Vietnam

Introduction 

Vietnam’s development is without doubt one of the most successful stories of the last decade. The populous south-eastern country (85 million people; World Bank database, 2010), from being an impoverished and  isolated nation with a long history of wars and divisions has become, in the world of Ajay Chhibber (cited in The Economist, 2008) the “poster child” for economic development. Today, in 2010, Vietnam is on the verge of joining the middle-income countries’ group (World Bank, 2008), setting itself the ambitious target to become a rich, high-tech country by 2020 (The Economist, 2008).

Vietnam’s rise from poverty has started from a very low base; in 1989 its GNI per capita, PPP in dollars was just 610$, three and an half times less than an average middle income country and nearly thirty times lower than the GNI PPP $ of an high income country. Yet, Vietnam’s GNI PPP $ over nearly twenty years has increased more than threefold,  averaging an annual rate of growth of 8% , twice faster than an average high income country and a typical low income country. However, despite its notable progress, Vietnam is still a poor country compared to other Asian economies; though, Vietnam’s income level (GNI PPP $) has doubled in the period 2001-2008 while other ASEAN countries such as Philippines, Thailand, Indonesia have only registered an average annual increase of their income level in the range of 3-6%  

The striking characteristic of Vietnam’s growth is the progress made in the eradication of poverty and in other development indicators. Vietnam ranks at the 116^th place in the latest Human Development report (2009), a position thirteen places higher than the equivalent GDP per capita table; a result that highlights the social and equitable focus of the Vietnamese development (Vietnam’s Gini coefficient is 0.37). In fact, Vietnam scores relatively well compared to other LDC countries in all the indicators that form the HDI index. It has met or it is likely to achieve six of the ten Millennium Development goals outlined by the United Nations Development Program (World Bank, 2008) and poverty has been reduced by two/thirds between 1993 and 2006; well beyond the target set by UNDP to halve the proportion of people living in poverty by 2015.

Vietnam has escaped deep poverty by embracing free trade;  as a result, Vietnam’s economy is today one of the world's most open with merchandise trade (exports plus imports) equal to 160% of GDP (World Bank, 2010).  The rapid integration of the Vietnamese economy explains 20% of the outstanding 7% average annual rate of GDP growth of the past twenty years.

If the size of the government is often determined by the degree of market failure in society, in a country such as Vietnam, in which private initiative was practically outlawed, it’s not surprising that the State has a major role in Vietnam’s economy. SOEs (State Owned Enterprises) still retain a major control over more “strategic” activities; in fact, the strongly nationally-owned character of Vietnam’s development strategy allows the government to have through the SOEs direct control over employment and FDI and thus fulfil its vision of an equitable development. However, despite the suspicion that often attracts the State’s involvement in the economy, SOEs have been maintaining a greater productivity compared to the private sector (Thoburn, 2004) resulting from years of experience of the Communist management’s elite in the field.   Nevertheless, its monopoly in the manufacturing sector has been partially declining (from 52% in 1995 to under 35% in 2006; World Bank, 2008) and a dynamic private sector is slowly emerging, sparking hopes that the country's latent entrepreneurialism has finally burst back into life (The Economist, 2008), although the generated share of output (22.7%) is still little more than an half of the share of foreign-invested enterprise (Thoburn, 2009). 

Commodity trade and Trade policy

The outstanding growth achieved by the south-eastern country certainly vindicates the many neo-liberals who advocates “trade as the main engine of economic development” (Todaro, 2009); indeed, Vietnam’s move to a market economy, its gradual integration into world trade and the swift openness to foreign investment have certainly helped sustaining a economic growth that has seen its total output tripling in 2008 to 90.7 US$ billions from 31.17 US$ billions in 2000 (World Bank Database, 2010).

