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Issue 32/26 January 2011

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1) World Economic Situation and Prospects 2011: United Nations

The recovery of the world economy has started to lose momentum since the middle of 2010, and all indicators point at weaker global economic growth, according to a new United Nations report. The UN expects that the world economy will expand by 3.1 per cent in 2011 and 3.5 per cent in 2012 – far from sufficient to enable recovering the jobs lost because of the crisis.

In the release of its annual report, the World Economic Situation and Prospects 2011 (WESP), the United Nations emphasizes that the outlook remains uncertain and surrounded by serious downside risks. The cooperative spirit among major economies is waning, which has debilitated the effectiveness of responses to the crisis. Uncoordinated monetary responses, in particular, have become a source of turbulence and uncertainty in financial markets. The recovery may suffer further setbacks if some of the downside risks materialize, in which case a double-dip recession is looming for Europe, Japan and the United States. WESP 2011 says that in the short run more fiscal stimulus will be needed to reinvigorate the recovery, but that it will need to be better coordinated with monetary policies and reoriented to provide stronger support to employment generation and facilitate a sustainable rebalancing of the global economy. This cannot be done without better international policy coordination.

Among developed economies, the United States has been on the mend from its longest and deepest recession since World War II. Yet, the pace of recovery has been the weakest in the country’s post- recession experience. At 2.6 per cent in 2010, growth is expected to moderate further to 2.2 per cent in 2011 before improving slightly to 2.8 per cent in 2012, according to the report. This pace will not make much of a dent in unemployment rates, and recovering the jobs lost during the crisis would take at least another four years.

The growth prospects for Europe and Japan are even dimmer, the report says. Assuming continued, albeit moderate, recovery in Germany, GDP growth in the Euro area is forecast to virtually stagnate at 1.3 per cent in 2011 and 1.7 per cent in 2012. Growth in 2010 was 1.6 per cent.

Some countries in Europe will see even less growth, especially where drastic fiscal austerity and continued high unemployment rates are draining domestic demand. This is especially the case in Greece, Ireland, Portugal and Spain, which are entrapped in sovereign debt distress. Their economies will either remain in recession or stagnate in the near term. Japan’s initially strong rebound, fuelled by net export growth, started to falter in the course of 2010. Challenged by persistent deflation and elevated public debt, the economy is expected to grow by a meagre 1.1 per cent in 2011 and 1.4 per cent in 2012.

Developing countries continue to drive the global recovery, but their output growth is also expected to moderate to 6.0 per cent during 2011-2012, down from 7.0 per cent in 2010, because of the slowdown in the advanced countries and phasing out of stimulus measures. Developing Asia, led by China and India, continues to show the strongest growth performance, but some moderation (to around 7 per cent) is expected in 2011 and 2012.

High unemployment is the Achilles heel for the recovery

The UN report says that the lack of employment growth is the weakest link of the economic recovery. Between 2007 and the end of 2009, at least 30 million jobs were lost worldwide as a result of the global financial crisis. As more governments embark on fiscal austerity, the prospects for a fast recovery of employment look even gloomier.

In 2010, employment conditions in the United States seemed to be improving earlier in the year, but started to falter later as the recovery decelerated and state and local governments started to lay off workers. The unemployment rate may increase to 10 per cent in early 2011, up from 9.6 per cent in the third quarter of 2010. All projections indicate that it will take several years for the unemployment rate to return to its pre-crisis level.

In the Euro area, despite improvements in Germany’s job market, the average unemployment rate has continued to drift upward, reaching 10.1 per cent in 2010, from 7.5 per cent before the crisis. In Spain, the unemployment rate more than doubled to 20.5 per cent. It also increased dramatically in Ireland, reaching 14.9 per cent in 2010, and other countries in the region. WESP predicts that unemployment in Europe will decline at a snail’s pace. In Japan, labour market conditions improved marginally during 2010, but the unemployment rate is expected to remain above 5 per cent in 2011.

High unemployment will constrain household consumption recovery, which in turn will drag output growth. WESP points out that below-potential output growth, in turn, will constrain employment growth. The longer this vicious cycle lasts, the higher the risk of “cyclical” unemployment becoming “structural”, further impairing long term economic growth potential.

The UN report also provides evidence that workers in developing countries and economies in transition have also been severely affected by the crisis, though the impact in terms of job losses emerged later and was much more short-lived than in developed countries. Indeed, employment started to rebound from the second half of 2009 and, by the end of the first quarter of 2010, unemployment rates had already fallen back to pre- crisis levels in a number of developing countries. Yet, despite the rebound in employment in parts of the world, the global economy still needs to create at least another 22 million new jobs in order to return to the pre-crisis level of global employment. At the current speed of the recovery, this would take at least five years to achieve.

Increased exchange rate instability

WESP 2011 says that a much weaker recovery of the world economy is far from a remote possibility. Besides the lack of job creation, especially in advanced economies, volatility in currency markets is generating additional macroeconomic uncertainty which could further jeopardize the recovery. In a more pessimistic scenario of greater uncertainty and no change in policies, the UN predicts that Europe could well see a double-dip recession, while the economies of the United States and Japan might virtually stagnate and possibly also fall back into recession during 2011. This would also significantly lower growth prospects for developing countries (by almost 1 percentage point).

