THE MYTH OF THE PRODUCTION FUNCTION

THE MYTH OF THE PRODUCTION FUNCTION

(This is an extract from chapter 2 of the unpublished book “Economics for Heretics: Debunking the Myths of Orthodox Economics” by Dante A. Urbina. You can see this and other articles by the same author in his blog "The Heretical Economist": http://thehereticaleconomist.blogspot.com/).

And with what produce?: ecologist criticism of the production function

Let us imagine for a moment that the production function that sustains the orthodox economics is valid. Furthermore, let us imagine that, in fact, we have to carry out an actual production process based on it. Let us think, for example, in the production of a cake. What do we need to do? According to the neoclassical production function –which has the general notation Q = f (K, L)- we would need capital and labor. Get together, then all elements of capital (defined as the set of instruments used to produce): jars, bowls, trays, pallets, oven, pans, knives, etc. Now we gather the elements of the labor factor: basically be our own labor (or the of a chef) incorporated with all the abilities to make cakes. Then, given a technological configuration, ie, an established relationship between the factors of production bringing together the elements of capital (K) and labor (L) which we have listed, we get the product, that is a cake. But we get nothing! It’s not possible... there has to be an explanation...

We try with an intensive increase of productive factors: we get much bigger bowls (K) and we hire several chefs (L)... but still not we get a single cake! “Why?”, we ask ourselves.

The answer is very simple: nothing is produced because there is nothing with what to produce! No matter how many bowls we get or how many cooks we hire if there's no cake dough to cook! In effect, on the basis of the neoclassical production function, we have gathered all the elements of capital and labor but we have not had any account of the raw material. We have listed several things, right. But at no time we have mentioned flour, sugar, eggs, etc. Thus, based on the neoclassical production function, we have tried to be God: we wanted to create something out of nothing! However, it becomes patently absurd in this context: cannot make cake without cake dough. Cannot produce without raw material.

Well, it is precisely on this basis that the great economist Nicholas Georgescu-Roegen, initiator of the ecologist approach, raises his criticism of the production function and orthodox economics. He begins by analyzing the physical basis of the production process (1) and immediately realizes the implications of the First Law of Thermodynamics (according to which “the matter is not created or destroyed, only transformed”): not possible to produce without a material basis. Consequently, the neoclassical production function becomes inconsistent and absurd for not taking into account the nature factor.

And this was to be expected. In the nineteenth century, when was born the neoclassical school, the modernists believed in the “theory of indefinite progress” and they claimed that the resources of nature were endless. Orthodox theorists assumed that belief and built on this basis in economic theory. So, the most essential factor of the economic process was relegated to the sidelines : the ecological factor. However, as rightly said Max Neef: “There is no economy possible regardless the services provided by ecosystems. This is so absolutely clear and so absolutely obvious that is truly a epistemological scandal that in any economics textbook, if you go to index words, may be find the words “ecosystem”, “nature” or “thermodynamics”. They do not exist! Simply they do not exist. Why? Because the economy that is taught is conceived as a closed system in itself that is not related to any other system (...) when obviously it is embedded in a bigger system called biosphere and around which are all services provide the elements of that biosphere. Where would be the economist if it ends the photosynthesis? Economists do would not exist! What would happen with the economy if suddenly all the bees died? There would be no pollination... But no economist presumes that he has to know that. (...) All this happens in a gigantic sea of ignorance on the part of the economy” (2). In other words, there can be no economy without ecology and orthodox economics still does not know it.

“But the problem is easy to solve!”, orthodox economists will say. “We add the variable R (natural resources) in the production function and ready!”. What ignorance! One ignorance comparable only with that ignorance that orthodox economists also show when claim to have understood the process of technological change just because they incorporate a variable “A” to the production function (3).

