Shifting Hegemony in the Future

Whether it be in news commentary or in my students' discussions and essays, there is a lot of concern about China's rising economic influence and what it means for the United States' position in the world. Many seem to think that China's economic growth will enable it to replace the US as a global hegemon.

The Boogie Man Du Jour?:

It is tempting to lump concerns about China in with past concerns about the Soviet Union and Japan that didn't pan out. As Paul Krugman pointed out in a 1994 Foreign Affairs article,  "The Myth of Asia's Miracle" (also available here and here),  the rapid economic growth in the Soviet Union and Warsaw pact nations in the 1950s and 60s provoked worries in the west that the Soviet bloc would outgrow them and actually deliver on Kruschev's threat to bury the west. These concerns proved false, in part, because they were based on projecting past performance forward in a linear fashion that did not account for the possibility that growth rates might slow down. In hindsight, the collapse of the communist economies makes the hand wringing of the 1960 look somewhat foolish.

Similar concerns were raised about Japan in the 1980s when, according to Krugman, a projection of their growth rates from the 1960s and 1970s suggested they would surpass the US in per capita income in 1985 and total output in 1998. Yet, neither of those things were close to happening when Krugman wrote in 1994 and, 20 years later, Japanese per capita income still lags about 10% behind that in the US while their GDP is less than half of that of the US. Though Japan hasn't collapsed on anything like the scale of the Soviet Union,, the concerns about "Japan Inc."  that were so prevalent in the 1980s now seem, if not foolish, at least overblown.

So then, is China just another economic boogie man in a growing line of them? A strong argument against this would be that China's large population virtually guarantees that will surpass the US in terms of GDP. After all, with 1.35 billion people, they only need to reach a per capita income of around  $12,300 (equivalent to that of Hungary or Poland) to match the US GDP of $16.6 trillion. If China achieved a per capita GDP equivalent to South Korea's ($22, 590),  their GDP would be about $30.5 trillion. So it seems not only possible, but quite probable that China will actually surpass the US in GDP at some point.

However, this begs the question of what that would mean. With an economy equal in size or larger than the US, China certainly could afford an equal or larger military than the US, which would challenge US military hegemony. But what economic advantage would a larger economy confer on China? Would it become the global economic hegemon? To answer this question, it is important to consider the difference between military and economic hegemony.


Military vs Economic Hegemony:

I think it is important to recognize that there is an important difference between military and economic hegemony. A military hegemon is one that possesses so much military capability that it cannot be defeated by any combination of other powers. An economic hegemon is a nation whose economy is large enough that it alone can influence global markets without the help of other nations. On the face of it, these seem to be very similar conditions, as they both involve comparisons of the size of the hegemon to everyone else in the word.

However, in practice, the relevant size comparisons are quite difference. While it is theoretically possible that a military hegemon might find itself in a war against every other power on earth, it is highly unlikely that this wil occur. In any given war, a military hegemon will probably find itself squaring off against a subset of the world's nations, with a large subset of nations sitting out (and perhaps another subset of allies helping it out). The probable outcome of any war will come down to the relative capabilities of the two sides actually engaged in it.

In contrast, when trying to intervene in global markets, the economic hegemon finds itself in a situation where, in essence, nobody is sitting it out. If the hegemon is trying to tip markets in one direction or another, it will find that it is essentially pitting its economic weight against the weight of everyone else in the market. It must not just need to outweigh those actively opposing it, but also everyone who is participating in the market. Therefore, in practice, it actually faces the theoretical extreme that the military hegemon usually avoids.

The point here is that bilateral comparisons of US and China military capabilities are more relevant to questions of military hegemon than are comparisons of economic size to questions of economic hegemony. In the latter case, the more relevant comparison will be the shares of the global economy that each nation's economy constitutes. Therefore, comparing predicted levels of  US GDP to those of Chinese GDP gives us a very incomplete picture of the amount of influence the two nations might wield in the global economy. Instead, what we need to do is look at is the ratio of each nations future GDP to the future Gross World Product (GWP).

Comparing China and US GDP/GWP:

Statistics on gross world product are not something you come across very often, but the Earth Policy Institute has aggregated data on GDP to produce a dataset of GDP in 2010 PPP dollars from 1950 to 2011 (links to xls file). Comparing these figures to Federal Reserve Economic Data on US Real GDP (admittedly in less comparable 2009 chained dollars), one finds that US GDP as a percentage of GWP has declined from around 30% in 1950 to around 20% in 2010. Though these numbers are imprecise due to the different units of measure, this gives one a sense of the declining size of the US economy vis-a-vis the world. Though the FED doesn't have data on real Chinese GDP, if we look at nominal figures for 2010, China's GDP was about 8% of GWP. Given that China's   GDP is rising faster than most nations in the world, it is obvious that their GDP as a percentage of GWP is rising.

But what of the future? Consider the following hypothetical scenario. Suppose we start off with  GWP, Chinese GDP and US GDP in 2011 at 77, 7 and 16 trillion dollars respectively. Then suppose that GWP increases at an annual rate of 4% (the average of its real growth rate in the Earth Institute's dataset, which will underestimate its nominal growth), that China's GDP grows at 6% a year and that US GDP grows at 2.5% per year (both seemingly conservative rates of growth for China and the US). If we project forward through 2057 (an arbitrarily chosen date), the picture that emerges is captured in the graph below. The hypothetical US GDP/GWP ratio is plotted in blue, while the hypothetical Chinese GDP/GWP ratio is plotted in red (I'll explain the orange line in a minute).

The red and blue lines lay out the scenario that most US commentators dread as China and the US swap positions vis-a-vis the world economy. Of course, in this scenario, China is no more a hegemon in 2057 than the US finds itself today, but the trend puts them on track to eventually claim the position the US held in the 1950s.

However, this scenario is flawed by the fact that it projects trends forward in a linear fashion, thus assuming that growth rates will stay about the same for China, the US and the world. It might make sense that the US and world growth rates will stay at about the same annual levels, since the US and world have been able to post that level of performance for decades. But is it likely that China's growth rate will stay the same level, in particular at one 50% higher than the global growth rate?

An Alternate Scenario:

While China has posted higher growth rates in the past, it is more likely that they will see their grow rates decline over time as they become more developed and diminishing returns begin to set in. Indeed, the World Bank reports annual growth rates for China of 10.4% from 1999-2003, 9.3% from 2004-2008, and 7.8% from 2009-2012, so the pattern of decline is already in evidence. Therefore, an alternate scenario might be that China's annual growth rate slows over time to match that of the global economy as a whole (ableit still higher than the US' rate of growth). The orange line in the graph plots a scenario in which annual growth in Chinese GDP starts at 6% and then decreases by 0.5% every 10 years until it hits 4% in 2052.

If we look at the orange and blue lines (instead of the red and blue ones), we see a very different picture of the future. US GDP will be about 10% of GWP and Chinese GDP will be about 15%. Therefore, though the US will have a smaller share of GWP than China, China will nonetheless be much less of a hegemon than the US is today.

Indeed, the US and China may not be the only ones in the 10-15% of GWP band. If India’s GDP surpasses that of the US, as it is expected to do, India will find itself with probably about a 12-13% share of GWP. Furthermore, the EU will probably have a share about equal to that of the US, especially if it continues to add members. Therefore, China may find itself first among a set of 3 or 4 major economic powers that account for about 40% of GWP (undoubtedly someone will come up with a pithy acronym out of C, I, US, and EU). In such a case, China would not be a hegemon so much as the largest member of an oligarchy in which the US is also a member (albeit a junior one).

Now, of course, the future probably won't look like either scenario. Unexpected shocks (especially an economic collapse and/or lost decade in China) will see to that. However, the rising hegemon scenario described by the red and blue lines, and fretted over by commentators, is probably the least likely one to occur as it is based on a linear project of sustained high growth over the course of several decades.

Race to the Bottom?

If Wikipedia is to be believed, the term Race to the Bottom was popularized by Justice Louis Brandeis in reference to regulatory competition between states in the US. In general, the problem states faced was that , if other states enacted more lenient regulations, businesses would flock to those states. This gave states incentives to undercut each other regulations to attract business or at least lower their regulatory controls to keep what businesses they had. Hence, states were engaged in a race to the bottom. Preventing such a race became a rationale for federal regulatory standards which would establish a floor to this competition.

