Thursday, January 3, 2008

A Kremlinologist in Dire Need of Econ 101 Textbook (Part 1)

A while back (on 17 December of last year to be precise), former Clinton advisor turned Kremlinologist Stephen Sestanovich tried an epic feat of measuring Russia's economy on the pages of the Wall Street Journal. Back then I ignored this attempt as barely competent and an obvious manipulation of well-known statistics, but I shouldn't have. It turned out that Sestanovich's bizarre economic theories became a revelation to other professional and amateur Kremlinologists who have never before come face to face with a macroeconomics course. If Sestanovich's article was barely competent, the extent to which some of his followers took his conclusions and misrepresented their new messiah's words is simply ludicrous. For that reason, let's take a look at Sestanovich's own claims.

Sestanovich takes exception to how those uppity Russians view the size of their economy by claiming that "Russian economy has overtaken that of Italy, and will overtake France in 2009" and "Russia will become the world's fifth largest economy by 2020". He correctly points out that these estimates are based on the ruble to dollar conversion using PPP (purchasing power parity) method, rather than the market exchange rate. At least he's not denying the apparent correctness of the estimates. No, Sestanovich is more sophisticated -- he's denying the validity of the PPP method for making comparisons between national economies. In particular, he writes:
PPP inflates the size of poor economies in which food and the other basics of life are cheap. In the Russian case, black bread, vodka and run-down apartments pump up GDP.

Apparently, Sestanovich hasn't bothered to actually look up what goods might make up a basket of goods and services normally used to derive comparative price levels if he thinks that it would include something as specific as "black bread" or something that isn't used in GDP calculations at all, i.e. "run-down aparments". Only new housing is calculated in the GDP under investment (when expenditure method is used). Something tells me Sestanovich slept through his macroeconomics class, if he ever took one.

But even if he were right, he still managed to demonstrate his incompetence in another area. By relying on tried and true propagandistic cliches from the 1990s (which weren't necessarily true even then), he forgot to mention that "run-down aparments" in Moscow might look like this. Or that if we compare the prices of a well-known Russian vodka brand, such as Stolichnaya, with a well-known American vodka brand, such as Gordon's, we will inevitably conclude that PPP comparison paints a picture of the American economy that is far too rosy -- the US GDP is inflated by cheap vodka. And as for "black bread", doesn't Sestanovich realize that this ain't the 19th century anymore? The whiter the bread, the cheaper it is. Russians' favorite bread (as implied by Sestanovich, not by me) is actually quite expensive. Doesn't Sestanovich read the news anymore, did he miss the fact that Moscow is the most expensive city in the world, while St. Petersburg is quite a bargain in comparison, "only" in 12th place in the world? What other conclusion can we draw if not the fact that the PPP method deflates Russia's GDP due to overly expensive black bread, vodka, and aparments that are not so run-down? Ridiculous, you might say? There are many other variables that need to be taken into account, you might say? Don't blame me, I do this analysis within the framework that our new economic guru has set up. Blame the framework. Blame the guru.

The sad reality of the matter is that no reliable methodology exists for comparisons of the relative sizes of world's economies. Sestanovich even managed to make some good points about the problems of PPP -- such as the assumption of the same price on products that might be substantially different (e.g. due to quality issues). One might also point out the limited scope of the basket used, or the effect from welfare policies that might subsidize certain goods and services, or non-tradeable goods and services for which no global equilibrium price can exist. All of these can distort the comparison, sometimes significantly. But Sestanovich's logical fallacy stems from the fact that by demonstrating the problems with PPP calculations, he smoothly transitions to a claim that the market exchange rate calculations are what needs to be used, ignoring the tiny fact that whatever problems there may be with PPP calculations, they pale in comparison with the can worms that market exchange rate calculations open.

True, Sestanovich does mention that "which system of measurement is 'right' depends on what you want to know", as well as makes a couple of other disclaimers. But these disclaimers are hardly credible due the simple fact that he started out by claiming that "PPP inflates the size of poor economies". The terminology used makes it abundantly clear which method Sestanovich considers to be "the one true method", and which one merely "inflates" (i.e. distorts) the alleged "real" picture.

