By Claus Vistesen, on August 5th, 2011
In case you did not notice it, the much discussed “range” on the SP500 broke in spectacular fashion yesterday as the short rollers bypassed the 1250 mark in the same style as the Germany pantzer passed the Maginot line back in the early stages of WWII.
Basically, two many people tried to catch the knife of the falling market (everywhere) in anticipation of just one good data point or perhaps CB intervention but nothing came. As such the pain trade is still down I think. Of course, we DID walk into the office to some JPY selling by the BOJ and the ECB finally looked outside the ivory tower to see the badlands that its stfu policy has so far engineered even if the continuing mention of inflation risks somehow strikes me as beyond crazy.
With most market participants probably now sitting shivering in a corner wishing that yesterday was Friday, there is indeed a day today and one has to assume that a bad jobs report will bring the whole world down on the back of stock investors. Blood is currently flowing but it can get worse, much worse than this.
Given the feedback loop between our recession indicators and the SP500 with the former taking the latter as an input there is clearly now a real risk of a recession in the US and on my casual calculation it is well above 50%.
Now, if the pain trade is still down the decision by BNY Mellon today to charge customers for holding large piles of cash indicates to me that the pendulum has swung extremely fast into uber fear mode. My feeling is that the market has much further downside from here in the short term, but nothing goes down in a straight line forever. In this sense a US recession market level is likely to be very close to this level, it may still squeeze the longs yet awhile.
More generally, I am constructive on how this might impact emerging markets in the sense that inflation is now likely to be even more a non issue. This is especially the case in economies who have mainly been combatting headline inflation (e.g. Chile with India as a rather more sinister case of demand pull inflation too). There will be no recession in EM and therfore a re-rotation into EM from here on as DM slumps into a recession is one way to stay constructive even in the midst of the bloodbath taking place.
By Claus Vistesen, on August 4th, 2011
Starting a new job and settling in a new city/flat has proved a little more unsettling for my blogging efforts than I had expected. Anyway, what better time to return to the fray when the SP500 completes its worst run in a long time returning to levels not last seen since March where we thought we had to write off the entire Japanese economy as a nuclear wasteland. So, is it all back to square one for the already weak recovery?
Arguably though the catalyst this time is more sinister in that it cannot really be pinned on any single event. Surely, the debt ceiling charade and the prospects of Spain and Italy spiralling further into the arms of what ever bailout that might be on offer are catalysts in themselves, but the underlying economic data is getting increasingly sour.
All the leading data we are looking at, both in terms of the global breadth of economic momentum and specifically on the US economy have rolled over in a dangerous fashion and a recession in the US cannot be entirely ruled out. Indeed, on some measures we would even be calling one. Elsewhere, the slump in the July Australian PMI also suggests that one of the hitherto strongest economies in the global recovery may be about to embark on its own homegrown downturn.
It was also interesting to see the SNB finally cave in (yet again) to the relentless rise of the CHF despite the bank’s efforts both communicative and with hard money to starve off the beast. As I have remarked before, safe haven flows hurts and can be akin to holding Old Maid. Indeed, it may turn interest rate decisions on their head as rates will be lowered going into a melt up of economic activity to attempt to deter speculative inflows.
Generally, one of the most obvious consequences of the recent bout of weakness will be that more stimulus is in the pipeline, at least in the US economy whereas the ECB will probably need a little time before the reality dawns on them. However, the underlying inflection point between an economic recovery that is clearly turning out much weaker than expected and the reality of too much debt is starting to hurt. In that vein, it is difficult to see a viable way out of the obvious need to cut spending and reign in excessive public spending with the simple fact that what has largely driven GDP in the recovery has been government consumption and investment.