The move towards a more open economy was the core of the trade strategy actuated with the doi moi reform programme in 1986. This approach, in line with the neo-classical theory, aimed at increasing the economic performance of Vietnam by integrating its economy in the global exchange of goods that is International trade. In fact, according to classical theory (Todaro, 2009), with trade a developing country can access goods that otherwise would be unable (or be too expensive) to produce in exchange for products in which it has a comparative advantage. Through this mechanism, based on the classical belief that trade allows a better allocation of resources (labour, land, capital), the country would focus on developing sectors of the economy where it is more efficient (in absolute or compared to its trading partners), hence where the margin of gains are greater. Indeed, the comparative advantage would be acquired by specialising in goods that have a relatively lower cost of production as explained by David Ricardo in his theory of comparative advantage (Todaro, 2009) or by maximising the use of factors which are abundant such as labour, as demonstrated by the Heckscher-Ohlin theory (Todaro, 2009). Though, the gains from trade arise because a bigger market allows economies of a large scale and so greater profits, because exposure to the world allows the access to foreign technology and finally because by opening the domestic market to foreign importers, internal competition is increased thus lowering the prices. (The Economist, 1998).

The increased integration of the economy also implies a notable change from its past. In fact prior to the “doi moi” reform plan, Vietnam was a rather isolated country; its isolationist approach, based on the concept of “developing from within” initially theorised by the Argentinean economist Raul Prebisch (cited in Cypher and Dietz, 2009), persistently pursued strict industrial policies of import substitution (ISI) aimed at manufacturing simple and non-durable goods that were being imported, while developing trade- links only with the former Soviet Union and other communist countries (Thoburn, 2009). Nevertheless, similarly to the unsuccessful attempts of other developing countries that engaged in inward-looking policies (Todaro, 2009), Vietnam also failed to sustain this strategy; indeed in 1986, Vietnam’s economy was surviving solely on aid flowing from the Soviet Union that shortly thereafter collapsed, inflation was over 700%, exports were only half the value of imports and there were severe shortages of food and consumer goods (Thoburn, 2009) that induced many desperate Vietnamese to flee the country (“boat people”, The Economist, 2008).  

However, although the evidence shows that the openness of its market to foreign goods has had a very positive effect on its rate of growth, Vietnam did not rapidly move towards a market-based system of foreign trade. In fact, Vietnam’s trade strategy, as in other Asian countries previously, was mainly centred on the development of an export-led industrialisation (ELI). Similar to ISI but outward looking; during this process the dismantling of imports restrictions such as tariffs and quotas happen quite gradually in order to protect the infant export industry from foreign competition while a programme of light industrialisation creates the basis for the creation of a competitive advantage in labour-intensive manufactures. Indeed, Vietnam’s effective rate of protection has been constantly high and it has only decreased recently as a result of joining the WTO in 2007

.

On the other hand, as noted in Cypher et al (2009) “an industrial revolution without an agricultural transformation would be a partial success”. Indeed, the de-collectivisation of the land (one of the biggest privatisations yet seen; The Economist, 2008) and the gradual alignment of farm prices toward market prices provided the basis for the spectacular development of the agricultural sector.   Vietnam from being a net importer of rice in the 1980 has moved to become the world second exporter (after Taiwan), resolving also the problem of food security, considering that at least 70% of population is a consumer of rice. Moreover, its produce is highly diversified; it ranges from coffee to nuts and from peppers to rubber (Thoburn, 2009). 

The Vietnamese process of modernisation of the rural area also went hand in hand with a gradual urban development. As often the success of structural changes of this sort are measured by the falling share of agriculture in the country's gross domestic product, Vietnam’s achievement is highlighted by the decline of its share of agriculture as percentage of GDP to a 20% in 2007 from the 46% of 1988, an average annual decline rate of 2.1% offset by a faster growth of the secondary and tertiary sector during the same period.

However, Vietnam’s strategic approach to export promotion was not limited only to the export of primary products but it was mainly intended for more productive and growth-inducing product lines. In fact, Vietnam has successfully been able to add manufactured goods to the existing export structure of the primary products (Fig. 6).  In 2007, the light industrial and handicraft goods represent the 45% of the export volume (in mill.USD; Fig.7). In fact, Vietnam’s diversification of its main manufacturing exports from garments and textiles into footwear reflects the country’s comparative advantage of a low-cost but high-quality labour force (World Bank, 2008) but also an effective strategy of limitation of export earning instability, a problem common to other Asian economies.

The positive characteristic of Vietnam’s development has been the successful although not complete transition to a more open economy. In fact, as protective tariffs were progressively reduced, the country has effectively managed to overcome common transactional inefficiencies that arise when moving from a highly protected economy to a more integrated one. In particular in three key areas, Vietnam created the conditions for a sustainable development; those are the economic climate, human capital and foreign investments.     

