Are Wars Good for the Economy?

One of the more enduring myths in Western society is that wars are somehow good for the economy. Many people see a great deal of evidence to support this myth, after all World War II came directly after the Great Depression. This faulty belief stems from a misunderstanding of the economic way of thinking.

The standard "a war gives the economy a boost" argument goes as follows: Let's suppose that the economy is in the low end of the business cycle, so we're in a recession or just a period of low economic growth. The unemployment rate is high, people may be making less purchases than they were a year or two ago, and overall output is flat. But then the country decides to prepare for war! The government needs to equip its soldiers with the extra gear and munitions needed in order to win the war. Corporations win contracts to supply boots, and bombs and vehicles to the army. Many of these companies will have to hire extra workers in order to meet this increased production. If the preparations for war are large enough, large numbers of workers will be hired reducing the unemployment rate. Other workers may need to be hired to cover reservists in private sector jobs who get sent overseas. With the unemployment rate down we have more people spending again and people who had jobs before will be less worried about losing their job in the future so they'll spend more than they did. This extra spending will help the retail sector, who will need to hire extra employees causing unemployment to drop even further. A spiral of positive economic activity is created by the government preparing for war, if you believe the story. The flawed logic of the story is an example of something economists call The Broken Window Fallacy.

The Broken Window Fallacy is brilliantly illustrated in Henry Hazlitt's Economics in one Lesson. The book is still as useful today as it was when it was first published in 1946; I give it my highest recommendation. In it, Hazlitt gives the example of a vandal throwing a brick through a shopkeeper's window. The shopkeeper will have to purchase a new window from a glass shop for a sum of money, say $250. A crowd of people who see the broken window decide that the broken window may have positive benefits:

After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $250 more to spend with other merchants, and these in turn will have $250 to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be ... that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor. (p. 23 - Hazlitt)

The crowd is correct in realizing that the local glass shop will benefit from this act of vandalism. They have not considered, however, what the shopkeeper would have spent the $250 on something else if he did not have to replace the window. He might have been saving that money for a new set of golf clubs, but since he has now spent the money, he cannot and the golf shop has lost a sale. He might have used the money to purchase new equipment for his business, or to take a vacation, or to purchase new clothing. So the glass store's gain is another store's loss, so there hasn't been a net gain in economic activity. In fact, there has been a decline in the economy:

Instead of [the shopkeeper] having a window and $250, he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window or the suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

(p. 24 - Hazlitt) The Broken Window Fallacy is enduring because of the difficulty of seeing what the shopkeeper would have done. We can see the gain that goes to the glass shop. We can see the new pane of glass in the front of the store. However, we cannot see what the shopkeeper would have done with the money if he had been allowed to keep it, precisely because he wasn't allowed to keep it. We cannot see the set of golf clubs not purchased or the new suit foregone. Since the winners are easily identifiable and the losers not, it's easy to conclude that there are only winners and the economy as a whole is better off.

The faulty logic of the Broken Window Fallacy occurs all the time with arguments supporting government programs. A politician will claim that his new government program to provide winter coats to poor families has been a roaring success, because he can point to all the people who have coats who didn't have them before. It's likely that there will be several new stories on the coat program, and pictures of people wearing the coats will be on the 6 o'clock news. Since we see the benefits of the program, the politician will convince the public that his program was a huge success. Of course, what we do not see is the school lunch proposal that was never implemented to implement the coat program, or the decline in economic activity from the added taxes needed to pay for the coats.

In a real life example, scientist and environmental activist David Suzuki has often claimed that a corporation polluting a river adds to a country's GDP. If the river has become polluted, an expensive program will be required to clean up the river. Residents may choose to buy more expensive bottled water rather than cheaper tap water. Suzuki points to this new economic activity, which will raise GDP, and claim that the GDP has risen overall in the community although the quality of life surely has decreased. Dr. Suzuki, however, forgot to take into account all the decreases in GDP that will be caused by the water pollution precisely because the economic losers are far more difficult to identify than the economic winners. We do not know what the government or the taxpayers would have done with the money had they not needed to clean up the river. We know from the Broken Window Fallacy that there will be an overall decline in GDP, not a rise. One has to wonder if politicians and activists are arguing in good faith or if they realize the logical fallacies in their arguments but hope the voters will not.

Now on to the war.