We can consequently expect that the Krugmans of the world to get another big chunk of the discourse as the call for further and bolder stimulus packages increases. In this respect, the Squid had nice note out on Monday on the possible avenues a new round of QE would take where the main message seems to be that the Fed will try to further cement its position of low rates for an extended period. But more interestingly is the widespread expectation that if the Fed engages in further asset purchases it will be on the long end of treasury curve and thus to flatten the curve on the long end. Surely, this makes sense in so far as goes the idea that the housing market remains in an extremely poor condition. Mortgage rates are thus likely to be driven more by long term rates than rates on the short end or at the middle. Coupled with outright targeted asset purchases of MBS using the proceeds from its securities portfolio the Fed would be signalling that the size of its balance sheet will remain inact.
Sufficient on to the day and all that but with the current sinister backdrop of market currents and poor economic data we can expect Bernanke to step up any time now.
It has occured to me here that what we might be facing in the developed world is a mirror image of the situation in the emerging world and that the combination is not the best of mixtures for the global economy.
Consider then the situation e.g. in India where the RBI is trying frantically to weigh against excessive government spending not to mention China where you get the distinct feeling that at least some part of the inflation problem comes from the central authorities’ credit policies (or lack of tight standards). Conversely, in the developed world austerity is the name of the game quite simply out of necessity and faced with extremely fragile economies it is largely up to the central banks to attempt giving the economy some tailwind. On a personal note, this is also why I consider the ECB’s recent hiking campaign as the biggest policy failure since, well, they raised just before a recession the last time. The very best we can hope for in Europe is then not a recovery but simply that we might end up back at square one.
By Ajay Shah, on May 27th, 2011
The recruitment of the IMF MD has turned into quite a controversy. For an interesting set of views, see this page on the website of The Economist. In a remarkable development, the EDs of India, China, Russia, Brazil and South Africa came out with a clear
joint statement on the silliness that is afoot.
There are four perspectives on this question which are worth noting:
- There is an obvious gap between the power structure at the IMF, which reflects the way the structure of the world economy after the Second World War, as compared with the present reality. As an example, at present, the Netherlands has 2.08% while India has 2.35%. But the Indian GDP is now $1.6 trillion while Netherlands is at half that.
- The world would benefit from a competent and capable IMF. The best man (or woman) for the job will not be obtained by having any restrictions on nationality. As an example, in today’s world, a name that leaps out to me is Stan Fischer. But he’s not European, and hence was never even considered for the top job in the last decade. (As with Montek, he is now over age 65 and is hence not eligible for the job today). Given that a large fraction of the top economists of the world are not European, this rule yields a less capable IMF.
- I feel that a quota system where the IMF MD must now be from an emerging market is as bad as a quota system where the IMF MD is only recruited from a European country. The key is to get away from all these quota systems, to only recruit the best person for the job. The emphasis should be on technical capability. The person recruited should be a technical expert and not a politican. As an example, see how in the UK, they recruited an American into their Monetary Policy Committee.
- In the standard narrative, one hears the idea that in this crisis in Europe, the Europeans are gaining from their
control of the IMF. I feel this is absolutely wrong. In the Asian crisis, it was good for Asia that the IMF was not conflicted
by considerations of domestic Asian politics. Similarly, the IMF program in India in 1981 and 1991 was uncontaminated by domestic Indian political considerations. This helped produce a technically sound program, which helped jumpstart India’s growth. It is not accidental that we see structural breaks in India’s GDP growth around these two dates.
What Europe needs most is a tough IMF, which will be a stern taskmaster, which will force difficult political choices so as to heal the economy. Economic policy in Europe today needs to be cruel to be kind. Instead, by placing a string of career politicians from France into the IMF MD’s job, the valuable role which the IMF could have played in solving the European Crisis is being negated. This damages Europe. The wise thing for Europe today is to say: Give us a tough and competent taskmaster, and let him be
anything in the world but let him not be a European politican. The biggest loser from the present arrangement is Europe.