Today, the term is often applied to nations in a globalized world. globalization. Among others, Daniel Tonelson used the term in his 2002 book, The Race To The Bottom: Why A Worldwide Worker Surplus And Uncontrolled Free Trade Are Sinking American Living Standards. Tonelson argues that there is a global competition among nation to have the lowest wages, environmental standards, and labor regulations in order to win investments from the US and Europe.

Daniel Drezner addressed this so-called 'Race to the Bottom' in a 2000 Foreign Policy article and was emphatic in his rejection of it:

The race-to-the-bottom hypothesis appears logical. But it is wrong. Indeed, the lack of supporting evidence is startling. Essayists usually mention an anecdote or two about firms moving from an advanced to a developing economy and then, depending on their political stripes, extrapolate visions of healthy international competition or impending environmental doom. However, there is no indication that the reduction of controls on trade and capital flows has forced a generalized downgrading in labor or environmental conditions. If anything, the opposite has occurred.

Drezner argues that, if the Race to the Bottom hypothesis were true, we should see two trends. First, states that are more open to trade should have lower levels of regulation. Second, foreign direct investment (FDI) should be flocking to nations with the lowest levels of regulations. In arguing that there is little evidence of these trends (and often evidence of the reverse), he make the following points:

• A 1996 OECD study found that "successfully sustained trade reforms" led to improvements in labor standards and that multinationals pay higher wage rates to recruit better workers. Indeed, the study argued that multinationals, who are used to working in better regulated environments, welcome host nation improvements in labor standards as they give the multinational an edge over local firms who lack such experience. 
• He notes that OECD nations are the most open to trade and have the toughest environmental and labor regulations. Also, the overwhelming majority of FDI is directed at the same OECD nations. 
• He argues that multinationals invest in nations for reasons other than low production costs, most notably access to large markets in or near the host nation. Because this market access makes investment in the host nation desirable, it provides the host nations government with significant leverage when negotiating with multinationals.

Despite this lack of evidence, Drezner argues the Race to the Bottom hypothesis will persist because it is a useful rhetorical device. In his words:

Given this dearth of evidence, why does the race to the bottom persist in policy debates? Because the image is politically useful for both pro- and antiglobalization forces. Unfortunately, by perpetuating the belief in a nonexistent threat, all sides contribute to a misunderstanding of both the effects of globalization and how governments in developing and advanced economies should -- or should not -- respond.

William Olney comes to a different conclusion in a 2013 Journal of International Economics article. Noting that there has been a lack of evidence supporting the existence of a Race to the Bottom (and Olney's review of the evidence provides a good survey of the empirical research), he argues that the previous research did not rigorously test the two key assumptions of the Race to the Bottom hypothesis, which he describes as follows:

There are two implicit assumptions in the race to the bottom hypothesis. The first is that multinationals increase FDI in response to reductions in employment protection rules in the foreign host country. The second assumption is that countries competitively undercut each other's labor standards in order to attract FDI. (Olney, 2013, p 203)

Therefore, he conducts two analyses. To test the first hypothesis, he looks at US FDI in OECD nations to see whether it tends to go to nations with lower labor protections as indicated by the OECD's composite employment protection index for the receiving nation. To test the second hypothesis, he looks for a correlation between the employment protection index of each nation and the average employment protection index of its nearest competitor nations. As a result of these analyses, he reaches the following conclusions:

The empirical results presented in this paper are consistent with both predictions of the race to the bottom hypothesis. First, employment protection rules have a significant negative impact on FDI. In addition, employment protection rules have a more negative impact on the relatively mobile types of FDI. Specifically, employment protection legislation in the host country has small impact on horizontal FDI, amore substantial negative impact on export-platform FDI, and a large, negative impact on vertical FDI. These results are consistent across a variety of different estimation strategies. 

Second, this paper examines whether labor standards in other foreign countries affect the employment protection rules in the foreign host country. Regardless of the weighting method or the estimation strategy, the results indicate a significant positive impact on the host country's own employment protection rules. Thus, there is evidence that countries are competitively undercutting each other's labor standards in order to attract foreign investment. Overall, this paper finds support for both predictions of the race to the bottom hypothesis. Multinationals invest in countries with lower labor standards and countries respond by competitively undercutting one another's labor standards in order to attract FDI. At the very least, the results in this paper indicate that a race to the bottom in labor standards cannot be easily dismissed by economists, as is often the case. (Olney, 2013, p 203)

All in all, Olney looks at exactly what one should look at to test the two hypotheses which, as he says, are the two pillars of the race to the bottom hypothesis. He also has exactly the results that one would expect from the conceptualization of the process as a race, i.e., that a 1% drop in competitors employment protection yields a greater than 1% decrease in a nation's own employment protection.

However, when one eyeballs the graphs he provides of the various nations' employment protection indexes, a different picture emerges. First, consider the graph of all nations' employment protections below.

 Note that the graph starts out in 1985 with the nations spread out vertically from close to .5 to over 4. As time goes on (and we move left to right), we see many downward movements and a few upward movements so that we end up with a slightly narrower range and a cluster of nations with employment protections around 2 (and perhaps some other smaller clusters around 1 & 1.5, and a very loose one around 3). This suggests a loose convergence on that level (or those levels) rather than a race to the bottom. This impression is reinforced when one looks at his graphs of the nations with the largest declines and largest increases in employment protect below.

Note that, with the exception of Denmark, all the nations in the graph above start at an employment protection level above 3 and all but Denmark and Italy end up above 2 (though Italy is quite close to it). So the story here is that the largest declines were in nations with initially high levels of employment protection.

Here we see that, with the exception of France, all the nations with large increases in employment protection start out below 1.5. However, with the exception of Poland, they do not get close to 2, and their increases are generally smaller than the declines seen in the previous graph.

The overall story these graphs suggest to me is that nations started out the period with levels of employment protection largely driven by differing domestic factors and that competitive pressure may have driven the nations with higher levels of protection to adjust their policies towards the mean. Nations with relatively low levels of protection do not appear to have faced pressure to lower their levels of protection further and instead many have edged their protections up (presumably for domestic policy reasons).

Furthermore, all the nations with largest declines in employment protection are members of the EU and most of their declines in employment protection were between 1992 and 1997, a period which includes the  implementation of the Maastricht Treaty. So one has to wonder how surprised we should be that policies are converging in Europe or that European nations are feeling more competitive pressure at that point in time. Indeed, one could argue that, by extraordinarily leveling the playing field among EU members, the Europeans knowingly created a situation in which they would have to converge or compete with one another in policy areas not directly covered by the Maastricht Treaty. So, if there is a race to the bottom, they fired the starting gun.

On a more tangential note, one can't help but note that France sticks out in the bottom graph as the only initially high protecting state that makes a large increase in employment protection.  Yet, France was the source of Olney's illustrative example in the second paragraph of his article. Olney's choice of Hoover's 1993 decision to move operations from France to Scotland is a reasonable one since it was a highly visible event and seems to be a smoking gun of "social dumping". However, looking at France's employment protections in comparison to all others, we see that France was going in the opposite direction of the trend both before and after the Hoover decision.  Therefore, the anecdote is somewhat more atypical than it first appears.

More broadly, one questions how generalizable Olney's result are, especially to cases of FDI in developing nations. By looking only at FDI and Employment protection in OECD nations (i.e., highly developed nations), there is very little variation in  factors other than labor rules, such as rule of law, business climate and workforce characteristics,  that are thought to affect the decision to invest in developing nations. As a result, Olney is looking at a dataset that is most prone to exhibit a race to the bottom, especially among the EU nations that make up the bulk of the nations in the sample. the results here strongly suggest that the EU is in a situation analogous to that of the United States, which Brandeis described as a Race to the Bottom. Whether the rest of the world is in such a position is still as doubtful as it was before.