Economic stabilization and the early “doi moi” reforms were closely linked. In 1988 a severely restrictive monetary policy was introduced to reduce the very high inflation. In fact, years of isolation and imports restrictions had artificially overvalued the Vietnamese “dong”. Hence, as part of the export –promoting strategy, the government devalued the currency in order to raise the local prices that firms receive for goods that can be exported.  This policy certainly renders the exports much cheaper to foreign importers, though more significantly accounts for a “veiled” subsidisation of the exports. 

Moreover, Vietnam’s record of investment in human capital

, both in education and in health provision generated “receptivity to technical change” (Van Arkadie cited in Thoburn, 2009). But more importantly, Vietnam’s entry into the world markets has been much helped by foreign firms, following a foreign investment law passed in 1988 (Thoburn, 2009) that de-facto liberalised foreign direct investments (FDI).

Indeed, this combination of stable environment, low production costs and specialised human capital has helped Vietnam to become the darling of foreign investors and multinationals (The Economist, 2008). In 2006 Vietnam’s inward foreign direct investment flows were accounting for 12.5 per cent of its gross fixed capital formation, compared to 8 per cent in China (UNCTAD, cited in Thoburn, 2004). Global buyers have also had an important part in directing FDI to Vietnam; the favourable investment environment has attracted many manufacturing companies to outsource their production in the south-eastern country. Indeed for buyers that seek for a useful “insurance” against relying too heavily in China (a “China plus one” strategy), Vietnam is often chosen as “the plus one” (The Economist, 2008)    

Finally, in line with many development economists that argue that developing countries should orientate their trade toward their regional neighbours (Todaro, 2009) Vietnam joined the ASEAN (Association of Southeast Asian Nations) in 1995. The ASEAN bloc is formed by ten members

 of whom Vietnam is one of the poorest (only Cambodia, Laos and Myanmar have a lower GNI PPP per capita); this circumstance raises the possibility for the Vietnamese economy to gain from a closer integration with other rich members such as Singapore and large markets such as Indonesia which has a population of more than 200 millions.

In fact, integration provides the members countries the opportunity for a greater utilisation of their industries and to take advantage of economies of scale made possible by the expanded market (Todaro, 2009). Indeed, in 2008, more than 20% of the total of Vietnam’s imports and exports were part of an intra-ASEAN trade (table 4). But more importantly, the Asian region is Vietnam’s main source of imports while the United States, after having imposed an embargo on Vietnam’s goods that lasted until 1993, today they are the main destination of Vietnam’ exports (19% of total exports)

Conclusions 

Vietnam’s successful story cannot be told as a triumph of the market fundamentalists and neither as the umpteenth Asian miracle or a light version of China; instead, the specificity of Vietnam’s development may lie in its ability to incorporate the best aspects of successful development models into something uniquely suited to it.

Although Vietnam’s development is similar to other Asian countries such as Taiwan and South Korea, the economic reform programme initiated in 1986 certainly mirrors the same economic and social transformation undertaken by China in 1978. As its northern neighbour, Vietnam abandoned its effort to introduce real Communism, (evidenced in the collectivising land ownership and the repression of private initiative) to embrace Capitalism; it dumped strict autarkic policies and the disastrous economic central-planning system that isolated the country and brought Vietnam to the brink of a humanitarian catastrophe, to open its domestic market to foreign goods and investments. But, more importantly, as the People's Republic of China, Vietnam preserves an authoritarian government structure of a one-party state that still maintain a strong grip on political debate and the private enterprise initiative.

The Vietnamese government has had the merit of courageously abandoning the ideological doctrine for the good of its own people. As the developmental state assumed by Evans (cited in Cypher and Dietz, 2009), the Vietnamese apparatus has had the power, the purpose and the capacity of directing and mobilise its development vision. However, the development project undertaken by Vietnam has not been certainly characterised by a sudden “laissez faire” approach; instead of the invisible hand of the market, Vietnam’s development has been characterised by a very visible State. 

