian Pinto (JIE 1991 and WBER 1989), as are the
associated chapters in Agenor and Montiel (sections on parallel
Forex and Credit markets and on the Credibility aspects of
disinflation programmes).

Later topics rely on materials from Bill Easterly, Clifford
Gaddy and Simon Commander among others (References
are provided later).

                      Macro Topics in Development                        2
                          and Transition 2007
          Our Earlier Results Include

• If the ER is FIXED and Financial Markets are THIN, Fiscal
  Deficits in LDCs easily get reflected in involuntary Foreign
  Borrowing/Decline in Foreign Reserves
• If the ER is FLEXIBLE and Financial Markets are THIN, Fiscal
  Deficits in LDCs easily get reflected in INFLATION
• The FIRST of these two cases easily dissolves into the
  SECOND in cases where (a) Foreign Reserves are Low and
  (b) Monetary Depth is Low
• In these cases, the First Generation Crisis Models
  (Krugman) easily provide the analytical explanation of what
  happens.




                     Macro Topics in Development             3
                         and Transition 2007
…………Continued

• Government Borrowing (Domestic or External) provides a
  POSSIBLE Escape from these traps
• However, this will depend on (a) the VOLUME of such
  borrowing that is possible and (b) the TERMS (interest
  rates and maturities) of the borrowing.
• Much LDC Borrowing in practice is either (a) INVOLUNTARY
  (e.g. forced sales of securities to local banks) or (b)
  LIMITED in Volumes or (c) HIGH COST with SHORT
  MATURITIES
• It is sometimes assumed that increased borrowing (for any
  given Fiscal Deficit) will result in a REDUCTION of long-term
  INFLATION (e.g. common in IMF thinking). But this is (a)
  not always true even for voluntary borrowing (c.f. Sargent
  and Wallace) and (b) is generally untrue for borrowing that
  is involuntary.

                     Macro Topics in Development              4
                         and Transition 2007
Example: Kenya - Interest rates and Inflation 1988-1996




  60
                                   Kenya: Inflation and Interest Rates

  50



  40
               Inflation (CPI) %
               Tbill Rate
               Bank Lending Rate
  30



  20


  10



   0
       1988   1989          1990     1991     1992     1993     1994     1995   1996




                             Macro Topics in Development                               5
                                 and Transition 2007
         Example: Kenya’s Liberalisation in 1991



0.6
             Kenya Shares of Government Revenue 1990-1996

0.5



0.4


0.3



0.2



0.1                                                          Wages and Salaries
                                                             Goods and services
                                                             Interest Payments
 0
      1990        1991      1992     1993      1994         1995          1996



                              Macro Topics in Development                         6
                                  and Transition 2007
      Exotic Alternatives to Borrowing
• LDC Governments have made extensive use of a wide
  range of “hidden” alternatives to explicit borrowing to
  finance their deficits (a list follows).
• Careful analysis of such alternatives (e.g. dual exchange
  rates) shows that they invariably (a) create an
  economic/structural inefficiency and (b) help to suppress
  the short-term inflation rate below the rate otherwise
  necessary.
• It follows that reforms to remove the STRUCTURAL
  INEFFICIENCY will almost always INCREASE the Inflation
  Rate unless the Fiscal Deficit is simultaneously reduced.
  (see the further example of a tax levied on commercial
  banks on the two later slides).

                    Macro Topics in Development               7
                        and Transition 2007
      Some Economics Of Hidden
          Taxes/Subsidies

Common Examples:
• Dual Exchange Rates –A Tax On Those Selling At The
More Appreciated Rate
•Tolerance Of Losses In State-owned Enterprises –
Requires Higher Conventional Or Inflation Taxes On Other
Agents
•Tolerance Of Non-payment By Budget Organisations Or
State-owned Enterprises – A Tax On Those Who Do Not Get
Paid In Timely Fashion
• High Un-remunerated Reserve Requirements In Banks – A
Tax On The Depositors And Borrowers
• Loan Losses In Banks Associated With Directed Loans To
State Enterprises – Again A Tax On Depositors/Lenders
• Price Controls On Certain “Essential” Goods – A Tax On
Those Supplying Those Goods

                 Macro Topics in Development           8
                     and Transition 2007
Standard Structure Of The Problem Which
                 Arises
  Allocative Efficiency Problems – Too Much (Or
  Too Little) Being Produced Of Subsidised (Or
  Taxed Goods)

  Broader Macro Effects Associated With Methods
  Of Budget Finance; Portfolio Choices For Private
  Agents Etc.