Bhagwati on MNCs

In his book, In Defense of Globalization, Jagdish Bhagwati devotes quite a bit of attention (11% of the book's total length) to the role of corporations. In general, Bhagwati argues that foreign corporations have a positive impact on the developing nations in which they set up operations, though this impact could be enhanced. However, corporate lobbying activities in their home countries with regard to trade rules in their home nation and international bodies can have a negative impact on developing nations. Some of his key points are listed below.

Big Corporation vs Small Countries: Bhagwati argues that the image of small nations facing big corporations, to the extent that it based on comparisons of the sales volumes of large corporate sales to the GDPs of small nations, is fallacious. He notes that sales volumes are gross figures while GDP measures value added in an economy, which is just portion of the gross activity in a nation. Therefore, comparing corporate sales to national GDP is comparing apples to oranges. A corporation's value added is only a fraction of its gross sales and, if these figures are compared to national GDPs, the supposed size disparity diminishes considerably.

Exploitation of Workers: Bhagwati argues that there is no evidence that multinational corporations  pay workers less than the prevailing wage or seek out nations with poor labor rights. To the contrary, he points to empirical research that shows that the opposite occurs. As discussed in a previous post, multinational corporations pay a wage premium of about 10% (and US affiliates can pay from 40-100%) over local wages. Other research by David Kucera shows that nations with higher unionization rates and less episodes of labor repression tend to have higher inflows of foreign direct investment. Noting research into the effect of environmental policies on multinational investment ( Smarzynska & Wei, and  Levinson) that finds little evidence of these corporations locating in places with lower environmental standards, Bhagwati argues that multinationals are not engaged in the 'Race to the Bottom' that they are often supposed to be in.

In discussing the question of hours and working conditions in foreign owned plants that violate international norms,  he notes that domestic regulations and common practices may may be more lax for good reason. Here he cites Kristof and WuDunn's NYT article "Two Cheers for Sweatshops" that described workers in so-called sweatshops as very happy to have a job for what they considered to be good pay and an opportunity to earn more of it by working long hours.

Spillover Effects: Bhagwati argues that multinational have what are called spillover effects when local firms learn better production techniques and management practices from multinationals. This occurs through observation,word of mouth, and, more importantly, from  workers and managers moving between domestic and foreign owned firms.

Effect of Bad Politics: Many of the supposed bad effects of multinationals are, in Bhagwati's view, the result of bad policies in the host nation. He notes that there are two dominant practices regarding social legislation in developing nations. The laws are either practically nonexistent, or they are excessively generous with little or no effort made to enforce them. In the latter case, the laws may have been only symbolic in nature when passed, or they may simply be out of date and are no longer considered desirable. Yet, they remain on the books because it is not worth the political cost to change them. Therefore, when a seemingly lenient set of rules is established for multinationals, say as is the case in an export promotion zone, it may represent a politically expedient means of policy change or experimentation.

Bhagwati sees  policies aimed at inward growth or import substitution as another example of bad politics. When governments try to encourage foreign direct investment aimed at supplying products to the domestic market (usually one protected by import tariffs and/or quotas) as opposed to the global market, they create a situation in which less employment and spillovers will occur. Multinationals, viewing the direct investment as a path around the tariffs and quotas, will seek to minimize the amount of work done in the host nation (perhaps assembling  the minimum number of imported parts to qualify as "domestic" production) and will not need to bring in their most productive techniques and practices.

Corporate Lobbying at Home: This is where Bhagwati sees corporations as having a more malign effect on developing nations. Corporate political influence in their home nations is more of a problem because their home governments tend to be fairly powerful, especially in the case of the US. Also, in this venue, the developing nations are at a disadvantage because they are largely shut out from the home nations' political process. Bhagwati points to the push to have protections for intellectual property included in the WTO as a trade-related issue. He sees this as an opening of the doors for other lobbying groups to have their issues labeled as trade-related and to take advantage of the WTO's enforcement mechanisms to coerce the governments of developing nations. This will not only force developing nations to acquiesce to unfavorable policies on the trade-related issues, but threatens to undercut the WTO's main efforts on trade liberalization itself.

Improving the Effect of Corporations: Though he argues that corporations tend to have a benign effect on developing nations, Bhagwati argues that these benign effects can be improved (and the occasional malign effects lessened) by improving corporate social responsibility. This can be done by employing a combination of three mechanisms:

1. Social Norming: This occurs when corporations sign on to uphold sets of broadly defined goals. While they do not agree to take concrete steps and face no enforcement mechanism, the act of agreeing to certain social goals (and not others) focuses the corporation and its critics on what the corporation intends to accomplish.
2. Voluntary Codes: These codes entail better defined obligations that the corporation agrees to meet if it signs on the code. One of the key aspects of voluntary codes, in Bhagwati's view, is that there is a diversity codes promoted by different groups from which to choose. This will allow codes that represent the developing nations' point view to compete with those promoted by western groups. 
3. Mandatory Codes:  These are national codes that regulate how a nation's corporations act in other nations.  Though Bhagwati expects these to vary across nations, he expects that best practices will emerge over time and this may lead to the emergence of more universal mandatory code.

Jagdish Bhagwati's Defense of Globalization

One of the seminal defenses of economic globalization was provided by Jagdish Bhagwati's, appropriately titled, In Defense of Globalization. The book was first released in 2004 and then re-released in 2007 with a new afterword  that addressed new criticisms of globalization that had arisen in the interim.

The globalization that Bhagwati defends is economic globalization. He defines economic globalization as the "integration of national economies into the international economy through trade, direct foreign investment (by corporations and multinationals), short term capital flows, international flows of workers and humanity generally, and flows of technology" (Bhagwati, 2007, p. 3). However, throughout the course of the book it becomes clear that he is most committed to the defense of trade and foreign direct investment which he sees as part of an outward oriented economic policy strategy that is necessary for growth. Indeed, as discussed in a previous post, he is very critical of financial liberalization, which he terms Gung Ho International Financial Capitalism. As for flows of people across border, while he does call from more flexible immigration policies, when it comes to issues such as the treatment of domestic workers in Middle East countries, he sets these issues aside as separate from economic globalization.

This is not to suggest that Bhagwati is being inconsistent. In fact, once one understands that he is defending the liberalization of trade and foreign direct investment from domestic and international political meddling, many apparent inconsistencies in his argument vanish. For instance, Bhagwati is highly critical of protections for intellectual property rights that are being written into the WTO code. While he provides an argument against the soundness of the basic principle (i.e., that preventing the diffusion of intellectual property can be as bad as undermining the incentives of innovators to create it), he also regards adding side issues to the WTO as ultimately harmful to its primary function of enabling greater trade. Furthermore, he sees an imbalance in power and capability between Western nations and NGOs that will ensure that any WTO rules will reflect their interests and values more than those of developing nations and their much less affluent NGOs.

The bulk of the original book is aimed at defending globalization from charges that it creates onerous social effects, or as Bhagwati puts it, that globalization does not have a human face. Going through these various criticisms, Bhagwati argues that when nations pursue outward oriented growth, the benefits far outweigh the ill effects which are often exaggerated, nonexistent, or the result of other factors unrelated to increase trade and foreign direct investment.

Poverty: Bhagwati argues that economic growth is necessary to reduce poverty and that increased trade can lead to economic growth. While there may be obstacles that prevent the war from fully anticipating an economic growth of the nation, without economic growth, there will not be resources available to lift them out of poverty. Thus, in contrast to the cliché that “a rising tide lifts all boats”, is essentially arguing that without a rising tide it will be hard to lift anybody’s boat. As for the link between trade and growth itself, Bhagwati argues that outward oriented strategies of growth have proven themselves to be superior to inward oriented strategies such as import substitution industrialization.

Child Labor: With regard to child labor, Bhagwati argues that the prevalence of child labor in developing nations is largely the result of domestic factors that have little to do with globalization. Poor people in developing nations face incentives to send their children to work, rather than to school, that are unlikely to go away if the governments of these nations simply proscribe child labor, which is essentially what globalization critics call for. However, citing research into households in Vietnam, Bhagwati argues that, if parents receive more income because of increases in prices or wages due to outward oriented economic growth, then they are more likely to send their children to school.