The main risk is that as the Communist ideology served as moral justification for the maintaining of the old status-quo, economic success may provide the pretext for the current regime to hang on to power. The role of the State has been certainly endogenous to the Vietnamese development; however this exploit has also been aided by external phenomena such as the increasing globalisation of the economies. Surely, the merit of the government has been to take full advantage of the global changes of the last twenty years, though many challenges lie ahead.

The latest financial crisis will definitely have the effect of re-balancing the world trade; this is likely to force Vietnam (as for other exporting countries) to stimulate the domestic demand to sustain its growth. However, Vietnam is still a very poor country, therefore, the extent of Vietnam’s reaction to external shocks will determine whether equality will be sustained or the problems facing the country will cause the government and other powerful interests to tighten their grip on the population and thus increasing discrimination. 

Because development must be conceived as a multidimensional process involving major changes in social structures, popular attitudes and national institutions (Todaro, 2009), if the Vietnamese government wants to continue to act as a developmental State it will have to certainly pave the way for the major freedom of its citizens and a declining authority of itself. It is often said that democracy is not a determinant in the development of a country and Vietnam may be the latest evidence, however it is worth remembering that that most of the world's richest countries by income per head are liberal democracies (The Economist, 2008); definitely another model to which Vietnam could aspire. 

My comment on "Silvio Berlusconi's antics: The return of Ruby"

Here's my comment posted on "The Economist" article on Berlusconi 14/11/2011 http://t.co/OOREqzR

Regardless of the outcome of yet another investigation on Mr. Berlusconi, I doubt that much will change in Italian politics. The Italian voters are way too much polarised to even change their mind in spite of the disgraceful charges brought against him and the Church (that so much power yield in Italian politics, but not in the population) will find a way to "contextualise" the fact.

The power of Viagra

Focusing on Berlusconi is a "false problem" or rather a distraction. He is just hanging on his power in order to prevent a correct functioning of democracy throwing him out of the country or worst in jail. He should have never been there in first place (as the Economist said at the very beginning) because of his conflict of interests. Indeed his interests have stopped him doing anything for the country and Italy going anywhere.

The latest episode will probably just accelerate his decline, as any empire in demise how the fall will be managed will be more important.

Italy's Finance minister Giulio Tremonti is in charge of the normal administration in Italy, of its enormous financial problems and of its embarrassing lack of competitiveness.
Despite doing quite well in minimising in the short term the effect of the Great Recession, the long term welfare of the country hangs on a thread.

Don't worry (ghe pensi me too!)

In this confusing situation, no one seems to have the capacity to lead the country out of mess. Again the "elite", that nothing did to prevent Berlusconi coming to power, is gone AWOL leaving Italy in near-anarchical situation.

In this confusion interest groups are using their power to save their skin or worst taking advantage of it( see Lega Nord backed by Tremonti, FIAT, etc)and again the sacrifices of the austerity measures will be mainly felt by the poor or not-aligned groups (workers, Southern Italy).

Whoever will come in power after the late Berlusconi empire will have to show some justice, the road to economic and welfare growth will be hard and painful but it can be shared more evenly that it is now.

Unfortunately no one seems to take the initiative to lead the country toward a more functioning democracy, leaving me wonder that Italians just can't.  

No Italian Jobs

Chimera's’ currency debate

“Chimera” is the term coined by Niall Ferguson to represent the heavenly marriage between China and America that between 1998 and 2007 accounted for about 40% of global growth (Ferguson, 2008). As put by the Harvard Professor, in this marriage “the Chinese did the saving, the Americans the spending. The Chinese did the exporting, the Americans the importing. The Chinese did the lending, the Americans the borrowing”

Yet, today, with the US economy scrambling to find a way to a sustainable recovery after the financial disaster of the 2007-8, many are asking China to re-balance its economy; definitely an indication that this marriage might be finally on the rocks.

That the economies of the US and China have become so intertwined is certainly a sign that times have changed; after years of isolation, the Communist China slowly started to integrate in the world economy, quickly flooding the world with its cheap exports while the Americans, leaving aside years of misunderstandings, soon took advantage of this situation and started to buy cheap Chinese goods, while US companies did not hesitate to outsource their operations in the favourably enterprise zone set up by the Chinese government. Indeed, to date, US are the second-biggest Chinese trade partner and China is the biggest exporter in the world.