  Significant Macroeconomic Consequences When
  The (Apparently Narrow) Reform Of The
  Specific Inefficiency Is Addressed

               Macro Topics in Development        9
                   and Transition 2007
Example One:

Taxing Banks




Macro Topics in Development   10
    and Transition 2007
                Example One: Taxing Banks
   Model from McKinnon, Mathieson in Princeton Papers,1982


Model uses three Equations: Govt Deficit; Banking Sector
Balance; and a Zero Profit (for banks) Condition


        D  [kq( , id )  f ( , id )].(   )..........1 ]
                                                         [
         h( , il )  1  k.q( , id ).......... 2 ]
                                               [
             id  il (1  k )..........
                                     [3]
Note the inefficiency here arises from the INABILITY of banks
to use their mobilised resources productively (an effect that
can also come from (a) excessive bad loan positions and (b)
excessive investment in fancy bank buildings)


                      Macro Topics in Development               11
                          and Transition 2007
            Solution


π
                                         Deficit 1




                                 Deficit 2




0   k1 Macro Topics in Development
        k2                                      k    12
           and Transition 2007
                           Africa- How Much is Available to Lend?
                                              Source: Peachey and Roe, 2004




         90%                                                                                                                                                                 90%
                                                                                                                                                                       13%
                                                                                                               15%
         80%                                                                                                                                                                 80%
         70%                                                                                                                                                                 70%
                                                                                                                                                             30%
         60%                                                                                              5%                                                                 60%
                                                                                                    14%                                           10%
                                                                                                                                        12%
% GDP




         50%                                                                                                                                                                 50%
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         40%                                                                                                                                                                 40%
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                                37%   48%                                   31%
         20%              66%                                   54%
                                                                                                                                                                             20%
         10%      100%
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                                                  Macro Topics in Development                                                                                                      13
                                                      and Transition 2007
                             Asia - How Much is Available to Lend?


        180%                                                                                                                                                                 180%
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        160%                                                                                                                                                                 160%

        140%                                                                                                                                                                 140%

        120%                                                                                                                                                 7%
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% GDP




        100%                                                                                                                                                                 100%
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        80%                                                                                                                                                                  80%
                                                                                                           21%
        60%                                                                      34%   33%   9%    8%                                                                        60%
                                                                           36%
                                                                    18%

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                                                             Macro Topics in Development                                                                                            14
                                                                 and Transition 2007
         Example Two:

Dual (or Multiple) Exchange Rates




          Macro Topics in Development   15
              and Transition 2007
     Example 2 – Multiple Exchange Rates

This Issue Has Three Aspects
The “real economy”
   What are the economic inefficiencies associated with dual exchange
    rates. How would production choices change in response to
    unification?
The monetary economy.
   How does unification impact money demand and the total financing
    available for the budget?


The macroeconomic problems of unification



                        Macro Topics in Development                    16
                            and Transition 2007
            The Policy Problem

Countries that have unified Dual Exchange Rates
have seen large surges of Inflation (e.g. Sierre
Leone 1986 when Inflation jumped from 70% to
200%)

Why? Theoretical Answer is in Pinto, Journal of
International Economics,1991 and World Bank
Economic Review, 1989


                Macro Topics in Development   17
                    and Transition 2007
                                  Context

    This is an issue that is relevant in countries where all or some of the
    following features are present

   The economy in question has low or zero foreign reserves and so needs to
    ration FOREX

   The rationing creates an excess demand for FOREX and so encourages the
    emergence of at least one black/parallel market

   Because of this exporters face at least two different local currency prices for
    their exports




                            Macro Topics in Development                          18
                                and Transition 2007
……………..Continued



 The government purchases at least some of its imports at the
 “official” rate and to that extent benefits from the export
 proceeds which are sold at that rate. Exporters required to sell
 at that rate can are “taxed” in a very real sense.

