Obama’s foreign policy in historical context: Wilson or Roosevelt?

Both Theodore Roosevelt (1901-09) and Woodrow Wilson (1913-21) had a major impact on US foreign policy during their time as president. However, their view of America’s role in the world was significantly different. Central to Roosevelt’s view was the expression and use of US power abroad, with a focus on protecting American interests around the world. He was a key figure in the first US foreign military engagement when he was serving then President McKinley—against Spain’s pacific fleet in Cuba following the explosion of US battleship Maine. Later, as president, Roosevelt would extend the Monroe Doctrine (a US foreign policy statement in 1823 that viewed further European colonisation of the Americas as an act of aggression, requiring US intervention). The extension became known as the Roosevelt corollary—that the US would intervene against any ‘brutal wrongdoing’ in the Western Hemisphere.  Roosevelt had orchestrated the most advanced US interventionist foreign policy to date, focusing not only on US interests abroad, but any perceived wrongdoing in the Western world.

Roosevelt was still capable of diplomacy, despite the militaristic tone of his corollary. He intervened in a number of foreign disputes: between Japan and Russia over Manchuria and Korea; between Germany and France over the control of Morocco. These diplomatic episodes are best viewed through one of Roosevelt’s favourite quotes—speak softly but carry a big stick. Roosevelt was willing and able to use diplomacy when the circumstance warranted it, but military strength was at the core of his foreign policy.

Wilson had an altogether different view of US foreign policy. Unlike Roosevelt, the military and US power abroad was not central to his view. Conversely, he had a different understanding of the active role that the US should play internationally. Wilson believed strongly in the power of democracy, the opening of markets and the role of international organisations to promote peace. World War I provided a key distinction between the views of Wilson and Roosevelt. Initially, Wilson declared US neutrality when the war began, much to the chagrin of Roosevelt. It took until 1917, three years after the war began, for Wilson to bring the US into battle, as the position of neutrality proved increasingly difficult to maintain. Although we have to assume that Roosevelt would have joined the war much earlier, Wilson’s decision to join the war was not a transformation to the Roosevelt view. Wilson’s view of foreign policy evolved in light of the circumstances, and US involvement in the war was justified on Wilsonian grounds as the ‘world must be safe for democracy’.

Both of these views of the US role in the world still live on to the current day. As Obama nears the end of his presidency, can we place his foreign policy in this historical context and ask was Obama’s policy Wilsonian or Rooseveltian?

Wilsonian: Driven by world view and circumstance

Early in his presidency Obama initiated a reset with Russia, with the aim of restoring relations after they had become severely strained under President Bush. Initially, the reset was a success, with Russia supporting the US in key areas of national interest: sanctions on Iran related to its nuclear program; the movement of troops through Russian territory during the Afghanistan war. Progress made from the reset of relations was reversed by a revanchist Russia in Ukraine and Crimea. The US, along with the EU, placed sanctions on Russia targeting state-owned banks and the oil and defense industries. Sanctions on Russia for its actions in Ukraine are not anti-Wilsonian, but recognition that open markets, the rule of law and international norms are central to the world order.

Obama & the Asia-Pacific—some Roosevelt, but much more Wilson

To analyse this question regarding Obama’s foreign policy, two key events stand out in the Asia-Pacific: the signing of the Trans-Pacific Partnership (TPP) and the freedom of navigation operation (FONOP) through the South China Sea. First, the TPP is a mega-regional trade deal covering almost 40% of the global economy, and as yet, it does not include China. It is the centrepiece of Obama’s pivot to Asia and is an attempt to embed the US-led order to international commerce. The TPP, therefore, is more aligned to the Wilson view of US power abroad. It could be argued that FONOPs through the South China Sea are a Rooseveltian expression of US power. On the other hand, they could be seen as the US expression of the importance of global trade and international law.