From the Broken Window Fallacy it is quite easy to see why the war will not benefit the economy. The extra money spent on the war is money that will not be spent elsewhere. The war can be funded in a combination of three ways:

1.               Increasing taxes

2.               Decrease spending in other areas

3.               Increasing the debt

Increasing taxes reduces consumer spending, which does not help the economy improve at all. Suppose we decrease government spending on social programs. Firstly we've lost the benefits those social programs provide. The recipients of those programs will now have less money to spend on other items, so the economy will decline as a whole. Increasing the debt means that we'll either have to decrease spending or increase taxes in the future; it's a way to delay the inevitable. Plus there's all those interest payments in the meantime.

If you're not convinced yet, imagine that instead of dropping bombs on Baghdad, the army was dropping refrigerators in the ocean. The army could get the refrigerators in one of two ways:

1.               They could get every American to give them $50 to pay for the fridges.

2.               The army could come to your house and take your fridge.

Does anyone seriously believe there would be an economic benefit to the first choice? You now have $50 less to spend on other goods and the price of fridges will likely increase due to the added demand. So you'd lose twice if you were planning on buying a new fridge. Sure the appliance manufacturers love it, and the army might have fun filling the Atlantic with Fridgidaires, but this would not outweigh the harm done to every American who is out $50 and all the stores that will experience a decline in sales due to the decline in consumer disposable income.

As far as the second one, do you think you'd feel wealthier if the army came and took your appliances away from you? The idea of the government coming in and taking your things may seem ridiculous, but it's not any different than increasing your taxes. At least under this plan you get to use the stuff for awhile, whereas with the extra taxes, you have to pay them before you have an opportunity to spend the money.

So in the short run the war will hurt the economy of the United States and their allies. It goes without saying that flattening most of Iraq to rubble will decimate the economy of that country. Hawks are hoping that by ridding Iraq of Saddam, a democratic pro-business leader can come in and improve the economy of that country in the long run. The economy of the United States could improve in the long run due to the war for a couple of reasons:

1.               An increased supply of oil
Depending on who you ask, the war either has everything to do with Iraq's vast oil supplies, or absolutely nothing to do with it. All sides should agree that if a regime with better American relations were set up in Iraq, the supply of oil to the United States would increase. This will drive down the price of oil, as well as driving down the costs of companies that use oil as a factor of production which will certainly help economic growth.

2.               Stability and Economic Growth in the Middle East If peace can somehow be established in the Middle East, the U.S. government might not have to spend as much money on the military as they do now. If the economies of the countries in the middle east become more stable and experience growth, this will give them more opportunities to trade with the United States, improving both the economies of those countries and the U.S.

Personally I do not see those factors outweighing the short term costs of the war in Iraq, but you can make a case for them. In the short term, however, the economy will decline due to the war as shown by the Broken Window Fallacy. Next time you hear someone discuss the economic benefits of the war, please tell them a little story about a windowbreaker and a shopkeeper.

IMF blames slow action for rising inflation in region

Inflation in both Kenya and Uganda is in danger of getting out of control unless firm action is taken by the respective governments.

That’s the key message from the IMF’s new Regional Economic Outlook for sub-Saharan Africa which nevertheless predicted a rosy picture for the region if inflation is tackled.

The IMF predicts that Kenyan economic growth will hit 5.3 per cent this year, rising to 6.1 per cent in 2012, while the figures from Tanzania are 6.1 per cent for both years.

In Uganda economic growth is predicted to fall from 6.4 per cent this year to 5.5 per cent in 2012.

But it is the issue of inflationary pressures on the East African region which most worries economists at the IMF.

Describing inflation rates of 16 per cent in Kenya and 21 per cent in Uganda as “worrying”, the IMF says that the trigger for Kenya and Uganda’s current difficulties was a combination of drought conditions and the surge in global food and fuel prices.

It adds that “with the economies already at close to full capacity, and the monetary policy responses to the shock not consistently robust, both food and non-food price increases have escalated.”

The IMF says that the surge in inflation in Kenya and Uganda “points to the dangers of (governments) delaying the monetary policy response to shocks.

It adds that the result of delay in taking action has seen inflation accelerating sharply and currencies have come under “significant” pressure.

“Only a handful of countries have so far adjusted monetary policy in response to faster inflation and, even then, not decisively,” the IMF report says.

“In most cases, interest rates are little changed from the levels they were lowered to during the global financial crisis.

Especially in countries that are running at close to capacity or where there have been serious signs of policy slippage, monetary policy needs to be tightened decisively to reduce the risks of entrenching inflationary expectations and creating unsustainable macroeconomic imbalances.

“Fiscal policy will play an important role in supporting monetary policy to avoid overheating and the possible reversal of several years’ hard-won gains in sub-Saharan Africa.”

Overall however, the IMF is painting a positive economic growth forecast for sub-Saharan Africa as a whole, saying growth rates are set to maintain their current pace in 2012, supported by higher commodity prices and rising export demand.