 Allocative inefficiencies are thereby created – i.e. legal exports
 are discouraged in favour of (a) smuggled exports and (b)
 production of non-traded goods. E.g Ghana in the 1970s – most
 of the country’s large production of cocoa smuggled out via
 neighbouring Cote d/Ivoire.



                      Macro Topics in Development                     19
                          and Transition 2007
……………..Continued

 The scarcity of “official” FOREX means that at the margin the
  pricing of imports is conditioned by the parallel exchange rate.
  official policy re. the exchange rate will have little effect on
  domestic pricing (notwithstanding the claims that politicians
  may make)

 An “official” devaluation is likely to have an intra marginal
  effect working through income distribution rather than the
  normal textbook effects on trade volumes etc.

 Equally the effective return on holding FOREX in asset
  portfolios will be motivated more by the parallel than by the
  official exchange rate.



                       Macro Topics in Development                20
                           and Transition 2007
               Monetary Component of Pinto Model


Assume that
                                  *                 *   *
                                 R  0, then M  D  S ( g  t )    [6]
                                          *
                                          M  S (g  t)            [1]
Define
                                           *
                                          M
Or                                           g-t
                                          S

                                      *
Re-write the left hand side as    M M b
                                   . .  g t                  [2]
                                  M b S


The three components are nominal money growth, the real money base (evaluated by
reference to the black market rate) and the black-market premium. Note how this
amends the normal definition of inflation tax revenues

                                 Macro Topics in Development                       21
                                     and Transition 2007
………..Continued

Defining b/S = φ and dividing [2] by φ gives

                        *
                        M M   g   t
                                                    [2' ]
                        M b      
Or                                  *
                    g       t       M M
                                          [3]
                                  M b

We see from this that when b>S ( φ >1) hidden taxes arise




                        Macro Topics in Development           22
                            and Transition 2007
                             Hidden Revenues


                                               *
These are
                               1       t mS
                         g (1  )  g            [4]
                                         
The components on the RH side are conventional taxes evaluated using “b”
i.e. tS/b; and the inflation tax also evaluated using “b” i.e.


         *
    M S S
      . .          and     M /S m
    S S b
Note for the case where φ =2
• HALF of all government expenditures financed from the hidden export tax
•CONVENTIONAL tax revenues have only half their apparent spending power
•INFLATION TAX FINANCING yields only half the spending power it does when
“S” is the equilibrium E.R.
 But there is an effect in the opposite direction IF import duties are calculated
at the official rate (= an implicit subsidy for importers that disappears on
unification (Agenor and Montiel Ch. 18)


                           Macro Topics in Development                         23
                               and Transition 2007
           How Big in Reality?

• African Examples from Ghura and Grennes
show that values near to or in excess of 2
have not been unusual (e.g. 2.8 Tanzania;
5.0 Ghana; 2.02 Zimbabwe etc.)


• Suriname in late 1980s = 10 plus!




              Macro Topics in Development    24
                  and Transition 2007
          Note the Distortions in Public Expenditure
            Allocations –Example from Suriname


                                   at 1.8 guilder = I dollar
                                                                      at parallel Exchange Rate (=17.5 g)

                              Public Outlays         % of Total       as appropriate           % of Total




General (incl Debt charges)                2499             34.7%                      6860             53.3%

of which External                              500             6.9%                    4861                 37.8%

Defence and Public Order                       598             8.3%                     598                 4.6%
Economic Sectors                               924          12.8%                       924                 7.2%
Housing                                        577             8.0%                     577                 4.5%
Health                                         591             8.2%                     591                 4.6%
Education and Culture                          959          13.3%
                                                                                       2267             17.6%
of which Foreign
      Scholarships                             150             2.1%                    1458                 11.3%