Obama & the Middle East—predominantly Wilsonian

When one thinks of the president’s middle-east policy, such words as rational, calculated and cerebral come to mind. His policy with Iraq and Afghanistan has been anything but rash. Indeed, he has often been referred to as a hyper-realist (perhaps the only exception to this account is his imposition of the red-line for chemical weapons use in Syria). He has been cautious in the use of US power—something that is clearly more Wilsonian—and he moved as quickly as possible to reduce US troops in the two wars that he inherited in 2008. In 2011, as the Arab Spring hit Cairo, he supported the people in this movement for the urge to achieve democracy. In Syria, he has been reluctant to commit military forces to the conflict, thus leaving a vacuum that countries such as Russia have since filled. He also failed to act on his threat to Bashar al Assad after the Syrian leader used chemical weapons on his own people—it is hard to see Roosevelt not following through on this threat. Events in all of these countries have since complicated matters: the rise of Islamic State in Iraq and Syria; the resurgence of the Taliban in parts of Afghanistan; the lack of democratic reform in Egypt.

Perhaps in response to his failure to act with military aggression after Assad crossed the red-line, Obama outlined his approach to US power in a speech to the UN in 2013. In that speech, he laid out the different US interests that would be protected by unilateral action, using the full force of US power, and those that would be defended by multilateral actions. There were four areas where the US was prepared to use the full force at its disposal: to protect its allies against ‘external aggression’; to guard against weapons of mass destruction; preventing terrorist attacks on the US; and ensuring the free flow of oil and gas. The phrase ‘external aggression’ sounds similar to ‘brutal wrongdoing’ of the Roosevelt view, but importantly it is only applied to allies, not the broader western hemisphere. Peripheral to these interests, the US will work with others to promote democracy and free markets.

Events since that speech have confirmed the Obama approach to international relations. In Iran, he has worked with other countries to change the course of their nuclear program (which may turn out to be the most significant policy of his presidency). The use of FONOPs in the South China Sea, as unilateral actions, demonstrates this distinction between central and peripheral interests. Obama has, arguably, displayed more attributes of Wilson’s world view than that of Roosevelt. Whether by circumstance or the sheer complexity of international relations, he has embedded elements of Roosevelt into his modern view of the role of the US in today’s world.


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Water, water everywhere – the looming water crisis

The world is facing a water crisis. In 2014, Nestle, a multinational company, warned that water scarcity was more of a concern than climate change. According to the UN, by 2030, the world demand for freshwater will outstrip supply by 40%. Were this to happen, the crisis would be characterised by severe health concerns, national and sub-national conflict and major migration from those areas worst affected. Little wonder, therefore, that water is a central feature of the Sustainable Development Goals (SDGs). SDG 6 outlines the world’s focus on this issue over the next 15 years: Ensure availability and sustainable management of water and sanitation for all. This will not be easy.

Conflict at many levels

The water crisis is already revealing itself in international tensions, community disharmony and outright conflict. According to the Pacific Institute—a non-profit think tank that tracks water-related conflict—the number of water-related episodes of conflict is rising and shows no signs of slowing down. For example, in South Africa, protestors in Cape Town rioted over the inability of local authorities to deliver water and other services in 2012. In Mexico City, in 2014, local residents clashed with police over the apparent exploitation of a water spring for new developments, leaving a number of people injured.

Internationally, access to rivers is a growing contributor to water scarcity. The Mekong River—taking in China, Myanmar, Thailand, Laos, Cambodia and Vietnam on its journey—is a prime example of the difficulties of cross-country resource management and the tensions this brings. China, where the river begins, is furiously building dams along the Mekong in an effort to provide hydropower to its growing population. This, inevitably, reduces the water to those users downstream, while also adding times of unpredictable flows as China manages the water levels in these dams. Although there are reports of more communication from the Chinese regarding dam level management, the sheer number of current and proposed dams along the Mekong – China plans a further 14 dams while downriver countries have plans for 11 more – will greatly reduce the flow of fish and the sediment that is so vital to fish stocks and soil used in downstream agriculture.