By Claus Vistesen, on January 17th, 2011
It would have been hard to believe only a few weeks ago that the euro zone could be the source of any good news let alone news to help push the market forward. Yet, with last week’s successful bond auctions and the pledge of international superpowers such as Japan and China to buy Euro zone debt and the ECB’s sudden more hawkish tones, the obvious question is; are we out the woods yet?
Hardly, but it was interesting to observe the almost coy manner in which the ECB slowly but surely began the move towards contemplating to think about raising interest rates. We are not there yet of course, and I still think that any hike in the ECB’s refi rate are, for now, confined Weber’s dreams and a very distant playbook sitting around somewhere on the lower levels in the Frankfurt tower. But let us be honest, stranger things have happened than the ECB raising rates just before the next downturn. Indeed, you might even call this a leading indicator.
In the meantime, the patchwork which is the Euro zone rescue/bail-out/backstopping mechanism is frantically being sown together. Barclay’s Capital collected the following from the market drums in terms of modifications to the hybrid (EFSF) already in place;
He [commissioner Oli Rehn] indicated that various options would be discussed among European policymakers but that it was too early to comment on this in more detail. However, Rehn mentioned that one modification could be related to the rate charged on EFSF loans, with a view to reduce those. Other media reports suggest this could also include the provision of short-term credits to euro area member countries requesting support, the purchase of government bonds through the EFSF, or a change of collateral rules to boost the fund’s effective lending ceiling.
A lot of things on the menu then it seems, but the most important question is really that no one has talked about yet; as Jack Barnes points out;
The system has reached the stage that a bankrupt sovereign state is issuing debt to buy bonds in a vehicle that is tasked with buying debt from a bankrupt Sovereign state that is no longer able to go to market. Folks this is reaching the level of a Monty Python skit.
This brings up a serious question not seen answered in the public yet.Who is ultimately responsible for the bonds that the rescue fund is going to be selling as AAA investments? Whose AAA balance sheet is guarantying these bonds that will be sold to investors like Japan?
So, apart from the obvious issue of issuing more debt to pay off the debt used to finance the debt of bankrupt sovereigns, there is a question of what exactly it is China and Japan will be buying. I am willing to give the EU some benefit of the doubt here especially since I have long been a strong advocate of issuing Euro bonds. But then, these are not Euro bonds as such, but rather instruments used to capitalise a fund which, as Jack Barnes succinctly notes, is in dire need of a capital injection even before it has deployed a single euro of capital. Obviously, the EFSF was created as an attempt to ring fence the problem in the periphery and thus to hedge against a future blow-up . But this always missed the point in the sense that we didn’t really need a bailout fund, but a rather a structural change in the way we perceive and organize the link between fiscal and monetary policy in the euro zone. As traders like to remind newcomers to the business, hedges are things you buy at a B&Q, not at your broker.
The EFSF could conceivably bailout a large part of the inflicted economies, but then there was always going to be Spain not to speak of Italy which it cannot deal with. On that note, it was eye-wateringly embarrassing to hear both the Spanish finance minister and the Portguese prime minister daftly using their respective “successful” bond auctions to note that neither of the their respective economies were going to need any form of bailout simply because they don’t need it!
This is then not to play down what was a long awaited successful event in the context of the European debt crisis which I unilaterally applaud (and hope for more to come) it is merely my attempt to put things a little into perspective. In this light, the gradually more hawkish tone by the ECB could be be seen as a little bit of stick to show economies that while we are here to help, we are also here to do our job which is to protect the purchasing power of all the euro zone citizenry. This may of course be waffle, but the ECB has long had a legitimate problem with simply playing the game in the form of providing liquidity and and even buying up peripheral bonds while playing into inability and flatfootedness of euro zone policy makers. Naturally, my bet is that we have only seen the nascent moves of what will become a full fledged measure of QE by the ECB and much more aggressive buying of sovereign bonds (simply because they have to), but this does not mean that policy makers can simply ignore the facts as they are presented by economic data and common sense.
