Friday, February 24, 2017

The Economics of Kidnap Insurance

There is reason to be dubious, at least in theory, about  how kidnap insurance can work. After all, buying kidnap insurance only makes sense if you believe that, in the case of being kidnapped, it will increase your chance of being released. After all, if kidnappers know (or can figure out) that certain people have kidnap insurance, won't they tend to target such people? Also, if a kidnap victim has insurance  has insurance, won't the kidnappers demand the monetary equivalent of the earth, moon, and stars as a ransom? In these ways, might the presence of kidnap insurance increase the amount of kidnapping? On the other side, insurance companies have a profit motive to take actions that would reduce the number of kidnappings and the size of ransom payments. But if kidnappers make extraordinarily high demands and the insurance company pushes back, then it seems likely that negotiations over ransom will tend to break down--in which case the rationale for buying kidnap insurance in the first place would disappear. And how can kidnap insurance companies figure out a way to deal with the situation of kidnap victims who don't have insurance: if the representatives of those victims (who may in some cases be national governments) pay high ransoms, then it will be harder for the companies that sell kidnap insurance to keep other ransom demands down.

 Anja Shortland explores "Governing kidnap for ransom: Lloyd's as a `private regime," in an article forthcoming in Governance magazine (the publisher, Wiley, has laudably made an "Early View" preprint version of the article available here). The short answer to the concerns over how kidnap insurance markets are likely to break down is that if all the companies providing that interact with each other, swap information, and follow common protocols, then kidnap insurance can function. For kidnap insurance, Lloyd's serves as a place where that interaction happens. Shortland writes (citations omitted):

Kidnapping is a major (if largely hidden) criminal market, with an estimated total turnover of up to US$1.5 billion a year. Transnational kidnaps, where the victims are foreign tourists, high-net-worth local residents insured by multinational insurers, and the employees of foreign enterprises, are scary one-off events for almost all families and most firms. Ransoming hostages is beset with trust and enforcement problems. Kidnappers seek to maximize ransoms and can employ extreme violence to pressurize stakeholders to reveal their assets. Law enforcement may prepare rescue operations while families (pretend to) negotiate a ransom. Any sequential payment process is potentially problematic, but ransom drops can fail even if both parties act in good faith. Kidnappers need not release (live) hostages after payment and may demand multiple ransoms. Yet, despite these considerable difficulties—and contrary to general perceptions based on newspaper headlines—the vast majority of transnational kidnap victims survive and most cases conclude relatively quickly.  ...
Commercially, kidnap insurance is only viable under three (related) conditions. First, kidnaps should be nonviolent and detentions short—otherwise, individuals and firms withdraw from high-risk areas. Second, insurance premia must be affordable. Although insurance is only demanded if people are concerned about kidnapping, actual kidnaps must be rare, and ransoms affordable. Insurers struggle in kidnapping hotspots: High premia deter potential customers. ... Third, ransoms and kidnap volumes must be predictable and premium income must cover (expected) losses. If kidnapping generates supernormal profits, more criminals enter the kidnap business. Premium ransoms quickly generate kidnapping booms. Insurers, therefore, have a common interest in ordering transactions and preventing ransom inflation. ...
[K]idnap insurance is indeed controlled by a single enterprise: Lloyd's of London. Yet within Lloyd's there are around 20 international syndicates underwriting kidnap for ransom insurance. The syndicates compete for business according to clear protocols regarding how insurance contracts are structured, how information is (discreetly) exchanged, and how ransom negotiations are conducted. ...
All kidnap insurance is underwritten or reinsured at Lloyd's. By setting clear parameters for commercial resolution, Lloyd's enables “fair” competition between different providers and avoids kidnap insurance being sold monopolistically. There is a protocol for insuring and resolving kidnaps, which emerged from the members themselves. Its use is mandatory and it (largely) prevents individual insurers from conferring externalities to the rest of the sector. The insurance market works smoothly because Lloyd's enables relevant case information to flow easily between insurers without compromising client confidentiality. Underwriters constantly interact with each other and individuals who do not pass (truthful) information to the Lloyd's insurance community or spread it beyond its confines can be ostracized.
 Shortland has compiled an array of evidence on kidnaps and ransoms from nations in Africa, Latin America, the Middle East, and elsewhere. But she also includes some specific anecdotes that tell the story of how these dynamics often work out:
The owner-manager of a Mexican company is abducted at gunpoint. A ransom of US$1 million is demanded with a threat of mutilating the hostage. His kidnap for ransom insurance is activated. A crisis response consultant coordinates a crisis management team with the hostage's brother as the only point of contact with the kidnappers. The consultant advises that previous cases in this area have settled for around US$100,000 and that “we have yet to actually receive an ear….” The brother makes an initial cash offer of US$40,000 citing liquidity problems at the firm. This is progressively raised, but in decreasing increments. After 16 days the wife tearfully pawns her engagement and wedding rings to bring the total offer to US$99,814. The kidnappers accept, the crisis responder manages the ransom drop, and the hostage is safely released.
An aid worker is kidnapped in Yemen. Unbeknownst to the family, the NGO's strategic risk management plan includes kidnap for ransom insurance. Within 24 hr, a crisis response specialist convenes a crisis management team of senior staff to conduct the negotiation with the kidnappers. He personally assures the family that “… everything will be done to ensure the timely and safe return of the hostage.” The NGO is advised to negotiate, but to stall and reject the ransom demand of US$500,000. A former SAS officer bases himself in war-torn Aden to open indirect negotiations with tribal elders. After 36 days, the local sheik indicates that the hostage could be released in exchange for a new generator for his village. The NGO agrees, the unharmed hostage is released, and the NGO operates undisturbed afterward.
If you  are teaching about insurance markets and need to spruce up your classroom with a fresh and vivid example of adverse selection, moral hazard, and potential spillovers, this topic and very readable article could be a useful resource.