Effects on Women: Bhagwati analyzes many of the criticisms by feminist groups in depth, so it is hard to summarize here. However, one piece of research he cites stand out. Black and Brainard (2004) look at wage discrimination in the US and find that the wage gap between men and women decreases in industries that face increased competition from trade. Therefore, to the extent that globalization exposes industries to greater competition, it should diminish any wage gap that is the result of non-economic (and, thus, inefficient) discrimination.

Exploitative Wages: The charge that globalization forces people to work for exploitative wages comes up in connection with effects on women and criticism of multinational corporations. Bhagwati cites several studies that show that, rather than paying their workers poorly, muiltinationals pay their workers a wage premium of up to 10% and that US affiliated multinational often pay a premium of 40 to 100% above the local market wage. One of the cited works, Brown, Deardorff, and Stern (2004), reviews a range of empirical work on the subject and concludes:

• It is true that, as a theoretical matter, multinationals can have an array of positive and negative impacts on host-country workers. However, as an empirical matter, some anecdotal evidence notwithstanding, there is virtually no careful and systematic evidence demonstrating that, as a generality, multinational firms adversely affect their workers, provide incentives to worsen working conditions, pay lower wages than in alternative employment, or repressed worker rights. In fact, there is a very large body of empirical evidence indicating that the opposite is the case. Foreign ownership raises wages, both by raising labor productivity, and by expanding the scale of production and, in the process, improves the conditions of work. Furthermore there appears to be some evidence that foreign-owned firms make use of aspects of labor organizations and Democratic institutions that improve the efficiency characteristics of their factor, the operations. (Brown, Deardorff and Stern, 2004, p 322)

In general, Bhagwati concludes that globalization does have a human face in the sense that it has a benign impact on most of the issues that concern its critics. However, it can have occasional unintended bad effects. He argues that the way to deal with these is, not to try to avoid them ahead of time by limiting the liberalization of trade or FDI, but to deal with them as they occur. One of the main reasons for taking a reactive approach is that the specific effects of changes in trade policy are difficult to predict, and many anticipated problems may not arise, while other unanticipated ones almost certainly will.

When a problem occurs, policy makers should either take steps to mitigate the negative impacts of the trade policy, or modify the policy. Bhagwati favors the first approach as generally being more efficient, but is surprisingly non-ideological about entertaining the possibility of the second.

Factoid: The Health of US Manufacturing

Tim Taylor covers two recent papers on the health of US manufacturing at his Conversable Economist blog.

The first paper is a report by the IMF, "The U.S. Manufacturing Recovery: Uptick or Renaissance?" which reports on the unusual speed of recovery in manufacturing since the end of the great recesssion. This is attributed to the weakness of the dollar (which encourages exports), restraint on wage growth, and lower US energy costs (presumably due to low prices on US natural gas produced by the fracking boom).

The second is a paper in the Journal of Economic Perspectives,  "US Manufacturing: Understanding Its  Past and Its Potential Future" by Martin Neil Baily and Barry P. Bosworth. Baily and Bosworth note that manufacturing employment as a percentage of the US workforce has been declining steadily for 40 years. The authors produce the following graphic to illustrate this:

Note that the decline in employment (as a share of total employment) has been very consistent since the mid 1960s. What is interesting here is that, if you look at the absolute number of people employed in manufacturing, the numbers actually increase into the 1980s and then decline mainly in two  steps, one small step down in the early 1980s and one precipitous drop in the last decade (See graph below). These downturns in absolute numbers give the impression of precipitous events rocking the industry, especially since 2001. However, the data presented by Baily and Bosworth above shows a more constant downward trend.

Why are the graphs so different? By looking at manufacturing's share of the work force, Baily and Bosworth are implicitly taking into account changes in the total workforce that affect the absolute number of people working in manufacturing. For instance, the FRED graph shows that the number of people working in US manufacturing grew about 20% in the 1960. Yet this was also when the baby-boomers started entering the workforce, Indeed, the first baby-boomers turned 18 in 1964 and  Baily and Bosworths's red employment line begins its downward slide soon afterwards. Note also that, in the FRED graph, manufacturing employment  has its ups and downs (which are mostly due to  recessions) in the 1970s and 1980s but stays close to 18 million. However, this is a period in which the remaining baby-boomers enter the workforce and the percentage of the population entering the workforce climbs from about 58% to 63% largely due to women entering the workforce in greater numbers. Therefore, by expressing employment as the share of total employment,  Baily and Bosworth's data weeds out the effect of recessions and changing demographics.

This is particularly important since, the apparent free fall in manufacturing employment from 2001 to 2010 shown in the FRED graph coincides with a precipitous drop in the percentage of the population in the total civilian workforce. In this period, the combined impact of retiring baby-boomers and the Great Recession pushed this percentage from a historic high above 64% to below 59% (essentially back to late 1970s levels).   Baily and Bosworth's data implicitly takes this into account and shows that, despite the appearance in the FRED graph, the alarming 5 million employee drop in manufacturing employment is nevertheless in line with the general trend since the mid 1960s.

Another thing to note in Baily and Bosworth's graph is that, since 1960,  manufacturing's share of GDP has remained quite steady. Thus, the above graph makes a point that I have been trying to make (perhaps not as well as they do) that manufacturing in the US has not declined, just the employment in it has.

Baily and Bosworth also find that this decline in share of employment in US manufacturing is equivalent to the average decline seen in the G-7 countries. So, whatever is driving the trend in declining employment in manufacturing, it is affecting the other most industrialized nations in equal measure.

The big point here is that, if you look at the number of people employed in manufacturing (the FRED graph), you see an accelerating downward trend starting in the 1980s and you look for causes in the 80s, 90s, and, especially, the 00s. This leads one to consider things like NAFTA and FTAs, globalization, and China's currency manipulation. However, theses factors seem less plausible as explanations for declining employment in US manufacturing when you see the decline as part of a longer term trend, as in the Baily and Bosworth graph.

Individual Decision Making in Rich vs Poor Nations

I have been reading Abhijit Banerjee and Esther Duflo's book, Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty. They look at what they call the rich economics of the decisions that poor people in poor nation make. Their book is notable not just from the depth of analysis into the microeconomic conditions of poor people in developing nations, but also for their reliance on good research methods, so I will have much more to say about their work in the future.

However, one thing struck me early on in their discussion of the healthcare decisions of poor people in poor nations. Banerjee and Duflo note that, abjectly poor as they are, these folks spend a goodly portion of their income on healthcare, even when the government provides it free of charge. However, they often spend their money on unqualified practitioners, such as the so called Bengali Doctors in India.

The authors also discuss the difficulty of getting poor parents to have children for immunized. Free monthly immunization camps set up near rural villages only get a 7% participation rate and offering incentives to parents only raises the rate to 36%.

It is easy to respond to observations like these with derision for the behavior, or the decision making involved in it. Indeed, when I mentioned the immunization numbers to my wife, she had the understandable reaction of asking aloud "what type of parent wouldn't immunize their child?"

While Bannerjee and Duflo  analyze these seemly bad decisions from a variety of perspectives,  one thing they discussed  particularly resonated with me.  In a later chapter on education, they noted that the patterns of rules, beliefs, and expectations in developed nations differed greatly from those in developing nations in such a way that people in developed nations don't have to devote much thought or effort to doing the things that we might deride poor people in developing nations for not doing. Though they were talking about parents sending their children to school, I thought this applied very well to their earlier healthcare examples.

For instance, think about the question of immunizing your children from the point of view of what you would have to do to avoid immunizing you children in the US. While not universal, most states mandate  DPT vaccination for children attending secondary school, and many mandate it for enrollment in primary school and daycare. More informally, but perhaps more importantly, the overwhelming majority of healthcare providers will emphatically encourage parents to get their children immunized whenever they see the child. Of course, there are personal belief  exemptions to many of the legal mandates, but the overarching point here is that most parents would have to work harder to keep their children from being immunized than to allow them to be immunized. Therefore, higher immunization rates in developed nations may not reflect better thinking or more informed beliefs among parents than that the path of least resistance (and, therefore, of less thought) for parents in developed nations is to have their children immunized.