Social Potection                           1050             14.6%                      1050                 8.2%




Total                                      7198            100.0%                      12867           100.0%
                                               Macro Topics in Development                                          25
                                                   and Transition 2007
    Digression on the ER and Fiscal Deficits
             (from Agenor notes)


A nominal exchange rate depreciation can exert direct effects on the fiscal
deficit through two channels:

 by affecting the domestic-currency value of foreign exchange receipts by
the government and foreign exchange outlays;
 by affecting the revenue derived from ad valorem taxes on imports.
 Since depreciation raises the prices of import-competing goods (and

exportables), it may also exert pressure on wages due to its effect on the
cost of living.




                         Macro Topics in Development                  26
                             and Transition 2007
……………Continued

This is particularly likely to occur in a setting in which indexation
mechanisms are pervasive.

Example: assume a country facing a sharp deterioration in
competitiveness and a large current account deficit:

 Policymakers decide to devalue the exchange rate.
 Devaluation will increase both the domestic-currency price of
 imported final goods as well as imported inputs.
This puts upward pressure on domestic (producer) prices.
The increase in prices can be large enough to outweigh the effect of
 the initial devaluation on competitiveness-thereby prompting
 policymakers to devalue again.




                          Macro Topics in Development                   27
                              and Transition 2007
………………Continued

The process can easily turn into a devaluation-inflation spiral.
Especially if wages are indexed on the cost of living, they will increase
also, putting further upward pressure on prices of domestic goods.
Evidence: Onis and Ozmucur (1990) for Turkey; Alba and Papell (1998)
for Malaysia, the Philippines, and Singapore.
NOTE: This is what Argentina et al were trying to avoid through their
“tablita” policies in the late 1970s.
BUT a similar process can be seen in countries where the official
exchange rate is fixed but the parallel market for foreign exchange is
large and also free (see Agenor’s macro model in IMF Staff Papers,
1990).
Deterioration in external accounts leads agents to expect a devaluation
of the official exchange rate to restore competitiveness .


                        Macro Topics in Development                     28
                            and Transition 2007
………Continued

Such expectations will be translated immediately into a depreciation of
the parallel exchange rate.

Because the parallel rate measures the marginal cost of foreign
exchange, domestic prices will tend to increase (also very quickly).

This increase in prices will further erode competitiveness, leading
agents to expect an even larger devaluation of the official exchange
rate.

Figure 5.5: although parallel exchange rates display a higher degree of
variability than prices, the correlation is positive in the case of Morocco
and Nigeria during the 1980s and early 1990s.




                         Macro Topics in Development                     29
                             and Transition 2007
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       Macro Topics in Development   30
           and Transition 2007
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       Macro Topics in Development        32
           and Transition 2007
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      Macro Topics in Development        33
          and Transition 2007
………………Agenor notes Continued

 When the government is directly involved in handling the exports
 of commodities such as oil, there may be:

    a direct effect of changes in the terms of trade on the budget;

 an indirect effect through taxes on corporate profits and
 domestic sales.

In addition any reduction in government revenue due to a negative
shock can cause new pressures for monetizing the fiscal
deficit.Even an improvement in the terms of trade may lead to
higher inflation in the future:
  1.if government spending has increased sharply in response to
  temporary commodity price booms and
  2.if such increases are difficult to reverse when commodity prices
  fall. (link this also to the later discussion about the natural
  resources curse)

                         Macro Topics in Development                   34
                             and Transition 2007
The Real Income Aspects (Pinto JIE, 1991)




             Macro Topics in Development    35
                 and Transition 2007
          Example Three:

 Distorting the Composition of the
Budget to limit the “statistical” deficit


            Macro Topics in Development   36
                and Transition 2007
 Example 3: Using a Net Worth Concept
          of the Fiscal Deficit

• This Topic explores the dangers of a conventional approach
  to Fiscal Adjustment by examining a simple inter-temporal
  model of Government Utility Maximisation
• It shows that these approaches are essentially about
  restricting Government LIABILITIES
• But responses to such restrictions may result in perverse
  results for Long Term Growth and Living Standards

 Main Source in W Easterly, 1999, Economic Policy April 1999
 but see also W Easterly, When is Fiscal Adjustment and
 Illusion? World Bank Policy Research paper 1998/99. Blejer
 and Cheasty, “How to Measure the Public Deficit” IMF 1993

                    Macro Topics in Development                37
                        and Transition 2007
 When is fiscal adjustment an illusion?