Without doubt, China’s rise has been the most successful development story of the past twenty years. It has embraced Capitalism while still preserving an authoritarian government structure of one-party state; it has opened its economy and attracted large flows of Foreign Direct Investments (FDI). From a country on the brink of a famine due to its disastrous central planning system, today China enjoys higher standard of living, to an extent that the number of people living in poverty have decreased to 8% in 2001 from 53% in 1991 (World Bank, 2010).

Nevertheless, the core of Chinese development has been an export–led growth strategy, a policy that has surely taken advantage of its abundant labour force (roughly 20% of world population) and relatively high human capital (typical of former Communist countries), an established, albeit not yet productive Industrial sector and the creation of special economic zones (SEZs) such as the ones in Shenzhen and in Guangdong.

The massive structural change that China undertook helped sustain the miraculous growth that followed the liberalisation of its economy. However, in order to make its exports even more competitive, the Chinese government had to embark on what has become an important milestone in its economic policy, that is the successful devaluation and unification of currency rates at the beginning of 1994 and the eventual peg of the Yuan (renminbi) to the US dollar (Naughton, 1996). 

China’s economic arguments for maintaining its currency pegged to the dollar have revolved around the need to maintain and increase the competitiveness of its exports as compared to competing countries. The mechanism (in general terms) is based on the fact that as the renminbi depreciated (hence the price of the US dollar in Yuan increased), China’s US dollar earnings from exports increased and the dollars spent on imports decreased. By keeping the renminbi artificially low, China created a dollar surplus, which in turn meant that the government had to buy the excess dollars (Krugman, 2010). If analyzed in a supply-demand framework, China’s increased exports lead to a proportionate spike in demand for Yuan (as items produced in China would have to be purchased in the local currency). In this situation, in order to maintain the peg, the Chinese government had to increase the demand for other currencies by buying dollars, euro, etc, and thus increase the supply of Yuan, which eventually helped maintain the peg.

The crawling peg system adopted by China could be placed in-between managed floating and the adjustable peg system (Sloman, 2006: 676). Thus the Chinese government adjusts the peg frequently by small amounts as the equilibrium exchange rate changes (ibid). In the short-term, therefore, the central bank of China had to intervene in the foreign exchange market in order to maintain the peg.

According to Fan Gang, a professor at the Chinese Academy of Social Sciences, the two main reasons why China decided to peg the renminbi to the US dollar were to maintain employment in export industries and to prevent its immature financial system from speculation that would occur if the Yuan was allowed to float freely (cited in Corden, 2009). Keeping the Yuan pegged to the dollar made Chinese exports cheaper, which is why China has been enjoying such a rapid export-led growth over the past decade. However, in order to maintain the exchange rate, the People’s Bank of China had to regularly purchase large amounts of dollars which led to more than 700 billion dollars  foreign exchange reserves by mid 2005 (Hill, 2009).

The People’s Bank of China has continued undertaking massive purchases of foreign currency ( to keep the exchange rate down, to an extent that in June 2009 it accumulated $2,132bn in foreign currency reserves, over 40 per cent of GDP (Wolf, 2009a). 

The fact that most of the foreign currency reserve (70%, ref) are in dollar-denominated securities, and a large proportion of these are in U.S. government bonds also had the unintended effect of helping finance the U.S. current-account deficit at very low interest rates. Still according to Ferguson (2008),"without those low long-term rates, it's hard to believe that the U.S. would have bubbled the way it did between 2002 and 2007".

Indeed, with the American shopping malls full of cheap goods made in China and the US consumer engaged in a buying spree thanks to a nearly costless borrowing financed by the same Chinese currency intervention, it is not coincidental that the US trade deficit with China reached worrying heights  of -268,039.8 in 2008 (US Census Bureau, 2010).

The record US trade deficit with China, as well as the claims that the Yuan was largely undervalued after so many years of rapid growth, were constantly putting pressure on China to let the Yuan float freely against the US dollar. Although since July 2005 China has introduced more flexibility in its exchange rate by linking it to a basket of currencies (the euro, yen and the US dollar), Morris and Lardy (2009) argue that the change to a crawling peg system has had very little effect in practice. 

China allowed the Yuan to rise by 21% against the dollar in the three years to July 2008 but since then it has more or less kept the rate fixed (ibid). 