Thursday, February 23, 2017

Wasteful Health Care Spending

The high costs of health care are not just an issue for the United States, but for countries all over the world. The OECD addresses the issue of How to Tackle Wasteful Health Care Spending in a January 2017 (which can be ordered or read online for free here). Here's a taste of the findings from the "Foreword":
Across OECD countries, a significant share of health care system spending and activities are wasteful at best, and harm our health at worst. One in ten patients in OECD countries is unnecessarily harmed at the point of care. More than 10% of hospital expenditure is spent on correcting preventable medical mistakes or infections that people catch in hospitals. One in three babies is delivered by caesarean section, whereas medical indications suggest that C-section rates should be 15% at most. Meanwhile, the market penetration of generic pharmaceuticals – drugs with effects equivalent to those of branded products but typically sold at lower prices – ranges between 10-80% across OECD countries. And a third of OECD citizens consider the health sector to be corrupt or even extremely corrupt. At a time when public budgets are under pressure worldwide, it is alarming that around one-fifth of health expenditure makes no or minimal contribution to good health outcomes. ... Actions to tackle waste are needed in the delivery of care, in the management of health services, and in the governance of health care systems. 
There's no magic bullet for reducing wasteful spending: instead, the strategy of the report is to pile up studies and examples until the sheer weight and number of opportunities to reduce health care spending is overwhelming. The report divides the evidence into three main categories: wasteful clinical care (care that either provides very low value or can even be counterproductive to health); operational waste (like paying excessively high prices or overusing expensive inputs like brand-name drugs); and governance-related waste (like ineffective or unnecessary administrative expenses). Here are a few words on each.

For example, Ian Forde and Carol Nader contribute a chapter on "Producing the right health care:
Reducing low-value care and adverse events." They write (citations omitted):
Health care systems still struggle to quantify the true extent of low-value care, partly because of the lack of consensus on how to define it. ...  A rare exception to the lack of consensus on defining low value concerns births by caesarean section. The internationally accepted consensus is that the ideal rate for caesarean sections is between 10% and 15% of all births. No OECD countries fall within this band ... 
Looking at a range of studies and evidence, they offer this list of "common areas of overdiagnosis or overtreatment": 
  • Imaging for low back pain.
  • Imaging for headaches.
  • Antibiotics for upper respiratory tract infection.
  • Dual energy X-ray absorptiometry (used to measure bone mineral density).
  • Preoperative testing in low-risk patients (electrocardiography, stress electrocardiography, chest radiography).
  • Antipsychotics in older patients.
  • Artificial nutrition in patients with advanced dementia or advanced cancer.
  • Proton pump inhibitors in gastro-oesophageal reflux disease.
  • Urinary catheter placement.
  • Cardiac imaging in low-risk patients.
  • Induction of labour.
  • Cancer screening (cervical smear test, CA-125 antigen for ovarian cancer, prostate-specific antigen screening, mammography).
  • Caesarean section.
The overview chapter of the volume, by Agnès Couffinhal and Karolina Socha-Dietrich, offers a short list of some overall evidence on wasteful clinical care:
  • A recent report suggesting that medical errors might be the third cause of death in the United States starkly calls attention to the problem (Makary and Daniel, 2016).
  • International studies indicate that adverse events in hospitals add between 13% an 16% to hospital costs (Jackson, 2009) and that between 28% and 72% of them are considered avoidable upon expert examination (Brennan et al., 1991; Rafter et al., 2016, among others).
  • Data on primary care are scarce, but the Primary Care International Study of Medical Errors showed that approximately 80% of errors could be classified as “process errors”, the vast majority of which are potentially remediable (Makeham et al., 2002). 
The idea that errors committed by US health care providers might be the proximate cause of death for tens of thousands or even several hundred thousand people each year may seem extreme, and it is often fiercely contested by health care providers, but it is a common finding in this literature. The study they cite is from Martin A. Makary and Michael Daniel, "Medical error—the third leading cause of death in the US," BMJ 2016, 353, i2139.  For a review of some earlier evidence, see my post on "How Many Deaths from Mistakes in US Health Care?" (November 12, 2015)

In the general area of operational waste, Karolina Socha-Dietrich, Chris James and Agnès Couffinha contribute a chapter on "Reducing ineffective health care spending on pharmaceuticals." They summarize their article this way: 
It starts with a discussion of perhaps the most intuitive case of waste, which occurs when prescribed pharmaceuticals (and other medical goods) are discarded unused. Next, the chapter proceeds to the foregone opportunities associated with not substituting originator drugs with cheaper therapeutic alternatives, such as generics or biosimilars. The final issue explored is whether lower prices for pharmaceuticals and other medical supplies could be obtained with more efficient procurement processes.
Chris James, Caroline Berchet and Tim Muir take up this theme in the context of hospital care, in their chapter on "Addressing operational waste by better targeting the use of hospital care." They write: 
Hospitals are a crucial component of every country’s health care system, providing specialised and technical care that cannot be delivered in primary care settings. But this specialised nature means hospitals are also expensive to operate, with high personnel, equipment and other running costs. Indeed, spending on hospital inpatient care comprises an average 28% of total health spending in OECD countries.  ... A well-established evidence base shows that hospitals are used more than is necessary to provide services needed by the population. That is, the treatment of patients with a number of prevalent diseases can be delivered safely and effectively at the primary care level.  ...
Having timely access to care means that primary care services can respond to patient needs 24 hours a day, 7 days a week. However, this is rarely the case. Recent OECD analysis shows that a significant proportion of patients in OECD countries face barriers to accessing their PCP either because of a lack of out-of-hours (OOH) services or because of long waiting times during normal office hours. Such barriers not only lead to delays in care (and a consequent greater risk of health complications), but also higher ED [emergency department] visits and avoidable hospital admissions. Evidence suggests an inverse relationship between the ability of patients to access their PCP quickly and the likelihood of reporting an avoidable hospital admission. Indeed, access to primary care can reduce avoidable hospitalisation for chronic conditions. Conversely, poor availability to PCPs outside normal hours is the main cause of hospitalisation for ACSCs [ambulatory care sensitive conditions] ... 
In the general area of governance-related waste, the essay on "Administrative spending in OECD health care systems: Where is the fat and can it be trimmed?" by Michael Mueller, Luc Hagenaars and David Morgan, includes this interesting figure comparing administrative costs across countries. The right-hand figure is a comparison of administrative costs in government health insurance programs, while the left-hand side is voluntary private health insurance programs.

The tricky part of interpreting this figure is that administrative costs play a bigger role in private sector health insurance, and the the US has much more of its health insurance in the private sector than other countries. So if you put these together, it turns out that the US administrative expenses related to health insurance are substantially larger than in other countries.

It would of course be foolish to argue that all administrative costs are wasteful, and the report is far too sharp to make such a claim. But it is fair to say that one of the costs in the way that the US has chosen to organize its health care sector is higher administrative costs. And of course, the answer to high administrative costs often seems to be hiring another set of administrators to oversee utilization, promulgate rules for provision of care, double-check payments, and so on.

In  many cases, decisions about what medical care to receive and how to deliver that care fall into a gray area. It's often not 100% clear whether a certain procedure was needed, or not needed; not 100% clear that an error was made, or whether a reasonable judgment call was made; or whether a certain administrative act is wasteful, or whether it is reasonable oversight that reduces the risk of poor care and holds down costs. But the report makes a persuasive case that a substantial share of health care spending, not just in the US but in all advanced economies, is not doing much to improve health.