Water-related tensions are also growing at the community level. In Australia, a historically dry country, the competing claims over water from the agricultural and industrial sectors is causing a lot of concern. A case in point is the Shenhua Watermark coal mine in New South Wales, a state in Australia. The Shenhua mine is yet to be built, but is the aim of the Chinese company to draw on the state’s natural resources. The problem, however, is that this may impact prime farming land, with concomitant concerns about the impact on the local water supply for town residents. At the time of writing, a solution seems a long way off, and the Shenhua mine is further delayed.

Technological and policy innovations

Cooperation, compromise and innovation will all play a role in addressing the water crisis. The Mekong River Commission has the potential to reduce tensions as more dams are built (Laos, Cambodia, Thailand and Vietnam are full members; China and Myanmar are ‘dialogue partners’). Firms such as Google are using seawater and sewer water to cool data facilities, rather than freshwater. When dealing with the Millennium Drought, Australian authorities used a range of demand and supply-side initiatives to manage freshwater resources. Although not used in Australia during that period, innovative water pricing mechanisms will likely play a bigger role in managing water in coming years. Policymakers will find reluctance from consumers to pay for what was a free resource, but charging heavy users and rewarding light users makes common sense in light of the looming water crisis.


Financial Times. Nestlé warns water scarcity ‘more urgent’ than climate change.

Gleick, P. H. & Heberger, M. (2012). Water and Conflict. Events, Trends and Analysis.



ABC Radio National. http://www.abc.net.au/radionational/programs/backgroundbriefing/shenhuas-mine-is-it-worth-the-risk/6997098


Turner, A., White, S., Chong, J., Dickinson, M.A., Cooley, H. and Donnelly, K., 2016. Managing drought: Learning from Australia, prepared by the Alliance for Water Efficiency, the Institute for Sustainable Futures, University of Technology Sydney and the Pacific Institute for the Metropolitan Water District of Southern California, the San Francisco Public Utilities Commission and the Water Research Foundation.

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Does Russia’s recent behaviour fit with Papayoanou’s framework?

For a personal project that I am working on, I have been looking into theories and frameworks that attempt to relate economic interdependence between countries to the potential for conflict. In his 1999 book, The Lexus and the Olive Tree, Thomas Friedman outlined his “Golden Arches theory of conflict prevention”, and it has been something that has stuck with me ever since. The reason for its resonance was probably the simplicity of its logic: when two countries both have McDonald’s restaurants, which signal the economic sophistication of their respective economies, they will be less inclined to engage in conflict with one another. Arguably, it is fair to say that the simplicity of this theory, while attractive, was probably its downfall. As an economist, it has always attracted me that once two countries, or regions for that matter, are economically integrated, the chances of a conflict are greatly reduced. Unfortunately for me, and for Friedman’s theory, the world is not this simple.

What really troubled me about this notion of economic interdependence and conflict was the level of integration between Great Britain and Germany before the First World War. A quick google search will reveal many articles and scholarly papers to point to the fact that Germany and Great Britain were significant trading partners, with areas covered in goods trade, investment and financial services linkages. So, given this, I needed to find some work that was a bit more sophisticated in terms of international economics and conflict.

After a bit of searching – and I should note that political economy theories were not a major part of my academic studies – I came across an incredibly thought-provoking article by Paul A. Papayoanou, “Interdependence, Institutions, and the Balance of Power: Britain, Germany, and World War”. While the article is worth a read in full, in summary, there are a few ideas that help to structure Papayoanou’s theory:

  • Countries are either ‘status-quo’ countries or ‘revisionists’. Status-quo countries are content with how things are, while revisionist countries would like a different world or regional structure;
  • Economic interdependence does matter, as it enters into the equation of the final decision to engage in conflictual behaviour. Leaders will consider the economic cost of conflict if there is an interdependence between. From Papayoanou: “Economic ties can affect mobilization capacities in two ways – by the role played in the political process by vested interests created by international economic ties, and by modern political leaders’ need to be concerned with the effects of security policies on their states’ economic links and economies.”
  • Political institutions also matter. Papayoanou talks about the ‘median’ voter as an important consideration. In a more democratic situation, the concerns of the median voter are more easily heard, and when there are great economic ties between the countries, it is probably that the median voter would not want conflict to go ahead.