In many of Africa’s low-income countries, growth is also being boosted by domestic demand and by adding value to exports, the report says.

The outlook, released on Wednesday, estimates that sub-Saharan Africa will grow by 5.25 per cent in 2011 and 5.75 per cent in 2012.

However, this projection assumes that the global economy will regain some of its momentum in the coming months. If not, then Africa will not be immune and growth could falter.

The report also highlights the increasing involvement of Chinese investment in Africa which was up from just one per cent of all FDI in 2003 to 16 per cent at the end of 2008.

In background studies published in the outlook, the IMF also highlights the quality and breadth of the region’s recent growth episode. These studies point to rising consumption of the poorest households, especially in countries where growth has been sustained at high levels, and the opportunities for intensifying trade with new growth markets.

In many of sub-Saharan Africa’s low-income countries, “growth is being supported by buoyant domestic demand along with export diversification into higher–value added production and to fast-growing emerging markets,” the IMF says.

Drought in the horn

However, higher food and fuel prices are bringing considerable difficulties, especially for the urban poor, and drought in the Horn of Africa is imposing untold hardships on households in that region.

The IMF says that the drought has probably cost Kenya around 0.5 per cent of economic growth this year.

In its outlook for the region, the IMF underlines the importance of aligning fiscal policy with financing and debt sustainability considerations, and draws attention to countries’ absorptive and project execution capacities.

For middle-income countries and others where growth is expected to be more subdued, and where output and employment are still below their pre-crisis levels, there is a strong case for maintaining a supportive policy stance provided there are no binding financing constraints.

In spite of promising growth prospects for the region, the outlook said a note of caution is warranted in the event that downside risks to the global economy materialise.

BENEFITS OF ICTS TO MSMES

Information and communication technologies (ICTs) have large potential of impacting MSMEs positively if used appropriately. These technologies have the benefits of enhancing access to and processing of information and of facilitating communication. To help us appreciate the facilitative role of ICTs, we need to understand the important place of both information and communication, both in our everyday lives as individuals but also in our businesses, communities, and societies at large.

Information is so important that without it we cannot be effectively functional in the communities and societies that we live and operate in. Without information, we cannot do effective business either. A few examples here will allow us to see the picture better: when you as an entrepreneur, get into business, you have to pass the information that you have started a business to other people before they and others can patronize your business. In your information package you have to say what product or service you have on offer, why you believe it is useful to your target audience, how it is used for optimal value and results, where and when it is available, what your charges are, and who will benefit most from it.

All the valuable information about your products and services, when effectively delivered (read communicated), sets the stage for the success of your enterprise. When this information is not articulated adequately with the necessary clarity, the business may not succeed as well as it should. So far as the communication component of ICTs, no matter how well the facts of the business are articulated and laid out, if they are not effectively communicated to the target audience, the business may still not succeed.

Even if you as an entrepreneur have the "perfect" product or service, your business will still not succeed until you articulate its information thoroughly and communicate that information effectively to the target audience. The technology in ICTs will allow the entrepreneur to package the information more effectively than otherwise. It will also allow the entrepreneur to communicate that information more effectively than otherwise. Technology allows us to capture, organize, manage, and disseminate our information in ways that make them more valuable. Probably the most common example today of how information and communication technology is able to help us capture, organize, and manage our information is the mobile telephone. No longer do we need pen and paper to write down phone numbers; nor do we need good memory capacity to remember those phone numbers since our electronic gadgets already do that for us. In fact many of us will confess that they do not know (off head) the phone number of even the best friend they talk to almost every evening. These devices also help us manage this valuable information by storing it in a specific order such as by date or in alphabetical order. The arrangement of electronic information can often be manipulated for ease of access, such as by sorting it in the desired order. The amount of time saved by having information appropriately sorted is tremendous.

The technology in ICTs will also allow an entrepreneur to communicate (disseminate) the information that has been captured, organized, and managed. Making a phone call, sending an SMS, sending an e-mail, accessing a website, and uploading and downloading internet content are some of the ways that we disseminate information and receive the information that has been disseminated by others. Many of us will agree that using these technologies, we are able to reach more people faster with more specific information than without them.

By posting information on your website about your products and services, for example, you as an entrepreneur are able to reach more people across the globe than you would have done otherwise, faster than would have been the case, and are able to provide that information more effectively using text, graphics, and sound. ICTs have indeed revolutionized the things we do and the way we do them. In fact, because of ICTs, an entrepreneur who uses them well is competing on the global market place with the entire world population as their potential target market.

