Jittery regimes fix prices

The puzzle

All of us are now curiously thinking about the abrupt phase transition that seems to sometimes occur in the endgame of an authoritarian regime. The traditional script was: The people rise up to rebel and the strongman murders them.

When the USSR collapsed, we thought it was special: it was a defunct regime that had just lost the will to live. But for the rest, the basic rulebook stood: the people get mowed down. And sure enough, that happened in Tiananmen Square.

But now, there are an increasing number of success stories with `velvet revolutions', and one has to think more carefully about what goes in an authoritarian regime.

Conflicts beneath the surface

What appears like a monolithic regime from the outside can actually often reflect a diverse array of interests tugging in different directions. In this beautiful article by Laurence Wright on Saudi Arabia, he says:

I had begun to look at Saudi society as a collection of opposing forces: the liberals against the religious conservatives, the royal family versus democratic reformers, the unemployed against the expats, the old against the young, men against women.

On that same thread, Why do protests bring down regimes? A follow up by Graeme Robertson says:

While the news media focus on "the dictator", almost all authoritarian regimes are really coalitions involving a range of players with different resources, including incumbent politicians but also other elites like businessmen, bureaucrats, leaders of mass organizations like labor unions and political parties, and, of course, specialists in coercion like the military or the security forces. These elites are pivotal in deciding the fate of the regime and as long as they continue to ally themselves with the incumbent leadership, the regime is likely to remain stable. By contrast, when these elites split and some defect and decide to throw in their lot with the opposition, then the incumbents are in danger.
So where do protests come in? The problem is that in authoritarian regimes there are few sources of reliable information that can help these pivotal elites decide whom to back. Restrictions on media freedom and civil and political rights limit the amount and quality of information that is available on both the incumbents and the opposition. Moreover, the powerful incentives to pay lip service to incumbent rulers make it hard to know what to make of what information there is.

I have also read others write similarly about China (but sadly, I do not have the reference): That in the absence of freedom of speech, the regime actually has no idea about where the problems lie, and is hence hypersensitive about criticism, and about solving the problems that it thinks do matter.

The behaviour of a jittery regime

Democracy matters in two ways. First, the regime has legitimacy. It is not worrying about a sudden upheaval that will destroy the regime. And, freedom of speech carries a steady flow of information to the regime. The UPA leadership does live in a bubble, but even they know that 8% inflation is a serious problem.

When a regime lacks legitimacy, and does not know what is going on, it is constantly fearful. It does not know what is going wrong and it can go off into extremes in trying to stave off some problems that it believes are first order. One area where this shows up is inflexible prices. To an external observer, it may be obvious that allowing price flexibility is better, but the regime is terrified about what will happen, so the price stays fixed.

Three examples

Egypt

In a blog post titled Garam Masala: Bread And The Life Of Egypt, Vikram Doctor writes:

I first realised how different Egypt was when I saw the bread in the street in Cairo. It was piled on low charpoy-like tables, thick rounds of freshlybaked bread, slightly scorched from the oven, a bit like tandoori rotis, but heavier.... Someone would replenish them from the bakery close by, and collect the money that people left, but nothing seemed to stop them just taking it away... the other reason why no one took the bread free was that it was so ridiculously cheap that they might as well just leave the few coins needed (in fact, buying bread seemed to be pretty much all that the piastre coins were used for). I calculated that, at that time (over 12 years back), the cost of a round of bread converted to something like three paise : something I could not imagine anything costing in any large Indian city. But this was the point: the price was unreal because a massive bread subsidy was one of the basic ways the Mubarak regime stayed in place.

Iran

From The regime tightens its belt and its first, in the Economist:

From top ayatollahs to the IMF, everyone agrees that spending $100 billion each year to pin down petrol, gas and electricity prices, besides the cost of staples such as flour and cooking oil, is a bad way to dispose of Iran's hydrocarbon revenues, accounting for more than 10% of GDP and encouraging waste on an epic scale. The symptoms of the malaise are legion: tea kettles simmer all day; the streets clog with recreational drivers out for a spin; lights glare because no one can be bothered to turn them off. `We can do it because we have oil,' Iranians used to tell incredulous visitors.

China

The outstanding price inflexibility of China is that of the exchange rate. Consider the Chinese and the Indian exchange rates of recent years:

There is a dramatic difference in the exchange rate flexibility. The Chinese authorities are extremely loath to allow the exchange rate to fluctuate, even though it induces massive distortions in the economy. Why? I would venture to guess that once a large export reprocessing sector has built up, the regime is just scared to rock the boat, to displease many workers.

The exchange rate is the most important price in any economy. A country that can handle a floating exchange rate is a flexible economy, one in which firms are born and die, workers move across locations and industries, and prices fluctuate. Deep and liquid markets are shock absorbers. Firms have ample equity capital, i.e. low leverage, so that they are able to absorb shocks. There is a whole configuration of institutional arrangements which are conducive to price flexibility. By and large, India fares well on these counts, particularly in the vast informal sector where there is extreme flexibility. And most of all, when things do hurt, individuals are able to express their discontent through democratic politics.

If India did not have these long-standing strengths, Governors Reddy and Subbarao would not have been able to move to a flexible exchange rate. And this exchange rate flexibility, in turn, enables an array of other economic reforms in favour of a market-based system.

Also see: The message for China from Tahrir Square by Minxin Pei in the Financial Times and The Secret Politburo Meeting Behind China's New Democracy Crackdown by Perry Link, on the New York Review of Books Blog.

Stability that is illusory

The regime change of recent years should make us think afresh about the notion of `political stability'. Democracy is always messy: demonstrations, machinations of party politics out in the open, colourful and often intemperate figures on television, elections, change in the ruling arrangement. But at a deeper level, this can be a more stable arrangement; there is no revolution at the end of the tunnel.

Similar reasoning applies in economics. Economists have always known that when prices appear to be stable, they often mask real trouble underneath. It is far better to have a small fluctuation every day, i.e. a steady flow of vol. The alternative -- of clamping down on price movements on most ordinary days -- merely yields big price movements on some days, which are far more difficult to handle.

Economic agents are not fooled by this stability on the surface. As Mark Roe says on Project Syndicate:

Even if all of the rules for finance are right, few will part with their money if they fear that an unfavorable regime change might occur during the lifetime of their investment.
More importantly, the grim stability of the type displayed by Hosni Mubarak's Egypt is oftentimes insufficient for genuine financial development. Authoritarian regimes, especially those with severe income and wealth inequality, inherently create a risk of arbitrariness, unpredictability, and instability. They are themselves arbitrary. And everyone knows that beneath the stability of the moment lurk explosive forces that can change the regime and devalue huge investments. Because financiers and savers have limited confidence in the future, such regimes can't readily build and maintain strong foundations for financial development.

Implications

This is a `capitalism and freedom' style argument: that democracy and markets interact in the double helix of modern civilisation.

Price flexibility works best when there is price flexibility in a lot of markets. If all prices were fixed, and you only freed up one, then it could easily make things worse. It is hard, crossing the hump, and reaching over to the other side where all prices are flexible. And, price flexibility goes well with democracy. Flexible prices are constantly disruptive. Every day, there are a few pockets of the economy that are really getting hurt in the creative destruction. It requires a confident regime to take these fluctuations in its stride. A jittery and illegitimate regime may be more likely to clamp down on price fluctuations since it fears these could destabilise it.