IS/LM in the Eurozone and Germany´s surplus

The title is a reference to Lance Taylor´s seminal “IS/LM in the Tropics”[1] , the diagrammatic tool stems from Jeffrey Frankel´s paper on optimal sterilization policies in emerging countries, a debate to which I contributed almost a quarter of a century ago[2]. However, quite exceptionally for this blog, this entry is neither on the tropics nor on emerging countries. It is on the dismal zone, better known as Eurozone. The model will illustrate Bundesbank boss Jens Weidmann´s cynical statement about the Euro borrowed from Fisherman´s Friends drops and applied to the Euro: “Ist er zu stark, bist Du zu schwach”[3].


Germany has maintained a large surplus on the current account of its balance of payments – oscillating between six and eight percent of GDP in recent years - although the Eurozone outside Germany weakened, China´s merchandise imports stagnated and other large emerging markets (Russia, Brazil) were in trouble. As demonstrated by Patrick Artus´ team at Natixis Economic Research, the German surplus can be explained neither by a drop in its domestic demand (as is often done) nor by improved terms of trade. It is largely due to improved market shares and trade balances with the United States, Japan, non-euro-zone Europe and China, which has offset the deterioration in its trade position in the euro zone. As will be shown below, Germany´s hyper competitiveness slows down the depreciation of the Euro, required by the rest of the Eurozone to make it a bit less dismal.

IS/LM in the Eurozone

The Eurozone is illustrated by the familiar textbook macroeconomic general-equilibrium model, with the IS, LM, and BP curves denoting goods market, money market and balance of payments equilibrium, respectively. Demand for output Y is shown on the horizontal axis, with the price level predetermined in the short run. A move to the right on the y-axis thus denotes only employment gains (and no inflationary pressure), a move to the left employment losses. Y is the sum of domestic aggregate demand and the trade balance (net foreign demand for domestic output). The interest rate i is presented on the vertical axis; as the Eurozone has open capital markets, the interest rate i is equal to i*, the international rate. The overall balance of payments, BP, the sum of the trade balance and the capital account, is horizontal: the capital account rules, the current account follows, and a rise in i above i* sucks in infinite capital inflows (as long as the Eurozone is still ´investible´).

Germany´s surplus is so huge that it translates into a surplus of the Eurozone. The IS curve shifts to the right as the trade balance improves, putting upward pressure on the interest rate and therefore on the capital account. As the Euro is a flexible currency (outside the Eurozone), money inflows (not trade) will appreciate the Euro. In the model, the currency will appreciate far enough to return the trade balance, the IS curve, and domestic aggregate demand back to point A. In plain words, Germany´s improved trade balance has to be ´paid´ by even more depressed demand in the rest of the Eurozone. Maybe, Jens Weidmann should have said: “Is Germany too strong, it should abstain from using the Euro”?

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[1] Lance Taylor (1981), „IS/LM in the Tropics: Diagrammatics of the New Structuralist Macro Critique”, Economic Stabilization in Developing Countries, Vol 502, Brookings Institution, Washington DC.

[2] Jeffrey Frankel (1997), „Sterilization of Money Inflows: Difficult (Calvo) or Easy (Reisen)?“, Estudios de Economía, Vol. 24.2, December, pp. 263-285.

[3] Interview Jens Weidmann „Ist er zu stark, bist Du zu schwach“,  in Süddeutsche Zeitung, 22.5.2014; see http://www.bundesbank.de/Redaktion/DE/Interviews/2014_05_22_weidmann_sz.html

The Virus of Multilateral Trust Funds

Would a stronger core budget funding of the World Health Organisation and less dominance of earmarked funding of global health spending have prevented the current rapid spread of Ebola? This daring thesis was expressed last week at a fascinating workshop, sponsored by the Swiss Network for International Studies (SNIS), at Zurich University, on the “Proliferation of Multilateral Funds”. WHO Director Dr. Margaret Chan recently complained: “My budget [is] highly earmarked, so it is driven by what I call donor interests”.

Earmarked multilateral funding has spread like a virus in recent decades, with earmarking defined in thematic, geographic and/or institutional terms. Bilateral donors channel earmarked funds to multilateral development agencies that implement activities for them, but without allowing these agencies to use the funds at their own discretion. The hybrid funding mechanism is often dubbed multi-bi aid. The Figure[1] below shows that earmarked multilateral funding has really won traction, ironically, since the Paris Declaration 2005 that sought to turn aid delivery less burdensome for the recipients, including by simplifying delivery channels. It is based on 680 (!) distinct multilateral development organisations (much more than the 280 ODA eligible counted by the OECD Report on Multilateral Aid). With a volume of 19 billion USD in 2012, multi-bi aid today amounts to almost 60 percent of the volume of multilateral aid.