Let us see. Given a variant “Solow-Stiglitz” (as it is called to the artifice upon which it has been tried solve the problem) of the production function we have that in the form Cobb-Douglas this will be:

Q = K^a.L^b.R^c

such that: a + b + c = 1

As this is a Cobb Douglas production function, this implies complete substitutability of factors, ie, that can be replaced one factor by another (or others) while maintaining the same level of production. But it is precisely where the inconsistency resides. Mathematically, if R (natural resources) tends to zero the reduction may be compensated by increases in K or L maintained the same level of production. The structure multiplicative of the function allows it. However, it is inconsistent in the facts because if R tends to zero necessarily have to do so at some time K and L. First, because they depend on R: the capital goods are products of a previous process which presupposes the nature factor and, in turn, the labor force needed of natural resources to sustain itself  (can anyone imagine what would happen with our productivity if we drank only one glass of water a month?). Second, because the quantity of product that capital and labor can generate depends always and necessarily of the flow of inputs to transform (no matter how quick work the cook or how big is the bowl which has, if he has only one gram of mass he can not do a single cake).

Thus, Georgescu-Roegen criticism to the production function shows clearly that the economy has ecological limits. And that brings us to the central concept of his analysis: “entropy”. Basically the entropy means that the availability of a certain amount of energy, once it has been used, not retains throughout time to the same properties to create useful work. Thus, as soon as the natural resources are transformed, they pass from a state of low entropy to a high entropy and, consequently, it is increasingly difficult transform them into products useful to man. Ergo, the use of our the natural resources have a objective limit: capital and labor can not exploit the nature indefinitely because this is also subject to the Law of diminishing returns.

And that not to mention the problem of the environmental pollution brought about by any production process. In effect, given that, because of the law of entropy-is impossible to achieve 100% efficiency, produce something always and necessarily generate a residue or waste (4) which should be treated. That is, after making a cake you need to clean the kitchen. And the same applies for the whole planet.

Nevertheless, orthodox economics has systematically left aside all this. According to this ecological factor is purely exogenous. But “economics” etymologically means “administration of the house” (5). And our house is ultimately the planet earth. But orthodox economics has shown as evidently a bad manager because, to leave out the ecological factor analysis, necessarily have a large part of guilt in the current global warming problem that we are facing. Conclusion: orthodox economics is a bad economics.

References:

1. Nicholas Georgescu-Roegen, The Entropy Law and the Economic Process, Harvard University Press, Cambridge, 1971.

2. Manfred Max Neef, “Economy and Environment”, conference at the Universidad Austral de Chile, Valdivia, on May 28, 2010.

3. For more details on this misery see the famous Solow growth model in any manual of “advanced” macroeconomics (!).

4. Cf. Nicholas Georgescu-Roegen, The Entropy Law and the Economic Process, Harvard University Press, Cambridge, 1971, p. 231.

5. From the Greek: oikos = house; nomos = order, administration.

You can contact the author of this article in: “Dante Abelardo Urbina Padilla” (Facebook) and dante.urbina1@gmail.com (email)

The policy dimensions of FDI

The Policy Dimensions of FDI

An analysis is now made of the different FDI policy dimensions in which PIs are made to be

implemented by host countries. It is important to note here that governments of developing

countries choose PIs – generalized as incentives – to attract FDI in relation to their overall

economic development goals. Thus, different dimensions of incentives can be depicted. First,

incentives can be either general or specific (with a discretionary perspective). A second

dimension is the durability of incentives. Indeed, according to the host country’s priorities,

incentives could be either permanent or temporal. However, pragmatically speaking, PIs related

to incentives need to change in duration so as to encourage the kinds of FDI and industrial

specialization the country desires. And therefore it is useful to think of these PIs as windows of

opportunity which open and close. Another dimension exists at the geographic – or spatial –

level since IP policies can target FDI either at a local, national level or regional level. Local

incentives can be used to promote specific regions of a country that are poorer or in greater need development. Further, incentives can be used to attract foreign investors to the whole economy or only to certain sectors or subsectors, according again to the specific needs of the country. In the past, this has carried the rubric ‘negative’ or ‘positive’ lists which cordoned off strategic sectors of the economy to foreign investors and reserved others for national firm.26 Finally, at the firm level, incentives can focus either on all FDI, or only on specific investors. These dimensions are depicted in figure 4, A Framework for Operationalizing FDI Policy Dimensions and Instruments.

To say that policy craft – creating policy coherence out of the conflicting demands from modal

neutrality, market contestability, as well as scaling and measuring the factors and variables

which must be considered in policy research and analysis – is a challenge, is an understatement.