In spite of calls for a stronger renminbi and threats of protectionist measures such as tariffs on Chinese steel pipes and tyres have started as early as 2005, the worst crisis since the 1929 crash has certainly exacerbated the unsustainability of the current imbalance. In fact, the current US administration in its stimulus bill passed in January 2009, with the inclusion of the controversial “Buy America” provision that bars foreign steel and iron from the infrastructure projects laid out by the $819 billion economic package (Faiola, 2009) has effectively tried to stimulate the domestic production in order to save jobs and help the heavy industry at the expense of otherwise cheap imports (a Trade diversion in practice).

Despite the relative success of these measures, the US trade deficit with China has slowly decreased - at December 2009 it was -226,826.1 (US Census Bureau, 2010). In order to re-balance the world economy it is required that the renminbi reflects its true value, hence an appreciation of the currency that mirrors the growing status of the Chinese economy.

On the other hand China has had a ‘good crisis’ (Wolf, 2009); the high Chinese saving rate helped finance a massive fiscal stimulus programme of 4 trillion Yuan or $586 billion (The Economist, 2009). It was targeted at increasing the very low household consumption, which in 2007 was just 35 per cent of GDP (Wolf, 2009a). As shown in the graphs below (ibid), the government recovery programme has certainly facilitated a surge in Chinese domestic demand and the shrinking of its current account.

China’s government apparatus is also aware that time has come for the Chinese to let loose the dormant spending power of a high-saving population and shift to a new economic model that abandons its reliance on investments and exports; as also said by the Prime Minister  Wen Jiabao “we should focus on restructuring the economy, and make greater effort to enhance the role of domestic demand, especially final consumption, in spurring growth” (cited in Wolf, 2009b).

Nevertheless, despite the fact that the huge trade surplus has almost halved, the nature of the stimulus focused on state-investment that will probably increase its current account surpluses once again in future (The Economist, 2009) and the government is still accumulating foreign currencies to keep the exchange rate pegged. It has been deaf to the international chorus of voices calling on China to allow the renminbi to appreciate; indeed, the Chinese intervention in the exchange rate market is looking every day as a disruptive manipulation of the global economy.

According to Wolf (2009a), China has lost its “liberty of insignificance”, or rather that its actions nowadays, have a huge impact on the rest of the world. It is argued that a stronger Yuan would help rebalance China’s economy towards domestic spending by increasing the purchasing power of Chinese consumers, as well as give China’s central bank more control over inflation by having more freedom in setting adequate interest rates (The Economist 2010b). Although such an appreciation could cause a wave of job-cuts in the export sector of the Chinese economy, the increased domestic purchasing power will contribute to a gradual restructuring towards services that tend to be rather labour-intensive and hence likely to mitigate the impact of this restructuring (The Economist, 2010c). Short-termism, protectionist and nationalist sentiment on behalf of China’s ruling elite that results in further postponing or even stubbornly refusing action is likely to make the avoidance of a trade war between the US and China, a trade war that is likely to result in not only a huge welfare loss for both countries but also in a suffocation of world-wide economic recovery. Ambition and pride, one would argue, have been both the blessing and the curse of great states – the question this time is whether the world is prepared to pay the price.

Adaptive Expectation model (AE)

The Adaptive Expectation model (AE) provides a theoretical underpinning to the purely algebraic process of the Koyck model. It provides a fairly simple means of modelling expectations in economic theory whilst postulating a mode of behaviour upon the part of economic agents which seems eminently sensible. The belief that people learn from experience is obviously a more sensible starting point than the implicit assumption that they are totally devoid of memory, characteristic of static expectations thesis. Moreover, the assertion that more distant experiences exert a lesser effect than more recent experience would accord with common sense and would appear to be amply confirmed by simple observation

Assume Y_t=b₀+b₁X_t* +u_t    (1)               Where X_t* is the expected value of a variable

• How are expectations formulated?

X_t^* - X^*_t-1=γ (X_t - X^*_t-1)                  Adaptive expectations.

X_t^* = X^*_t-1 + γ (X_t - X^*_t-1)

Where γ (such that 0<γ<1) is known as the coefficient of expectation.  