• Fiscal adjustment is an illusion when it lowers the
  budget deficit or public debt leaving government
  net worth unchanged
• Net Worth = Assets - Liabilities
• The paper focuses on government forced to lower
  its conventional deficit
• Given an optimal path of net worth, government
  will be indifferent about its composition between
  assets, explicit liabilities and implicit liabilities

                   Macro Topics in Development                  38
                       and Transition 2007       * World Bank
                   Government ASSETS

•   Physical Capital such as Buildings
•   Equity in State Enterprises
•   PV of Future Tax Revenues
•   PV of Future Seignorage

Most Assets are associated with an ANNUAL RETURN (“r”)
to Govt.

Examples:
• Roads - higher user charges or higher revenues from fuel
taxes
• Schools - higher future income from improved human
capital or higher user charges
Some of these are returned as REVENUE in a conventional
sense - others are not
                       Macro Topics in Development           39
                           and Transition 2007
           Aspects of the Asset Returns


• Think of “returns” from the viewpoint of those in charge of
  government not as “social returns” in the normal sense
• PV of new projects yields a potential return that may not be
  immediately captured in today’s user charges
• Return to Govt. is a part of the Return to Society that can
  be taxed
• Infrastructure Projects can give return via improved levels
  of economic activity leading to better tax compliance
• Even Prestige - white elephant projects - can give
  Return/Utility to the “Government”
• Even “bad” projects yielding corruption rents to
  government have a “return” in this narrow sense


                     Macro Topics in Development            40
                         and Transition 2007
                Government Liabilities




• Standard Domestic and External Debt
• Future Social Service Obligations
• Contingent (off-balance-sheet) elements e.g. bail-outs of
  insolvent banks
• Arrears of payments to Civil Servants and to the National
  Pension Fund




                     Macro Topics in Development              41
                         and Transition 2007
     Net Worth: difficult to carry out estimation but relevant for government
                                     behaviour


                   assets                                      liabilities
  social overhead capital                   net interest-bearing debt den. in domestic
                                            currency, held by residents
  equities in public enterprises            net interest-bearing debt den. in domestic
                                            currency, held by non residents
  land and mineral assets                   net interest-bearing debt den. in foreign
                                            currency, held by residents
  net foreign exchange reserve              net interest-bearing debt den. in foreign
                                            currency, held by non residents
  present value of future tax program       net interest-bearing debt index-linked, held by
  including social security contributions   residents
  tariff revenue etc (implicit asset)
  Imputed net value of gov.'s cash          net interest-bearing debt dindex-linked, held by
  monopoly                                  non residents
                                            stock of hight-powered money
                                            p.v. of social insurance and other entitlement
                                            program (implicit liability)


Source: Buiter 1998 p.109          Macro Topics in Development                                 42
                                       and Transition 2007
                        Expenditure shifting




• To meet today’s cash deficit targets, gov. shifts
  expenditure and revenue across time, simply
  deferring spending to the future
• Usual devices:
   – Delaying payments to government workers or suppliers
      encouraging switching to projects that disburse
     slowly, even if at a higher unit cost
   – Shifting taxes over time  advance payment of taxes in
     a different fiscal year
   – Delaying the resolution (ands so the high fiscal costs) of
     financial crises in banks


                     Macro Topics in Development              43
                         and Transition 2007
                 Expenditure shifting (cont.)