This paper makes early reference to the growing importance of investment and business climate

benchmarking as a guide to policy-making. However, econometrically, as every factor or

variable (or their combinations) has its own FDI inflow- and stock-elasticity, IPAs and policy

makers with limited resources should concentrate their policy craft on those FDI factors and

variables with the highest FDI-elasticities . In rank order, these are: (i)

growth-competitiveness, which combines macroeconomic and technology variables, with an FDI inflow elasticity of 0.63; (ii) economic freedom, combining government intervention, property rights, wages/prices and regulation variables, with an FDI inflow-elasticity of 0.56; (iii) taxation and regulation with an FDI inflow-elasticity of -0.50; (iv) quality of telecommunication services with FDI inflow-elasticity of -0.28;28 and (v) labour market regulation with FDI inflow-elasticity of -0.26. Furthermore, these elasticities have short- medium- and long-term adjustment rates.

This approach begins to lay out the choices available to policy makers in making viable PIs in a

systematic manner based on rigorous analysis. Hence, from a fourth-generation IP perspective, a focus on the macroeconomic environment stability and technology policies to increase the rates of innovation and transfer by PIs that facilitate licensing and franchising, for example, would be needed. In a similar vein, harmonizing taxation regulation across regional space would be a viable policy.

All these elements and issues in figure 4 reflect the need for sequencing and switching PIs and

incentives, both in space and time. In other words, while FDI policy-making is increasingly more complex and diverse, host governments, according to their development needs, have to adapt to the MNEs dynamic activities by sequencing and switching (in a predictable manner) their FDI PIs. Moreover, these different policy dimensions also indicate the importance for host

governments to create different levels of policies: the meta- or supra-national level, the macro or national level, the meso or regional and cluster level, the micro or industrial sector and subsector level and the firm level of organizational strategy and competitiveness . The complexity of FDI host policy-making is obvious but the policy dimensions have to be chosen and established in harmony with the general development goals set up by the government.

Whereas industrialized countries typically utilize financial incentives, such as grants, developing countries usually use fiscal incentives, such as reductions in the base rate of corporate income tax, tax holidays and import-duty exemptions and drawbacks (Oman, 2000). Incentives are widely used to attract MNEs and thus create a climate of policy competition for FDI. Fiscal incentives might be successful for attracting MNEs, but incentives-based competition also creates some problems. Indeed, the first problem of incentives is that they represent opportunity cost of resources to host governments. Secondly, there can be a significant lack of transparency regarding incentives, which leaves space for corruption and other kinds of rent-seeking behaviour. Finally, given the dimension choices in figure 4, incentives also provoke market distortions. Among them, the major ones are the fact that incentives tend to favour large corporate investors to the detriment of small ones, as well as foreign over the domestic firms because of their lower risk profile and higher bargaining power. The distortion would tend to disappear (over time) in countries adopting fourth generation of IP, as they would treat foreign and domestic firms equally with regard to incentives.

ECB FACES HURDLE FOR MONETARY POLICY

ECB FACES HURDLE FOR MONETARY POLICY

With growth picking up only gradually and inflation likely to remain below target for the foreseeable future, it would be premature to rule out further monetary easing in the euro area. But following this week’s hawkish press conference, the hurdle for further action is probably higher than we thought.
We had thought there was a good chance that the European Central Bank (ECB) would cut interest rates at this week’s Governing Council meeting. In the end, though, it seems that data released over the last month have pushed the ECB further from easing than we thought and that the Governing Council did not give any serious consideration to a rate cut. Moreover, the tone of yesterday’s press conference was hawkish, suggesting that the probability of a rate cut in April is also lower than we previously expected.
The ECB’s explanation for not cutting rates this week was fairly straightforward. First, data released over the past month have tended to confirm its baseline forecast for a moderate but sustained recovery in euro-area output growth and, “by and large,” have been stronger than expected. Moreover, while the ECB still thinks the outlook is subject to downside risks, neither of the two contingencies that would trigger an immediate policy response—an unwanted tightening of money-market conditions or a sudden worsening of the medium-term outlook for price stability—has been met.
None of this is particularly surprising. What we did find surprising, though, was the renewed emphasis that the ECB put on the strength of recent survey data—like the composite Purchasing Managers’ Index, which reached a two-and-a-half year high in February (Display 1)—and the relaxed stance adopted towards persistently low inflation. Earlier this week, ECB president Mario Draghi warned that the longer inflation remained low, the greater the risk that it would not return to target in any “reasonable” time frame and that inflation expectations might become “disanchored.” Yesterday, the ECB left interest rates on hold despite the fact that its new staff forecasts show inflation below target for at least the next three years (Display 2).