Great Britain and Germany pre WW1 as a case study….

In the build up to the first World War, Papayoanou’s theory would predict a weak British response to the growing threat from Germany due to two factors: the interdependence of the two economies and the democratic political structure of Great Britain that allowed the vested interests of these economic relationships to have political influence. Indeed, Papayoanou cites a number of examples that supports his assertions about the British response to the German threat:

“Britain’s ambivalent “straddle policy” in the period leading up to August 1914 is consistent with the prediction. The policy included entente balancing with France and Russia and a response to the German naval challenge. However, the ententes were merely agreements to consult in a crisis; no commitments to come to the aid of France or Russia were made. And while the naval buildup helped insure Britain’s survival, it added little to the security of the Continent. Moreover, Britain failed to build up its army’s resources or to undertake conscription, and was unwilling to commit to sending the expeditionary force to the Continent. Britain also pursued something of a detente with the Germans, negotiating over naval, political, economic, and colonial matters after 1911. And in the crisis of July 1914, Grey pursued mediation and only issued a private, informal warning to Germany. All in all, then, British policy was a mix of balancing and conciliation, as predicted.”

Russia, Ukraine and Papayoanou

The ongoing conflict in Eastern Ukraine would seem to fit Papayounou’s framework quite well. In particular, the mixed and less-than-united response from European countries seems to be driven by the varying economic ties that some European countries have to the Russian economy. For example, France took a longer than expected amount of time to cancel a delivery of warships to Russia, as the conflict had been going on for a while when this decision came in November 2014. At the time of writing the conflict has escalated after a brief respite following the Minsk agreement, but in December, the divisions were evident again. From Bloomberg:

“French President Francois Hollande floated the prospect of scaling back sanctions on Russia, becoming the first major European Union leader to offer to ease the Kremlin’s economic pain. “If gestures are sent by Russia as we expect, there would be no reason to impose new sanctions but on the contrary to look at how we could bring about a de-escalation from our side,” Hollande said as he headed into an EU summit in Brussels yesterday….

Hollande’s initiative put him at odds with Germany, Britain and most of eastern Europe as well as the U.S., which want Russia to comply with demands on Ukraine before offering any easing of sanctions. The divergence became public as rival EU factions added up the costs and benefits for Europe’s sluggish economy of the curbs on business with Russia.”


The last sentence highlighted from this article captures Papayoanou’s theory nicely: the decision to ‘balance’ against Russian aggression in eastern Ukraine is heavily influenced by considerations of the economic costs that the conflict, and any escalation, would have on the domestic economies.

Papayoanou on Russia

While this theory was outlined in 1996, Papayoanou had some insightful views on Russia:

“If Russia becomes part of the international economy without, however, having made a transition to full-fledged democratic institutions, economic ties could have a negative effect, as in the years preceding World War I…

There is thus no assurance that economic integration would have pacifying consequences on Russian foreign policy because internationalists might not have much of a restraining influence in the domestic arena in the future. And if that happens, Western democratic leaders may find themselves constrained by domestic economic interests just as Britain was before the First World War.

While it is essential that Russia be brought into the international economy to see a transition to a stable market democracy, the West must do so with great care. It should carefully design economic concessions and interactions that will support internationalists and democratizing forces within Russia, without creating ties in the West that would be too politically costly to break should the nationalists win domestic political battles and promote aggressive foreign policies that need to be balanced against. To do otherwise risks revisiting 1914.”