This is probably even more true in the case of choosing to go to a qualified healthcare provider. In the US, our choices are highly constrained by several factors. The government and professional organizations have established rules about what constitutes a qualified healthcare provider and an approved treatment for any given illness. These rules are enforced not only by direct government action, but also through health insurance providers (who will not pay for unapproved treatments or visits to unqualified practitioners) and the threat of civil litigation for malpractice (which produces another layer of enforcement from malpractice insurers). Therefore, when we in the US get sick, we really don't have much choice as far as seeing a qualified doctor or an unqualified one goes.

This dramatically simplifies our healthcare decisions. When I go see a healthcare provider, I don't have to directly assess their qualification and the effectiveness of their services (which I am really not qualified to do being the wrong type of "Dr." for that) to be assured that they aren't quacks. If  the doctor or clinic I patronize is openly doing business as a healthcare provider, if my insurer ( BC/BS) has approved them to receive payments, and if my pharmacy will fill their prescriptions, then it is a good bet that they are at least minimally competent. Furthermore, if my doctor prescribes a test or a treatment, I can be reasonably sure that it is appropriate if my insurer is willing to pay for it. I can also be somewhat confident that their treatment won't make cause me any great harm because I (or my heirs) will own them in court if they commit malpractice. Because of this, they have to get malpractice insurance and that insurance company has probably done its homework regarding the practice of the doctor or clinic that I visit.

Of course, there are many lapses in the system and being entirely careless or sanguine can lead to a lower quality of care. The point is that, given that I bother to seek treatment in the first place, the path of least thought and resistance is going to lead me to a healthcare provider who is minimally qualified and  faces incentives to do at least minimal testing and prescribe the standard course of treatment. I am not going to end up with someone who will use crystals or prayer to heal me, or is going to give me an unneeded shot of anti-biotics or steroids from an unsanitized needle.

In contrast, poor people in developing nations face a much more difficult situation. Take the case of India with its free healthcare for the poor and competing  private system of unlicensed Bengali Doctors (ignoring the higher cost system of qualified doctors that are priced out out of reach for the impoverished). Banerjee and Duflo note that in India, the government healthcare system is plagued by absenteeism (with primary clinics as likely as not to be closed during stated operating hours) and a poor quality of care. They cite research that shows that government doctors spends less than two minutes with their patients, generally ask the patient for their own diagnosis, and then prescribe treatment based on the self-diagnosis. Thee doctors typically do not touch their patients and rarely give any advice about administering the treatment or following up.

In contrast, the private sector Bengali Doctors, who can have as little education as a high school diploma, tend to observe a 3-3-3 rule: they spend 3 minutes with the patient, ask 3 questions, and prescribe 3 medications. They also generally lay hands on the patient and often administer medications as a shot (which patients generally perceive as more effective than oral medication). Of course, being self-employed, Bengali Doctors are generally at work when they say they are going to be there. The point here is that, based on the most easily observed criteria, the Bengali Doctors appear to be giving higher quality care and, apparently for this reason, the poor are willing to pay for it.

Therefore, the existence of an unregulated market for low cost healthcare alongside a perceptibly low quality free government healthcare system forces the impoverished in India to make choices that are more challenging than those facing people in wealthier nations. They are implicitly forced to make judgments about the efficacy of different types of practitioners and courses of medical treatment that are, for better or worse, kept beyond the scope of choice for healthcare consumers in developed nations.

This is on top of the fact that the poor have much less information and education to help them do so. For instance, Bannerjee and Duflo argue that it takes a junior high school knowledge of biology to understand how the gastric and circulatory systems work and, thus, to understand that oral medication will get to your bloodstream about as well as an injected medication will. The same can be said for understanding the need for, and proper means of, sterilizing needles. This all means that the poor in developing nations need to think harder about a wider range of choices and have less resources to do so than most people in developed nations.

This seems to me to be an example of how institutions, using Douglass Norths' broad definition of institutions as the formal and informal rules of the game in a society, can lead people to better or worse outcomes. The formal and informal 'rules of the game' for  healthcare in the US create a situation where little or no thought will lead people to make better choices (if they can be called choices) than poor people in India make after putting much more thought into the decision.

As Banerjee and Duflo point out regarding education, there is a decidedly paternalistic quality to the rules of the game in developed nations. Postmodernists and Critical Theorists would be quick to point out that such paternalism is likely to herd people's choices in a direction that serves the interests of the powerful in the society. Thus, it constitutes a potent means of oppression that renders "choice" an illusion. Milton Friedman, who argued in Capitalism and Freedom that the government should not regulate healthcare but allow consumers to decide what was most effective, would argue that such paternalism constrains individual choice, stifles innovation, and produces inferior outcomes. Douglass North himself would caution that more developed institutions, especially formal ones established by the political system,  do not necessarily lead to better outcomes and can lead to persistent inferior outcomes.

Still, I think this is an example of the potency of institutions (again in their more broadly defined sense) and the role they play in affecting the outcome and efficiency of individual choice.

Hall of Shame: Possible NTB on EVOO

For those of you that don't watch Rachel Ray (who uses the acronym with somewhat annoying frequency), EVOO is Extra Virgin Olive Oil. For those who haven't taken my IPE class, an NTB is a Non-Tariff Barrier to trade.

The AP reports that US olive oil producers are pushing Congress to impose standards and testing on imported olive oil labeled as Extra Virgin. They claim this is a truth in advertising issue, but it is clearly aimed at expanding their market share from its current level of 3%.

In fairness to them, they are asking that domestic USDA testing and labeling standards be extended to imports. Therefore, their proposal might not be WTO illegal (as it does not subject imports to different standards than domestic products). Of course, in the inevitable case of a challenge from the EU, the WTO might rule on the scientific merits of the regulation (which is a somewhat controversial aspect of the WTOs rules).

However, the thing that irked me about the AP article was the comparison to California wine included in these passages:

"U.S. producers are seeking to build on that growth in a struggle reminiscent of the California wine industry's push to gain acceptance decades ago.

"They've mounted an aggressive push in Washington, holding olive oil tastings for members of Congress and lobbying for stricter standards on imports. The strategy almost worked last year when industry-proposed language was included in a massive farm bill passed out of the House Agriculture Committee."

What struck me about the above comments was that, from a political economic point of view, the olive oil producers are hardly reminiscent of the wine producers. If you have seen the movie Bottle Shock or are familiar with the story of the "Judgement of Paris" (the 1976 blind taste test in which pitting California wine versus French wine), you will know that California wine rose in prominence due to its quality. California vinters benefited from a taste testing by private experts in Paris, not a taste testing by politicians in DC. California wine, therefore, represents a case of consumer sovereignty in action.

As for the case of olive oil  producers, while they too are in a situation in which the imported product has a better reputation for quality, they are attacking it by seeking government intervention rather than appealing to consumers directly. Indeed, by seeking to have the testing done on their product extended to imports, they are giving up on a potentially important claim to quality for their product (i.e., that it is tested). If testing of imports is implemented, the resulting testing might only enhance the reputation of the imported brands that pass the test.

Now, I am an admittedly bizarre consumer due to the time I spend studying this stuff, but I do use EVOO quite a bit and favor imported brands. I currently use Bertoli, which is made in Italy. Knowing that domestic EVOO is tested and Betorli's is not actually inclines me to give a domestic oil a try.  If, however, uniform testing is imposed (and Bertoli's wasn't pulled from the shelves), I would have no such inclination. This is what really qualifies this case as a Hall of Shame moment.

China's High Speed Rail: Wealth Destroying Investment?

On Jan. 14th, SkyNews posted a report on China's high speed rail (HSR) network. The headline was that China was doubling its HSR network and the subtitle was "China builds 6,000 miles of track in the time the UK only debates the merits of constructing 100 miles of high-speed rail line."

This captures the tone of much reporting on Chinese HSR. People marvel at the rapid rate of construction, the vastness of the network, the quality of the service, and the ambitious plans for even more. Indeed, China has constructed 6,000 miles of HSR since 2008 and, as Sky reports, plans to invest the equivalent of 6o billion pounds ($97 billion) in the coming year. So China has a HSR network twice as long as the combined length of Japan's and Europe's networks and is spending heavily make it even larger.