Overall, the ECB now seems to be more confident that the recovery will push inflation back towards its target of “below but close to 2%” and no longer feels compelled to hasten this process. In our view, there are clear echoes here of the old, reactive, ECB from the pre-Draghi era.
Focus on Spare Capacity
We also detected an important change of tone when the ECB president was asked whether any of his colleagues wanted to ease policy this week. After saying that there had been a “broad discussion“on changes in interest rates and other policy tools, Draghi said that if he had to “flag a key point“ in the discussion, it was the importance that the Governing Council attached to the large amount of spare capacity in the economy. This, he added, would allow the ECB’s monetary policy stance to “stay in place” even after the economy had started to improve.
The focus on spare capacity was probably intended to reinforce the ECB’s forward guidance—that the Governing Council expects interest rates “to remain at present or lower levels for an extended period of time.” In our view, though, the underlying message is surprisingly close to the one currently being sent by the Bank of England. In other words, it sounds more like a central bank trying to manage its exit strategy than one thinking about injecting fresh monetary stimulus.
Where Now?
Given the speed with which the ECB cut interest rates in response to low inflation last November, the dovish inclinations of many Council members and the subdued nature of the recovery, we think it is too early to rule out further monetary easing in the euro area. Indeed, the ECB stressed again yesterday that it was willing to use “all instruments available to us” and that it would “take further decisive action if required”.
But following yesterday’s press conference, it looks as if the hurdle for further action is higher than we thought. With inflation set to hit a new low in March, a rate cut at April’s Council meeting is still possible. But the probability is lower than we thought and it may now require a more significant deviation from the ECB’s central forecast, or marked appreciation of the euro— which received particular attention at yesterday’s press conference—to trigger additional action. Moreover, barring a wholesale change in the outlook, the market’s hopes for more aggressive policy moves, such as quantitative easing, seem to be well wide of the mark.

WORLD TRADE

World Trade

World merchandise exports have more than tripled over the last two decades and reached US$18 trillion (in current prices) in 2012, with a quarter of that trade comprising exports among developing countries - so-called "South-South" trade -- which reached a record $4.7 trillion, according to the UNCTAD Handbook of Statistics 2013.
Total developing economies' exports now account for 45 per cent of the world total, with half of the increase in global exports between 1995 and 2012 accounted for by developing countries.
The share of South-South trade in total world exports has doubled over the last 20 years, to over 25 per cent. Fuels and manufactured goods now account for roughly 25 per cent and 58 per cent of South-South trade, respectively.
The Handbook helps to document that the South-South trend has been led by developing Asia, followed by developing America. Intra-regional trade within developing Asia amounted to $3.5 trillion in 2012. The Handbook also reports that the growth of the South-South commerce was higher in developing Africa between 1995 and 2012 than in the developing regions of Asia and America. Moreover, South-South trade from least developed countries (LDCs) in Africa climbed significantly in value over the figure for 1995. African LDCs have increasingly benefited from commercial exchanges with developing Asia.
China's exports to other developing countries, recorded at $1 trillion last year, alone represent more than 20 per cent of developing countries' intra-trade. Apart from China and major petroleum and gas exporters, Viet Nam, Egypt, India, Turkey, Peru, Colombia, Brazil, Mexico, and Chile are among the economies that have expanded the most in the South-South trade during last two decades.
Manufactured goods classified chiefly by material and miscellaneous manufactured articles hold the second highest share, 19 per cent of total South-South trade, after fuels (25 per cent), followed by parts and components for electrical and electronic goods, which accounts for 15 per cent.

