Tag Archives: economics

Incentive Pay in Education

Comment on the podcast by Professor Hanushek for Sense and Sustainability.

Here are some of my thoughts on a podcast on the economics of education given by Professor Hanushek to Sense and Sustainability. They’ll be going up on that site soon but for the moment read on if you’re interested…. Check out the S&S website and podcasts too. There’s some brilliant stuff on there.

In his podcast on Monday, Professor Eric Hanushek extolled the merits of incentive based pay in education. This post critically reviews his claims, arguing that, although raising the quality of teachers is a key challenge for policymakers, performance pay is not the most effective mechanism for achieving this end. The nature of teaching jobs should be transformed, rather than just their pay. Channels for career development within the education system should be created as a means of attracting the most ambitious, able individuals. Employment contracts must also be reformed to remove poor quality teachers from classrooms, quickly.

Teachers matter but how much is not clear. Hanushek starts from the premise that teacher quality matters for educational outcomes. On the face of it, this claim is uncontroversial. However, the quantitative significance of the effect is not as clear as presented. There is debate surrounding the robustness of figures such as those presented by Hanushek. Firstly, defining and measuring teacher quality is hard. The attributes associated with being a great teacher are multidimensional, diffuse and largely unmeasured, which clearly creates difficulty for researchers. Second, good quality teachers are likely to be attracted to the ‘best’ schools, with bright students from supportive backgrounds and other favorable institutional features. Studies thus risk confounding the effect of teacher quality with other “good school” features, overestimating the magnitude of teachers’ impact. Yet, saying this, arguing that outcomes are independent of teacher quality is going too far. Studies that use variation within individual schools still pick up positive impacts of able teachers and common sense tells us that there is going to be some kind of link there. It should be known, however, that the strength of this link, and thus its policy salience, is by no means clear empirically.

Incentive pay to improve selection Taking as given that we should raise the quality of teachers to improve educational standards, how should governments do this? Haunshek argues that incentive pay schemes will help. One can consider two broad mechanisms via which this reform may be beneficial. First, motivational: incentive pay could induce greater effort on the job, making for better teachers. This is a dead-end, as Hanushek concedes. Quality in teaching among those already in the profession is at best negligibly affected by monetary incentives and at worse inversely related. Given that performance in education multidimensional and difficult to measure, tying pay to easily observable indicators such as test scores comes at the risk of distorting energy and attention within the classroom, ultimately making for a less conducive learning environment. Think greater ‘teaching for the test’ as a probable consequence.

Rather, Hanushek argues that the dispersion in rewards induced by incentive pay will induce selection of higher quality teachers into the profession. Incentive pay won’t do much for those already in the job but by paying more, and having greater differentiation in pay levels, it is thought we will attract a different kind of person into teaching. Hanushek states that the independence of pay and performance implies teaching is not thought of as a “profession” in the usual sense. Teachers do not face the same pressures of responsibility and accountability forthcoming in other careers, which puts off the most able candidates. Implicit in his argument is the idea that responsibility and recognition flows from differentiated rewards. It is then these job factors that make it more likely that able individuals will decide to become teachers.

Alternative ways to attract the best. However, pay differentiation is neither a necessary nor a sufficient means of making teaching “a profession” and attracting top people. Rather than focusing on pay, I believe it is more profitable to consider transforming the structure of the job itself, building in more channels for career progression and space for personal responsibility. My perception is that, currently, if you are a teacher the broad nature of what you do day-to-day doesn’t change much over time and it is this that is off putting to top graduates; the idea of career progression is attractive for many. Thinking creatively about how to formally build in opportunities for postgraduate study and develop interactions with government and the development of wider education policy will help to attract the most ambitious. Transforming pay alone cannot turn teaching into a profession in the sense described by Hanushek.

Further, although incentive pay is inappropriate in this context, performance evaluation is still obviously important in education. However, what we are measuring should change. Rather than using output measures, such as test scores, to evaluate teachers, more emphasis should be placed on “input” measures to raise teacher accountability and ‘ownership’ of their job. Moving away from simply looking at attainment to consider classroom atmosphere, pupil feedback and the quality and innovativeness of lesson plans should foster more imaginative teaching and greater responsibility, again making for a job which appeals to more ambitious individuals.