Wednesday, February 22, 2017

Agriculture in Sub-Saharan Africa

Agriculture in countries across sub-Saharan Africa is a large share of GDP, but a much larger share of jobs for many of the poorest people, in an economic context of widespread malnutrition. The OECD‑FAO Agricultural Outlook 2016‑2025 devotes a chapter to "Agriculture in Sub-Saharan Africa: Prospects and challenges for the next decade." Here are some basic facts:
"The Sub-Saharan Africa (SSA) region accounts for more than 950 million people, approximately 13% of the global population. By 2050, this share is projected to increase to almost 22% or 2.1 billion. Undernourishment has been a long-standing challenge, with uneven progress across the region. Despite being reduced from 33% in 1990-92 to 23% in 2014-16, the percentage of undernourishment remains the highest among developing regions. Owing to rapid population growth of 2.7% p.a. over the same period, the absolute number of undernourished people has increased by 44 million to reach 218 million. ... 
"The high contribution of the agricultural sector to GDP also underlines the limited diversification of most African economies. On average, agriculture contributes 15% of total GDP, however it ranges from below 3% in Botswana and South Africa to more than 50% in Chad ... Agriculture employs more than half of the total labour force and within the rural population, provides a livelihood for multitudes of small-scale producers. Smallholder farms constitute approximately 80% of all farms in SSA and employ about 175 million people directly. ... [R]ecent surveys suggest that agriculture is also the primary source of livelihood for 10% to 25% of urban households."
Economic development typically involves a process of rising productivity in agriculture, along with a shift to producing not just commodity products, but products with higher value-added. How might that process be encouraged and facilitated across sub-Saharan Africa? The report has lots of detail on specifics of cereals, pulses, fruits, livestock, dairy, fish, and so on. Here are some of the broader insights:

Output of agriculture in sub-Saharan Africa has more than doubled in the last 25 years.

However, "[p]roduction growth in SSA has failed to keep pace with demand deriving from population and income growth, resulting in rising imports for food commodities such as wheat, rice and poultry. In many instances, import tariffs have been employed to support domestic producers, particularly relative to other producers outside the region."

In the past, output growth in African agriculture has tended to be driven by more land and more intense cropping, not by improvements in productivity or mechanisation.
"The African model of agricultural growth differed significantly from that of Asia or South America. In Asia, growth was driven largely by intensification, whereas in South America, it was the result of significant improvement in labour productivity arising from mechanisation. By contrast, strong growth in SSA agricultural output has accrued predominantly from area expansion and intensification of cropping systems, as opposed to large-scale improvement in productivity. ,,, [P]roductivity per agricultural worker has improved by a factor of only 1.6 in Africa over the past 30 years, compared to 2.5 in Asia."
However, future major expansions in agricultural land seem unlikely. "Much of the underutilised land is concentrated in relatively few countries and between one half and two thirds of surplus land is currently under forest cover. Conversion of such forest land to agriculture would come at considerable environmental cost." Thus, the projections for the next decade show only  modest rise in agricultural land. More intensive cropping on that land has natural limits, too.
What are some of the main priorities that could help African agriculture to evolve in the direction of higher productivity and higher value-added?
"[A]n important uncertainty that will have a far ranging impact on production practices and productivity growth is the extent of concentration of agricultural land, which in turn will also be influenced by land tenure policies. Increasing concentration and commercialisation of medium-scale farmers could accelerate the rate of technology adoption, which has been fairly slow to date. Efficiency gains by a growing number of small, medium and large-scale farms linked into vertically integrated value chain with greater opportunity for access to credit, technology, extension services and off-take agreements, could have a meaningful impact on output levels in the coming decade. Commensurate development of upstream and downstream food sectors could increase the opportunities for non-farm income, which may in turn provide relatively productive small-scale producers with the capital to break through the barriers of subsistence agriculture into more commercialised medium-scale stature. ... 
"Arguably the greatest challenge facing the agricultural sector in SSA is weak infrastructure including transportation networks, access to energy, irrigation systems and stockholding facilities. Poor transportation networks limit access to markets, often exacerbate high levels of post-harvest losses and also inhibit efficient distribution of inputs such as seed and fertiliser. At the same time, it is an underlying factor in high food prices, as it raises the cost of both inputs and imported food products. Substantial differences in price levels between surplus and deficit regions suggest that investments able to reduce the cost of transportation would hold significant benefits to producers and consumers alike."
This chapter mentions issues like investing in agricultural research and development as well, but the main priorities emphasized are these issues of infrastructure, property rights, and production chains.

The enormous population boom coming in sub-Saharan Africa in the next several decades is one of those unseen demographic earthquakes that is going to shake up the world economy in all kinds of ways. For example, there will be enormous economic pressures for migration to the relatively nearby countries of the European Union.  The evolution of Africa's agriculture sector will play a major role in shaping the characteristics and consequences of its population boom.

Tuesday, February 21, 2017

Why All Exchange Rates Are Bad

The economics of exchange rates can be tough sledding. Every now and then, I post on the bulletin board beside my office a quotation from Kenneth Kasa back in 1995: "If you asked a random sample of economists to name the three most difficult questions confronting mankind, the answers would probably be: (1) What is the meaning of life? (2) What is the relationship between quantum mechanics and general relativity? and (3) What's going on in the foreign exchange market. (Not necessarily in that order)."

But even after duly acknowledging that exchange rates can be a tough subject, the political discussion of how exchange rates are manipulated and unfair to the US economy is a dog's breakfast of confusions about facts, institutions, and economics. For one of many possible examples, see the op-ed published in the Wall Street Journal last week by Judy Shelton, an economist identified as an adviser to the Trump transition team, titled "Currency Manipulation is a Real Problem." The obvious conclusion to draw from that essay, and from a number of other writing on manipulated exchange rates, is that all exchange rates are bad.

Sometimes other countries have policies that the value of their currency is lower relative to that of the US dollar. This is bad, because it benefits exporters from those countries and helps them to sell against US companies in world markets.

But other times, countries are manipulating the value of the exchange rate so that the value of their currency is higher relative to the US dollar, like China. This is also bad, as Shelton write in the WSJ: "Whether China is propping up exchange rates or holding them down, manipulation is manipulation and should not be overlooked. ... A country that props up the value of its currency against the dollar may have strategic goals for investing in U.S. assets."

Exchanges rates that move are bad, too. Shelton writes that "free trade should be based on stable exchange rates so that goods and capital flow in accordance with free-market principles."
But stable exchange rates are also bad.  After all, China is apparently stabilizing its exchange rate at the "wrong" level, and the argument that exchange rate manipulation is a problem clearly implies that many major exchange rates around the world should be reshuffled to different levels.