Figure: Multi-bi aid relative to multilateral contributions,

                                                        in percent, 1990 - 2012

Source: Reinsberg et al. (2014)

Viewed from a principal-agent perspective (with the donors as principals and the multilaterals as agents), the higher share of non-core budgets in multilateral organizations has gone along the move from collective principals to multiple principals, from member country groupings with largely homogenous preferences to groupings with heterogeneous policy goals. Applied to the UN system, the US called the shots after WWII based on its Western European and Latin American allies in what was then a much smaller country grouping. To the extent that the UN enlarged and raised its member base, the US, the UK and other leading countries lost the majority. This explains the start and rise of voluntary multilateral aid funding from the 1960s. Multiple principals have multiple interests that they see better implemented in earmarked rather than general policy programs.

The recent rapid rise of the share of earmarked contributions to multilateral aid over the past two decades, however, needs further explanation. The rise is closely correlated with the establishment of so-called trust funds, either umbrella funds with many donors or, somehow perversely, single-donor funds. Mid-2013, the overall number of active trust funds at the World Bank was more than 900(!).

So what makes trust funds attractive to donor governments? First, the voluntary nature of multi-bi contributions to trust funds provides more flexibility as they are typically independent of long-term agreements at the international level (such as the three-year IDA replenishment rounds). In contrast, they are released on a short-term basis.  Second, governance and management structures can be designed in ways that may also allow for leverage from private charities, foundations, firms, or charities. Third, and perhaps most importantly, trust funds (especially the rapidly rising single-donor funds) can be tailored to the (ever changing) policy priorities of donor governments. Arguably, the vehicle is well suited to mobilise resources to fund global public goods – under the condition that these resources are complementary (which seems largely the case).

What then has made multilateral trust funds so much more attractive? Two further papers presented at the SNIS workshop provide some convincing hints[2]. First, the simple existence of trust funds influences the aid allocation by donors across available channels: the possibility of earmarking multilateral aid decreases donors' contributions to the multilateral's discretionary core budget and the amount of bilateral aid. Second, the existence of earmarking may also stimulate some active agents (the boss or management team of an international organisation) to enlarge their fiefdoms; I for one have worked in such an organization. Third, policy priorities do change but multilaterals can be very slow to accommodate those changes, partly for bureaucratic inertia but also for perfectly justified governance rules; the more this results in incompatible goals between donors and agencies, the higher will be the incentive to create trust funds and earmark funds. Finally, the same impact will occur to the extent that policy priorities become more heterogeneous across donors.

The demise of the United States as the benevolent Kindleberger-type hegemon in a multipolar world  and the rise of the emerging donors such as China would lead to predict that there will be more, not less, earmarked multilateral funding in the future. The multilateral donor chaos is alive and kicking[3].

 

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[1] Modified from and based on a forthcoming article by Reinsberg, Michaleowa and Eichenbauer (2014), “The rise of multi-bi aid and the proliferation of trust funds”, Handbook of Development Economics 2014.

[2] Eichenbauer and Hug (2014), “The politics of special-purpose trust funds”, unpublished, Heidelberg University and Université de Génève; Reinsberg, Michaelowa, and Knack (2014), “Which donors, which funds? The choice of multilateral funds by bilateral donors at the World Bank”, unpublished, University of Zurich and World Bank.

[3] Reisen (2010), "The multilateral donor non-system: towards accountability and efficient role assignment," Economics - The Open-Access, Open-Assessment E-Journal, vol. 4(5), pages 1-22.

BMZ study ´The Future of Multilateral Concessional Finance´ online

Ready by June 2014, Chris Garroway and myself had to wait a while until the BMZ put our study online. Here is the link:

http://star-www.giz.de/fetch/3dQ00u3Xc0001Qgm0f/giz2014-1668en-mulilateral-concessional-finance.pdf

You can discuss with me (or us) at the following events.

• This Wednesday, I will present the study to BMZ staff at their luncheon Events (BMZ-Mittagsgespräche),
• on 8th October at ETH Zürich (http://www.nadel.ethz.ch/aktuell/Events)
• 2nd half October at ODI in London (still to be determined, 30th Oct likely, and
• on 8th December at Cologne University (http://www.iwp.uni-koeln.de/veranstaltungen/ringvorlesung/aktuelle-veranstaltung/

Executive Summary

Emboldened by a decade of poor-country convergence and poverty reduction, many are now imagining a world without extreme poverty (often defined as 3 percent of the world population living on USD 1.25 Purchasing Power Parity a day or less) in not too distant a future.  This paper presents the major determinants of the future demand for concessional finance and produces scenarios for multilateral concessional finance eligibility. It then discusses general strategic implications for the future orientation of multilateral concessional finance and presents actionable options for the development of each the International Development Association (IDA), the Asian Development Fund (ADF), the African Development Fund (AfDF) and concessional facilities of the International Monetary Fund (IMF).