Some comfort from Papayoanou’s theory

In his theory, Papayoanou talks often about ‘adjustment costs’, or the economic costs that would occur should a conflict take place and economic ties break down. Papayoanou usually talks about this from the perspective of the ‘status quo’ countries, but it would also apply to a ‘revisionist ‘like Russia. In this sense, the economic sanctions, especially when combined with the large fall in the oil price and the Russian currency, seem to offer strong ‘adjustment costs’ on the Russian economy. As I would assume policymakers in the West would hope, these adjustment costs are becoming quite severe and should serve as a deterrent to future escalations of the conflict. Even today, the latest news is that the West is considering cutting the Russian economy off from the SWIFT system – which is the international financial system used for settling transactions between banks. This would hurt the Russian economy even more and take these adjustment costs to an even higher level.

Going forward: what can we glean from this theory about Russia’s behaviour in 2015

The Economist Intelligence Unit recently released it’s latest Democracy Index, where Russia was ranked 132nd. Given the state of democracy in Russia, it is relatively easier for Putin to carry out his security strategy in eastern Ukraine than a country with a democratic system of governance. However, as the economic adjustment costs rise – with increasing inflation, recession and unemployment – we would expect to see growing dissent in the country. So to maintain his strategy in Ukraine, Putin would need minimise this dissent, consolidate power and control the public message of this conflict. Indeed, this is what is happening now in Russia, from The Economist:

This ratcheting up of anti-Western rhetoric is in part a response to a deteriorating economy. Indeed, Mr Putin upgraded the war into a Russia-NATO conflict just as Standard & Poor’s, a rating agency, was downgrading Russia’s credit rating to junk…. Mr Putin has also planted new defences within Russia. On the day the rebels launched their attack on Donetsk airport, an “anti-Maidan” movement was launched, consisting of tough-looking Cossacks, Russian veterans of wars in Afghanistan and Chechnya, black-leather-clad bikers called night wolves and professional sportsmen trained to fight any sign of liberalism.


As tensions escalate again and the Minsk agreement fades into the distance, it must be hoped that the mounting economic costs to the Russian economy will ultimately persuade Putin to change course. With the threat of SWIFT sanctions in the air, these costs will continue to mount. Not wanting to ignite a broader conflict and regional war with Russia, the West has stepped cautiously with it’s response to Russia. With the humanitarian costs of such a war so obvious and striking, the West should stay the course on Russia and continue to exploit its economic power. Ironically, although Papayoanou notes that economic interdependence can weaken the West’s resolve in these matters, once the first stages of a conflict have begun, they can and should be utilised to exert maximum pressure on the Russian economy in the hope of avoiding larger scale conflict and all-out war.

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What is the long-term economic impact of the US shale revolution?

Recently, I had the pleasure of listening to a podcast of a recent event from the Peterson Institute of International Economics, on the economic impacts of the US oil and gas boom (see link here). The event focused on the release of a new book titled Fuelling Up: The Economic implications of America’s Oil and Gas Boom, with presentations from the authors Trevor Houser and Shashank Mohan. The topic of fracking, or hydraulic fracturing, to release gas and tight oil from shale rock, is quite intriguing, as it has the potential to alter long-run trends in both economics and geo-politics.

Geo-politically, the US shale boom, and whether or not it can reach its potential, holds great interest for international relations, as countries like Saudi Arabia and Russia have a lot to lose if US gas is exported freely. While this impact of the shale boom is vitally important, the other angle worth considering is the economic impact of the energy revolution. This is the key focus of the book, and thanks to the comment from the IMF’s Prakash Loungani, was also the focus of a recent chapter IV article on the US economy from the IMF.