Chart 1 - World, developing economie's and South-south merchandise exports
(billion US dollars)

                  Source: UNCTADStat

Developing economies have also been gaining market share in international trade in services, Handbook figures show. The share of exports from developing countries grew from 22 per cent of the world total in 1995 to 30 per cent in 2012. Services-sector exports from these countries increased by almost 8 per cent in 2012, while they expanded by 6 per cent in the transition economies. At the same time, practically no growth was observed in services exports from developed countries last year. In construction and travel exports, developing economies now hold over 40 per cent of the global market. Their importance is also growing in transport and in computer services trade. However, developing and transition countries do not account for much of global trade in financial services or in trade related to intellectual property (royalties and license fees).

Chart 2 - Market shares of developing and developed economies' exports of selected services
(per cent)

                  Source: UNCTADStat

Along with providing detailed statistics on international merchandise and services trade, the updated Handbook covers investment, commodity prices, maritime transport, and other economic and social data, for all individual economies for which data are available. In addition, it includes figures for geographical regions, various economic groupings, and world totals. The Handbook aims each year to provide data for the analysis and evaluation of world trade, investment, international financial flows, and development. To the extent possible, UNCTAD provides estimates to fill in data gaps in order to furnish the most complete datasets.

WOMEN EMPOWERMENT

Women Empowerment

Women’s economic empowerment is seen today as the single most important factor contributing to equality between women and men. Economic stability increases an individual’s options and choices in life. Economic empowerment puts women in a stronger position

and gives them the power to participate, together with men, in

the shaping of society, to influence development at all levels of

society, and to make decisions that promote their family’s and

their own wellbeing. Economic empowerment of women is a

matter of human rights and social justice.

Conceptualizing women’s economic empowerment. A common definition of empowerment encompasses both the process of change that enables individuals to have greater freedom of choice,

and the actions and choices that the individual makes. The

World Bank is one of the few actors to have defined women’s

economic empowerment. However, the World Bank definition

focuses principally on markets, that is, “…making markets

work for women and empowering women to compete in markets”.

Access to markets is important because inequality prevents

women from having equal access to productive resources

and economic opportunities. Sida’s definition of women’s economic

empowerment goes beyond the market and also encompasses

change in relation to access to and control over critical

economic resources and opportunities; it also addresses the

need to eliminate structural gender inequalities in the labour

market and reduce women’s unpaid work.

Sida defines women’s economic empowerment as the process which

increases women’s real power over economic decisions that influence their lives and priorities in society. Women’s Economic Empowerment can be achieved through equal access to and control over critical economic resources and opportunities, and the elimination of structural gender inequalities in the labour market including a better sharing of unpaid care work.

Women can achieve economic empowerment if

(1) the resources are available and women have the skills to

utilize them;

(2) they have access to economic opportunities and control

over the economic benefits of those opportunities; and

(3) they can use those benefits to make strategic choices leading

to positive changes in their lives.

In reality, women face obstacles throughout this process and overcoming many of them requires society to actively reduce gender discriminatory norms and practices and to ensure that public institutions are accountable for putting gender rights into practice. Female illiteracy, women’s lack of access to information, and gender discriminatory norms that prevent women from using and/or owning land are examples of obstacles that limit their access to and control of economic resources. Exploitative and discriminatory working conditions, gender segregation in the labour market, restricted mobility, women’s double work burden and diminished health – caused by gender-based violence, for instance

– are examples of factors that limit women’s ability to access

and/or enjoy the returns on their work.

Unpaid work, both in the productive and domestic spheres is one of the single most important obstacles to women’s economic empowerment.

Overall, women across the world endure heavy workloads

both outside and inside the home. Many studies show that

women’s work day is longer than men’s and that the proportion

of work receiving economic remuneration is smaller. A

substantial part of productive agricultural work today is unpaid

and carried out by women. In addition to productive

work, one of the major differences in economic empowerment

of women compared to men is the fact that women shoulder

the primary responsibility for unpaid care work within the

home. Indeed, society depends heavily on women’s unpaid

work to provide the necessary care of its citizens today. This

limits women’s free time to engage effectively in income-generating

work, and in many developing countries results in women’s acute ‘time poverty’. As a result more women than men lack access to valued resources and opportunities and continue to have a subordinate status in society.