Tensions over currencies have emerged in part as a result of uncoordinated expansionary monetary policies, essentially consisting of more money printing. The stronger quantitative easing in the United States has put downward pressure on the dollar, causing ripples in currency markets worldwide. The quantitative easing is to lower interest rates and stimulate investment. The UN says this will not be very effective as long as financial systems are still clogged and hence not channelling much money to finance productive investments. Instead, more capital is flowing to emerging and other developing countries, in search of higher profitability. As a result of these developments, the Euro and the yen have appreciated against the dollar, as have the currencies of emerging market economies. This has led to interventions in currency markets and introduction of capital controls in a number of markets. The report says that heightened tensions over currency and trade could well trigger renewed turmoil in financial markets, jeopardizing the recovery.

Five challenges for sustainable recovery

These potentially damaging spillover effects of national policies once again highlight the need for strengthened international policy coordination, according to the report. Unfortunately, during 2010 the cooperative spirit among policymakers in the major economies has been waning. “Avoiding a double- dip recession and moving towards a more balanced and sustainable global recovery would require addressing at least five related major policy challenges”, said Rob Vos, who led the team of UN economists that prepared the report.

The first is to provide additional fiscal stimulus, by using the ample fiscal space that, according to WESP 2011, is still available in many countries. Such fiscal action should be adequately coordinated among the major economies to ensure a reinvigoration of global growth that will also provide external demand for those economies which have exhausted their fiscal space. The present shift towards severe fiscal austerity measures in developed economies could well trigger a spiral of pro-cyclical fiscal adjustment, the UN report argues, with the result that that fiscal consolidation will turn out to be self- defeating on a global scale.

The second challenge is to redesign fiscal stimulus and other economic policies to lend a stronger orientation towards measures that directly support job growth, reduce income inequality and strengthen sustainable production capacity on the supply side.

The third challenge, the UN report stresses, is to find greater synergy between fiscal and monetary stimulus, while counteracting damaging international spillover effects in the form of increased currency tensions and volatile short-term capital flows. This will require reaching agreement about the magnitude, speed and timing of quantitative easing policies within a broader framework of targets to redress the global imbalances. It will also require deeper reforms of financial regulation, including for managing cross-border capital flows, and in the global reserve system, reducing dependence on the US dollar.

The fourth challenge is to ensure that sufficient and stable development finance is made available for developing countries with limited fiscal space and large developmental deficits, including resources for achieving the Millennium Development Goals and investing in sustainable and resilient growth.

The fifth challenge is to find ways to come to credible and effective policy coordination among major economies. The UN report says it is urgent in this regard to make the G20 framework for sustainable global rebalancing more specific and concrete. In this sense, establishing concrete “current-account target zones” could be a meaningful way forward, if it is part of a broader package aiming at addressing all of these challenges.

To access the full report click here.

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2) Valuing longevity in the Human Development Index by Martin Ravallion, Director of the Development Research Group, World Bank Martin Ravallion

Measuring and comparing the level of human development across the world continues to be a highly contentious issue. This column argues that the new Human Development Index has – perhaps inadvertently – sharply reduced its valuation of longevity, raising doubts about whether it is sending the right signals to the governments of poor countries aiming to promote human development.

The 20th edition of the annual Human Development Report has introduced a new version of its famous Human Development Index (HDI) (UNDP 2010). The HDI aggregates country-level attainments in three dimensions: life expectancy at birth, education, and income per capita. Each year’s country rankings by the index have been keenly watched (in both rich and poor countries) since they first appeared in 1990. UNDP (undated) documents many examples of the influence of the HDI, including on policymakers in developing countries.

As for any composite index, we need to know the trade-offs built into the HDI if it is to be properly assessed and used (Ravallion 2010a). The trade-off can be defined as how much of one desired component must be given up for an extra unit of another, keeping the overall HDI constant. In other words, the trade-off is what economists call the “marginal rate of substitution”. If one of the positively-valued dimensions increases at the expense of another, then it is the marginal rate of substitution that tells us whether human development is deemed to have risen or fallen.

What then are the trade-offs embodied in the HDI, and how have they changed?

The new Human Development Index

While there have been some changes to the HDI over its 20 year history, these are clearly the biggest yet. Only one of the three components is the same, namely life expectancy. Gross national income has replaced GDP, both at purchasing power parity and logged. The measures for education have also changed. And new bounds are used to map each component into a common (0,1) scale. But the change with greatest bearing on the implied trade-offs is that the HDI now uses the geometric mean of its three components, rather than the arithmetic mean. This was done to avoid the long-standing feature that the three dimensions of the HDI were assumed to be perfect substitutes (UNDP, 2010, p.15), as implied by the arithmetic mean.1

What do these changes mean for the HDI’s implicit valuations? Here I focus on the implications for the valuation of longevity. In Ravallion (2010b) I also examine the HDI’s valuations of schooling and discuss an alternative aggregation function for the HDI that would go a long way toward avoiding the problems identified here.