Raising average quality involves removing poor teachers from the classroom, in addition to attracting the best.Thus, employment contracts in teaching must be transformed. As Hanushek notes, evidence suggests that one’s ability as a teacher stays relatively constant over time. Either you’re good, or you’re not. The use of short term employment contracts in the early years of a teacher’s career thus seem like a good way of removing those at the bottom end of the quality distribution from the classroom quickly.

In conclusion, incentive pay in education is neither necessary nor sufficient for raising teacher quality. Rather than focusing on pay, I believe a creative transformation of teaching jobs, to explicitly build in greater responsibility and career progression to other spheres within the education system, is a more direct and profitable approach. More effort should be deployed considering how best to redefine teaching jobs themselves rather than their pay structure.

Budget and Trade Deficits 101: Two Sides of the Same Coin

The economics behind trade and budget imbalances applied to the Eurozone crisis. 

In my last post I argued that fiscal profligacy is too highly stressed as an underlying cause to the Eurozone crisis. Rather, deep rooted differences in  productivity and competitiveness have resulted in divergent trade balances and public finance disaster zones. Why have trade imbalances contributed to a government debt crisis? What does a single currency have to do with it? Let’s see….

Setting the scene

Many Eurozone countries’ budget deficits are astronomical, incomprehensibly large. Despite all the hype, they aren’t necessarily shrinking. The Greek budget deficit continued to widen throughout 2011, growing to €20.52bn in the first 11 months of 2011 (a 5.5% year-on-year increase), as did Ireland’s, widening to €24.9bn in 2011 from €18.7bn in 2010. Further, it’s not just the problematic PIGS creating trouble: Belgium, Malta, Cyprus, Hungary and Poland are all waiting to hear if they face EU financial penalties to punish for the poor state of their public finances.

Trade figures highlight significant imbalances between Eurozone countries in the run up to the crisis. To talk of a common European trade experience is grossly misleading. The pattern of imbalances across the Eurozone in the period running up to the crisis was dominated by a few outlier countries: Ireland, Italy and Greece on the ‘negative’ front and Germany and the Netherlands on the ‘positive’ (see a relevant IMF paper here). Helping to convey the power of German export machine, the WTO estimated the value of German exports at $1.334tn in 2010, placing them second in the world behind China. This is more than double the value of UK exports and 60 times larger than those of Greeks. (See the following graph from this FT article and this IMF analysis for more data and graphs).

Trade imbalances correctly identify the countries at the heart of the Eurozone crisis. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. High trade deficits going along with dreadful public finances. A coincidence? No. Exploring the economics behind trade and budget imbalances highlights that the two are intimately related.

Talkin’ the talk: trade terminology

In the global economy, countries interact via trade in goods and saving/borrowing. The “current account” records the net effect of a country’s international trade, constituted of goods and transfer payments. More often than not, commentators simply refer to ‘trade balances’, which don’t incorporate transfer payments. Exports feature as positives, and imports as negatives in these accounts. Thus, a trade deficit denotes a situation where the value of a country’s imports exceeds that of its exports.

The “capital account” records the net effect of international financial flows. Foreign investment, purchases of domestic assets and foreign loans to a country all feature as positives; they represent flows of money into the national economy. Conversely, domestic investment into foreign markets and loans made by domestic institutions abroad features as negatives, representing flows of money out of a country. Thus, a capital account surplus refers to a situation where there is a net flow of funds into a country.

By definition, the balances of the two accounts are inversely related. Given a particular level of total output, any trade deficit must be reflected in inflows of money from outside the country (borrowing basically) to fund that deficit. This is shown most easily by exploring the national accounting framework in a bit of detail. It involves a few equations but there’ll be no more after this, promise!

Total spending in the economy (Y) is made up of what we, consumers, spend (C), investment (I), government spending (G), foreign spending on our goods, i.e. exports (X) minus what is spent on foreign goods, i.e. imports (M).