CBK COMMITTING AN ECONOMIC CRIME

What ails the Kenya shilling? In spite of the several knee-jerk measures by theCentral Bank, the shilling continues to depreciate. Even after the Central Bank Rates (CBR) was raised to 11 per cent this week, it remained in free fall, selling at over Sh104 to the US dollar on Friday. In its usual confusion, CBK has reversed its earlier proposal to sell dollars directly to the importers. Treasury too has taken its familiar line – asking for more IMF loans! Will these measures help?

Is the currency crisis due to increased demand for the dollar by importers? Highly unlikely! Import demands for oil and commodities have been gradual and does not explain overnight drop of Sh2-5 we have seen in recent weeks. In any case, CBK has 3-4 months import cover.

Is it the impact of Euro zone crisis? Not entirely. Kenya may be a major trading partner with Europe but certainly not with Italy, Spain or Greece that face the crisis. We export more to these countries and the payments are largely in Euros, which has lost value against the dollar. Arguments that importers are shifting to dollar from the euro does not count. Furthermore, there are many other countries with much larger economic relationship with Europe that have suffered only marginal depreciation in their currencies.

Inflation may also have contributed but not as much as the CBK would want us to believe; which is why I think raising CBR to 11 per cent is misplaced and likely to hurt the economy more. It is based on the notion that increased demand for dollars by the private sector is to blame, and hence the need for credit squeeze. The rising inflation is largely a function of the high energy cost occasioned by the drought and global oil prices, and erratic money supply adjustments will not help.

Our economy is not very sensitive to monetary instruments. In early 2009, CBK reduced CBR by 100 basis points from nine to eight per cent, and reduced Cash Reserve Ratio in order to encouragecommercial banks to lower lending rates but it did not succeed. CBK pleaded with banks in vain. Higher risk perception by the banks aside, they didn’t play ball.

The exchange rate crisis started in 2008 when the shilling declined from Sh68 to Sh80 between September and October, losing substantial value. CBK blamed Safaricom investors offloading their shares after the IPO. That may not have been the real reason though. The CBK Governor has in the past come out strongly in favour of a weaker shilling, ostensibly to address the current account deficit. Similarly, Finance Minister Uhuru Kenyatta in his 2010/11 Budget speech urged him to pursue that policy. IMF also weighed in on the same policy after they granted the Enhanced Credit Facility (ECF) last year.

This explains why the Governor dillydallied earlier this year when the shilling started sliding very fast. A weaker shilling to help shore up the current account is a wrong policy. You cannot promote exports and enhance our competitiveness through currency devaluation, a failed policy IMF so catastrophically pursued in the 1980s.

Domestic and external shocks may be a factor in the currency slide. But truth be told, in our current predicament, it is speculation by some commercial banks that is largely responsible. These banks are engaging in economic crime, but for CBK and Treasury, the end justifies the means. CBK has itself alluded to this by stating categorically the banks are hoarding the dollars.

As the regulator, they know which bank is holding what amount. Are we seeing the return of political banks? The Government’s proposal to reduce its spending and borrowings, if at all, are welcome. Borrowing from IMF is taking the wrong turn.

But the solution to this crisis lies in CBK acting against errant banks left:T � i @ 7 margin-top: 0px !important; margin-right: 0px !important; margin-bottom: 0px !important; margin-left: 0px !important; float: none; left: auto; right: auto; top: auto; bottom: auto; border-top-style: none; border-right-style: none; border-bottom-style: solid; border-left-style: none; border-width: initial; border-color: initial; background-color: transparent; line-height: normal; text-align: left; position: static; display: inline; white-space: normal; font-family: inherit; font-variant: normal; font-size: inherit; text-transform: none !important; border-width: initial; border-color: initial; border-width: initial; border-color: initial; border-width: initial; border-color: initial; background-image: initial; background-attachment: initial; background-origin: initial; background-clip: initial; font-weight: inherit; border-bottom-width: 2px; border-bottom-color: transparent; color: rgb(43, 101, 176); background-position: initial initial; background-repeat: initial initial; ">oil prices, and erratic money supply adjustments will not help.

Our economy is not very sensitive to monetary instruments. In early 2009, CBK reduced CBR by 100 basis points from nine to eight per cent, and reduced Cash Reserve Ratio in order to encouragecommercial banks to lower lending rates but it did not succeed. CBK pleaded with banks in vain. Higher risk perception by the banks aside, they didn’t play ball.