So what is the problem with exchange rate methodology? The basic problem is that it calculates anything but GDP. GDP's purpose is to measure the amount of goods and services produced in the economy. By necessity, due to extreme variety of goods and services normally produced, this is expressed in terms of currency. In the market, exchange rates have nothing to do with the amount of goods and services produced, but everything to do with numerous other factors such as supply and demand of a certain currency, relative openness of the economy (stimulates demand), manipulation by central banks (affects supply), perceived political risks, etc. If the currency of country A tanks because hot money investors from country B rush for the exits due to their domestic liquidity problems, does it mean that country A now produces less VCRs or rice? No, its economy keeps chugging along, and even the quality and the price of its domestic products is unaffected. Yet, by exchange rate calculations in terms of the currency of country B, it would appear that the GDP has shrunk. The obvious conclusion is: Do not ever use the currency of country B to describe the GDP of country A. Or if you do, at least convert using the purchasing power parity between country A and country B, in order to eliminate unrelated factors such as a spike in supply of country A's currency while it is being dumped by country B's fearful investors.

The problems posed by central banks are even more significant. This, incidentally, relates to the paranoia toward PPP exhibited by so many Americans as exemplified by Sestanovich. If one looks at the GDP by PPP country ranking, one will soon find an unpleasant (for the Americans) reality: that reality is called China. If current trends persist, the world's #1 economy within the next five years or so will be China. The US will be #2. And since so many Americans suffer from the "we're #1" complex, this simple fact scares them. Hence this wide following that Sestanovich's article generated, which was completely unforeseen by me. Fear can be a powerful driver for the chattering masses, capable of mobilizing them into all sorts of unseemly statistical manipulations. Specifically with China, its Central Bank, and Sestanovich's claims, we run into a fundamental contradiction. According to Sestanovich and his followers, China's GDP is significantly "inflated" by PPP conversion. But at the same time the US government insists that China deliberately manipulates the exchange rate in order to keep the RMB weak compared to the USD, and thus its enterprises are able to outcompete US manufacturers on cost. In effect, while the sufferers from the "we're #1" complex keep trying to convince themselves that China is tiny, the US government is trying to convince China that it is much bigger than it pretends to be (since its GDP will "magically" expand as soon as its currency is revalued). Well, you can't have it both ways: either PPP rate is where the exchange rate should be, in which case you can keep pressing China to allow its currency to revalue, or market exchange rate is "the one true measure", in which case stop pestering China about the alleged "unfairness" of the exchange rate.

Russia's Central Bank manipulates RUR exchange rate to a significant extent as well, as is apparent from the growth in foreign currency reserves and the corresponding expansion of the money supply (i.e. CBR buys up dollars that enter the country to prevent revaluation of the ruble). For that reason, there is a significant (but shrinking due to market pressure) difference between the market and PPP value of RUR. How does this affect the size of Russia's economy, the amount of goods and services produced, expressed in fixed rubles or PPP dollars? That's right, it doesn't, at least not directly. Russia's GDP growth helps illustrate it. If calculated in current dollars, it turns out that between 1999 and 2006 Russia's GDP grew from USD 195.9 bln to USD 984.9 bln, or almost 26% annual growth rate. If calculated in PPP dollars, it increased from USD 923.7 bln to USD 1,739.0 bln for the same period, or 9.5% annual growth rate. Which of these numbers is more credible? And which one more closely matches the real GDP growth rates reported by Russia's own statistical service, once USD inflation is factored out? Obviously, it is PPP.

Even more ridiculous is Sestanovich's assertion that
Measured in conventional terms, Russia, far from overtaking France in two years, is actually less than half its size -- $1.22 trillion vs. $2.52 trillion. At current growth rates, their GDPs will not be equal for 17 years.

That's some bizarre math, but let's try to work through it anyway. Sestanovich's data for current GDP comes from IMF estimates for 2007 (estimates, not real data). IMF estimates real GDP growth for Russia to be 7.0% and France -- 1.9%. So if we take IMF estimates at face value and project them into the future, we will find out that Russia will surpass France in 2022, 15 years from now, rather than Sestanovich's 17.

But Sestanovich's problem is even greater than his inability to multiply numbers correctly. Remember, the source data used are estimates, not real numbers. I don't know about France, but Russia's GDP growth for 2007 is expected to come significantly higher than 7.0% -- somewhere around 7.4% expected by the Economy Ministry, which habitually underestimates to be on the safe side (for example, they started 2007 expecting only 6.4% growth, and in the end revised it to 7.4% -- first real estimate from Rosstat will be available only somewhere in April 2008, and judging by the Economy Ministry's previous predictive record, it should be higher than 7.4%). Another factor is that the dollar collapsed even further against the ruble after the IMF made their estimate; thus, these two factors will likely bring Russia's exchange rate GDP to USD 1.34 trillion in 2007 (my rough estimate). If we plug in these new numbers, this further brings down the expected "catch-up time" to 12 years. For what possible reason Sestanovich would use 2007 estimates rather than real data from 2006 remains a mystery. Maybe he can't tell them apart?