Y = C + I + G + X – M


Y – C = I + G + X – M

The difference between total income and what households spend, can instead be thought of as what gets taken away in tax (T) and what we choose to save (S). Thus,

S + T = I + G + X – M


X – M = (S – I)  + (T – G)


Current Account Balance = – (Capital Account Balance)

Thus, imagine we have a current account deficit, then the capital account balance must be positive, i.e. foreign funds must be flowing into the economy to fund that deficit.

How does the exchange rate fit into all this?

Take a step back from the Eurozone, to a country like the UK, which has its own currency. The current and capital account balances measure, respectively, the demand for, and supply of, domestic currency.

Take a current account surplus. Foreigners must acquire £s to pay for all the UK exports they are buying. The current account balance is therefore negatively related to the exchange rate. The exchange rate gives the relative ‘price’ of currencies. A depreciated currency (think cheap) boosts exports and limits imports, making for a more positive current account balance.

The negative of the capital account gives the supply of a currency. A capital account deficit represents a situation where money is leaving a country to be invested abroad. To be invested abroad, these funds need to be transferred into the relevant foreign currency. Thus, domestic currency must be supplied to the market in exchange for foreign currency.

So, for a country with its own currency, the net balances of the current and capital accounts determine the net demand and supply of currency and therefore the exchange rate at which its currency trades.

Budget and trade deficits: Two sides of the same coin

How can the build up of large trade deficits cause government finances to go awry? Imagine some country, getting along pretty well by today’s standards, without a government or trade deficit: taxes are just sufficient to cover government spending, and the value of imports equals that of exports. Oh, imagine such a country!

Then, the world changes. Other countries fall into recession, reducing their demand for our country’s exports. Assuming our demand for imports is unchanged, this would cause a trade deficit to develop: exports are now lower than imports. (Alternatively, one could think of imports rising relative to exports if, for example, another country starts producing higher quality goods or invents a new products highly demanded by our own citizens). Unless something changes, this widening of the trade balance will hit total demand in the economy resulting in lower national output and higher unemployment. To prevent this, or at last cushion the blow, the government could prop the economy up by running a budget deficit, pumping money into the economy to make up for the loss of exports, borrowing from abroad to fund this build up of debt (capital account surplus). Thus, a trade deficit can prompt a budget deficit, financed by borrowing from abroad.

If a country has its own currency, exchange rate movements can also occur to stabilize the economy, reducing the extent to which a government has to get embroiled in the situation. A trade deficit implies a fall in demand for domestic currency and thus one would expect an exchange rate depreciation to follow. This depreciation makes exports cheaper, boosting their demand, helping to close the trade gap and support domestic demand and employment.

Applying to the crisis

As stated above, it’s those Eurozone countries that ran sizable trade deficits in the years running up to the crisis who have seen their government debt explode.

Building up imbalances….

There are significant asymmetries in productivity growth across the Eurozone. German real wage growth (wage growth adjusted for inflation) has been much lower than the Eurozone average. In fact, it fell by approximately 20% relative to the Eurozone average in the period 1994-2009. As a result, the labour cost of output rose by a much less in Germany, 5.8% for the period 2000-09, than in its trading partners (equivalent labour costs in Ireland, Spain, Greece and Italy rose by roughly 30% in the same period). Production costs in ultra-efficient Germany are, therefore, much lower than those of its peers.

The Euro accentuated Germany’s competitive advantage. All Eurozone countries trade in the same currency but German goods are cheaper to produce, hurting domestic industries in the other countries that cannot hope to compete with these cheap exports. The trade balances of Eurozone countries have thus been following divergent trajectories: the German trade balance shooting up to the stars, while those of the Club Med descended further into the murky depths of the underworld.

…and funding them

As explained above, trade deficits imply that foreign funds must be flowing into a country and this is what we have observed. The majority of Eurozone governments’ debt is held by nonresidents. In fact, banks and financial institutions in the advanced European economies financed a large part of the build up of debt in the periphery as noted by Blanchard and Giavazzi (2002). BusinessWeek notes that German banks are on the hook for at least $250bn in troubled Eurozone nations’ bonds.