The economic empowerment of women requires working with men, and challenging long-standing gender stereotypes. A vital starting point for increasing women’s economic participation is to work with

men to address the double burden of care-giving and paid work. Working with men and women to confront gender stereotypes

is important for economic empowerment of both women

and men, as it will expand men and women’s opportunities

to provide for themselves. Addressing the gender stereotyped

division of labour that condemns women to carry out the bulk

of unpaid work will also provide men with opportunities to expand

their role in society. It will allow men to combine family

and work, and engage in the care of their children and other

family members; it will also increase opportunities for them to

take up non-traditional male jobs and increase their options

for income-generating work. Overall, increasing women bargaining

power within the family is essential to enable women to take control over economic benefits and to expand their strategic life choices. Interventions that change power relations within the family for example addressing gender norms and practices limiting women and men’s choices will be essential to achieve women’s economic empowerment.Finally, a precondition for the effective economic empowerment of women is increased accountability by and systematic transformation of institutions to actively promote gender equality and women’s rights. In practical terms this means institutions questioning and changing their goals, strategies and working processes to promote gender equality. Understanding women’s economic empowerment in this way opens up opportunities to improve the situation of women through a number of interventions in different sectors.

Managing Forest through Provincial Strategy

 Managing Forest through Provincial Strategy

Managing the forest ecosystems of the province continues to evolve from an initial period of exploitation, to timber management, to integrated forest management and, today, to sustainable forest management. During this time, aboriginal people have used forests for shelter and subsistence purposes and, likewise, when European settlers arrived, they cleared land and used the forest for lumber to build homes, fishing stages and subsistence requirements.
Over time, the management of forests has changed from one of single value use to sustainable forest management involving environmental, economic and social values. This Provincial Strategy presents the direction for managing the forest ecosystems of the province. Embraced is the philosophy of finding a balance between environmental, economic and social values desired by society. The four strategic directions identified in this Strategy give guidance to balancing all forest values. The environmental, economic and social directions incorporate the Canadian Council of Forest Ministers criteria and indicators framework to measure progress towards sustainable forest management. A separate
strategic direction for Labrador is presented to address issues unique to that region of the province. A short summary of each strategic direction follows:
1. Ecologically-based forest management:
The foundation for sustainable forest management will be establishing an ecological planning framework. Ecosystem-based guidelines will be developed using existing information. A biodiversity assessment program will continue to be developed.
Biodiversity:
This Strategy will address three biodiversity values; protecting forest ecosystems, special places and wildlife habitat.
Healthy Forests:
Healthy forests will require maintaining the natural ecological processes and productivity of forest ecosystems.
Water and soil:
Essential to ecosystem productivity, aquatic habitat and human survival is the protection of soil and water.
Global impacts:
Work will be initiated to determine the total amount of carbon in the province's forest ecosystems.
2. Economic considerations:
Forest ecosystems will continue to provide many economic benefits to the province. This Provincial Strategy will guide the further development of both timber and non-timber forest products industries.
3. Social considerations:
This Strategy will ensure continued meaningful public participation in forest management planning.
4. Labrador
Aboriginal participation will continue to be supported and forest
management tools will be enhanced to enable responsible forest
management in Labrador.
All four strategic directions in this Provincial Strategy will require specific directing of financial and human resources, as well as partnerships with other groups in order to achieve successful implementation. To address the cross-departmental issues, a working group of government departments associated with this Strategy will be established. To ensure continued openness and transparency in managing our forests, the Department of Forest Resources and Agrifoods Forest Policy Committee will adopt an evaluation framework which will guide implementation of this Strategy and be the basis of an annual report on implementation progress.
Measuring the province's success in achieving sustainable forest management will be through the criteria and indicators defined in this Provincial Strategy. The Department of Forest Resources and Agrifoods will report to the people of Newfoundland and Labrador
by December 31, 2004 and again by December 31, 2009.
This Provincial Strategy will lead Newfoundland and Labrador into the 21st century of sustainable forest management. It provides the vision and direction to ensure that present and future generations will enjoy the benefits from our province's valuable forest ecosystems.