Very often the growth of Chinese HSR is contrasted to the lack of growth in the author's country, as in the subtitle to the Sky News post. Indeed, China's 6,000 miles of HSR are a stark contrast to the US's 0 miles, and proponents of US HSR (notably the  planned LA to San Francisco  route) might be excused for using China's investment in HSR as a rhetorical lever against opponents. However,  seemingly few people ask why China has invested so much more in HSR than other countries, or to question the wisdom of the massive scale of their investment.

One person who does so (albeit indirectly) is Michael Pettis in The Great Rebalancing. Pettis argues that China has been pursuing the Japanese growth model that is based largely on establishing the following three conditions:

1. Undervalued Currency: the central banks systematically intervenes to keep the exchange rate down
2. Low wage growth: labor policies ensure wages grow more slowly than productivity
3. Financial repression:  the government allocates credit and the central bank keeps interest rates below their equilibrium rate (Pettis, 203, p 53)

This last condition is relevant to China's HSR. Pettis argues that China has set up its financial system in a manner that sets interest rates paid to depositors extremely low and ensures that there are few alternatives for savers to avoid them opting out of the banking system. This provides borrowers with a large supply of capital at a low rate of interest. These borrowers generally include, the government, infrastructure investor, and corporations (Pettis, 2013, pp. 60-61). Thus, financial repression provides an excess amount of savings and investment.

While having an abundance of savings and investment can spark wealth generation at first, when the existing stock of capital is low, eventually diminishing returns set in and the return on investment shrinks. However, the artificially low cost of capital encourages investment to continue at an above optimal rate. Pettis describes the situations as follows:

• "The longer heavily subsidized investment continues, however, the more likely that cheap capital and socialized credit risk will fund economically wasteful projects. Dirt roads quickly become paved roads. Paved roads become highways. And highways become superhighways with eight lanes in either direction. The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for fraud and what economist politely call rent seeking behavior, while the costs are spread to the entire country through the banking system and over the many years during which the debt is repaid (and most at his rollover continuously)." (Pettis, 2013, p 90)

When reading the above passage, it is hard not to think of China's HSR as analogous to Pettis' hypothetical superhighway (or at least it was for me). Of course, one might argue that China is simply trying to catch up with the more developed world and is avoiding past (supposed) mistakes by building HSR instead of highways. One could argue that, since China is starting from such a low level of capital development that it would be a long time before they were in danger of overbuilding things like their transportation system.  However, Pettis addresses this line of thought, as follows:

• "The problem with this reasoning of course is that it ignores economic reason for upgrading capital stock and assumes the capital infrastructure have the same value everywhere in the world. They don't. Worker productivity and wages are so much lower in China than in the developed world. This means that the economic value of infrastructure in China, which is based primarily on the value of wages it saves, is a fraction of the value of identical infrastructure in the developed world. It makes no economic sense, in other words, for China and have levels of infrastructure and capital stock anywhere near those of much richer countries because this would represent wasted resources - like exchanging cheap labor for much more expensive labor-saving devices." (Pettis, 2013, pp. 90-91)

The above passage gets right to the point I am raising about China's HSR. The primary advantatge of high speed rail is that it is high speed and therefore saves travelers time. Generally, the economic value placed on time saved is parameterized by wages and productivity.  If I earn $20/hour, than spending an hour doing anything else represents an opportunity cost of $20 (i,e., the wages I could have earned). From a societal point of view, if my productivity is $70/hour, than having me do anything else represents an opportunity cost of $70 (i.e., the output I could have generated). So if a trip on a bullet train saves me 2 hours over another alternative, than the value of that savings is either $40 from the individual point of view or $140 from the society's point of view. Of course, this is an oversimplification that ignores, among other things, the fact that individual's generally value their free time at a higher rate than their wage (or else they working), but it gives you an idea of the type of calculation involved.

The point here is that, if we apply the same methodology (however oversimplified) to China, Japan, Europe and the US, the much higher wages and productivity in the last three would suggest that the economic benefit of HSR is much higher in them than in China. Yet China has chosen to build more HSR than all 3 countries/region combined.

This should at least raise an eyebrow or two, especially if one considers the conditions under which HSR has been successful elsewhere in the world. Tom Zoellner at the WSJ looks at the potential for HSR in the US and notes that the most successful routes in operation are those connecting capital and major business center in Japan (Tokyo-Osaka, 246 miles) and France (Paris-Lyon, 289). Besides connecting cities that provide a reliable passenger base, these routes fall in what Zoellner calls the sweet spot for revenue, distance of between 200 and 600 miles. Indeed, as Zollener notes, even the lumbering Amtrak, with trains averaging 68 mph, is able to capture 3/4s of the combined rail and air travel on the 225 mile route between D.C. and New York.

This suggests two points. First, that an extensive HSR system is questionable on the face of itself. We should expect to see 200-600 mile segments selectively placed between major metropolitan areas. Of course, if you have a string on larges cities 200-600 miles from each other, you might expect a longer line to connect them. However, you don't expect to see a huge network that includes an 1100 mile run through Tibet and the Gobi Desert to the far flung city of Urumqui.

Second, the example of the much lower tech US Northeast Corridor (NEC) suggests how much might be accomplished with less than high speed rail. Amtrak not only captures 75% of the non-automobile/bus traffic between DC and New York, but the four track NEC provides rail capacity for daily commuter trains. Where Amtrak has about 11 million passengers on its NEC trains (which includes the New York to Boston segment), the total passengers carried by Amtrak and various commuter rail services that use the NEC amount to 260 million/year. That's about a 22 to 1 ratio of commuters to intercity passengers.

Of course, another alternative to HSR, especially for routes over 600 miles, is airline travel, which China has not neglected. Indeed, Gordon Change at Forbes notes that China's Commercial Aircraft Corporation of China (COMAC) is hoping to start selling its C919 aircraft in 2016 and is hoping to sell over 4600 to Chinese airlines. However, though air travel in China is increasing at the rate of 10% a year, Chang notes that HSR travel has been growing at nearly three times the rate, 28%. He notes that subsidized rail prices are much lower than airline prices and have not seen increase in nearly a decade. So, Change argues that Chinese HSR is dampening demand for air travel and endangering future sales of its C919. However, he doubts that China will be able to operate the extensive network currently envisioned envision, and he notes that the rail operator is already $500 billion in debt.

Indeed, Pettis predicts future difficulties for the economy as a whole if the systemic imbalance between consumption and investment is not adjusted. The money being poured into HSR, and into may other infrastructure and manufacturing investments, may be sparking apparent short term growth, but this apparent growth may be masking the destruction of wealth if these investments are economically unsound. In the long run, any destroyed wealth will take the form of bad debt that will have to be paid down, which will slow future growth (or possibly cause a contraction in GDP). Pettis argues that if China does not take strong action to adjust its policies, it may face a Lost Decade similar to what Brazil experienced in the 1980s (Pettis, 2013, p 81-82).

This leads me to question whether China's investments in HSR, especially the current and future investments aimed at doubling the system, might ultimately be wealth destroying. Will they find themselves with a system that is greatly overbuilt and containing large segments that are untenable? While one might draw a fanciful parallel to the Simpson's monorail episode, more apt comparisons might be the overbuilding of American railroads at the turn of the last century or of the internet during the dot-com bubble. Both these examples involved over investment in infrastructure, one in steel rails and the other in fiber optics, that was ultimately unprofitable.

Of course, both the above examples left us with some infrastructure that, if not worth the cost of building, was nonetheless of enduring value. This is likely to be true of China's HSR as well. Indeed, it may well continue to be the pride of the nation even after its debt goes bad and large segments have to be abandoned or downgraded. After all, the NEC is the legacy of the Pennsylvania Railroad and then, after its merger with the New York Central) the notoriously bankrupt PennCentral.

Indeed, the more unequivocal example wealth destroying investment are likely to be in manufacturing where unprofitable firms are plowed under by their competition and their shuttered factories are of limited enduring value. In that sense, COMAC, if it fails to break up the Boeing-Airbus duopoly in midsized commercial aircraft, may end up looking like a more unmitigated failure than Chinese HSR.

Postscript: BBC Two has a report by Robert Preston that details the scale of Chinese investment and accompanying debt and warns of a future economic crisis.