If each country had its own currency, trade deficits and excessive foreign borrowing witnessed would have put pressure on the exchange rate, helping to restore the export-import and borrow-lend balances between European states. For example, we would have expected to see the Greek drachma fall in value relative to the German Deutsche Mark, effectively raising the cost of German goods and helping to rebalance the European economy. This has not happened, allowing imbalances to get out of control and the single currency has also eliminated stabilization mechanisms which would have provided additional routes, other than higher government spending, to prop up the economy.

Missing the heart

Thus, although financial mismanagement and recklessness have had parts to play in the Eurozone crisis, fundamental structural imbalances between Eurozone economies lie at the center of the mess. The singular prescription of harsh fiscal discipline thus does not hit at the heart of the matter. Not even the stomach. Adjustment on the part of creditor nations is also required. At present there is nothing to temper the onset of austerity across Europe. All adjustment is being forced through by depression and default. This is far from efficient. Germany has benefited enormously from Euro membership, taking advantage of an undervalued currency and low trade costs. Others have not been so fortunate, shackled with an over-valued currency and the withering of domestic industries.

Can such adjustment and rebalancing be achieved? Can the Euro be sustained in the long run given the imbalances and limited mobility within its domain? Oh I wonder, I wonder….

To Be or Not To Be?

European leaders face an acute existential migraine this New Year. If only AlcaSeltzer could help them.  

Gone are the days when “greek spread” referred primarily to tzatiki and taramasalata. The eurozone crisis is now generally regarded as a problem with a solution “technically and politically beyond reach”. The evidence certainly supports this dour viewpoint. Fifteen summits, seven changes of government and five master plans later, we are left with precisely zero in terms of substantive achievements. €457bn of European government debt must be refinanced by April, thus few grains remain in the hourglass. In the near term, ‘now’ in other words, European governments’ must acknowledge that contractionary fiscal policy is, yes, contractionary and revise the quack medicine of austerity that is currently prescribed to assuage our economic ills. In the longer term, the failure of the neoliberal underpinnings to the Euro must be acknowledged and institutions redesigned accordingly….if democratic support for a fiscal union is forthcoming.

What started as “the Greek problem” is now a fully fledged “Europe” problem. The credit rating of the entire European Union, not simply those of the pesky PIGS, is under threat of downgrade. Output and employment remain depressed. August witnessed the largest monthly decrease in eurozone industrial production since 2009 and many are predicting a slide back into recession in 2012. Unemployment in the region has soared to a new euro-era high, reaching 10.3% of the labour force in October. Joblessness has remained highest in Spain, where a staggering 22.8% (!!!) of workers are without jobs.

Rebalancing, not retribution, required

The strategies currently pursued by Eurozone institutions either do not go far enough or are opposite to what is required. Further, faster fiscal tightening continues to be dictated. Only yesterday, Spain announced plans to cut €8.9bn from public spending in 2012. Amartya Sen, a Nobel laureate in Economics, described austerity in the current climate as a “snake” within the wider metaphor of the game “Snakes and Ladders”. It is getting us further from where we want to be.

Austerity continues to be prescribed because fiscal profligacy is too highly stressed as an underlying cause of the debt crisis. Inexcusably poor financial discipline, in part a consequence of the moral hazard generated by Euro membership (see previous post), clearly played a role in the Greek debacle, however, fundamental imbalances in competitiveness across the Eurozone cannot be ignored as a salient causal factor.

The health of government finances pre-crisis provided little clue as to which countries would be sucked into economic chaos. As Martin Wolf notes, “fiscal deficits were useless as indicators of looming crises”.  Trade imbalances, on the other hand, correctly identify the countries at the heart of the problem. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. A trade deficit occurs when the value of what a country imports exceeds that of its exports. In contrast to these tales of woe, Germany has experienced an increase in its trade surplus since 1999. The asymmetries in competitiveness and economic strength between Germany and the ‘peripheral’ states really are stark. Joblessness in Germany has been falling for the last 2 years and the financial market turbulence that is wreaking havoc in many European countries is said to have had “little impact” on the country’s economy. In Europe it really isn’t a case of ‘all in it together’.

