Nudging Economic Normalcy - "The Animal is Innocent" (A Bit Techical)

I have just finished reading David Pilling's interesting new book (2018) titled 'The Growth Delusion - The Wealth and Well-Being of Nations". It is an easy read with a compelling story on how an economy can be seen, at least by policy makers, to be doing well while that is all delusional (my review of the book is forthcoming). 

If we were to talk matters economic and public policy, Pilling's book is a reminder of two other classics, one by Paul Krugman in 1995 (Peddling Prosperity) and the other is by William Easterly in 2001 (The Elusive Quest for Growth).

But if we were to talk of economic policy discourse in Kenya as propagated - and sometimes actually initiated by a pretentious media - then Pilling's book reminds me of  John Ward's 1993 The Animals are Innocent. I am serious! The book is about the Mr Ward's search for the killers of  his daughter who disappeared while on a trip to Masai Mara. The popular stories about the death that Mr Ward discounts in the book shifted from suicide to "she was killed by wild animals".

If you are wondering how this relates to economic policy, you just need to look at headlines such as Kenyans to feel the pinch as Treasury implements IMF's 'painful' reforms.  If you substitute wild animals with the IMF, then you know what am talking about. As a society, we have become experts in looking for somebody to blame for problems of our own authorship.

It all starts with our misplaced sense of optimism that has blinded us from seeing grave undercurrents (hey, don't get me wrong; I too listen to motivational speakers who tell anybody within their headshots to always be positive!).  Recent episodes illustrates this vividly.

The beginning of 2018 has been characterised by an official feel-good sense insofar as the economy is concerned. The extent of such feeling varies, ranging from expectations of modest recovery to a drastic upward swing form the slow growth seen in 2017. If one was to take the Central Bank of Kenya's 2018 output projection of 6.2 percent as the exemplar of optimism of the state of the economy, then one need sot ask oneself: what will it take for the "stellar" growth to be realised?

The answer, I could argue, lies in looking at how far the economy's performance is from its potential - the so-called output gap. Unfortunately, not many analysis - even economists - look for answers from on economic growth or stability from that front. Instead, the preoccupation is on how the economy is "doing better" than the global or continental average - which in itself may look interesting but not very helpful.

There are a few critical things  to appreciate about potential output - which is also referred to as the production capacity of the economy. One is that just like GDP can rise or fall, the deviation of the economy's output from its potential can be bi-directional - it can be positive (meaning actual output is more than full capacity) or negative  (meaning actual capacity I less than what the economy can produce at full capacity).

Either way, an output gap is a pointer that the economy is running inefficiently (either under stretching or over-stretching its resources). While potential output is unobservable, therefore needs to be estimated, there can be tell-tale sign on whether we are on the negative or positive side.

All indications are that we are currently on the negative side, meaning that there is spare capacity of slack in the economy due to weak demand. The fact that core inflation (also called underlying inflation) - which excludes food and fuel, therefore signals demand pressure - is very subdued.

Meanwhile, the headline inflation (overall inflation) has not been consistently low; in instances it has breached the official target and hit double digit levels largely on account of challenges on the real economy (supply side challenges that monetary policy has no tools to directly address).

It is from here that the second critical issue about output gap - the employment gap - enters the equation. Unemployment gap is tightly linked with output and both are central to the conduct of both fiscal and monetary policies.

In order to appreciate this link, one must have an understanding of a situation that economists call the nonaccelerating inflation rate of unemployment (NAIRU). This is the unemployment rate that is consistent with a constant rate of inflation.

In the event that there are deviations of the unemployment rate from the NAIRU,  they point to deviations of the output from its potential. If for argument sake the actual unemployment is equal to the NAIRU, the economy will be producing at its maximum level without straining resources. That will be an economic nirvana - no output gap; no inflation pressure; all good!

Reality Check

But the nirvana in our case can only be imagined, not real. The dipping of real output growth to below 5 percent means that a quick reversal that must confront four factors.

1. Private sector investment needs to be on a positive trajectory. That is not happening; the intuitive sequencing when firms are operating at excess capacity means that there has to be optimal capacity utilisation before demand for new investment becomes a priority.
2. while the dynamics on the investment side represent the supply side of the equation, there has to be a corresponding demand side response. As already noted, demand is muted an inflation - which if low and stable promotes a predictable environment for investment and consumption - is hardly anchored to the target (a recent paper on this subject is my authority here - Hachem K., and Wu J.K., 2017, "Inflation and Social Dynamics", Journal of Money, Credit and Banking, Vol. 48, No. 8, December);  the reality is that inflation expectations could be undertaking econometrician's "random walk". So you can imagine the random walk in the field of sagging consumer confidence (according to a recent survey)!  
3. It is a no-brainer that the public expenditure led growth often runs its course; in our case, the party that has lasted for well over four years has run full cycle. Now its time to pick the tab; such growth having bee a function of a huge fiscal deficit running over an equivalent of 8.0 percent of GDP. Public debt  is now an issue of great concern even to those (IMF - World Bank) who not too long ago argued that "Kenya's risk of external debt remains low, while overall public sector debt dynamics continue to be sustainable" - if you can't take me for my word,  read what they said in December 2016!  Of course, the hot and cold rating agencies do not want to be left out of the loud cry of "fire!" 
4. There is a premature declaration victory on the external sector.  The closure of the current account deficit from double digit levels in GDP equivalent to below 6.0 percent is attributable more to less imports bill than vibrancy of exports. It's hardly surprising that the stand-by arrangement with the IMF remains critical (see here) no matter what a senior advisor loudly muses (see here). We needed the IMF arrangement in March 2018; nothing has changed to make us say we don't need it now. The oil prices are on the rise; add VAT on fuel (what the media is lazily calling the IMF tax while it truly is a lazy response to the need for the necessary fiscal consolidation) and you see how household's disposable incomes are eroded. The downside risks to the global economy have been by the potential dire consequences of the US trade tariffs.

The Delusion

On the back of the foregoing arguments it is easy to see why it is difficult to nudge optimism and think all is well. It is also easy to see why IMF could well be an acronym for "It's My Fault". It is a delusion that we are anywhere close to the nirvana. Unemployment is sky high and wages are low and sticky; we hardly talk of wage inflation in this country. It is a delusion to imagine that reducing fiscal deficit by way of rationalising expenditure is symmetrical to reducing the deficit by way of levying arbitrary taxes. It is a delusion for any proposal -policy or otherwise - to be portrayed as an IMF policy. As things stand, "the animal (in Washington) is innocent".