The rationale behind adaptive expectation argues “economic agents will adapt their expectations in the light of past experiences and that in particular they will learn from their mistakes” (Shaw cited in Gujarati, 2009 p.630). 

The hypothesis of adaptive expectation contends that expectations are based only on the past values of the variable X_t    

More specifically it states that, expectations are revised each period by a fraction γ of the gap between current actual value and the previous expected value.

From equation (2) we have

X_t*  = X_t-1* + γ (X_t - X_t-1*)

X_t*  = γ X_t  + (1- γ )X_t-1* (3) Therefore if γ=0, it means that the expectations are static, while if γ=1 the expectations are realised immediately 

Substituting (3) into (1)

(4)

Now lag (1) one period 

And multiply by (1- γ)

(5)

Subtract (5) from (4)

   

Y_t= γ β₀+  β₁γ X_t+ (1- γ) Y_t-1+ v_t (6)

 v_t= μ_t-(1- γ) μ_t-1 

Dummy variables

In regression analysis the dependent variable is often not influenced just by ratio scale variables but also by variables that are qualitative or nominal scale that are not measurable in quantitative terms such as sex, race, and nationality. Indeed, Dummy variables are used to capture the effects of these qualitative factors. 

There are numerous social science applications in which dummy variables play an important role. For example, any regression analysis involving information such as race, age group, would use dummy variables. For example, holding all other factors constant, female workers are found to earn less than their male counterparts. This pattern may result from sex discrimination, but whether the reason, qualitative variable such as sex seem to influence the regressand and clearly should be included among the explanatory variables, or regressors.

Dummy variables indicate the presence or the absence of an attribute, such as male or female. One way we could “quantify” such attributes is by constructing artificial variables that take on values of 1 or 0, 1 indicating the presence (or the possession) of that attribute and 0 otherwise. There are two types of dummy variables: intercept dummies and slope dummies.

• Intercept dummy variables pick up a change in the intercept of the regression
• Slope dummy variables that pick up a change in the slope of the regression

For example : 

1.  You are investigating the impact of years of work experience on earnings. In your sample you have information on a number of individual characteristics including gender and type of occupation (manual, non manual, or mix)

D1_i=1 if the individual is female, 0 otherwise.

D2_i=1 if the individual has a manual occupation, 0 otherwise.

D3_i=1 if the individual has a non-manual occupation, 0 otherwise

An Illustration of the Koyck model

Although very useful in Economics, a distributed lag-model with a not defined length of the lag (infinite lag-model) or rather how far back we want go  poses some serious problem of estimation. Ad Hoc estimation implies a sequential procedure. Therefore, first regress Y_t on X_t then regress Y_t on X_t-1 and so on.  

A test significance of β_i (the coefficient of the lagged variable) is run each time until the coefficient start becoming statistically insignificant. This approach, however suffers from many drawbacks such as there is no prior guide of what is the maximum length of the lag; as one estimate successive lags, there are fewer degrees of freedom left; successive values (lags) tend to be highly correlated and the sequential search for the lag length opens the researcher to the charge of data mining.  

The Koyck model proposed a method to estimate distributed-lag model. It assumes an infinite lag distributed-lag model.

Y_t = α + β₀ X_t+ β₁X_t-1+ β₁X_t-2+ …. + μ_t

Hence assuming that the β’s are all of the same sign, Koyck assumes that they decline geometrically. 

β_k= β₀λ^k    where k=0,1,… and  0<λ<1  where λ : rate of decline and (1-λ): speed of decline 

This equation postulates that each successive coefficient (β) is numerically less than each preceding β since λ<1, implying that as one goes back into distant past, the effect of that lag on Y became smaller . Therefore the closer λ is to 1, the slower the rate of decline. 