The exchange rate crisis started in 2008 when the shilling declined from Sh68 to Sh80 between September and October, losing substantial value. CBK blamed Safaricom investors offloading their shares after the IPO. That may not have been the real reason though. The CBK Governor has in the past come out strongly in favour of a weaker shilling, ostensibly to address the current account deficit. Similarly, Finance Minister Uhuru Kenyatta in his 2010/11 Budget speech urged him to pursue that policy. IMF also weighed in on the same policy after they granted the Enhanced Credit Facility (ECF) last year.

This explains why the Governor dillydallied earlier this year when the shilling started sliding very fast. A weaker shilling to help shore up the current account is a wrong policy. You cannot promote exports and enhance our competitiveness through currency devaluation, a failed policy IMF so catastrophically pursued in the 1980s.

Domestic and external shocks may be a factor in the currency slide. But truth be told, in our current predicament, it is speculation by some commercial banks that is largely responsible. These banks are engaging in economic crime, but for CBK and Treasury, the end justifies the means. CBK has itself alluded to this by stating categorically the banks are hoarding the dollars.

As the regulator, they know which bank is holding what amount. Are we seeing the return of political banks? The Government’s proposal to reduce its spending and borrowings, if at all, are welcome. Borrowing from IMF is taking the wrong turn.

But the solution to this crisis lies in CBK acting against errant banks.

Loan pain as CBK raises interest rates

you have a loan from the bank, you might need to dig deeper into your pocket to service it.

The Central Bank of Kenya (CBK) on Wednesday increased its key interest rate by 400 basis points — that is, from 7 per cent to 11 per cent — in a bold move to stabilize the shilling.

The decision to raise the Central Bank Rate, known in the trade as the CBR, is intended to attract investors back into the country and strengthen the flow of much-needed dollars.

However, the measure will hit borrowers particularly hard because banks are likely to raise the lending rates.

The shilling has lost about 26 per cent of its value this year, reaching a record low of Sh104 to the dollar last week, and is one of the world’s worst performing currencies at the moment.

At 11 per cent, the current interest rate is the highest since 2006 and is expected to discourage borrowing, which has been blamed for increasing the amount of money in circulation and therefore fuelling inflation.

“Though it will fix the shilling crisis, Kenyans must be prepared for costlier bank loans,” said Mr Dickson Magecha, a forex trader at Standard Chartered Bank.

However, some economists think the measure is not enough, citing the rising inflation rate projected to reach 20 per cent before the end of the year.

“This is not enough if the inflation figures are to be believed. To contain the situation fully, the CBK should have increased the rate to about 15 per cent, close to inflation figures. The higher rates are needed to convince foreign investors that the government is taking inflation seriously and therefore inject back into the country foreign exchange,” said Mr Gitau Githongo, an economist based in Nairobi. More than six commercial banks, including Standard Chartered, Development Bank.

Bank of India, I&M Bank, Commercial Bank of Africa and Victoria Commercial Bank, have increased minimum interest on loans to about 16.5 per cent.

With the latest increment, made after a Monetary Policy Committee (MPC) meeting, it is now inevitable that the rest will follow suit.

Analysts argue that the move will be counter-productive in the long term as it will discourage borrowing, which is critical in growing businesses and creating jobs.

Kenya’s traditional source of dollars has been agricultural cash crops such as coffee, tea and horticulture.

But these have been affected by the drought, leading to low production. At the same time, the drought has led to importation of the country’s staple food, maize, piling pressure on the currency.

In its statement, the MPC said the move was necessary to protect the country’s economic growth that was under threat from a weakening shilling and rising cost of living.

The CBK, for the first time, publicly admitted that it had underestimated the crisis.

“The committee carefully examined a broad array of available information and analyses that showed these developments are a threat to economic recovery and macroeconomic stability: second quarter growth declined to 4.1 per cent,” the statement signed by CBK’s governor Njuguna Ndung’u said.

“Decisive and immediate action is required from the monetary policy side to stem these inflationary pressures, stabilize the exchange rate and re-establish a healthy growth base.”

News of the increase was welcomed by the market after the shilling gained marginally to trade at about 101.20 against the dollar.

However, several players said the decision had taken too long to come.

“This was long overdue given the prevailing differences between the CBR and Treasury Bill rates. For instance, whereas the CBR rates had only risen by about 100 per cent, the T-bill had shot up by up to 1,300 per cent in the same period,” Mr Magecha said.

Though the market was prepared for an increase, it was not expecting it would be of such a magnitude given CBK’s previous policy stances.

The CBK reckons that though an enhanced tightening of the monetary policy stance is required at this time it must be complemented by increasing supply of food, fuel and energy to tame inflation that has shot up to 17.32 per cent in September.