The bottom line is clear as mud. Exchange rates are bad if they are higher, or lower, or moving, or stable. The goal is that exchange rates should be manipulated to arrive at some perfect level, and then should just stick at that level without any further manipulation, which would be forbidden. This perspective on exchange rates is so confused as to be incoherent. With the perils of explaining exchange rates in mind, let me lay out some alternative facts and perspectives.

Currencies are traded in international markets; indeed, about $5 trillion per day is traded on foreign exchange markets. This amount is vastly more than what is needed for international trade of goods and services (about $24 trillion per year) or for foreign direct investment (which is about $1.0-1.5 trillion per year). Thus, exchange rate markets are driven by investors trying to figure out where higher rates of return will be available in the future, while simultanously trying to reduce and diversify the risks they face if exchange rates shift in a way they didn't expect. Because of these dynamics, exchange rate markets are notoriously volatile. For example, they often react quickly and sharply when new information arises about the possibilities of changes in national-level interest rates, inflation rates, and growth rates.

In this context, deciding whether exchange rates have bubbled too high or too low is a tricky business. But William R. Cline regularly puts out a set of estimates. For example, he writes in "Estimates of Fundamental Equilibrium Exchange Rates, November 2016" (Peterson Institute for International Economics, Policy Brief 16-22):
"As of mid-November, the US dollar has become overvalued by about 11 percent. The prospect of fiscal stimulus and associated interest rate increases under the new US administration risks still further increases in the dollar.  The new estimates, all based on October exchange rates, again find a modest undervaluation of the yen (by 3 percent) but no misalignment of the euro and Chinese renminbi. The Korean won is undervalued by 6 percent. Cases of significant overvaluation besides that of the United States include Argentina (by about 7 percent), Turkey (by about 9 percent), Australia (by about 6 percent), and New Zealand (by about 4 percent). A familiar list of smaller economies with significantly undervalued currencies once again shows undervaluation in Singapore and Taiwan (by 26 to 27 percent), and Sweden and Switzerland (by 5 to 7 percent)."
Several points are worth emphasizing here. The exchange rates of the euro, China's renminbi, and Japan's yen don't appear much overvalued. The US dollar does seem overvalued, but the underlying economic reasons aren't mainly about manipulation by other countries. Instead, it's because investor in the turbulent foreign exchange markets are looking ahead at promises from the Trump administration that would lead to large fiscal stimulus and predictions from the Federal Reserve of higher exchange rates, and demanding more US dollars as a result.

Countries around the world have sought different ways to grapple with risks of exchange rate fluctuations. Small- and medium-sized economies around the world are vulnerable to a nasty cycle in which they first become a popular destination for investors around the world, who hasten to buy their currency (thus driving up its value), as well as investing in their national stock and real estate markets (driving up their prices), and also lending money. But when the news shifts and some other destination becomes the flavor-of-the-month as an investment destination, then as investors sell off the currency and their investments in the country, the exchange rate, stock market, and real estate can all crash. This situation can become even worse if the country has done a lot of borrowing in US dollars, because when the exchange rate falls, it becomes impossible to repay those US-dollar loans. The combination of falling stock market and real estate prices, together with a wave of bad loans, can lead to severe distress in the country's financial sector and steep recession. For details, check with Argentina, Mexico, Thailand, Indonesia, Russia, and a number of others.

The International Monetary Fund puts out regular reports describing exchange rate arrangements, like the Annual Report on Exchange Arrangements and Exchange Restrictions 2014. That report points out that about one-third of the countries in the world have floating exchange rates--that is, rates that are mostly or entirely determined by those $5 trillion per day exchange rate markets. About one-eighth of the countries in the world have "hard peg" exchange rate, in which the country either doesn't have its own separate currency (like the countries sharing the euro) or else the countries technically have a separate currency but manage it so that the exchange rate is always identical (a "currency board" arrangement).

The rest of the economies in the world have some form of "soft peg" or "managed" exchange rate policy. These countries don't dare to leave themselves open to the full force and fluctuations of the international exchange rate markets. But on the other hand, they also don't dare lock in a stable exchange rate in a way that can't change, no matter the cross-national patterns of interest rates, inflation rates, and growth rates. Many of these countries are quite aware that the ultra-stable exchange rate known as the euro has not, to put it mildly, been an unmixed blessing for the countries of Europe.

The fundamental issue is that an exchange rate is a price, the price of one currency in terms of another currency. A weaker currency tends to favor exporters, because their production costs in the domestic currency are lower compared to the revenue they gain when selling in a foreign currency.
A stronger currency tends to favor importers, because they can afford to buy more goods in the supermarket that is the world economy.

Of course, the reality is that the US economy has all kinds of different players, some of whom would benefit from a stronger exchange rate and some of whom would benefit from a weaker exchange rate. Think about the difference between a firm that imports inputs, uses them in production, and re-exports much of the output, as opposed to a form that imports goods that are sold directly to US consumers. Think about the difference between a worker in a firm that does almost no exporting, but benefits as a consumer from stronger exchange rates, and a worker in a firm that does most of its production in the US and then exports heavily, where the employer would benefit from a weaker exchange rate. Think about a firm which has invested heavily in foreign assets: a weaker US dollar makes those foreign assets worth relatively more in US dollar terms, thus rewarding the firm for its foresight in investing abroad.

Here's one useful way to cut through the confusions about what a higher or lower exchange rate means, which is from work done by economists Gita Gopinath,  Emmanuel Farhi, Oleg Itskhoki, who point out that the economic effects of changes in exchange rates are fundamentally the same as a  policy that combines changes in value-added and payroll taxes. Specifically, a weaker currency has the same effect as a policy of a policy of raising value-added taxes and cutting payroll taxes by an equivalent amount. This should make some intuitive sense, because a weaker currency makes it harder for buyers (like a higher value-added tax) but reduces the relative costs of domestic production (like a lower payroll tax).

In short, every time the US exchange rate moves, for whatever reason, there will be a mixed bag of those who benefit and those who are harmed. A weaker currency is the economic equivalent of combining a higher tax that hinders consumption, like the higher value-added (or sales) tax, with an offsetting cut in a tax that lowers costs of domestic production, like the lower payroll tax. If the policy goal is to help US exporters, but not to impose costs on US importers and consumers, then seeking a lower US dollar exchange rate is the wrong policy tool. It is a mirage (and a fundamental confusion) to argue that some change in the dollar exchange rate will be all benefits and no costs for the US economy.