As a result, the infinite lag model can be written as 

Y_t = α + β₀ X_t+ β₀ λX_t-1+ β₀ λ²X_t-2+ …. + μ_t (1)

The model cannot be easily estimated in this form therefore, Koyck transformation proceeds with these steps:

 It lags one period to obtain 

 Y_t-1 = α + β₀ X_t-1+ β₀ λX_t-2+ β₀ λ²X_t-3+ ….+ μ_t-1 (2)    Then he multiplies by λ to obtain

 λ Y_t-1 = λ α + λ β₀ X_t-1+ λ β₀ λX_t-2+ λ β₀ λ²X_t-3+ ….+ λ μ_t-1              (3)   Subtracting (3) from (1) 

he obtains

 Y_t- λ Y_t-1 = α (1- λ) + β₀ X_t+ (μ_t - λ μ_t-1)

Thus, rearranging 

Y_t= α (1- λ) + β₀ X_t+ λ Y_t-1+ v_t                                                    where v_t= μ_t - λ μ_t-1 

Therefore we have converted a distributed model into an auto regressive model. This transformation implies that we know have only three unknowns (α, β₀, λ); there is no reason to expect multi-collinearity, although we may have a problem of serial correlation because of v_{t .} 

Rational Expectation model

Until the advent of the rational expectations (RE) hypothesis, initially put forward by J. Muth and later propagated by Robert Lucas and Thomas Sargent, the AE hypothesis was quite popular in empirical economics. The proponents of the RE hypothesis contend that the AE hypothesis is inadequate because it relies solely on the past values of a variable in formulating expectations, whereas the RE hypothesis assumes that “individual economic agents use current available and relevant information in forming their expectations and do not rely purely upon past experience. In short, the RE hypothesis contends that expectations are ‘rational’ in the sense that they efficiently incorporate all information available at the time the expectation is formulated and not just the past information. (Gujarati, 2009 p.631)

Under rational expectations it is assumed that individuals possess completed knowledge about the functioning of the economic system and put this knowledge to the best possible use when forming their expectations together with all the available information. 

X*_t =  E (X*_t / I_t) 

X*_t is the expectations formed at time t of X in time t+1. This is dependent on the information available at time t (I_t).

It may turn out that actual X is not the same as expected. That is agents may make a prediction error

• X_t+1 = X_t* + u_t    or       X_t+1-X_t*=u_t

u_t is the error of the expectation 

E(u_t)=0  The expected value of the prediction error is zero. This means that under the rational expectations hypothesis forecasts by individuals are assumed to be correct on average. 

Cov (X*_t,  u_t) should also be equal to 0. In addition, the prediction error must be uncorrelated with any information available at the time the prediction is made. If not, this would imply that the forecast has not made use of all available information. Since all available information is summed up in the variable X*_t , this implies that u_t must be uncorrelated with X*_t.

Italy and Berlusconi

This comment was posted as response to an article on "The Economist" on 10/10/09

The fact that Mr.Berlusconi doesn't accept the decision from the Court and he's trying hard to undermine it is not new and in true it's pretty boring now. Even when he lost in the precedent general election he refused to accept the outcome invoking electoral frauds. Was at time the will of people not to be respected? No, unless Mr Berlusconi doesn't get his way. To be honest, in 1994,I did believe that the actual PM would have been a good thing for my country, I thought that his experience and his entrepreneurship would have given modernity to a nation that has underachieved in the past 20 years. However, soon I became disillusioned by his antics, his inability to do anything concrete for the country apart from resuscitate old communist ghosts when it was time to look forward and to exacerbate the political debate to an extent that today I don't see how we (italians) will ever be able to work together again to make Italy a better place. And so, nowadays it seems to assist the show of little boy that just can't lose, that cries foul and doesn't respect anything. If he ever loves his country, he should leave his place to whoever but not him, in order to reinstitute a bit of dignity to our beloved Italy. I'm not a leftist and I would love to see a modern, liberal and conservative government in Italy that would make those reforms that are urgently needed, but I'm sorry Berlusconi is obviously not the person to do that, he's unfit and dangerous.
Moreover, I'd love to understand, why with all the leftist judges and communist press, the left is not even able to form a coherent opposition or at least be able to govern when needed. I think is just an excuse and an enormous lie, pretending that the left controls everything and that it's going to destroy democracy in Italy.
Finally,to everyone thinking that the Lodo Alfano was in place to guarantee our PM to dedicate his precious time for governing, I'm afraid but I don't believe anyone with such unclear past should be able to messed up my country and then being processed at a latter stage. If he's clean as he affirms he should have clarified his justice's problems before entering in politics.
Mr. Berlusconi I truly regret having voted you 15 years ago, you are the scorn of our Nation..please, for Italy's sake, leave as soon possible!