How easily can a small country produce above capacity?

by on May 4, 2013 at 2:53 am in Economics | Permalink

Paul Krugman raises that question in connection with the Baltics.  In contrast to Krugman’s claim, I would think it is especially easy for small, open economies to produce “above capacity,” if only because resources can flow in from abroad.

As I understand the case for capital controls, recently endorsed by Krugman, that case almost requires a notion of an economy “heating up” in an “unsustainable” fashion; otherwise what’s the worry with the capital inflow?  Better to have the capital than not, unless you fear unsustainability.  (Don’t, by the way, be shocked if people who totally reject the rationale behind the capital controls idea are also inconsistent on this point and wish to argue that the Baltics were unsustainably over capacity.)

Imagine a lot of capital flows into a small, open economy, but based on unrealistic assessments of risks and future prospects.  Economic activity will be much higher.  Labor will come back home or reject what would otherwise be a decision to leave.  A lot more will be produced, at least temporarily.

Eventually foreign investors come to their senses and the whole process goes in reverse.  Now that foreign investors have learned their lessons, and withdrawn their capital and their ambitious plans for the future, the small economy cannot easily get back to where it was, at least not anytime soon.  To my eye this process and its unraveling seems fairly simple to grasp.  The fact that lots of labor is leaving, as has been the case in Latvia, if anything supports the plausibility of this scenario.

If you are focused on per capita effects, capital may move faster than labor, there may be ranges with increasing returns to scale, it may be the more productive workers who can leave, and momentum effects, among other possible mechanisms.

I also would reject any hard notion of “capacity” and view the matter as a sliding scale, depending on expectations and how much risk and fragility investors and suppliers of labor are willing to accept; see my Risk and Business Cycles for more on this point.

Andre May 4, 2013 at 5:58 am

Martin Wolf had a nice piece on the performance of the Eastern European countries as well. Do they have any lessons for the rest of Europe. Where is 10% of the population of Spain supposed to go? Where is 7% of Britain supposed to move to? If you scale up those ‘success’ stories they don’t really look all that successful. Of course not falling back into Russia’s sphere of influence is probably good enough, but economically…

Filll.com May 4, 2013 at 6:17 am

The perspective is great as long as you can have a ‘realistic assessment of risks and future prospects’ – when that is not possible, the capital flows in either directions cannot be stopped (except by some regulatory measures). That is the reality.

Andrew' May 4, 2013 at 7:10 am

Savings glut? Hidinflation?

ThomasH May 4, 2013 at 7:21 am

I do not thing the concept of “over capacity” is the most useful way to think about this.

For a small economy, this is the issue of exchange rate management, similar to “Dutch Disease. If policy makers are concerned about the sectorial investment implications of what they judge to be temporary controls on the inflow of capital might help vs creating an offshore sovereign wealth fund. Chile, Colombia, and Switzerland have had controls on the inflow of capital from time to time. The decision will be bound up with why the authorities might be concerned that the inflow is temporary.

I the case of the Euro zone the problem was that capital inflows were based on foreign investors not taking into account that country risk remained (and arguably increased) after exchange risk was eliminated. Of course policy makers in Spain and Greece and Ireland probably did not see this risk, either nor did they have an easy way to deal with the inflow except by running a countervailing fiscal surplus, a pretty difficult policy to sell to the public.

Cameron Murray May 4, 2013 at 7:38 am

When you say
“Better to have the capital than not,”
Are you talking about physical capital – more buildings, machines, roads etc? Or simply money?
Because capital in the money sense doesn’t flow across borders does it? You trade one currency for another – you shift your purchasing power to another country. But there is nothing new produced, nor is the capacity for production increased.

Willitts May 4, 2013 at 7:57 am

BS. Nothing can produce beyond its capacity. If it can produce more, then you have not properly measured its capacity.

There might be a “safe” measure of capacity, and producing beyond that is feasible but risky. However, it is still within the feasible set of choices.