But in the end none of these gross errors are important. Sestanovich's biggest misunderstanding of the numbers he operates with is the fact that he uses real growth rates which, as we have established, more closely correlate with PPP numbers, to project GDP that was calculated using market exchange rates. And, as we found out, Russia's "growth" in 1999-2006 came out to 26%, rather than 7.4%, if market exchange rates are used. If we plug that number in, we'll find out that Russia will catch up with France in 2010, which is 3 years from now. Of course, France's number will need to be recalculated as well, but such an exercise was pointless to begin with. The simple fact that got lost on Sestanovich is that real GDP growth figures cannot be used with market exchange rate GDP without assuming that USD to RUR exchange rate will remain constant. But we cannot make that assumption because RUR has been appreciating even in nominal terms (before factoring out inflation) against the USD for a number of years now, and will continue to appreciate for the foreseeable future. Its appreciation in real terms has been even greater, and outpaced that of the EUR.

Consequently, Sestanovich's own projection is not only based on mathematical errors and basic misunderstanding of the source data, but is also utterly incompetent methodologically.

But Sestanovich really begins to shine when it comes to manipulation of numbers, where numbers themselves are not in dispute. For starters, trying to demonstrate just how "unimportant" Russia is to Europe, he quoted another genius: "Russia's exports to the EU are, apart from energy, 'about the same as those of Morocco or Argentina'". That's all great, but why would you subtract energy from Russia's exports? Energy exports make up the bulk of Russia's exports precisely because Russia has a comparative advantage in energy production. If Russia did not have a comparative advantage in energy, then Russia's exports would be similar to those of any other East European country, except bigger. Otherwise, specialization occurs. This effect is described in any introductory macroecon text, which Sestanovich apparently hasn't gotten around to reading. Somebody get this man a textbook!

Moreover, do energy exports make Russia more important or less important? Imagine the situation where US exports, such as software or Hollywood movies, disappeared from the world market. What calamity would follow? Something tells me that the world would hardly blink. Now, imagine that Russian oil disappears from the market. What's going to be the consequent price of oil? $200/barrel? $400/barrel? I don't know, but I do now that with the current tight supply, it will shoot into the stratosphere. Next time you fill up your tank, you might want to consider the relative importance of Russia's trade with the rest of the world in between the sobs about your rapidly emptying pockets. Not to mention the effect oil prices will have on every other product on the market.

Sestanovich goes on to play with more numbers: "Just consider per-capita GDP growth in Russia, France and Italy. Under Mr. Putin, Russian per-capita income -- even in PPP terms -- has gone from somewhat less than a third of the level of France and Italy to somewhat more than a third." Translated from propagandese into normal human language, it means that Russia's GDP per capita increased from 26% of France's level at the time Putin took office, to 41% last year. If I were into propaganda, I'd say that it increased "from a quarter to almost half". Fortunately, I prefer real numbers. Does it mean that Russia remains "Europe's poor relation"? Sure, except it's Western Europe's. Russia, along with the whole of Eastern Europe, and most of the world too, is Western Europe's "poor relation". I wouldn't say it's a major discovery. But the level of 40% does not make for such a poor relation anymore. If you add the current dynamics to the mix, and project it into the future, as Sestanovich has so poorly attempted to do, the picture that emerges might be disconcerting for some.

This is precisely why Sestanovich and his followers now have a favorite new mantra: "Russia [China] is poor, Russia [China] is unimportant, let's pretend that Russia [China] will always remain this way." Well, they do sound convincing. Unfortunately, only to themselves.

P.S. On an unrelated note, it wouldn't hurt Sestanovich to brush up on his Soviet history as well. I know that the subject is considered optional in Kremlinological circles (as well as any other subject that might be described as a "science"), but still, claiming that there was some mysterious "Red Army" during the Cold War doesn't look good when coming from a supposed expert on Russian affairs. Hint: use Wikipedia to look up in what year the Red Army was renamed into the Soviet Army.