But I might just be too harsh here and all it might be me who are behind the curve as those very same policy makers are now moving ahead of the curve in the form of, allegedly, a two-front attack on the situation with a bail-out of Portugal and a full euro zone backstop to whatever black hole the Spanish banking sector might turn out to be. Especially this last bit is interesting because it coincides with the news (albeit not fully confirmed and digested by the analysts) that Spain would stand ready to inject a hefty sum of money to shore up its banking system.
Here is Tracy Alloway from the FT Alphaville;
Just as the European Central Bank announced that Spanish bank borrowing resumed its upward trajectory last month (€70bn in December, up from €64.5bn in November) El Confidencial is reporting that Spain is preparing a massive capital injection of between €30 and €80bn to clean up the cajas, or local savings banks.
Having long been the twenty thousand pound elephant in the china shop this is indeed something worth noting more than in passing. Going into perma bear mode I am thinking about Ireland and the sudden reversal of a relatively good sovereign who was brought to its knees by its promise to see through the bailout of its financial sector. The point is that Spain is structurally similar with high private debt, and relatively low sovereign debt and while Ireland was probably going to hit the canvas in any case, its situation got worse by the ongoing quibble about what euro zone bailout funds could be used for. Specifically, the explicit refusal to allow the funds to bail out banks put the whole Irish situation in a tight spot although it was eventually an academic demarcation as the two got fused through the dreaded Irish government guarantee to backstop its largest banks.
So, I am carefully assuming that whatever Spain is brewing on here they have the potential firepower of the euro zone in the back. I have passed on this notion to a friend of mine much closer to the Spanish situation (guess who!) and here are the main points;
1) This is only the cajas, there will then need to be more for the banks (somehow). In fact, once the political argument is settled, the thing is much easier in the cajas case, since because they can’t go to the market with shares, the only thing to do is semi nationalise them, and then refloat later.
2) This then will be the first de facto step of Spain into the arms of the EFSF, since obviously the Spanish sovereign won’t be able to fund the injection (at least not at viable interest rates). Spain should be in completely between May and August.
As such, if it is part of a general euro zone backstop to the Spanish financial system it may be quite a move (and also as noted a sea change since all the quibble on Ireland concerning the use of bailouts would be presumably have been put in the past). I emphasize this since the clock is ticking and the same momumental structural challenges lie ahead even if one country’s successful bond auction may seem to have changed the situation for a while.
As such it might be worth having a look at those fundamentals of the euro zone again and what the proposed (and inevitable) correction mechanism presents in terms of challenges.
Remember the Catch 22
Structurally then we are still faced with the same seemingly irreconcilable issues in the form of imposing internal devaluations, fiscal austerity and returning to economic growth all at the same time from within a currency union. I have called this the catch 22 of euro zone imbalances not least in relation to the idea of a debt snowball;
[...] the forces which have lead to the build-up of imbalances are joined at the hip with the same forces which make it almost impossible to correct from within the Euro zone. Specifically the idea of a debt snowball effect is a good way to show why it will be almost impossible for some economies to correct their external imbalances without an explosive evolution in government debt and since they need to correct external competitiveness issues in order to achieve economic growth, the whole thing turns into a vice and essentially a catch 22.
It is consequently, the rapid deterioration in the private and public debt dyanmics which euro zone policy makers and the IMF are so concerned with and thus trying hard to backstop and reverse. But it might not be so easy as to focus entirely austerity since debt dynamics are also driven by your ability to grow.
At this point you may rightfully wonder then what the hell a debt snowball looks like? Well, why don’t I show you then (see this paper for the model).
Now, in any economic model we need assumptions and instead of feeding in any of the forecasts for the periphery (which are hugely uncertain) let me take the point of view in a model economy with somewhat better fundamentals than many of the peripheral economies. As you shall see, the initial condition matters less than the underlying dynamics for creating a debt snowball.