It is an accounting identity that a country with a trade deficit must be a net borrower in order to fund that deficit. Within the Eurozone, surpluses in Germany and the Netherlands were previously channeled through the financial system to fund deficits in others, i.e. Greece Ireland, Portugal and Spain. The credit crunch caused these channels to seize up, eliminating this flow of funds, and also initiated a collapse in private borrowing, prompting government deficits to go through the roof.

Acknowledging that deep rooted differences in productivity and competitiveness have played a role in the crisis, leads one to the conclusion that reforms cannot simply be piled on debtor countries. Retributive justice, in the form of harsh spending cuts, is misapplied as reckless profligacy has had but a minor role to play. Rather, shifts in external balances across the eurozone are called for. As one country’s trade deficit is another’s surplus, this calls for adjustment and transfers on the part of surplus countries such as Germany. It is reckless to hold deficit countries to pro-cyclical austerity without countervailing measures to boost import demand elsewhere in Europe. In the absence of demand and credit expansion in healthy eurozone nations, fiscal tightening will continue to have the same impact that it has had up to now: to prolong and intensify the downturn.

Furthermore, not only does ‘more austerity’ inadequately deal with the root causes of the crisis, it is also aggravating our woes and is thus ultimately self-defeating. The Keynesian “Paradox of Thrift” is relevant here. To reduce the size of a budget deficit, a government must increase the size of tax receipts relative to its spending. Governments’ have focused their energies on fashioning large reductions in government spending as opposed to playing around with tax receipts. Public sector layoffs and pay freezes, cuts to departmental budgets and welfare bills are thus the name of the day. However, such coordinated, fierce austerity across the Eurozone is hampering growth and recovery, reducing tax revenues by more than the cuts in spending. Thus, paradoxically, the current austerity measures are ultimately making it harder for governments to repay those dreaded debts .

Eurozone countries are facing an even harder time of it than the UK as, for these countries, there is no exchange rate mechanism through which austerity and low domestic demand can boost exports to their main trading partners. Further, as implied above, credit and demand expansion among creditor nations has not been sufficiently boosted to provide any countervailing force to the cuts made in the peripheral countries.

ECB to the rescue?

In short, the fiscal policy of eurozone countries is a disaster zone: off target and self-defeating. What of monetary policy, that concerned with interest rates and money supply? The ECB has raised its game in the last few weeks but, by only offering credit to commercial banks, has not done enough to pull Europe back from the brink. Basic interest rates have been lowered to 1% and unlimited cash offered to commercial banks for up to three years. These actions will help to alleviate short term liquidity problems in the banking system but will not have any noticeable impact on the real economy or the debt crisis. Banks are adding this additional cheap funding to their capital buffers, compensating for the losses they face on their holdings of government bonds and household mortgages. Therefore, very little of this additional cheap capital is being devoted to easing the funding pressures on households, firms and their governments.

The hope was that, despite only offering credit to commercial banks, these banks would in turn buy the bonds of European governments, thereby easing the sovereign funding crisis. This has failed to occur as commercial banks are unwilling to purchase further government debt. The European Banking Authority recently announced that European banks still need to raise €115billion in additional capital to offset the falling value of government bonds they currently hold. Unsurprisingly, it is the Spanish, Greek and Italian banks with the biggest capital shortfalls. Thus, the banks in the most financially fragile countries are likely to go to their governments for assistance rather than with fresh funds. The ECB’s current actions are thus unlikely to do much to ease the debt crisis: banks are still turning to governments to bail them out, rather than the banks bailing out the governments as was hoped.

Sideshow Summit

The last Europe wide effort to produce a grand plan was, sadly, another grand waste of time. It was attention grabbing for the wrong reasons, bringing the continent no closer to a workable resolution. The fallout between the UK and its European peers may have some unpalatable consequences for us but is really a minor pothole in the road to Eurozone recovery. David Cameron’s actions did nothing positive to protect the City, it will now be harder for EU rules to be negotiated in our favour, and served to marginalise us within the European Union.