I don’t intend to suggest that there cannot be bubbles or overheating or whatever metaphor you wish to use. The production is within capacity, but there will be costs later.

Using a basic model of a production frontier ignores many other factors that permit the economy to produce or consume beyond that frontier. It does NOT mean that the enhance production/consumption is infeasible. It just means that the basic model ignores gains from trade and other forms of efficiency enhancing measures.

It amazes me that in this modern age we still look at economics in a static sense when dynamic factors are readily observable. While the analogy to personal consumption is fraught with errors, one can easily live beyond ones means through borrowing. Similarly, a country can live beyond its means through a form of borrowing. But this borrowing must be repaid, and thus a future cost is incurred. This has an impact on future consumption/production.

In a dynamic world, the science is stuck in a static equilibrium. And when the most brilliant minds are caught in this trap, it doesn’t bode well for the profession. For example, the housing and financial bubble and subsequent bust is perfectly understandable if one embraces a dynamic view of leverage cycles. Guys like Sumner think that it was Fed mismanagement that caused both effects and people like Krugman think that government ought to have done more. Geez, it is a hit parade of central planning mentality rather than understanding basic market dynamics. People had unrealistic expectations, and they got slammed for it. Incentives were aligned to create it. And the market corrected for it. There is no such thing as perfect markets, but markets are very powerful at doing what they do.The housing and financial bubble and collapse were both predictable and preventable. We just needed to allow the market to do its job. Planning wrecked the economy.

Planning the economy is like trying to put a queen sized fitted sheet on a king sized waterbed.

Ray Lopez May 4, 2013 at 8:52 am

I agree with you 110% that one cannot exceed their capacity. But TC makes good points, however, as Table 1.1 of his book on business cycles notes, capital intensive goods have lifespans of between 20 to 30 years. So these cycles might take a generation to play out, or at least 10 years. Witness Japan’s funk and the collapse of the Asian Tigers after decades of seeming unflappability.

RC May 6, 2013 at 6:13 am

“I agree with you 110% that one cannot exceed their capacity.”

Beautiful sentence.

Claudia May 4, 2013 at 9:43 am

Another fun macro blog debate … I like the emphasis on expectations, but I think TC is being a bit deep-y in his arguments … find an economist who believes capacity (or potential output) is a static concept? … but I am “stunned but not surprised” at PK’s arguments. Of course, the economy can run above potential and past peaks driven by bubbles may not be the right benchmark for subsequent recoveries. His arguments have little to do with capacity and everything to do with austerity. Reality is probably somewhere in between. Here’s a very nice piece on potential output with a discussion related to the US in the recession: http://research.stlouisfed.org/publications/review/09/07/Basu.pdf

Brian Donohue May 4, 2013 at 10:19 am

I don’t think it helps the cause of clarity for the economics profession to assign esoteric definitions to words like ‘potential’ and ‘austerity’ that are at odds with historical and vernacular definitions for these words.

Claudia May 4, 2013 at 10:30 am

Name a profession that doesn’t use technical terms. Capacity is not the same as potential … and TC’s quasi-Austrian views may not even include potential exactly (I don’t know). I find the mixing of everyday and technical words on blogs creates a lot of space for mischief. Maybe I am reading too much into it but but there seems to be a lot going on here here that sounds silly in common, quick words.

Brian Donohue May 6, 2013 at 8:39 am

‘Potential’ or ‘capacity’ suggest, to me, a constraint – an idea that is very useful in economics. Maybe I’m just not giving 110%.

Brian Donohue May 6, 2013 at 8:41 am

And ‘austerity’ has of course, become utterly malleable and, therefore, meaningless. I liked it better when everyone understood ‘austerity’ to be spending less than your income, not running a $500 billion deficit on top of a $17 trillion debt.

Zach May 4, 2013 at 10:03 am

Krugman’s in favor of capital controls, too?

Just asking, but are there any disastrous economic policies that Krugman actually opposes?