As such, I assume that my model economy starts with a debt/gdp at a humble 60% to GDP (say in 2010) and that it pays 5% on its entire sovereign debt portfolio. The point here is that while e.g Portugal might have paid 6.7% on its last issuance it does not pay this on its entire portfolio of liabilities. This is also why we have been talking so much as about roll over schedule since if you are so unfortunate that you need to roll over and refinance in times of trouble you are likely to incur a high cost that affects your entire liability side.
Finally, I crucially assume that you can’t have both austerity and growth at the same time. If you want growth it will cost a higher fiscal deficit and if you to run down the fiscal deficit you must endure deflation (negative nominal GDP growth in essence) and it is this latter which the ECB and EU are pushing. Especially this last assumption is absolutely crucial to understand since it is this situation the periphery faces with an internal devaluation in the euro zone (click on all pictures for better viewing).
The bar shows the average from the simulations shown by the line plots. As you can see the numbers are obviously fantasy numbers, but since this an average across many different scenarios where both the fiscal decifit (austerity measures) and growth are dynamic it might not be entirely irrelevant. The set up of these simulations are quite simple. I can change three things in my model; the growth rate, the interest rate, and the budget deficit (primary deficit) [1]. In all the simulations the interest rate is set at 5% and then I build a cross section where I dynamically change the growth rate and budget deficit building in the trade off that you cannot have a low budget deficit and “high growth” at the same time.
Obviously, the results are quite sensitive with respect to how strong you believe the trade-off is between growth and fiscal austerity. I have built in a pretty strong trade off in order to demonstrate what I believe are signficantly worse short term growth dynamics than the consensus. This is also why the model’s result becomes exponential at longer time horizons.
Consider then the debt/GDP dynamics of our model economy in the first 10 years;
Suddenly, the numbers look more realistic but not less scary since you need to remember that this is the average evolution of public debt across all policy mixes (i.e. in a continuum from high growth negative and large budget deficit and low negative growth and fiscal surplus). It is exactly because correcting from within the euro zone imposes this trade off that you end up in a catch 22. Take the example that our model economy manages to realize a constant budget deficit of 6% of GDP which results in a zero growth rate of GDP. In that situation the model predicts a debt/gdp ratio of 160% in 2020 (98% in 2015). It goes without saying that if your initial level of debt is higher, the corresponding level of debt will be corrected up.
I am not presenting this as truisms and prediction tools since evidently economic models are anything but. Instead, they should serve mainly as evidence that bailouts are going to be needed and also sadly that defaults of both the sovereign and private ones are coming and they will be costly.
Finally and just for the sake of argument I thought that I would demonstrate that this model is not simply about exponentially increasing debt/gdp ratios. Consequently, the “good economy” and “bad economy” below both pay 5% on interest on their government bond portfolio but the former has a budget surplus of 3% a year and grows at a rate of 3% a year as well. The latter on the other hand looks more like the periphery with a budget deficit of 5% and a negative growth rate of 1%.
Again, the point is not to extrapolate into the infinite unknown, but to observe that even in the very short run this creates unsustainable debt dynamicsfor the “bad economy”.
—
[1] – So I am being very nice here not even considering interest rate payments on existing debt.
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By Ajay Shah, on December 29th, 2010
Since most of us in India can talk about little else other than corruption, do read this article by Nauro F. Campos and Ralitza Dimova on voxEU which is an interesting meta-analysis about papers which analyze the impact of corruption on growth. I have long heard about meta-analysis, but this one made me sit up and notice.
Anand Giridharadas in the New York Times on Arthur Bunder Road in Bombay.
Roger Bate and Tom Woods, in The American, point to a new dimension in India’s crisis of fake medicines.
II Sc will now use the IIT JEE as their entrance examination for the new Bachelor in Science course. Given that the IIT JEE is a well managed and difficult examination, it would make sense to have more and more schools plugging into it in order to filter their intake. But as you move away from the top .01% of the distribution, the statistical precision of the score on a very difficult exam as a measure of student capability tends to decline. The managers of the IIT JEE will need to shift towards adaptive testing, where the questions are dynamically modified based on student characteristics, in order to retain efficiency across the distribution. Once this is done, the IIT JEE would be useful for sifting through millions of students, and exert a beneficial effect of all of them facing a more demanding high-stakes examination.