 This report considers four major determinants of the future demand for concessional finance: (i) national productivity and welfare, (ii) the extent of poverty and deprivation, (iii) the capacity to mobilize domestic financial resources and (iv) the vulnerability to exogenous shocks and global public “bads”.

 The paper finds that recent studies on poverty and growth projections have been overly optimistic. The 2000s may well have been a special decade, and growth rates in the coming decades may hardly approach the past high levels. This paper projects the number of countries eligible for multilateral soft finance to decline to 26 in 2025, down from 39 in 2012 (based on GNI per capita simulations).

The number of extreme poor population will have been halved globally by 2025, estimated at still more than half a billion according to the basic scenario of the study. Prospective graduates India and Nigeria as well as Democratic Republic Congo are likely to constitute half of global poverty ten years from now. At the same time, the distribution of incomes has blurred the distinction between poor people and poor countries. Projected relative poverty headcount ratios indicate that even if the number of extreme poor population is strongly reduced globally by 2025, most countries will face sizeable problems with social exclusion and relative deprivation. 

Higher domestic resource mobilization may reduce reliance on concessional flows. However, marginal tax rates required to close the poverty gap remain prohibitively high in most developing countries. Moreover, tax effort calculations show little untapped potential for domestic resource mobilization for most Sub-Saharan African countries. In South Asian countries - in particular Bangladesh, India and Pakistan - where a higher domestic tax effort could be envisaged to help combat extreme poverty, challenges for fiscal federalism and cross-state revenue sharing remain nonetheless formidable and require technical support.

Climate change and natural disasters threaten to derail efforts to eradicate poverty over the next decade. In Asia, disaster damage cost in selected IDA recipient countries is substantially higher than concessional IDA flows. In Africa, disaster costs are of about the same magnitude as IDA credits. A major political decision hence relates to the provisioning of global public goods through multilateral concessional finance, especially adaptation to and mitigation of climate change as well as disaster management. Mainstreaming climate change into development cooperation would require multilateral donors to integrate vulnerability to environmental and global risks into their allocation criteria for concessional funds.

Abovementioned uncertainties would suggest a gradualist, precautionary and insurance-oriented approach to the future of multilateral concessional windows. Shrinking multilateral aid would ignore the option value of preserving IFIs and their concessional windows in a world with considerable uncertainty about future poverty outcomes. Realistic options presented in this study are:

1. redefining eligibility criteria for concessional funds based either on relative or absolute poverty terms, e.g. as per capita income relative to per capita income in a specified grouping, or even as overall levels of extreme poverty; alternatively new and more comprehensive measures such as the UN Human Development Index or the Multidimensional Poverty Index could be considered; 
2. smoothing transition periods from IDA-only via blend to IBRD-status for upper-middle-income countries (UMICs), with similar graduation paths in the other multilateral windows; such an “IDA+ transitional window” would be available for countries with a per capita income between the current IDA threshold and its double, and funds could be directed towards measures of social inclusion and redistribution; 
3. strengthening sub-sovereign allocation to take account of the rural-urban duality of inequality and higher disaster risks in certain provinces; 
4. opening the multilateral-soft windows for regional and global public goods, with climate change mitigation and disaster risk management as tracer sectors; this could take the form of turning MDBs into global/regional public goods facilities or the greening of MDB’s projects.

Finally, this paper presents strategic options for the four soft windows covered in the analysis. It suggests for the IMF to increase its share of blended finance, increase its grant element for Poverty Reduction Growth Trust (PRGT)-only countries and add an insurance-type instrument to the PRGT lending facilities. For IDA, often a lead institution in defining rules for concessional finance, it recommends increasing the grant element of its loans, considering a two-window approach with the second window focusing on transitional support, focusing the performance-based allocation (PBA) on direct poverty reduction outcomes and including vulnerability to environmental and global risks in the allocation criteria. The division of labor between IDA and the AfDF needs to be sharpened in the conceivable case of a largely overlapping client group. The report concludes that the provision of regional public goods in the form of trade development may become an AfDF focus while IDA could concentrate on climate-change related finance.  The AfDF may further consider departing from an IDA-pegged to a specific allocation mechanism tracking the AfDF’s performance; recent changes to its loan policy in its core fields of infrastructure development might be extended to regional integration by the means of structural indicators. The ADF on the other hand, with its largely different client base, is already on a good track with its current effort to merge the ADF with ordinary capital resources (OCR), thereby increasing the institution’s lending and leveraging capacity; the latter would be greatly enhanced by raising China´s and India´s capital shares.