Just to be clear, I'm certainly not arguing that exchange rates are never "too high" or "too low"; it's clear that exchange rates are volatile and can have bubbles and valleys.

Nor am I arguing that countries never try to manipulate their exchange rates; indeed, I would argue that every country manipulates its exchange rates in one way or another.   If countries allow their exchange rates to float, then when the central bank adjusts interest rates or allows a chance in inflation or stimulates an economy, the exchange rate is going to shift, which is clearly a way in which exchange rates are manipulated by policy.  If countries don't let their exchange rates move, that's clearly a form of manipulation. And if countries allow their exchange rates to move, but act to limit big swings in those movements, that is also manipulation.

What I am arguing is that given even a basic notion how exchange rate markets work and the economic forces that affect exchange rates, it is opaque how "non-manipulation" would work. Are exchange rates going to be held stable across countries, even in the face of cross-national economic changes in interest rates, inflation, and  growth? A wide variety of experience, including the breakdown of the Bretton Woods agreement in the early 1970s and the current problems with euro, suggest that holding exchange rates stable is impractical over time and can have some very bad consequences. But if exchange rates are going to be allowed to move, then the question arises of who decides when and how much. Most national governments, especially after having watched the euro in action, will want to keep some power over exchange rates. There are serious people who discuss what kind of international agreements and cooperation it would take to have greater exchange rate stability, but it's a hard task, and squawking about how all exchange rates are bad--stronger, weaker, moving, stable--is not a serious answer.

Friday, February 17, 2017

Declining US Investment, Gross and Net

In any given year, a sizable chunk of investment goes to replacing what wore out or became obsolete in the previous year. Thus, the Bureau of Economic Analysis calculates both gross investment, which is the total invested, and net investment, which is what is actually added to the capital stock after accounting for investment that only offset the depreciation of the older capital. Both gross and net investment by private business have been declining in the US economy--but net investment is declining faster. Consider some a couple of figures.

This blue line on the graph shows gross investment by private domestic firms, while the red line shows net investment by private firms, both divided by GDP. You can see that from the 1970s and up into the 1990s, high levels of gross investment exceeded 14% of GDP. But since 2000, high levels of gross investment don't reach 14% of GDP. Interestingly, the drop-off in investment seems more visible in the red line showing net investment.



In the next figure, net domestic investment by private domestic firms is divided by gross investment: in effect, this calculation shows what percentage of total investment is actually adding to the capital stock, rather than just replacing earlier investments that have depreciated. The striking pattern is that from the 1960s up to the early 1980s, it was common for about 40% or more of total investment to be "net" or  new investment. But since about 2000, it's been common for about 20% of total investment to be "net" or new investment, while the other 80% is replacing older capital stock.


The decline in net investment also shows up in government infrastructure investment, especially in the years since the Great Recession. Here's a figure from "If You Build It: A Guide to the Economicsof Infrastructure Investment," a useful overview of issues related to infrastructure spending by Diane Whitmore Schanzenbach, Ryan Nunn, and Greg Nantz (Hamilton Project, February 2017).



I haven't done a deep enough dive into the underlying methodologies here to see why the net/gross ratio for private investment is falling so sharply, or if some of these reasons may help to to explain the fall in net infrastructure investment. I have seen some discussion that part of the reason is that capital investment is more likely to be in the form of computers and software, which become outdated more quickly (given technological progress in this area) than, say, large machine purchased for industrial production in old-style plants. But there are other possible explanations. (If someone out there has dug down into the growing gap between gross and net investment and how it manifests itself in the Bureau of Economic Analysis statistics, please send me the paper or a link. I'd be happy to learn more.)

The decline in investment is bothersome in a number of ways. Investment in physical capital is one of the factors that over time raises productivity and wages. It's a little troublesome that 80% of gross investment is going to replace old capital, rather than add to the capital stock. And low investment is at the root of concerns about the possibility of "secular stagnation," which is a worry that the economy is headed for a slow-growth future because investment spending is likely to remain low.

Thursday, February 16, 2017

The Economic Vision for Precocious, Cleavaged India

India has more than 1.2 billion people, and it is has been growing rapidly and carrying out substantial policy changes, but it seems to get only a small fraction of the attention paid to China. For those looking to get up to speed on India's economy, a useful starting point is the Economic Survey 2016-2017, published in January 2017 by India's Ministry of Finance (where Arvind Subramanian is the Chief Economic Adviser). The page also has a drop-down menu with links to previous annual surveys.

The title of this post is taken from the title of Chapter 2 of the report. "Precocious" refers to the facgt that India has been a democracy for so long, and that it turned to democracy started when the country was at such low level of per capita GDP. The term "cleavaged" refers to separations in India. As the report notes: At the same time, India was also a highly cleavaged society. Historians have
remarked how it has many more axes of cleavage than other countries: language and scripts, religion, region, caste, gender, and class ..." Here are seven points from the report that stuck with me.

1) In recent years, India's rate of economic growth is faster than China, and India has not been taking on the extraordinary debt load of China. 

The left-hand panel shows GDP growth (blue line) and debt/GDP level (red line) for China. The right-hand panel shows the same patterns for India.
2) India has become quite open to foreign trade,but also to internal trade across regions of India. 

For example, here's a figure comparing China and India on trade as a share of GDP.
And here's a figure showing where the horizontal axis shows the size of a country's population (measured in logs) and the vertical axis shows trade/GDP. Countries with more people tend to have  relatively more internal trade, and thus their ratio of external trade/GDP is lower. China and India are both out at the far right as large-population countries. Both are above the best-fit line, which means that their level of external trade is higher than the usual pattern, given their population levels.

When it comes to India's internal market, and flows across state borders, the report notes:
India’s aggregate interstate trade (54 per cent of GDP) is not as high as that of the United States (78 per cent of GDP) or China (74 per cent of GDP) but substantially greater than provincial trade within Canada and greater than trade between Europe Union (EU) countries (which is governed by the “four freedoms”: allowing unfettered movement of goods, services, capital, and people). This is all the more striking given that the data here covers mainly manufactured goods, excludes agricultural products, and is therefore an underestimate of total internal trade in goods. A substantial portion (almost half) of trade across states in India occurs as stock transfers within firms. That is, intrafirm trade is high relative to arms-length trade ... 
3) India has become fairly open to inflows of foreign capital. 

The left-hand panel shows capital flows as a share of GDP over five years, in which India is pretty similar to Indonesia, Mexico, and China. The right-hand panel shows patterns just for India of inflow of foreign direct investment, which have been rising as a share of GDP.



4) In many Indians states, wages for semi-skilled workers are low by world standards. 

The report discusses the possibility that India could latch on to a substantial share of low-wage manufacturing in areas like apparel and shoes.