Shobhana Subramanian in the Financial Express on C. B. Bhave.
A fascinating article by Nicolai Ourussoff in the New York Times about the attempt to reinvent Saudi Arabia.
Sadness about Europe by Orhan Pamuk in the New York Review of Books, and a tragic perspective on Istanbul by Claire Berlinski in City Journal.
A dystopian future for the world: a story of ageing and depopulation from Amakusa in Japan.
Liu Xiaobo’s beautiful acceptance speech for the Nobel Prize for Peace. A lot of countries of the world, including India, have much to do in order to achieve freedom.
Philippines?
Tourism in Afghanistan by Damon Tabor.
Steven Johnson in the Financial Times on the future of linking to information sources on the web.
With 75% of world GDP in service, trade liberalisation in agriculture or manufacturing is not that important. The really big story is trade liberalisation in services, and there the picture is quite bad. Read this article on voxEU by Bernard Hoekman and Aaditya Matoo on how to obtain progress.
Understanding the rise in currency turnover by Michael R. King and Dagfinn Rime on voxEU.
Anders Aslund, on Project Syndicate, on the remarkable story of the global crisis as it played out in East Europe. Also see this
story in The Economist on the same subject, which is a bit less optimistic. The recovery in East Europe matters for recovery in Europe and elsewhere. It also illuminates our thinking on some of the grand policy questions.
David Alexander points out how Australia is the role model for the world.
Barry Eichengreen, Daniel Gros and Ila Patnaik on the resolution of Europe’s problems.
Devin Friedman in GQ on the strange world of social networking.
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By Eldon Mast, on August 9th, 2010
Market fear continues to subside drastically following a peak six weeks ago. Fear about the insolvency of European banks — which was a basic staple of bear analysts has now proven itself to be grossly overblown. And as the fear about Europe has subsided so has the VIX S&P Volality Index
(chart source: Yahoo! Finance)
The index — which appeared to be on its way to 50 at the height of the European Crisis — now appears to be headed for the teens again.
And there were plenty of signs this week that August news will continue to calm the markets.
1. The Institute for Supply Management released 2 reports this past week. Pointed to continued growth in both the manufacturing and non-manufacturing service sectors.
2. Construction spending — which was forecast to decrease — actually increased during the June reporting period.
3. Domestic motor vehicle sales for July came in stronger than most economists had predicted.
4. According to the most reliable retail indexes, the retail sector (which accounts for nearly three quarters of the US GDP) continues to growth at a healthy rate between three and four percent year over year.
5. The mortgage purchase index for the purchase of new homes has now been up for three weeks in a row. Refinancing and purchase interest rates continue to fall.
6. Although jobs creation is always the last sign of a healthy recovery, the private sector is now clearly beginning to add jobs — ADP reports + 42,000 private sector additions and the U.S. government calculated 71,000 additions in July. The return to jobs growth can be argued as the quickest return to growth from a recession than at any point in modern U.S. history.
7. It is now clear — as evidenced by earnings calls and transcripts — that the majority of U.S. businesses have returned to profitability. Not only have the majority report Q2 results better than expected, but the majority now forecast continued growth and profitability into the end of the year.
And investors are finally starting to agree with the positive business assessment. Not only is the VIX index on a steady decline, but stock markets finished the first week of August up nearly 2 percent for the week and over 6 percentage points year to date.
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By Eldon Mast, on July 1st, 2010
Negative moods in Europe are finally being calmed by news on Wednesday that the European Central Bank will likely lend less money than expected for the next three months. The data suggests that region’s banks’ cash needs were wildly overblown again by the crisis fear-mongers.