7 Characteristics of good International Monetary System

 7 Characteristics of good International Monetary System

On the improvement and reform of international monetary system, I would like to make three points.
First, what is a good international monetary system? If we want to make reforms and improvements to the
international monetary system, they must promote the characteristics that such a system should have. I suggest the following seven characteristics of a good international monetary system:
1) It should promote development, which means that the system can facilitate trade and investment.
2) It should provide correct incentives for those who work hard, so their efforts can pay-off. This means,
whether the country is big or small, and regardless of its region or religious makeup, et cetera, it should provide the right incentives.
3) It should be able to do the adjustment when the balance of payment is imbalanced. International history
suggests that countries compete for different reasons,some based on mercantilism (and a positive balance of
trade) others to make their money cheap. The system should be able to provide a mechanism to adjust each of these kinds of imbalances.
4) It should be able to provide a safety net so that during a crisis it can provide the necessary liquidity to deal
with the crisis.
5) It should have an accurate representation of the world and reflect the world economic fundamentals.
6) It should be stable and resilient against all kinds of shocks—economic, political and otherwise.
7) It should contribute to maintain the stability of exchange rates and effective regional arrangements.
If we consider human history for the last 100 or more years, we have experienced the gold standard, the Bretton Woods system and also the post-Bretton Woods (Jamaica Accord). Each of these different versions of the international monetary system can address some problems better than others. A desirable system should find an efficient balance between the strengths and weaknesses of the various systems.
The second remark I want to make is that if we know what a good international monetary system should look like, the next step is deciding how to reform the current international monetary system accordingly. Before we answer that question we have to ask, »What are the vulnerable points, the shortcomings of the current system?
We need to focus our surveillance on those points in order to prevent another crisis. The Lehman Brothers
crisis of 2008 shows that a lack of financial supervision is a vulnerable point that can trigger systemic risk.
Another example is the sovereign debt crisis of Europe: for a long time, surveillance and supervision of the advanced economies was largely ignored, then suddenly they built up high budget deficits and accumulated too much government debt, producing a sovereign debt crisis which has also caused systemic risk.
A third example concerns global liquidity and capital flows. And if we provide too much liquidity globally, we
risk triggering abrupt capital flows in or out, which can be dangerous. Some say that liquidity is a term that’s not defined clearly enough. Roughly speaking, global liquidity, as the term is used in IMF and Bank for International Settlements (BIS) research papers, refers to the total supply of the main reserve currencies. Global liquidity has two dimensions: one is the quantity of the money supply; the other is the price, e.g. the interest rate. If the quantity of supply is very large while the interest rate is very low, it means there is abundant liquidity globally. The fourth vulnerable point concerns imbalances. We know that the accumulation of a trade surplus, the accumulation of a trade deficit, can produce dangerous external imbalances. If we can identify these vulnerable points, we can focus our surveillance to prevent a crisis from happening. But this is difficult: sometimes there is a focus on one dimension combined with a neglect of other dimensions that can then produce instability. For example, in 2008 and 2009 the sovereign debt crisis occurred. With institutions like the International Monetary Fund, the capacity of surveillance is limited. It is impossible for surveillance to detect every vulnerability, every time, so we have hard choices.
In my third remark, I will comment briefly on broadening the SDR basket. Broadening the SDR basket is a good idea but we also have to look closely at the two IMF on this:
1) the basket of currencies should consist of the largest exporters. (This means that trade, especially export, is the most important consideration for currency to be in the basket), and 2) the currency should be freely usable. Keep in mind that the IMF is not using the term »fully convertible,«but »freely usable« which means that it’s freely usable for payments, settlements of trade and maybe some Foreign Direct Investment (FDI) transactions. The obvious candidates among the currencies are the BRICS countries. We should look to both the BRICS countries and the IMF for criteria. For most of the BRICS countries, the first criterion—export—is already satisfied, but the second criterion is rather weak. But a lot of countries are working on it and there has been rapid improvement.
If we put the BRICS countries into the present SDR basket, or even if we consider more countries to make up the SDR basket, we find that the new basket would decrease the volatility of the present basket in terms of variance and standard deviation. The broader basket would also have better representation, which reflects world economic fundamentals. I think in terms of commodity trade and export, and in terms of the valuation and the resilience of the SDR, this would be beneficial. I know that it takes time and we have to follow
the rules. There is no hurry, but I suggest to IMF, we’re starting to calculate. We shadow the SDR, which means that the IMF should calculate the simulation by using data so that we can accumulate statistics and evidence to inform future discussions and consideration of this issue.