In summary, both of the studies described positive impacts from the energy boom, but they are only modest in nature. This economic impact is minor, according to the IMF, not least because the mining and energy-intensive sectors of the economy are only a small fraction. While both studies do highlight some potential short term benefit to the US economy, both of them seemed to agree that the shale boom will not lead to a long-run increase in the potential growth rate of the US economy. This is due to the notion that the energy boom is simply about making energy cheaper, and as the economic slack subsides in the short term, the increased activity from some sectors will be competing against other sectors in a general equilibrium setting, and thus not actually increasing the supply potential of the economy overall. So this got me thinking, is it really the case that the shale boom, with all the hype around it, does not increase the supply potential or long-run economic growth of the US economy? Is it true, as Prakash Loungani says at the conference, that we should not get ‘carried away with the shale gale’?

In what ways could the shale revolution in the US increase the long-run, potential output of the economy?

In and of itself, it may well be right that the shale revolution is no more than a lower energy price in the longer run than would have occurred in the absence of this technology. But the question could be raised as to what indirect effects could it encourage that would increase potential GDP?

One indirect effect could result from American firms importing more machinery and the embodied technology due to lower energy costs for production. At the margin, lower energy costs may encourage more firms to enter manufacturing, and for those already in the sector, it may allow more expenditure on machinery and research and development. If this were to occur, it would have an impact on the productivity of the US economy and thus impact long run growth.

Another possible indirect channel could be the terms of trade over the longer run. While not part of the classical theory of long run growth, there is a lot of empirical evidence that a country’s terms of trade can influence it’s economic growth. Papers like Mendoza et al (1997) have hypothesized a link between terms of trade and savings behaviour, with a positive change in the terms of trade leading to increased consumption and thus growth in the long run. Consequently, if the shale revolution led to an improvement in the terms of trade over the next decade or so, then it may also lead to an increase in the long run growth of the US economy.

All very interesting and quite important implications of the US energy boom to keep an eye on.

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The World in 2040: Major issues for Long term Macro

A recent post from Paul Krugman, (see here) where he discusses the new work by Thomas Piketty, got me thinking about some of the major long-term questions facing the global economy, and consequently, long-term macroeconomics. For my own clarity, I wanted to pull these areas together and summarise the key questions. At this point, ones view on the longer-term outlook for the global economy rests on two questions:

  •          Are you an optimist or pessimist, particularly when it comes to the role of technology in our future?
  •          On this technology, a related question is how technological advances will impact the jobs market. Will these developments, in robotics for example, lead to greater inequality, or will the benefits be shared more equally?

Gordon & the pessimistic case for long term growth

As a starting point, Bob Gordon set out the pessimistic case for longer term growth[1] in a 2012 NBER working paper. Gordon’s key point is that the rapid economic growth seen over the last 250 years could turn out to be a unique period in our history. He comes to this conclusion after analysing the economic growth of the three industrial revolutions: IR#1 from 1750 to 1830, covering steam and railroads; IR#2 1870 to 1900, covering advances such as electricity, communications, running water and the internal combustion engine; & IR#3 from 1960 to the present, which includes computers, the web and mobile phones.

Gordon states that IR#2 was the most important, as it led to nearly 80 years of rapid productivity growth. The problem is that these advances could happen only once, like transportation speed, and IR#3 has not been as encouraging from a growth perspective. To support his case, he also discusses six headwinds that will face the frontier economy in coming decades: demography, education, inequality, globalisation, energy/environment and the overhang of consumer and government debt.

Krugman and The Androids

Paul Krugman posits the technological optimists’ case in a recent post about Androids -robots that could do what humans do (see here). He asks the question of what would it look like if the digital revolution lived up to that of past industrial revolutions, and uses the advances in robotics to show how it might be possible. Such inventions like the driver-less car and speech recognition have the potential to be transformative technologies capable of new waves of economic growth.

r-g and Picketty

As Krugman points out, one might be an optimist regarding the ability of technology to support future growth, but a pessimist when it comes to how those gains will be shared. This brings us to a related long-term issue, espoused by Thomas Piketty, which is the potential trend towards inequality driven by inherited wealth. Krugman demonstrates the best model to place this theme within, which essentially is a way of understanding the difference between r, the return on assets, and g, the growth rate. It is this difference between r and g that is key to the outlook for inequality – if r is greater than g, owners of capital will do better and inequality will rise.