“The result of the ECB’s money market operations indicated that money markets have been less distorted than originally feared,” BNP Paribas said in a note. BNP Paribas is considered the leading financial group of the eurozone.
Also providing a hopeful sign, Germany’s unemployment rate declined to 7.5% in June thanks not only to the traditional springtime upturn, but also an improving economy, according to the country’s labor agency report. They released data showing that the jobless rate was down from 7.7% in May.
The German data raised hopes on Wednesday that consumer spending in Europe’s biggest economy will help the region, a zone where doomsters have suggested that severe spending cuts will darken the growth outlook.
The European reality now mirrors what most analysts now recognize in the U.S. economic prognostications. “The U.S. economy has stabilized in the near term,” said Castor Pang, director of research at Cinda International. “Maybe the U.S. markets are overreacting a little.”
By Rok Spruk, on June 7th, 2010
Gary Becker (link) and Richard Posner (link) have initiated an interesting debate on low economic growth as the main macroeconomic concern of European economies in overcoming the increasing burden of public debt.
By Rok Spruk, on June 4th, 2010
In the WSJ, Vaclav Klaus, the president of Czech Republic, draw important conclusions from the long-term economic sustainability of the Eurozone (link), arguing that the Eurozone is not an optimum currency area as suggested by the famous four criteria from economic theory. In a puzzling essay, Mr. Klaus demarks the Eurozone as a monetary union of particular economic viability and, based on the assessment of growth dynamics in Europe, suggests that the Eurozone will face a deepening problem in the future.
By Rok Spruk, on May 24th, 2010
The OECD Factblog highlighted a comparison of tax burden across the OECD countries. The main findings of the comparison is that overall tax burden, measured as a percentage of labor costs, is the highest in Western European countries. Belgium, Hungary, Germany and France are the countries with the highest overall tax burden while Ireland, Iceland, Australia and Korea have sustained a low tax wedge. The data acquired by the OECD pose an intriguing question: is slow economic growth in European countries attributed to high tax burden of labor supply and, if so, has the gap between the U.S. and Europe grown further?
Let’s decompose the data and underline the main findings. Tax wedge, measured as a percentage of taxes and transfers paid in the share of total labor costs, is a sufficient measure of the overall level of taxation. In the analysis of the effect of taxation on labor supply, the economic theory distinguishes between substitution and income effect. The former means that tax rate on labor supply would reduce the number of working hours and shift the individuals to allocate more time into leisure. The income effect, on the other hand, states that the effect of tax on labor supply would be neutral and would, hence, not have an effect on the relative allocation of resources between working hours and leisure. In general, there are two largely opposing views in economic policy regarding the relationship between taxation and labor supply. Conservative and liberal economists tend to emphasize the role of incentives. Higher tax rate would raise the labor cost and the corresponding decline in wages would be offset by the re-allocation of resources into leisure sector of the economy. Left-wing economists mostly disagree with the abovementioned proposition. Instead, they emphasize the role of elasticity of labor supply. According to New Keynesian view, short-run tax elasticity of labor supply is low in absolute terms, meaning that the amount of working hours does not respond significantly to relative changes in tax rates. The Keynesian economists thus emphasize the significance of income effect while the conservative and liberal economists tend to emphasize the substitution effect. The distinctions and policy effects of these two theoretical propositions remains a controversial issue of economic policy debate.
The country distribution data is extensively underlined in the data (link). For example, one-earner married couple at 100 percent of earnings distribution is taxed at 20 percent of the overall labor cost in the United States, 22 percent in Australia, 18 percent in Switzerland and 13 percent in New Zealand. On the other tax wedge statistics for Western Europe is a completely different picture. In Sweden, one-earner married couple at 100 percent of earnings distribution will earn only 57 percent of net earnings, indicating a 43 percent effective tax rate on labor supply. In Belgium, the effective tax rate on labor supply is 42.6 percent. Is the difference in effective tax rates statistically significant feature of productivity variation across OECD countries. The OECD recently composed a breakdown in key productivity statistics in developed countries (link). To estimate the relationship between productivity and tax burden, I collected data on multifactor productivity dynamics from Groningen Growth and Development Center (link) and data on tax wedge across OECD countries (link). I estimated the noted relationship for 16 developed OECD countries. Multifactor productivity is a dependent variable while tax wedge is an explanatory variable.The estimates are displayed on the graph below.