• Allowing state pension funds to lend to
  government at a negative real interest rate
• Advantage: cutting budget deficit today
• Disadvantage: reducing the fund assets
  necessary to meet future claims
• Example of hidden liability accumulation




                 Macro Topics in Development    44
                     and Transition 2007
    A positive theory of govt intertemporal behaviour




   Net worth      NW = A – Le – Li

Where    A is total assets
        Le is explicit government debt
        Li is implicit government liabilities
The model
                              
                                                                           The

                              e
                                   t
                  Max                   ln C dt                 govt. finances its current
                                                             consumption with asset income
                               0                               minus debt interest, asset
                                                            decumulation, debt accumulation,
  s.t. C  rA  rLe  rLi  A  Le  Li            (1)   and hidden liability accumulation
                         
          A  Le  Li   e  rt Ct dt (2)            The govt’s intertemporal budget
                         0                          constraint: net worth must be greater
                                                             than or equal to the
                                                         present value of all future
                                                                 consumption.
 Where:     C is government consumption,
            A is the valuation of the government’s assets,
            Le is explicit government debt,
            Li is implicit government liabilities,
             r is both the rate of return on government assets and the interest
            rate on government liabilities,
            and ρ is the government’s discount rate.
...(continued)



 Conventional budget
  deficit
          D  C  rLe  rLi  A  rA  Li                   (3)


       First                D  Le          from (3) and (1)
    conclusion             NW  A  Le  Li
   Since the govt. is indifferent about the composition of net worth, any
   externally imposed constraint on a subset of its components can
   immediately be substituted by other components and has no effect on the
   optimal path for consumption. The apparent fiscal adjustment caused
   when the external constraint bites on explicit debt accumulation is entirely
   illusory.


                           Macro Topics in Development                            47
                               and Transition 2007
The solution



 The optimal path for govt. consumption and for
  govt net worth
                N W
                      r   & C   NW
                 NW


                Second         NW r  
               conclusion         
                                C    




                     Macro Topics in Development   48
                         and Transition 2007
The effect of deficit-reduction programs:
‘creative accounting’

 1. Govt.                 Public govt. consumption in
            comparison of investment
 Consumptio stand-by and not stand-by periods
             (15 intensive adjustment lending countries)

            for 89 countries that received a
 n
                 stand by loans in 1967-’96

                 Govt. consumption is independent
                 of fiscal requirements

 2. Public       In period of restrictive fiscal policy
 Investment      capital expenditure are the first to
                 be reduced (Ex. Zambia)
Implicit pension debt of euro countries
                     Main conclusions
1. Theoretically Δ in GOV net worth is ideal measure of deficit
   but practically measurement difficulties exist
2. If the components of net worth are PERFECT SUBSTITUTES
   (i.e. they yield the same returns), the Government cares only
   about the net worth as a whole, regardless of its composition.



Eventual constraints on deficit will lead to adjustments in assets
and hidden liabilities (composition), leaving the optimal path of
GOV consumption unchanged  ILLUSIVE FISCAL
ADJUSTMENT
                     Policy implications
1. Outside agents (EU, IMF,WB) during adjustment
   programmes should check for cuts in public investments or
   operations and maintenance, for “fiscal” privatisations and
   for expenditure shifting over time
       WB and IMF since 1996 are trying “to enhance the
       transparency of fiscal policy by persevering with efforts to reduce
       off-budget transactions and quasi-fiscal deficits”

2. They should select countries on the basis of indicators
   showing low discount-rate GOV (indicating sustained
   improvements in the public finances)
3. Maastricht criteria in terms of debt net of marketable assets
   rather than gross debt and deficit targets in terms of
   structural (long run) deficits, excluding cyclical fluctuations
                   Net worth measures
1st Best      All public sector assets (infrastructures, present
              value of taxes, mkt value of state enterprises) and all
              liabilities (official debt, implicit pension debt,
              expected value of bank/enterprises bailouts)
                    BUT Measurement difficulties
2nd Best      Purely financial balance sheet
                                 BUT
    • Also difficult to evaluate before actually sold on the mkt
    • Would not prevent illusive and creative accounting