Tim Taylor on the Status of Microfinance

Microfinance, the provision of small loans to poor individuals, got a lot of buzz in 2005-2006 and one of its pioneers, Muhammad Yunus, received a Noble Prize for his work with the Grameen Bank in 2006.

However, it appears that some of the shine is off the apple. Research by Abhijit Banerjee, Esther Duflo, Rachel Glennerster, and Cynthia Kinnan found mixed results from micro-credit efforts in Hyderabad, India. In discussing the research with Deseret News, Kinnan noted that fewer households than expected took out loans and, among those that did, their monthly consumption did not increase and neither their businesses' profits. They also found no evidence that the microcredit had an impact on the education, health or role of women in the households that took out loans. While microcredit loans did have potentially positive effects on household spending, such as increasing the purchase of durable goods and decreasing spending on temptation goods, the loans did not seem to have the dramatic effects claimed by microcredit proponents.

At the Conversable Economist blog, Tim Taylor looks at recent research by David Roodman (you can see Roodman's orginal work here). The story that Taylor pulls out of Roodman's research is that, whether or not microcredit lifts people out of poverty, it gives the impoverished more control over their lives by providing otherwise unavailable access to credit. Thus, microcredit institutions are increasingly filling a void  in their nation's banking system.

Indeed, according to Roodman's data,  microcredit loans have expanded greatly since 2006 in both the number of loans outstanding (from 55 million in 2006 to 80 million loans in 2001) and the total amount of money lent (from $25 billion to $80 billion in the same period). Being able to get capital from donors or from below market interest rate loans has allowed microlenders to become largely self-sufficient  and to begin attracting money from the private sector.

The fly in the ointment appears to be that these institutions are operating in an un- or under-regulated environment. While they have been building up institutional capabilities from the bottom up, the banking industries in these countries are still deficient in top down systemic institutions. Taylor provides the following quote from Roodman:

• "The microfinance industry has demonstrated an ability to build enduring institutions to deliver a variety of inherently useful services on a large scale. Nevertheless, the recent travails are signs that something is wrong in the industry. What is wrong is, ironically, what was once so right about the industry: it largely bypassed governments in favor of an experimental, bottom-up approach to institution building. The industry got so good at building institutions and injecting funds into them that it often forgot that a durable financial system consists of more than retail institutions and their investors. The narrow focus became a widening problem as microfinance grew. ... To mature, the industry and its supporters should recognize the imbalance it has created. Where possible, they should work to strengthen institutions of moderation such as credit bureaus and regulators. Accepting that such institutions will often be weak, they should err on the side of investing less. In microfinance funding, less is sometimes more."

So once again, we come back to the importance of institutions in developing nations (for that matter any nation).

Acemoglu and Robinson on 'Why Aid Fails'

Daron Acemoglu and James A. Robinson, the authors of Why Nations Fail: The Origins of Power, Prosperity, and Poverty, had an article in The Spectator last month on why aids fails.

Their main argument is that poor nations tend to be poor because the have extractive economic institutions that "sap the incentives and opportunities of the vast mass of the population and thereby keep a society poor." This not only impoverishes the poor but denies the society as a whole the full productive benefit of a large part of the population.

As far as aid goes, Acemoglu and Robinson argue:

• Recognising that poor countries are poor because they have extractive institutions helps us understand how best to help them. It also casts a different light on the idea of foreign aid. We do not argue for its reduction. Even if a huge amount of aid is siphoned off by the powerful, the cash can still do a lot of good. It can put roofs on schools, lay roads or build wells. Giving money can feed the hungry, and help the sick — but it does not free people from the institutions that make them hungry and sick in the first place. It doesn’t free them from the system which saps their opportunities and incentives. When aid is given to governments that preside over extractive institutions, it can be at best irrelevant, at worst downright counter-productive. Aid to Angola, for example, is likely to help the president’s daughter rather than the average citizen.

Therefore, they recommend that policymakers need to not only give aid to poor nations but use their financial and diplomatic clout to encourage the growth of more inclusive economic institutions.

Of course, this is easier said than done. If we recall Selectorate Theory. The survival of Leaders in small Winning Coalition political systems depend on providing private benefits to their supporters. Therefore, the extractive institutions that Acemoglu and Robinson decry are probably instrumental in providing these benefits and keeping the Leader in power. Only a fundamental change in the political system that expands the WC will change the logic of political survival from one of providing private benefits to supporters to one of providing public benefits to the society as a whole.

Of course, the case of China suggests that certain reforms can increase national income enough that private benefits to the WC can be increased while allowing the income of the nations residents to increase. China has certainly reduced poverty by a large amount while keeping the CCP in power. However, I don't know that this is the kind of reform that western democracies will want to encourage.

This leads one to wonder if China itself will export its policy experience as it engages more in Africa and whether doing so will promote economic growth among authoritarian regimes. Most of the discussion I have seen about China's role in Africa has focused on the geo-strategic and anti-democratic implications, not on economic policy spillovers. 

Venezuela's Troubles and Perry's 19 year-old "Why Socialism Failed"

Mark Perry at Carpe Diem links to a USA Today report on the decline of Venezuela's auto industry. The USA Today piece is interesting as another installment in the saga of Venezuela's economic decline.  The government's currency controls have created shortages not just in consumer goods but also in producer inputs. Auto manufacturers owe $1.5 billion dollars to overseas suppliers, and production has dropped from 500,000 vehicles in 2007 to 100,00 last year. Last month only 296 cars were sold. Meanwhile, consumers are on waiting lists to buy cars (one man is reported to have been waiting over two years). So, it's small wonder that Toyota is closing its plant in Venezuela.

Yet the president, Nicolas Maduro is demanding that Toyota explain its decision and threatening to take over companies. This is on top of setting a ceiling on profits and mandating lower prices.

After covering the highlights of the USA Today piece, Perry ends with a quip and a link to what I think is a really useful piece he wrote in 1995, Why Socialism Failed. In it, Perry diagnoses the fundamental fault of socialism as its reliance on faulty premises about human behavior, specifically that it ignores the role of incentives in guiding it.

Perry then goes on to lay out the role incentives play in capitalism. Here he concisely explains the role of prices, profits & losses, and property rights in the capitalist system. While he might get a little over exuberant in his conclusion at the end of the piece, this explanation of the role of incentives is worth the read.

Indeed, reading Perry's essay after reading the USA Today article, one is struck at the similarities between the failures Perry pointed to 19 years ago and those occurring in Venezuela today.

Additional Thoughts (2/14/2014): Despite my enthusiasm for Perry's article, I am a bit uncomfortable with the ideological tint to the discussion.  It is one thing to argue that capitalism outperforms socialism because it makes better use of incentives.It is another thing to assert that capitalism works and its spread will lead to "a global revival of liberty and prosperity." Doing so edges us closer to translating valuable insights about the role of incentives into doctrinaire policy prescriptions.

Indeed, one could argue that this is what happened with the Washington Consensus. To a certain (and debatable) extent, the WC took the insights of economic theory (such as those discussed on Perry's piece) and translated them into a set of specific policy prescriptions, the very specificity of which obscured the essence of the original insights.

In contrast, it could be argued that China achieved its recent economic growth by harnessing the power of individual choice motivated by incentives without a wholesale transition to capitalism. While their incremental approach has created its own problems and may eventually require the Chinese to fully transition to the capitalist model, their success to date provides a compelling counter argument to dogmatic capitalism if the debate is cast in terms of rigid ideals of economic organization. That is to say, if one argues that capitalism in a specific form is an optimal system, than the success of other systems needs to be explained away (or an argument needs to be made that the success would have been greater if the optimal system was imposed).

However, if we pull capitalism apart to see what makes it tick, then we can recognize the aspects of it that work well not just in a capitalist system, but in other types as well. The case of China then becomes not an apparently successful alternative to capitalism, but a successful  application of one of the key aspects of capitalism. This gives us a better view of what works and doesn't work in the world than does an analysis framed in broad terms such as capitalism and socialism.