5) India has has more success than many low-income countries in participating in international trade in services, but with the tides seemingly running against globalization, there is some question about whether this will continue.
"If India grows rapidly on the back of dynamic services exports, the world’s service exports-GDP ratio will increase by 0.5 percentage points—which would be a considerable proportion of global exports. Put differently, India’s services exports growth will test the world’s globalisation carrying capacity in services. Responses could take not just the form of restrictions on labor mobility but also restrictions in advanced countries on outsourcing. 
"It is possible that the world’s carrying capacity will actually be much greater for India’s services than it was for China’s goods. After all, China’s export expansion over the past two decades was imbalanced in several ways: the country exported far more than it imported; it exported manufactured goods to advanced countries, displacing production there, but imported goods (raw materials) from developing countries; and when it did import from advanced economies, it often imported services rather than goods. As a result, China’s development created relatively few export-oriented jobs in advanced countries, insufficient to compensate for the jobs lost in manufacturing – and where it did create jobs, these were in advanced services (such as finance), which were not possible for displaced manufacturing workers to obtain.
"In contrast, India’s expansion may well prove much more balanced. India has tended to run a current account deficit, rather than a surplus; and while its service exports might also displace workers in advanced countries, their skill set will make relocation to other service activities easier; indeed, they may well simply move on to complementary tasks, such as more advanced computer programming in the IT sector itself. On the other hand, since skilled labour in advanced economies will be exposed to Indian competition, their ability to mobilize political opinion might also be greater."
6) India is experiencing a sharp divergence and widening gaps in income and consumption across the states of India. 

Here's a figure showing per capita GDP, with each row showing a state of India. The red squares show the levels in 1984; the blue circles, in 1994; the green triangles, 2004; the yellow diamonds, 2014. The spread across regions is clearly widening. The figure reminds me of an old line about the economy of India, describing it as "part southern California, part sub-Saharan Africa."



There are several layers of puzzle here, as the report notes:
"Poorer countries are catching up with richer countries, the poorer Chinese provinces are catching up with the richer ones, but in India, the less developed states are not catching up; instead they are, on average, falling behind the richer states. ... This trend is particularly puzzling since that the forces of equalization—trade in goods and movement of people—are stronger within India than they are across countries, and they are getting stronger over time. This raises the possibility that governance traps are impeding equalization within India. ...
[O]ne possible hypothesis is that convergence fails to occur due to governance or institutional traps. If that is the case, capital will not flow to regions of high productivity because this high productivity may be more notional than real. Poor governance could make the risk-adjusted returns on capital low even in capital scarce states. Moreover, greater labor mobility or exodus from these areas,  especially of the higher skilled, could worsen governance.  A second hypothesis relates to India’s pattern of development. India, unlike most growth successes in Asia, has relied on growth of skill-intensive sectors rather than low-skill ones (reflected not just in the dominance of services over manufacturing but also in the patterns of specialization within manufacturing). Thus, if the binding constraint on growth is the availability of skills, there is no reason why labor productivity would necessarily be high in capital scarce states. Unless the less developed regions are able to generate skills, (in addition to providing good governance)
convergence may not occur. ... 
Both these hypotheses are ultimately not satisfying because they only raise an even deeper political economy puzzle. Given the dynamic of competition between states where successful states serve both as models (examples that become evident widely) and magnets (attracting capital, talent, and people), why isn’t there pressure on the less developed states to reform their governance in ways that would be competitively attractive? In other words, persistent divergence amongst the states runs up against the dynamic of competitive federalism ...
7) India's economy is mostly driven by the private sector, but surveys in India reveal a high level of ambivalence about the public sector.  

The green bars show production from state-owned enterprises in India--known there as "public sector undertakings" or PSUs--as measured by share of sales, profits, assets, and market value. The red bars show the same measures for China; yellow bars, Russia; dark blue bars, Brazil; gray bars, Indonesia; light blue bars, South Africa; purple bars, Malaysia. All of these countries show what would be a large level of state-owned enterprises by the standards of high-income countries, but India does not especially stand out. .


However, India does stand out in how its citizens feel about the private sector. This graph shows the results from a group of questions about the private sector on the World Values Survey. The level of pro-market sentiment in India is comparable to Argentina and Russia.



There is much more in the report. For example, a number of chapters are focused on specific policy changes and proposals. One chapter discusses the "demonetisation," in which India recently took its two largest-denomination notes out of circulation, abruptly and without warning, as a way of fighting corruption, crime, and the underground economy.  Another chapter discusses the possibility of a large public agency to take on the legacy of bad debt, and clear the balance sheets for large companies and banks, so that they can focus on looking ahead rather than on cleaning up past problems. Yet another chapter discusses the idea of a universal basic income in India. "The central government alone runs about 950 central sector and centrally sponsored sub-schemes which cost about 5 percent of GDP." But these programs impose considerable bureaucratic cost and fail to assist many of the actually poor.

Homage: I ran across a mention of this report in a post by Alex Tabarrok at the always-interesting Marginal Revolution website, which focuses on a chapter of the report discussing how a number of India's governmental redistribution programs are ineffective and even counterproductive.

Wednesday, February 15, 2017

Update on the Social Cost of Carbon

That task of estimating the social cost of carbon emissions is fraught with uncertainty. Still, it's a question where some answers are going to be more plausible than others--and assuming that the correct answer is "zero" runs a risk of incurring substantial costs in the future. Those who would like to dig down into how these estimates are done might be interested in "Valuing Climate Damages: Updating Estimation of the Social Cost of Carbon Dioxide," published in January 2017 by a National Academy of Sciences Committee on Assessing Approaches to Updating the Social Cost of Carbon, co-chaired by Maureen Cropper and Richard Newell. (The report is available here, and uncorrected galley proofs of the report can be downloaded free.)

The NAS report is mainly about how these estimates are done and how they might be improved, but it also provides some background on the existing estimates. As the report explains:
The social cost of carbon (SC-CO2) for a given year is an estimate, in dollars, of the present discounted value of the future damage caused by a 1-metric ton increase in carbon dioxide (CO2) emissions into the atmosphere in that year or, equivalently, the benefits of reducing CO2 emissions by the same amount in that year. The SC-CO2 is intended to provide a comprehensive measure of the net damages—that is, the monetized value of the net impacts—from global climate change that result from an additional ton of CO2. Those damages include, but are not limited to, changes in net agricultural productivity, energy use, human health, property damage from increased flood risk, as well as nonmarket damages, such as the services that natural ecosystems provide to society. Many of these damages from CO2 emissions today will affect economic outcomes throughout the next several centuries.
The US government has for some year had an Interagency Working Group that produces estimates of the social cost of carbon. As the report notes:
The IWG’s current estimate of the SC-CO2 in the year 2020 for a 3.0 percent discount rate is $42 per metric ton of CO2 emissions in 2007 U.S. dollars. If, for example, a particular regulation was projected to reduce CO2 emissions by 1 million metric tons in 2020, the estimate of the value of its CO2 emissions benefits in 2020 for this SC-CO2 would be $42 million dollars.
It's worth unpacking that number just a bit. Here's an illustrative table giving a sense of the range of estimates under various conditions.