It’s funny how seamlessly economics can turn into a rubber stamp for political elites serving their own interests.

Josh May 4, 2013 at 10:07 am

The idea that a country may experience a slump after a lot of foreign investment seems consistent with the idea that countries can’t operate far above capacity. Advocates for capital controls likely believe that the country could have grown at a slightly slower but sustainable rate with those controls, because no slump would have occurred.

James Hass May 4, 2013 at 10:14 am

When talking about the big boom times in the Baltics, it is important to remember that they were accompanied by double digit current account deficits, and that these deficits went mostly into private capital formation. Latvia is not a big exporter of structures. So while we may think that those structures built in the last decade showed a capacity that exists, but would not be useful to keep employed in that pursuit. Neither would devaluation create a market for that construction. Latvia and all the baltics were spending beyond their sustainable financial capacity.

Millian May 4, 2013 at 12:47 pm

Ireland, yeah, pretty well-described by this model. But I agree with commenters that the word “capacity” is infelicitous to describe this characteristic of economies.

Dismalist May 4, 2013 at 1:04 pm

I once heard Fritz Machlup denounce “capacity” as a non-economic concept.: He asked one to think of toilet, and consider if one even desired full capacity utilization.

mulp May 5, 2013 at 1:15 am

Nauru produced above capacity thanks to capital inflows for a century.

Now it is effectively uninhabitable. Its population of less than 10,000 depends entirely on foreign aid.

I would guess the people of Nauru would offer it to anyone who wants to establish a charter city in exchange for assuming the debts of Nauru.

Boonton May 5, 2013 at 12:14 pm

1. I think you’re confusing financial capital with actual capital. GDP is made out of actual capital and labor. A bubble or bursting of a bubble consists of financial capital flowing in and out of a small economy like Latvia. The flowing in of capital swells the price of capital (real estate, businesses, etc.) but it doesn’t actually increase the stock of real capital except very slowly. When the bubble bursts you may get lots of bankruptcies as those who borrowed to buy real estate and other capital go bust, it doesn’t change the fact that the real capital that exists in the economy still exists.

A real example, imagine an office building built in the bubble. Now that the bubble is gone, those who borrowed to build it cannot turn over their loan or sell the building to pay it off so they are bankrupt. That doesn’t alter the fact that the building exists, it’s real capital and there’s plenty of real labor to put with it to make output (GDP).

2. If labor is leaving then the unemployment rate should not be impacted. If Latvia’s trouble now signals that labor should go elsewhere in Europe, then the base from which the rate is calculated should be shrinking. No need for a prolonged ‘recession’ or high unemployment rate.

Boonton May 5, 2013 at 12:38 pm

Just to clarify with illustration of the office building:

During the ‘bubble’, financial markets lent $50M to build a new multi-story tower on a track of land that was only worth $20M. A year later financial markets lend someone else $100M to buy this new building. Then later on someone else gets lent $150M to buy the building from that person. The real capital of this economy has increased by $50M but the ‘electronic herd’ has swept into the economy with $200M ($50M to build the building, then $150M to buy it).

Now the bubble bursts. The chap who borrowed $50M to build then sold it to someone else for $150M is happy and rich. The unlucky fellow who borrowed $150M to buy it discovers the rental income can’t cover his loan. He tries to sell but discovers the building will only fetch $40M in the market. He is bankrupt and the building will soon be in the hands of the creditors who will sell it for whatever it will get.

This is the point in the story where Tyler will talk about capital ‘leaving’ the country upon realizing the market had set expectations too high. After all, the bonds or stocks or mutual fund shares or whatever that had been trading at $200M are now worthless….that’s $200M leaving a small economy right?

But in real terms this economy has more capital than before, and if Tyler’s story is correct about labor moving back into the country, more labor. There’s no special reason why the economy’s productive capacity isn’t greater than it was before (it does, after all, have more capital and more labor!) and no reason why that office building shouldn’t be filled with businesses.