Indeed, we can look at the cases of China and Venezuela, both of which might be considered quasi-socialist systems, and note important differences in policy. One could argue that China, while limiting private ownership more than Venezuela, has done a better job of letting prices and markets work. Where Venezuela seems determined to ruin its economy rather than allow its currency to float, China abandoned its peg to the dollar (albeit in favor of a partial liberalization) long before a crisis emerged. Ultimately, Venezuela's obstinacy is all the more remarkable given China's 2005 compromise on the issue.

PEW Research on the "Rising Cost of Not Going to College"

This week PEW Research published survey results showing the effect of a 4 year degree on earnings unemployment and poverty.  They found that the median income of respondents with a 4 year degree was $45,500 while the median income of respondents with only a high school degree was $28,000. Respondents with a 2 year degree did not fair much better with a median income of $30,000. So a Bachelors degree (or more) produces a 62.5% wage premium over a HS diploma and a 51.6% wage premium over an Associates degree or some college.

Comparing their current results to earlier PEW studies, they found that the gap between the earnings of college grads and non-grads has been growing since 1979. The results are best viewed in their graph of earnings from 1965 to 2013. The authors note that, even though the percentage of college graduates in their sample has been increasing (and the percentage of people with only a HS degree has been shrinking), median income in their surveys has remained flat since 1965.

Their report goes on to consider many more aspects of the situation and is definitely a must read. Of particular interest to college students and their parents is the section on regrets among college graduates. While one might expect that many would regret their choice of major, only 29% listed that as a major regret. The most commonly mentioned regret (50%) was not gaining more work related experience while in school.

While on the subject of income, the subject of assortative mating is getting some play due to an NBER paper by Greenwood, Gunar, Kocharkov, and Santos. Assortative mating refers to the tendency of people to marry other people with similar education/skill levels which results in people with high (low) earning potential forming households with someone with a high (low) earning potential. The prevalence of high-high and low-low pairings in comparison to low-high pairings exacerbates measures of income inequality where the unit of analysis is households, not individuals. Looking at 2005 data on incomes, the authors find that, if people were randomly paired with others, the gini coefficent of household income would decrease from .43 among actual households to .34 among randomly paired households (a 25% reduction).

So what do you do with this. Matthew Yglesias at Slate's Moneybox gives it a whirl.

Factoid: US Debt, Expenditures and Receipts

A couple of graphics of my own choosing to share today. First, is a  FRED graph showing total public debt as a percentage of GDP:

To my way of thinking, looking at government debt as a percentage of GDP is the best way to get a sense of the nations public debt burden. If you look at it in absolute terms, you  just see an exponential curve with flatter spot here and a step spot there.

In contrast, the graph above tells a more vivid story. We see that public debt as a % of GDP was actually shrinking through  the late 1960s and 1970s. You can clearly see that it rose dramatically during the Reagan-Bush41 years before begin to recede in the Clinton administration (with proper credit also due to Gingrich led House Republicans). The trend reversed and debt grew a bit under Bush43 due to the Bush tax cuts, the 2001 recession and the wars in Afghanistan and Iraq.

However, all these changes pale in comparison to the steep climb as a result of the Great Recession. In looking at this steep rise it is important to note that the recession had a double whammy effect on the Debt/GDP ratio. The recession expanded the numerator as government expenditures increased and receipts fell (as will be discussed below). It also shrunk the denominator.

Whatever the causes, we have entered a new era of US government debt burden, and we are going to have to do something about it sooner or later. That something logically entails some combination of GDP growth (to shrink the denominator), and cut to federal spending and/or increases in federal revenue (to shrink the numerator). Since GDP growth is not directly controlled by government policy (though it nay be effected by it), policy makers must focus there attention on reveune and expenditures, which leads to the next graph.

I have used Federal Reserve data on current federal expebditures and receipts (along with data on US GDP) to produce the graph below, which shows current expenditures (blue line) and receipts (red line) both as a percentage of US GDP from 1929 to 2012.

Clearly, expenditures have been running higher than receipts since 1950, but we knew that. We can also see that government expenditures moved from the 16-17% of GDP range into the 20-23% of GDP range in the 1960s (presumably due to the Vietnam War ad Great Society programs) and then edged up more to the 23% mark during the Reagan years (presumably due to higher military spending and lack of compromise on social spending). What is perhaps more interesting is the size in the decline of federal expenditures versus GDP during the Clinton-Gingrich years which brought federal spending as a % GDP down to the lowest level since 1965. While the 2001 recession and spending on the wars edged federal expenditure back up to the 20% (or 1968) level, they held there until the beginning of the Great Recession. Obviously, expenditures/GDP jumped in the Great Recession, again with part of the apparent increase due to a precipitous decrease in GDP.

However, I think the graph of federal receipts/GDP tells a more interesting story, or at least one that is more counter-conventional wisdom. Federal receipts as a % of GDP have been remarkably stable since 1950, staying within the 15-20% range. While they edged up a couple percentage points in the late 1970s and 1980 and peaked in the 1990s, they have receded due to the Bush tax cuts and the effect of two recessions. Indeed, in 2012 federal receipts/GDP were at their lowest level since the mid 1970s.

This factoid runs counter to the convention wisdom that taxes in the US have increased over time. While individual tax rates may have risen and fallen, the percentage of national income siphoned off by the Federal government hasn't changed much over the long run. Of course, this runs counter to most individual experiences since the personal income of most Americans trends upwards throughout most of their life. This exposes them to higher marginal tax rates as they climb through the tax brackets.

If we put this personal experience aside, we can see that our public debt is not just the result of increases in spending, but also of a conspicuous lack of corresponding increases in overall taxes. In short, the problem is not that we have had tax-and-spend policies, but  that we have had same-tax-and-more-spending policies. Therefore, when dealing with government debt, one would consider revenue increases to be on the table with spending cuts.

Alas, this is not the case. Despite the objective evidence, I doubt any politician in either major party would get far by arguing that Federal taxes (not matter how measured) have not increased over the past decades. The GOP is wedded to the reverse narrative and Democrats tacitly concede the point to the Republicans by trying to employ a narrative of fairness impaired by inequality.

US Trade Tops $5 Trillion and US Oil Production Expected to set Record in 2015

Mark Perry notes two interesting bits of news on his Carpe Diem blog.

Total US Trade (imports + exports) hit $5.016 Trillion in 2013. US exports totaled $2.27 trillion and imports totaled $2.74 trillion in 2013. So the export/import ratio was 82%, which means that 82 cents of every dollar spent on exports came back to the US in the form of payments for US exports (with the other 18 cents coming back in the form of purchases of US capital).

Perry notes that most of the media coverage is talking in terms of the "bad news" of the US trade deficit or "good news" of strong US exports. Perry sees a different story:

What probably won’t receive any media attention is the good news that total US trade activity (Exports + Imports) set a record high in 2013, reflecting the improvement in both the US and world economies last year. Foreign consumers and producers purchased a record volume of “Made in the USA” exports, and American consumers, businesses and producers purchased a near record volume of “Made Outside the USA” imports, which is a positive sign of economic recovery and vibrancy both here and around the world.

You can see the original BEA report here

EIA Projects US Oil Production will increase toover 10 million barrels/day (mbd) in 2015. Perry notes that this level of production would match the previous high of US oil production in November 1970. As usual, Perry has a good graphic plotting US oil production from 1920 to EIAs projections for 2014 and 2015. One look at this graph should dispel any belief in so-called peak oil arguments.

Perry also notes that the BEA's data on exports shows that US exports of petroleum products (things like gasoline, diesel, jet fueling and heating oil) increased by 14% in 2013. The $82.9 billion in petroleum product exports in 2013 were about double the $41.9 (in inflation adjusted dollars) exported in 2008.

It should be pointed out that the increase in exports of petroleum products has little to do with the increase in US crude oil production. Instead, it has to do with the decline in demand for gasoline and other petroleum products which has left US refineries with excess capacity that can be exported, mainly to Latin American markets. The refineries along the Texas Gulf coast are a valuable source of US economic strength.

Unfortunately, Perry takes a somewhat partisan tone in his conclusion to this post. Perry notes that in 2010 President Obama promised to double US exports in 5 years, but probably won't extol the success of this industry due to a green bias. While I can't really disagree with the substance of his criticism, I like to keep at arms length from partisanship. I suppose that's a bias of its own kind.