Country-level trade-offs between income and longevity

Aggregating income with life expectancy in a single index implicitly puts a monetary value on an extra year of life. The HDI’s marginal rate of substitution between life expectancy and income gives the extra income needed to compensate for one year less life expectancy, keeping the HDI constant.

The Human Development Reports have never discussed explicitly the marginal rate of substitutions embedded in their index, and they can be questioned. Past comments on the HDI have pointed out the seemingly low value attached to longevity in poor countries (Ravallion 1997). As we will see, it turns out that the changes introduced in the 2010 Report have lowered the HDI’s valuations of longevity even further.

Using the geometric mean changes the implied trade-offs. The direction of this effect is theoretically ambiguous, and depends crucially on both the data and the bounds used for rescaling the variables. As it turns out, for the vast bulk of countries (all but eight of the 169 countries for which the HDI is reported), switching to the geometric mean lowers the index’s valuation of longevity (see Ravallion 2010 for more detail).

So what are the HDI’s new trade-offs? Figure 1 gives my calculations of the new valuations of an extra year of life expectancy for each country, plotted against national income (logged to avoid bunching up at low incomes). The HDI’s valuation for the poorest country, Zimbabwe, is $0.51 per year, representing less than 0.3% of that country’s (very low) mean income in 2008. Thus the new HDI implies that if Zimbabwe takes a policy action that increases national income by a mere $0.52 or more per person per year at the cost of reducing average life expectancy by one year, then the country will have promoted its “human development”.

Granted Zimbabwe now has an unusually low GNI per capita. The next lowest valuation of longevity is for Liberia, at $5.51 per year (1.7% of annual income). The value tends to rise with income and reaches about $9,000 per year in the richest countries (Figure 1). The implicit value of extra longevity as a proportion of mean income also rises with mean income (Figure 2). (The highest proportion of GNI is 16%, in Equatorial Guinea, though this is clearly an outlier).

Figure 1. Monetary valuations of extra longevity in the 2010 HDI table 2

Source (this figure and all following ones): Author’s calculations from data for 2008 provided in the 2010 Human Development Report. The fitted line is a locally smoothed (nonparametric) regression.

Figure 2. Valuations of longevity as a percentage of national income

table 2

So the trade-offs embedded in the HDI imply that, in the interests of promoting “human development”, poor countries should only be willing to pay a small sum (in dollars and as a percentage of national income) to attain an extra year of life expectancy, but that rich countries should be willing to pay about 10% of their mean income.

The changes introduced by the 2010 Report have markedly lowered the value of longevity relative to the old HDI. The change is particularly notable among low and middle income countries. This can be seen in Figure 3, which provides a “blow up” of Figure 1 for the poorest half of countries (in terms of GNI per capita), as well as the values implied by the old HDI aggregation formula using the arithmetic mean. (I also give the old valuation of longevity using the arithmetic mean and old bounds.)

Figure 3. HDI’s revised values of life expectancy in the poorest half of countries

table 2

It can be seen from Figure 3 that changing the bounds alone did not produce this large downward revision to the HDI’s valuation of longevity. It was the switch to the geometric mean that did the work, although it can be shown that different assumptions about the bounds would have made the HDI’s valuations less sensitive to the new aggregation method (Ravallion 2010).

Conclusions

The changes introduced in the new HDI have reduced its (seemingly low) valuations of longevity in poor countries even further. The Human Development Report’s implicit valuation on an extra year of life expectancy is now over 17,000 times higher in the richest country than in the poorest – a far greater difference than in their average income (which is 460 times higher in the richest country than the poorest). A poor country experiencing falling life expectancy due to (say) a collapse in its healthcare system could still see its HDI improve with even a small rate of economic growth.

A rich person will be able to afford to spend more to live longer than a poor person, and will typically do so. But how much should one build such inequalities into our assessment of a country’s progress in “human development”? That is a difficult question, which has certainly not been resolved here. However, given that the last 20 Human Development Reports have clearly intended to support a high value in development policymaking on attainments in health, it is puzzling that the 2010 Report has chosen a trade-off that puts such seemingly low value on the gains from longevity in poor countries. Possibly the construction of the HDI did not adequately consider what trade-offs were acceptable. Good intentions alone do not make for good measurement.

Note: These are the views of the author, and need not reflect those of the World Bank or any affiliated organisation.

References

Ravallion, Martin (1997), “Good and Bad Growth: The Human Development Reports”, World Development, 25(5):631-638.

Ravallion, Martin (2010a), "Your new composite index has arrived: Please handle with care", VoxEU.org, 14 October.

Ravallion, Martin (2010b), “Troublesome Tradeoffs in the Human Development Index”, Policy Research Working Paper 5484, World Bank, Washington DC.

United Nations Development Programme, undated, Ideas, Innovation and Impact: How Human Development Reports Influence Change. United Nations Development Programme, New York.

United Nations Development Programme (2010), Human Development Report: The Real Wealth of Nations, New York: Palgrave Macmillan for the UNDP.

1 Strictly speaking, since income enters on a log scale, income and life expectancy (or schooling) were not in fact perfect substitutes even in the old HDI.

Copyright VoxEU.org

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