Inequality and Future of jobs

While Piketty’s book is more focused on inherited wealth and inequality, there is also a major question over the future of inequality due to technological innovation. This was the focus of a recent Economist briefing from Ryan Avent (see here). Avent looked into the possible trend of capital substituting for labour, while citing the recent study that showed fully 47% of occupational categories are at risk of being automated in the future.

Importantly, the briefing notes that technological changes do not affect all workers equally – some will find their skills automated, while others will find their skills complementary to the technology. Moreover, Avent notes that just because a job can be automated, does not mean that it will. Citing Nissan as an example, Avent describes how Nissan relies more on robots in Japan when producing cars, whereas it relies more on cheap labour in places like India.

The productivity gains from the forthcoming technology will be real, according to Avent, but it is also thought that the change will be disruptive. This is the case made by Erik Brynjolfsson and Andrew McAfee, professors at MIT, in “The Second Machine Age”, as the exponential growth of chip processing and memory capacity lead to disorienting change.

A Wolf ‘Institutional’ regime change

If one is a long term technological optimist, and accepts that productivity gains will ensue, even with a short term disruptive influence, it does not seem inevitable that inequality will increase. This is where the economic and political institutions of the day will play a major role, as discussed in a recent column by Martin Wolf (see here). According to Wolf, we will need to shape the good, and manage the bad from technology. One prescription required is to redistribute wealth and income, and a way to achieve this is to have the state own a share of the intellectual property of this technology. Thus the state, and hence the general population, will automatically receive a share of the income generated from these advances.

Long term questions these are, but answers will be needed sooner than we realise.

[1] Is US economic growth over? Faltering Innovation confronts six headwinds. NBER Working Paper no. 18315.

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Inflation, recession and the labour market

Perhaps it is due to the fact that I’m focusing a lot on labour markets for my day job, or perhaps it is simply an intriguing topic, but a recent Free Exchange  post really took my attention. It was a terribly interesting piece and one that I read over and over again. Whilst the article cited three studies, the key point was that inflation during a recession matters for how the labour market adjusts, via its influence on real wages. When inflation is high, this translates into low real wages, and firms during a recession can more readily hold onto workers due to this falling wage cost. Conversely, when inflation is low, real wages and ‘sticky’ and firms will be more inclined to lay staff off as a way of reducing costs.

This is highly interesting stuff, as although Okun’s law is still relevant (see this post), the presence of inflation during a recession can influence the type of adjustment that the labour market will make. With stubbornly high inflation in the UK, the recession and recovery has been ‘wageless’, whereas the lower inflation environment in the US has meant that the recession has been jobless.

The endogeneity issue

An ongoing debate over recent times has centred on the curious case of falling productivity in the UK during its recession. The pessismistic view of this ‘productivity puzzle’ is that the supply side of the Bristish economy took such a hit during the financial crisis that the productive capacity of the economy had been damaged. I always found this a difficult concept to come to terms with. When I look back to undergraduate economics, one thinks about the productive potential of an economy being dependent on things like the quality of the workforce, education and skill levels, infrastructure concerns such as roads, ports and even IT, and the quality of institutions. The global financial crisis was especially severe, but I could not understand why it would have significantly damaged any of these factors for the UK economy.

Consequently, I was always curious about the endogeneity issue of this productivity puzzle – was output low because of falling productivity, or was productivity falling because of low output. The latter view stated here is a more ‘demand’ side view of productivity, in that output per worker is influenced by the current state of the economy, even if its long run determinants are the supply side factors listed above.