The social cost of carbon is based on a range of computer simulations. There are several different "integrated assessment models," in which which a "CO2 emissions pulse is introduced in a particular year, creating a trajectory of CO2 concentrations, temperature change, sea level rise, and climate damages." Another key parameter the "equilibrium climate sensitivity," which represents a distribution of the effect that carbon emissions could have on climate in the future. There are also various scenarios for how emissions and various socioeconomic variables will evolve. The approach of the Interagency Working Group is to run a bunch of computer simulations with different combinations of these variables and different random draws of the "equilibrium climate sensitivity" parameter from its overall distribution, thus giving them a sense of how these different underlying assumptions can interact with each other.

The rows of the table show different years. The social cost of carbon rises over time, as the levels in the atmosphere rise and the costs become greater.

The columns show different assumptions about what economists call the "discount rate." Most analysts accept the idea that if we are thinking about spending a fixed amount of current resources, it makes more sense to spend the money reducing a current harm than a future harm. To put the point more bluntly, taking an action to save 500 lives right now is more valuable in the present than taking an action to save 500 lives a century from now.  Exactly how much more valuable are current benefits than future benefits? As you  might imagine, the answer to that question is controversial, and so standard practice is to offer a range of estimates. A commonly used discount rate is 3%, which implies that each year a benefit is further off in the future, it's worth 3% less. A higher discount rate thus puts a lower weight on future benefits; a zero discount rate would mean that a benefit receives at any time in the future, no matter how far into the future, would be just as valuable as a benefit received right now.

The social cost of carbon calculation matters for public policy, because it's the value that is currently used by government rules and regulations when taking carbon costs into account. For perspective, the federal gasoline tax is currently 18.4 cents/gallon, and when state and local gas taxes (which vary across jurisdictions) are added to the mixture, total gasoline taxes are now about 49 cents/gallon. The usual rationale for such taxes is that they are a "user tax" so that those who drive also pay for updating and maintaining the roads. If the government set a carbon tax so that those who are emitting carbon through burning gasoline would would pay the cost of their emissions, a carbon tax of $42/ton of carbon emissions would work out to a gasoline tax of about 38 cents/gallon.

Tuesday, February 14, 2017

China: The Economic Story of Our Time

A few decades from now, when historians look back at the economic history of the late 20th and early 21st century, my expectation is that the most important storyline, by far, will be the rise of China's economy from poverty-stricken and unimportant in the 1970s to becoming the largest economy in the world less than four decades later. The Winter 2017 issue of the Journal of Economic Perspectives, where I labor in the vineyards as Managing Editor, devoted seven papers to China. Here are some of the main insights: by all means turn to the papers themselves for more. Courtesy of the publisher, the American Economic Association, all JEP papers from the most recent issue back to the first issue in Summer 1987 are freely available online.

What Defines the Chinese Model of Socialism? 

Defining the "Chinese model" of economic growth is quite difficult, because China's development process has gone through a number of stages since around 1980.  The swings and changes have been severe enough that Barry Naughton can reasonably ask: "Is China Socialist?" He writes:
"Forty years ago, in 1978, China was unquestionably a socialist economy of the familiar and well-studied “command economy” variant, even though it was more decentralized and more loosely planned than its Soviet progenitor. Twenty years ago—that is, by the late 1990s—China had completely discarded this type of socialism and was moving decisively to a market economy. At that time, the question “Is China Socialist?” seemed meaningless to most people. China had shrugged off its old model of socialism, and obviously was never going back. China had officially recognized that no economy that excluded the market could hope to deliver satisfactory outcomes. Moreover, powerful trends at this time were limiting the scope of what China’s government could achieve. Government tax revenues relative to GDP had declined dramatically, substantially limiting government capacity. Social service provision had collapsed in most rural areas; inequality soared and a new wealthy class emerged; and de facto privatization enriched a group of people. At the time, it appeared that China’s economic success had been achieved at the cost of discarding socialist values. In the mid-1990s, the important question seemed to be: Would China continue to be a kind of “Wild West Capitalism,” in which almost anything might be for sale, or would it converge with the developed market economies, with improved regulation and rule of law? 
"China today is quite different both from the command economy of 40 years ago, and from the “Wild West Capitalism” of 20 years ago. The government in China has much more influence over the economy than in virtually any other middle-income or developed economy. State firms and state banks remain prominent. Government five-year plans command attention, both domestically and internationally. The Communist Party remains in power. ... Today, the question `Is China Socialist?' can reasonably be asked and left open."
Naughton explores these changes over time. I found especially interesting his description of China as an "authoritarian growth machine," in which local government officials have strong incentives--if they wish rise in the government hierarchy" to promote economic growth in their local area. He writes:
"China’s system of incentivized hierarchy—the authoritarian growth machine—was effective in mobilizing resources and maximizing growth during a “miracle growth” phase, when demographic, structural, and international factors all came together to raise growth rates. It also gave the Chinese government unprecedented control of resources and incentives, which it used predominantly to drive an enormous physical investment effort. The positive achievements are remarkable: the world’s best record of growth, tremendous success in alleviating poverty, and a national physical infrastructure built at unprecedented speed that is quickly approaching developed country standards. However, this “growth miracle” phase is now ending. Fundamental demographic changes, completion of many infrastructure programs, and a much-reduced distance to the global technological frontier are combining to lower China’s potential growth rate in a dramatic manner. China has less need for growth-before-all-else, but this also means that the incentivization of the hierarchy, so fundamental to the past growth model, is no longer central to China’s most important goals. The Chinese government has only belatedly begun to introduce a new set of instruments to achieve other objectives, and so far there is little evidence that China has developed a new way to steer the economy in a “socialist” direction while retaining some of the benefits of the developmental state ..."

Can China's Educational System Keep Up? 

China has been expanding its education system dramatically. Consider how college admissions in China rose from 1 million in 1999 to over 7 million in 2014. But will there be enough skilled workers in China to keep economic growth humming at the pace of 6-7% per year that the government seems to view as its goal?

