Scorpions, unemployment and development

There is a well-known fable in which a scorpion asks a frog to carry him across a river. Although the frog is afraid of being stung during the journey, the scorpion convinces it otherwise, saying that if the frog sinks, the scorpion would drown too. The frog agrees, but, in the middle of the river, the scorpion stings the frog. The frog asks why and the scorpion just answers: “This is my nature.” The fable has many variations, substituting the frog with a turtle or the scorpion with a snake. In the end, it’s about the fact that many times nature determines behavior, notwithstanding the consequences.

Putting this fable into perspective with the current global crisis, the unregulated financial sector killed the real sector, while politicians and the government were applauding and some economists were constructing mathematical models to explain and support what was happening. Taking into consideration that any economic policy implemented by politicians is based on economic models developed by the academia, are economists guilty of the crisis? The answer is: partially. For sure they helped to establish an ideology giving pseudo-scientific support to the idea that an unregulated financial sector would boost development and welfare, and politicians avidly bought this idea.

The idea is that markets are perfect and government is always bad. Based on this presupposition, economists did academic work inventing parallel universes, where societies produce only one product, where the aggregate production function is constant, one agent represents all consumers and producers, and there are neither credit nor stock markets. Sounds unrealistic, isn’t it? Economists know it is. That’s why economists can now argue that the politicians are guilty. After all, they believed in and misused models that were about imaginary worlds. On the other hand, bad choices for economic policy leading to unemployment results in bad performance in elections. Latvia’s People’s Party is a good example. And then politicians can also argue: “But we trusted you! You fooled us with your unreal models.”

A good example of this pattern is the IMF Working Paper 12/189, E. B. Yehoue’s “On Price Stability and Welfare.” He concludes that using “a conservative representative-agent general equilibrium model, and based on parameter values that are consistent with U.S. data, the paper estimates welfare costs associated with various levels of inflation targets, in particular, 2, 4, and 10 percent. The findings suggest that the additional welfare costs of raising inflation targets from 2 to 4 percent are equal to about 0.3 percent of real income. For a rise from 2 to 10 percent, the additional welfare costs are estimated at about 1 percent of real income. Finally, the use of other values for the constant parameter in the money demand curves yield estimates as high as 7 percent of real income for raising the inflation target from 2 to 4 percent, and 30 percent of real income for raising the target from 2 to10 percent.” (p. 4).

As a good econometrist, the rule is “give the numbers and I’ll prove anything you want.” In the paper’s 35 pages, only once (p. 21) does the word unemployment appear, and none of the 58 reference titles mention unemployment. This is the economic ideology that has been guiding Latvia’s economic policy until now. Losing around 6.5 percent of its population due to migration since 2008, Latvia is a victim of this ideology.

The government was right to not pursue populist measures like permitting uncontrolled budget deficits and devaluation. Because of the lack of a pragmatic plan of development and industrial policy, that would only make things worse. In this sense, the chosen policies were correct to deal with the crisis and getting rid of the IMF. However, a crucial mistake was assuming that austerity and internal devaluation would result in strong development. They don’t, as the effects of internal devaluation are already gone.

That’s why it’s good news that now there is a development plan. Although it has been very much criticized, it’s the first time Latvia has such a plan with concrete measures to promote development and employment, instead of just repeating “we will be the most competitive nation in 20 years,” hoping that some miracle will happen.

The plan is not perfect. Still there’s a lot to do and discuss, but at least it seems that the government finally understood that a sound financial sector is only part of the equation for development. Much more needed is the correct set of incentives to let the private sector develop in a way that will result in employment, higher productivity and higher wages. Hopefully this will stop migration and will make Latvians abroad come back to Latvia.