Here the Austrian story with its ‘malinvestment’ falters. Maybe in retrospect, if we had a time machine, it would have been better to spend $50M to build that office building in Berlin and then maybe if someone had spent $150 to buy it in Berlin the rent would have been enough to have made a decent profit. But that’s the sunk cost fallacy. Latvia may not have been the best place to build a new office building, but now that it’s built there’s no reason it should be harming or holding back Latvia’s economy! No capital has actually left the economy unless creditors have come in with a giant helicopter to take the building off to Berlin!

The Anti-Gnostic May 6, 2013 at 1:11 pm

Latvia may not have been the best place to build a new office building, but now that it’s built there’s no reason it should be harming or holding back Latvia’s economy!

If that were really the case, then market actors (as opposed to academic economists) would not price in a discount later. The Latvians simply weren’t as rich as they thought they were. And now they’ve got to tear down a whole office building if they want to put anything else there.

If you think the market actors are wrong and the macro-economists poring over generic aggregates are right, then Pontiac, Michigan would have loved to have heard from you in 2009.

Boonton May 6, 2013 at 5:11 pm

Not quite good enough. Malinvestment can’t simply be a bad investment that cost more money to build than to sell. It has to be an investment that costs money each year BUT it would cost much more to get rid of it. That would literally be an investment which reduces GDP.

In the example you cited, a city spent $55M to build a stadium that costs maybe $1.5M a year to maintain. It was hoping to sell it but the highest bid came in at only $500K.

But now think about the person offering $500K for it. He is willing to incur $1.5M a year for maintaince plus the cost of the $500K loan. Clearly he thinks the stadium can generate enough revenue to service the loan and cover its upkeep. Let’s say his interest on the loan is $50,000 each year. He thinks the stadium will yield at least $1,550,000 each year in revenue. Sorry that’s a net plus to GDP for the city so that still wouldn’t be malinvestment.

If the stadium was really malinvestment it’s sale price would have to be negative. The city couldn’t just sell it for less than it cost to build it, it would have to literally pay someone to take it over. Malinvestment can’t just be garbage, it literally has to generate ‘anti-GDP’ that cancels out positive GDP generated by healthy investments.

And let’s note your inclination to go to such an extreme example. Most investment is not giant stadiums in declining cities. Most investment is of a very hum drum sort, like an office building. This is investment that can be put to many different uses and can usually be customized to new customers and new businesses at modest cost. Restaurants are an excellent example of this, how often does one start then fail only to see the site taken over by another restaurant.

It seems pretty implausible to assert that the market, driven by a crazy bubble, would not just make bad investment decisions that cause individual investors to lose but make a huge set of positively evil investments that sap the economy even long after the original decision maker has been driven into bankruptcy! Esp. when most of the ‘stuff’ built during such booms (houses, office buildings, standard infrastructure etc.) looks pretty much like the capital goods you find in a more successful economy like Germany.

Geoff May 11, 2013 at 9:33 pm

“Don’t, by the way, be shocked if people who totally reject the rationale behind the capital controls idea are also inconsistent on this point and wish to argue that the Baltics were unsustainably over capacity.”

I guess I shouldn’t be shocked that Cowen can’t grasp how one can in fact be 100% consistent in both rejecting the rationale behind capital controls and at the same time arguing that the Baltics are unsustainably over capacity.

For one could be a free market advocate who rejects capital controls and correctly identifies the over-capacity in the Baltics to be the fault of state intervention in the market, and that the unsustainable over-capacity can be corrected if the market process is allowed to function.

It does not follow from rejecting capital controls that one is somehow no longer permitted to identify unsustainable capital structures.

It also does not follow from identifying unsustainable capital structures that one is somehow obligated to support capital controls as the solution.

The only way that we can find out which investments should be liquidated due to unsustainability, and which investments should not to liquidated, is via the market process itself. Regulators have no clue as to what the correct level investment should be.

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