This quote from the paper by Bill Martin and Robert Rowthorn[i] sums up their findings perfectly:

The UK’s poor productivity is more plausibly interpreted as a symptom of a largely demand‐constrained, cheaper labour economy ‐ a condition misinterpreted by supply pessimists as a sign of structural weakness. Output is well below potential because workers, while cheaper to employ, are not working to potential. More output could be produced, but not sold. There is an effective demand failure, high unemployment and, within companies, under‐utilisation of the employed workforce – a form of “labour hoarding”.

 A mechanism for this effect, both in a ‘financial’ and ‘normal’ recession

The paper from Calvo, Coricelli & Ottonello, titled “The labour market consequences of financial crises with or without inflation: Jobless and wageless recoveries,” outlines an intriguing model that specifies how this might work in a ‘financial recession.’ In the model, a financial shock takes the form of a drop in loan collateral values, but this effect is different for labour versus capital of a given firm. Because capital can be more easily collateralised, as a share of a firm’s capital can be handed over to creditors if a default occurs, loans are skewed to more capital-intensive projects during the recovery. This mechanism in the credit market works to exacerbate the impact of inflation described above.

While the econometric and theoretical paper of Calvo et al was great reading, I can also see how high inflation could impact the labour market in a ‘normal’ recession. Particularly in a cross-country framework, as countries have differing labour market institutions, it seems intuitive that firms seeing high inflation and low real wages  have an incentive to hoard labour, thus leading to a wageless recovery. I’m sure we’ll see more work in this area.

What does this mean for policy?

This work has a number of implications for economic policymakers. Firstly, it has an impact on any assessment of ‘spare capacity’ in an economy, as an unemployment rate around the historical average may still be disguising labour market weakness and economic slack. This is particularly relevant for the UK right now and in my opinion, is something the Bank of England is focusing on. In the UK at present, the unemployment rate has been falling faster than the BoE expected, which put the previous ‘forward guidance’ under pressure. If the unemployment rate was the only indicator to assess slack in the economy, then the BoE might be inclined to raise rates. However, this would be premature, as the BoE believe there is ‘underemployment’ in terms of the hours worked by employees.

It also has implications for conventional monetary policy, if and when developed economies return to historically average policy rates. The point about spare capacity also applies in this economic environment as well.

Finally, it has also broadened our awareness of labour market responsiveness, which will influence our expectations and forecasts of labour market adjustments in future recessions. All in all, some very interesting research indeed.

[i] Martin, B & Rowthorn, R (2012), Is the British economy supply constrained II? A renewed critique of the productivity pessimism. Centre for Business Research, University of Cambridge.

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Noted: Blanchard’s response to Krugman’s Mundell Fleming lecture

Just a short note to record a few of Olivier Blanchard’s
comments in response Paul Krugman’s recent IMF lecture.
Krugman’s paper included a ‘scratching pad’ analysis using an IS-MP
model, an inter temporal model and supporting evidence. It provided
a very convincing case that economies like the US, the UK and
Japan, with their floating currencies and independent central
banks, would not conceivably experience a Greek style crisis. Seen
in the video of the presentation and a follow up vox post, Olivier
Blanchard raised a few interesting points that are worth

1. The term premium on longer term sovereign bonds. In
his lecture Krugman spoke of the expectational view of interest
rates, where market participants expect low short rates to continue,
then this would translate in low long rates as well. Blanchard
subsequently raised the point that if investors lost confidence
then they would require a higher premium on longer term bonds, thus
pushing up these longer rates. I would presume that Krugman could
respond to this by stating that the Fed could perform QE or
Operation Twist type programs to offset this increase in the term

2. For Blanchard, it is a puzzle as to why rates on
Japanese Government bonds are so low. And he asked Krugman to show
him the model for that.

3. Krugman’s key point was that economies
with independent central banks and floating currencies can absorb
the loss of investor confidence and sell off in government bonds by
a depreciating currency. One of Blanchard’s points from the vox
article was that a large depreciation could be disruptive for both
the real economy and the financial markets.

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