Multifactor productivity in OECD relative to the U.S. and total tax burden (% of labor cost)
Source: GGDC, OECD Factblog
The horizontal line on the graphs marks the U.S. level of multifactor productivity. As the graph shows, the underlying relationship between multifactor productivity (MFP)and tax wedge is fitted with quadratic equation. Total tax wedge explains about 34.5 percent of the variation in multifactor productivity index across OECD countries. The trend exerts a decreasing MFP as the tax wedge rises and, after reaching a local minimum, a slight increase alongside the proporional rise in tax wedge. The relevant question is at which rate of tax wedge the MFP reaches the minimum. Setting the first-order derivate to zero (dy/dx=0) yields 0.0016x-0.0488=0. Rearranging the equation yields x=30.5. The first-order derivative implies that MFP reaches the minimum at 30.5 percent tax wedge. The estimate sample-based tax elasticity of productivity ((dy/dx)(x/y)) is 1.78. The elasticity indicates that 1 percentage point increase in tax wedge would reduce the multifactor productivity in a sample country by 1.78 percent, ceteris paribus. In other words, the estimated slope coefficient suggests that a 1 percentage point increase in tax wedge would widen the MFP gap between the average country and the US by additional 0.05 index points.
In economic terms, MFP would decrease as long as the countries in the sample would exert less than 30.5 percent tax wedge. In the horizon after the local minimum (30.5 percent), MFP would initially increase but at a smaller rate than before the function would reaches the minimum point. At 20 percent tax wedge (close to Japanese level), the expected decrease in MFP would be 0.0168 index point. At 40 percent tax wedge, the expected increase in MFP would be 0.0152 index point. Economically, the relationship between MFP and tax wedge should not be interpreted as a mixed effect of tax wedge on MFP. In countries, where tax wedge exceeds 30.5 percent (Austria, Denmark, Sweden, Belgium etc.) , the multifactor productivity is close to the U.S. level. The only country with higher MFP level than the United States is Luxembourg. In these countries, the average number of annual hours worked per worker is lower than in the U.S. Hence, hourly productivity output is higher. The following graph illustrates the relationship between annual hours worked (per worker) and MFP level.
Average annual hours worked per worker and multifactor productivity relative to the US
 Source: OECD Statistics (2010) As the graph illustrates, there is a negative relationship between average annual hours worked and MFP. The estimated regression coefficient suggests that an increase in annual hours worked by 100 hours would reduce MFP level (compared to the U.S) by 0.06 index points. As expected, the implied elasticity of productivity is negative. Taking the average values ov both variables, an increase in average annual hours worked (per worker) by 1 percent would reduce the MFP relative to the U.S level by 1.16 percent, ceteris paribus.
The conclusion is that there is a significant and negative impact of tax wedge on multifactor productivity. Taking the differences in annual hours worked into account, tax wedge alone explains almost 35 percent of the differential in multifactor productivity across the OECD. The findings suggest that there is a relatively strong substitution effect in labor supply. The finding is underlined by the fact that higher tax wedge would correspondingly reduce annual hours worked. However, the interpretation should be taken with a grain of warning. As previous empirical studies have shown, there is a widespread disparity in the distribution of working hours in formal and household sector of the economy. A sizeable proportion of working hours in household sector of the economy is not officially measured. Consequently, a blick of distortion of the real relationship between labor supply and tax wedge, in its broadest sense, is a major impediment to the measurement of labor supply dynamics. These estimates will, in a large part, determine the future research of the effect of taxation on labor productivity.
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