3rd Best      Δ in whatever can be measured in the most all-
              inclusive balance sheet
                     Minimum for EU, IMF,WB
         Example Four:

Barter Payments and the “Virtual”
            Economy


          Macro Topics in Development   54
              and Transition 2007
                The “Virtual” Economy

• This phenemenon was brought into prominence by the extreme
manifestation of the problem in Russia and other countries of the
FSU after 1994. Papers by Clifford Gaddy and Barry Ickes (Brookings
Institution) and by Simon Commander and Christian Mumssen
(EBRD) are the best known. But aspects of the same phenomenon
also manifest themselves in other contexts

• It relies on the basic point that IF prices are not uniquely specified
then any set of values can appear in, for example, estimates of GDP
and in estimates of corporate profitability and tax liabilities
• IF companies and individuals can use false values for some of their
transactions with government then the fiscal picture may be
completely distorted.
• This is more likely if various forms of non-monetary payment are
tacitly or explicitly permitted



                        Macro Topics in Development                    55
                            and Transition 2007
    A clue to this in Russian Monetary Accounts
Source is S.Commander and C. M umssen, Understnding Barter in Russia, EBRD, 2002




                         Macro Topics in Development                               56
                             and Transition 2007
Compare Barter Volumes and the Monetary
              Aggregates




            Macro Topics in Development   57
                and Transition 2007
and the Fiscal Position




    Macro Topics in Development   58
        and Transition 2007
   Gaddy and Ickes – 4 Sector Model


                                                      Gazprom
      Households
                                                      (G) =
      (H)                                             Profitable
                                                      Co.

                                                Gas                Payment
Social                                                             for Gas
Payments



           Government                          All Loss-
           (B)                                 Making
                                               Enterprises
                               Taxes           (M)



                        Macro Topics in Development                          59
                            and Transition 2007
Payments and Barter by the Four Sectors

•   H produces 100 units of Labour Output       •   The only tax in the system is a 100%
    that it supplies to M. This is also the         value-added tax
    market value of the labour supply           •   So G is charged 100 of tax
•   G produces 100 units of Gas (at zero        •   G cannot pay in cash and so transfers
    cost) that it supplies to M. This is also       the 100 of barter claims it received
    the market value of the gas supply              from M as an alternative. B accepts
•   M uses these inputs to produces 100             this 100 as full payment
    units of manufactured goods and so          •   M is charged 100 of tax but also
    makes a loss. Since it cannot sell              cannot pay cash and so transfers a
    these goods on the market (it used to           further one third of its output to B. B
    make ballistic missiles and tanks               accepts this barter payment as full
    etc….), it makes a loss of 100.                 payment
•   However with no market test, M              •    B has an obligation to H which it must
    continues to produce and to claim its           settle in cash. (it is assumed that all
    output value as 300 units (so it has            budget receipts are fully transferred to
    value-added in false prices of 300-             households). So it sells the 200 that it
    200=100) but G and B accept this                has received as barter payments from
    valuation. So G accepts one third of            M and G to their market value of 67
    M’s output on a barter basis to “pay            and pays this to H. It still owes 133
    for” the 100 of Gas supplied.               •   So H has received in cash the 100 that
•   Since Households need cash, M sells             it needs to cover its basic subsistence
    one third of its output for cash                costs (assumed to be equal to the
    (realising 33) and pays this to                 labour it supplies)
    households. It still owes H 67 units


                               Macro Topics in Development                               60
                                   and Transition 2007
The Necessary Conditions for the Virtual
         Economy to Persist
There are THREE Conditions:

1.There is a Value-Producer namely Gazprom that
pumps true value into the system
2.Both the Budget and Gazprom have to go along
with the pretence that M’s “hard-to-sell” output is
still worth 300
3.There must be some external buyer who supplies
cash to buy M’s output at the discount (relative to
“false” prices) of 67%)
AND = all participants have SOME incentive for this
system to persist.