However, Mr Cameron’s mistakes are a mere sideshow. Of much greater importance was the failure of European leaders to acknowledge the arguments above that imply the need for reform that is balanced across creditor and debtor nations. Rather tougher controls on budget deficits, written into individual country constitutions, were focused on, with no countervailing measures to boost demand and credit availability at the eurozone core. It was agreed there is to be no fiscal union, only greater fiscal discipline. Therefore, Europe remains decidedly doomed. This summit got leaders no nearer to a credible cure to the continent’s troubles.

A New Year’s Resolution?

A tourniquet must be quickly applied, and life support machine turned on, to prevent the death of the Euro. Leaders must immediately acknowledge that further harsh austerity is wrongly targeted and self-defeating. The focus must be on growth and reducing unemployment. Public sector layoffs must be put on hold and tightening strategies rebalanced to put more weight on tax rises. Effort should be focused on designing a stabilisation strategy that expands import demand and credit supply among those eurozone countries that can afford it, i.e. Germany and the Netherlands.

More fundamentally, the failure of the neoliberal underpinnings to the Euro must be acknowledged. The existence of pervasive market imperfections implies the need to transform the design of eurozone institutions, promote greater fiscal integration and change the role and mandate of the ECB. A single currency eliminates a number of stabilisation mechanisms for individual economies, creating the need for much larger wage and price movements to prevent recessions, especially given that labour and capital are far from perfectly mobile (see my previous post). In this imperfect world, fiscal union is the essential counterpart to a monetary union. Fiscal transfers can then provide a counter-cyclical mechanism to support regional economies in tough times. This is what occurs in the United States, with Virginia playing the role of Greece.

Further, the ECB’s role and mandate must be reviewed. The ECB is not simply independent of European governments, as the Bank of England is to our own, but is ‘detached’. There is full separation of central bank and government finances, with the ECB legally forbidden from buying large amounts of government debt. This again reflects the euro’s neoliberal birthright, subordinating fiscal policy and the role of the state to the market. The neoliberal school of thought sees the sole role of central banks as inflation control. In the future the ECB must be mandated to target wider aggregates than just inflation, unemployment a key indicator. Further, the full detachment of the ECB from the governments it is supposed to serve must end. One potential institutional solution is given by Thomas Palley, who suggests the creation of a European Finance Authority that issues collective Eurozone debt on behalf of member governments which the ECB could then buy.

However, it must be noted that closer European fiscal integration requires the mandate of European citizens. In the short term, the advantages of installing technocrats and making executive decisions outweigh the cost of temporary infringement of democratic rights. However, these rights must not be continually subordinated, especially when it comes to thinking about the future of Europe more generally. It is far from clear that the necessary support for a more integrated Europe is there. Populist parties are increasingly sceptical of the Europe project and extremist politics appears to be making a comeback in a number of nations.

I remain sceptical that there is sufficient support for the extent of fiscal integration required to sustain the Euro. In my opinion, a common European identity is insufficiently forthcoming to motivate popular support for a United States of Europe, especially given the build up of anti-Europe and anti-Germany sentiment currently occurring. The unbalanced prescription of austerity and the stark asymmetries in adjustment pain across the continent is fuelling resentment and riots. Without adjustment by creditor nations who have benefited enormously from Euro membership, unemployment will continue to rise and times toughen in peripheral countries. Without a fiscal union to accompany the monetary union, wage falls and large variation in growth will continue to be the norm. This is a far from ideal backdrop to popular debates on the future of Europe.

In conclusion, we end 2011 with no end in sight to the eurozone debt crisis. Proposed solutions will continue to be off target and inadequate so long as fiscal mismanagement is stressed as the root cause of our woes. Although the consequences of a eurozone break-up will surely be enormously damaging, so too is the continued, futile application of austerity. Especially given that, if leaders continue in 2012 as they have done up to now, a disorderly disintegration looks inevitable. Happy New Year!