Tuesday, September 14, 2010

Why Cuba's economic model failed

Fidel Castro, Cuba's long-standing dictator, recently confessed (link) to the American journalist that Cuba's communist political and economic model never worked. This is nonetheless a shocking statement revealing the actual awareness of the fundamental fallacies of the communist economic model. Cuba was long known for miserable social and economic indicators that were tried to be hidden by the ruling Communist party of Cuba. So, why is Cuban economic model destined to fail?

First, prior to the 1959 communist revolution, Cuba enjoyed the status of one of the wealthiest countries in Latin America, known for high level of judicial independence and strong protection of private property rights. Not surprisingly, before the revolution, Cuba recorded the highest stock market capitalization of any Latin American countries. The solid level of capital market development was a mere reflection of sound contract enforcement instituted by the judicial protection and the rule of law. When the revolution began, Cuba eliminated all private property rights by collectivization of land and by a complete nationalization of private enterprises. By that time, the very fundamentals of economic development were destroyed.

Second, Cuban communist leaders looked up to the Soviet Union as a role model of the socialist society. By the time of the revolution, Cuba followed the course of destructive economic policy. It began imposing price controls and the trade with the rest of the world, except for the socialist countries, was ended. In addition, civil and personal liberties vanished under the communist regime. Therefore, Cuban economic model resulted in food shortages, land depletion, massive immigration and frequent oil crises.

The collapse of the Cuban system was anticipated since every communist nation ended its Marxist economic experiment in the disastrous failure. For instance, Yugoslavia's socialist model resulted in the political disintegration of the country, record-breaking hyperinflation and a civil war. Cuba long praised its supposedly superior health care system which was said to outperform the quality of the American health care system. It is not difficult to infer that the majority of health indicators was manipulated by the government bureaucracy. Recently, Raul Castro decided to fire 500.000 government employees as an attempt to boost the growth of the struggling socialist economy (link).

The ultimate roots of Cuban economic failure lie in the belief of the power of the state to replace free price mechanism and free enterprise system as the coordinator of economic decisions of individuals and firms. The intention of Cuban revolutionary leaders to create "heaven on earth" resulted in probably the most significant economic and social stagnation in the 20th and 21st century. The case of Cuba reaffirmed the unprecendent failure and theoretical inconsistency of Marxist economic theory and policy. Cuban political and economic experiment once again showed that socialist political philosophy is based on false and misguided philosophical premises that completely misunderstood the meaning and nature of human liberty.

Friday, September 10, 2010

Spain's labor market reform

According to WSJ (link), Spain has finally implemented the broader reform of the labor market structure. Spain's 20 percent unemployment rate is the highest in the Euroarea. Traditionally, Spain was known for its notorious and heavily regulated labor market. The country used to maintain high levels of minimum wage and high cost of dismissal. The reform introduced by the Zapatero government removed the restrictions for dismissals on a fair basis and deregulated dismissal procedures on indefinite labor contracts. Dismissal cost has been decreased from 45 days to 33 days of salary per year worked.

The labor reform in Spain led to a lot of controversy among economists. Dani Rodrik (link), for instance, claims that labor market deregulation and fewer firing restrictions will further increase the unemployment rate since the major cause of it is the lack of labor demand. On the other hand, a handful of economists claim that Spain's persistent labor market rigidities are the major cause of country's high unemployment rate.

According to World Bank, redundancy cost in Spain averages 56 weeks of wages, more than twice the OECD level. During recessions, the decline in labor demand usually increases the unemployment rate and, therefore, hiring and firing restrictions do not exert the major influence on firm's decisions to employ additional units of labor. However, the persistence of strong labor market regulation imposes significant economic costs.

First, firms do not employ the optimum amount of labor. High redundancy cost and rigid dismissal procedures lead to either under-employment or over-employment of labor. Thus, firms shift the burden of high labor cost on higher prices, lower dividends and lower net wages.

Second, labor market regulation has broader implications. It eventually leads to more institutional rigidities and more pressure on higher wages by trade unions through collective bargaining. Consequently, wages become downward rigid. During the economic recovery, firms are therefore less motivated to employ new workers or extend the existing labor contracts.

As Spain finally recovered from the recession, the ongoing labor rigidity and even the increasing labor demand could not alleviate Spain's high unemployment rate. It would only put more pressure on Spain's government to increase government spending on unemployment schemes. Therefore, the reform of the labor law based on labor market flexibility is the most plausible alternative for Spain to boost employment and decrease the widening budget deficit that threatens country's economic recovery.

Monday, September 6, 2010

Should Bush tax cuts be extended?

According to WSJ (link), the majority of surveyed economists in the U.S. suggests that Obama administration should extend personal income tax cuts imposed under Bush administration between 2001 and 2003. Given the dismal effects of $787 billion stimulus, the U.S. economy would greatly benefit from tax cuts on earners in all income brackets. However, is the administration under president Obama willing to reverse the growing trend of government spending?

Critics of Bush tax cuts claim that reduction in personal income tax rates between 2001 and 2003 resulted in a disproportionate windfall gain to the wealthiest U.S. households while the families in the lower tail of income distribution received very low or zero gains from 2001-2003 tax cuts. What would happen if the Obama administration extended tax cuts for all taxpayers? Would the reduction of tax burden lead to stronger and faster U.S. economic recovery? To answer the question, it is essential to understand what actually happened with the U.S. economy when Bush tax cuts were implemented.

Between 2001 and 2003, Bush administration enacted a series of tax cuts aimed at boosting the recovery of the U.S. economy from the 2001 recesion. In this year, tax rate on income in the lowest bracket was reduced to 10 percent while top marginal tax rate was slashed to 35 percent from 39.6 percent. Tax rates were also reduced for middle-income earners. In 2002, the administration reduced tax burden on new business investment while in 2003 tax rates on dividends and capital gains was decreased. These measures were a part of broader $1.35 trillion tax cut program approved by the Congress over a ten year course.

However, tax cuts didn't pay for themselves as President Bush promised. The reason is the growth of federal government spending which increased by 2.5 percentage points of GDP between 2001 and 2008. During his term, President Bush signed the so called Medicare Part D plan which assured seniors additional drug prescription. The act created $8.4 trillion in unfunded obligations in present value terms. The CBO (Congressional Budget Office) estimated that extending Bush tax cuts would cost the U.S. Treasury $1.8 trillion in the following decade and would dramatically increase the federal budget deficit.

The war in Iraq was the major source of a growing public debt. Between 2001 and 2008 the federal public debt increased by 5.4 percentage points of GDP. Due to the growth of government spending, tax cuts led to a widening budget deficit. It should be noted that tax cuts were not the cause of the 2008-2009 budget deficit as critics often argue. An analysis by Center for Budget and Policy Priorities has shown that Bush tax cuts account for about 25 percent of the 2009 federal budget deficit.

If tax cuts are not accompanied by the reduction in government spending, the outcome is likely to result in either budget deficit or growing public debt. This is exactly what happened in the medium term with Bush tax cuts. A reduction in tax burden on personal income can result in higher tax revenue only if government spending is reduced. The U.S. budget outlook suggests a dismal fiscal future for America, marred by high public debt and a wide budget deficit that is unlikely to disappear before 2017. Bush tax cuts should be extended for earners in all income brackets, but only under a permanent reduction of government spending. Otherwise, any further tax cut would only add to the magnitude of federal budget deficit.