                 Macro Topics in Development      61
                     and Transition 2007
 The Distortions of Data

                                 Virtual Economy       Real Economy

Total sales (gross)                   400          200 (G=100 and M=100)
Total Profits                         200          0 (G=100, M = minus100)
Profit Rate                           50%                    0%

Total Value-Added or GDP     300 (G=100, M=200)             100
Wages                               100                     100
Paid                                 33                     50

Budget Revenues & Expenditures
Planned                               200                   100
Actuals                               67                    50

Household Income
Accrued                               300                   200
Actuals                               100                   100

Arrears of Payments
Wages                                  67                   50
Inter-Enterprise                      none                  50
Budget to Households                   133                  50
Taxes                                 none                  50
TOTAL Arrears                          200                  200




                  Macro Topics in Development                                62
                      and Transition 2007
       Gaddy and Ickes on the Siberian “Boom”
                                   The Moscow Times, November 12, 2003


• GDP by definition is supposed to measure the total market value of all goods and services purchased
for final use during a given year. The key phrase is "market value." Even without blatant statistical
deception, a nation can increase its GDP if the government rather than the market decides what has
value and what does not. This is precisely what the Soviet government did during the industrialization
of Siberia under central planning.

• Western analysts were astounded by the magnitude of projects, the scale of investment in Siberia,
and the rapid rate of growth. But neither the scale of projects nor the size of Soviet GDP meant that
the allocation of resources involved was determined by market rules. Siberia's growth was entirely
driven by communist planners bent on creating an industrial utopia in this vast region.

•Most of the Siberian endeavors would never have been undertaken under market conditions. Some of
the largest construction projects were located in the harshest climatic zones of the so -called Russian
North, where the costs of construction were extremely high. By the late 1980s, Siberian project offered
an extremely low return on their massive investment.

• The Siberian industrial enterprise was brought to a screeching halt by the collapse of the Soviet
Union. Today's Russia has inherited the burdens of maintaining all the huge enterprises communist
planners left for it in distant places. And millions of Russian citizens find themselves stuck in Siberian
cities with bankrupt industries and dismal living conditions. Those who would like to move are
prevented from doing so by persistent institutional barriers to mobility and insufficient jobs and housing
in other parts of the country.



                                    Macro Topics in Development                                         63
                                        and Transition 2007
Figure 1:            Investment Choices in Market and Planned
Economies
Return on Investment (%)




                                Financial returns >economic
                                returns




                                                                     Cost of capital in the market


                                                                        Financial returns <economic
                                                                        returns
       Possible hurdle rate in a planned economy


               1     2     3     4     5     6     7   8      9 10 11 12 13 14
                                                                  Possible Investments ranked by
                                                                  financial rates of return


But an absolutely key issue is that economic principles prevail in both the
market and the socialist planned economies. In both cases the marginal
returns on investment will tend towards zero unless there is some market cost
of capital (in the market economy) or hurdle rate of return (in the planned
economy) that can signal the scarcity of capital.

                           Macro Topics in Development                                                64
                               and Transition 2007
                Selected Conclusions

• A Virtual Economy can exist in any situation where there is
  disagreement about the “correct” prices of particularly outputs
• But it also needs clear incentives for all parties to any transaction
  at “false prices” to accept those prices as meaningful
• This being the case, basic economic statistics including data about
  the size of GDP, the growth rate, the budget and the budget
  deficit can become seriously misleading
• The break up of the USSR after 1989 provided one conjuncture of
  circumstances (a damaged economy where many had incentives
  to operate as though it was not so badly damaged
• The chaos and mass insolvencies that followed most recent
  Emerging Market financial crises provide another similar
  conjuncture of circumstances where prices are not unified and
  asset prices cannot be instantly and correctly re-assessed (by
  anyone). NOTE, in particular the problem of enforcing normal
  bankruptcy mechanisms when 30-50% of all enterprises (not 2-
  3%) are technically insolvent.


                        Macro Topics in Development                  65
                            and Transition 2007

				
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