In "Human Capital and China's Future Growth," Hongbin Li, Prashant Loyalka, Scott Rozelle, and Binzhen Wu raise some hard questions. They point out that children from rural areas often suffer from malnutrition or other problems that hinder learning, that children of migrants within China suffer from unequal access to schools, and that some of the rise in college education involves a  dubious quality of education.

The authors also carry out an interesting prediction, taking fairly optimistic estimates about the improvement and expansion of China's educational system in the next couple of decades, and then looking at what the education level of China's population will be in about 20 years. Based on the skill level of China's labor force, they suggest: "In this best-case scenario, 26 percent of China’s adults will have a college degree and 42 percent will have at least a high school education by 2035." This would give China a level of human capital similar to the current level prevailing in Greece, and would involve an annual economic growth rate of about 3% per year. The authors write:
"For a different perspective on why China is unlikely to experience a 7 percent annual rate of growth moving forward, consider a comparison with the US economy. At 7 percent annual growth, China’s per capita income would reach the level of $54,682 (in purchasing power exchange rate terms) by 2035, which is almost exactly the per capita income level of the US economy in 2014 ($54,629). In 2014, about 44 percent of the US labor force had at least a college education (and many more have attended college, although not graduated) and 89 percent of the labor force had at least a high school diploma. Even given the optimistic predictions above, China’s education levels will be far below these US levels in 2035. Thus, the unlikely hope for 7 percent annual growth in China over the next 20 years would mean that China would need to have a relationship between human capital and per capita income that is considerably higher than the typical global experience would suggest is plausible."

Can China's Economy Make the Transition from Manufacturing to Innovation? 

A number of countries seem to experience a "middle income trap," in which economic growth takes them up to a certain plateau, but then stagnates. Shang-Jin Wei, Zhuan Xie, and Xiaobo Zhang look at the evidence on whether China can break out of this trap in "From `Made in China' to `Innovated in China': Necessity, Prospect, and Challenges." They write:
"China’s economic growth of the previous three and a half decades was based on several key factors: a sequence of market-oriented institutional reforms, including openness to international trade and direct investment, combined with low wages and a favorable demographic structure. Chinese wages are now higher than a majority of non-OECD economies. For example, China’s wages are almost three times as high as India, an economy with almost the same-sized labor force. The Chinese working-age cohort has been shrinking since 2012."
The authors note that in recent years, economic growth in China has been driven almost entirely by high levels of physical capital investment, not by productivity growth. To evaluate prospects for future growth, they focus on China's investment in R&D and on data involving patents granted to Chinese firms. When it comes to R&D, China is doing more than one would expect from a country with its level of per capita GDP.

When it comes to patents, the absolute numbers of patents going to Chinese firms have been rising substantially, and various measures of patent quality (like the extent to which US patents by Chinese firms are being cited by other patents) suggests that China's patents are of reasonably high quality. As they write (citations omitted):
"Since 2003, real wages in China have grown by more than 10 percent a year. Some reckon that China has passed the so-called “Lewis turning point,” which means that an era of ultra-low-wage production is over. While patents are rising for both capital- and labor-intensive firms, the fraction of patents granted to labor-intensive firms increased from 55 percent in 1998 to 66 percent in 2009. Rising labor costs may have induced labor-intensive sectors to come up with more innovations to substitute for labor ...
 For those interested in this subject, I also recommend the discussion of China in the "The Global Innovation Index 2016: Winning with Global Innovation," published in August 2016 by the World Intellectual Property Organization along with INSEAD and the Johnson Graduate School of Management at Cornell University.

Is China Turning a Corner on Pollution? 

Starting around 2000, in particular, China experienced explosive growth in heavy industry, largely powered by burning coal. Air and other pollution have been severe. But there is some reason to think that the situation is at least not getting worse, and may be getting better.  Siqi Zheng and Matthew E. Kahn make the case in "A New Era of Pollution Progress in Urban China?"

To set the stage, here is a striking figure showing China's consumption of coal, compared to the rest of the world.

And alongside, here is a measure of particulate air pollution across 85 cities in China, both for the population as a whole and for cities in the 75th and 25 percentiles of the distribution.

There doesn't seem to be any dispute that areas of China with high levels of pollution have paid the price in terms of lower life expectancy and diminished health. However, Zheng and Kahn make the case that China's government is taking pollution seriously with an array of regulatory and tax policies, as well as providing incentives for local officials to make it a priority. Oil prices in China are no longer subsidized, and instead are set by global markets. China's future economic growth is shifting to service industries, rather than heavy manufacturing. Many countries have found an "environmental Kuznets curve," that as per capita GDP increases the political imperatives for a greater degree of environmental protection increase, and Zheng and Kahn present evidence that China is following this pattern, too.


Will China's Real Estate Boom Melt Down? 

China has been experiencing a real estate boom that makes the US housing boom of about a decade ago look mild. In "A Real Estate Boom with Chinese Characteristics," Edward Glaeser, Wei Huang, Yueran Ma, and Andrei Shleifer tell the story. Here's an overview of China's real estate situation (citations omitted):
"Yet this US housing cycle looks stable and dull relative to the great Chinese real estate boom. In China’s top cities, real prices grew by 13.1 percent annually from 2003 to 2013. Real land prices in 35 large Chinese cities increased almost five-fold between 2004 and 2015. As prices rose, so did construction. Between 2003 and 2014, Chinese builders added 100 billion square feet of floor space, or 74 square feet for every person in China. During this time, China built an average of 5.5 million apartments per year. In 2014, 29 million people worked in China’s construction industry, or 16 percent of urban employment. By comparison, construction industry accounted for 8 percent of total employment in the United States and 13 percent of that in Spain at the peak of their most recent housing booms. ... Unlike in the United States, high vacancy rates are a distinct feature of Chinese housing markets. Vacancies include both completed units unsold by developers, and purchased units that remain unoccupied. We estimate that this stock of empty housing now adds up to at least 20 billion square feet."
Can China's housing prices possibly be sustainable? The answer is potentially "yes," but if China wants stable real estate prices, it probably needs to constrict the growth of supply--which poses tradeoffs if its own. The author summarize this way:

"It is tempting to view these events from afar and conclude that a price drop is imminent. As we have tried to demonstrate, this scenario is far from certain. Chinese home-buyers appear to be investing for the long run and are unlikely to sell voluntarily even if home prices decline. Nor are they heavily leveraged, so repossessions and liquidations of homes are unlikely. Chinese developers are more leveraged, but are cozy with state banks, so their loans are likely to be restructured if necessary. Even if banks repossess properties from developers, they are unlikely to dump them on the market. Compared to Chinese stocks, more inertia is built into China’s housing market. In addition, there is the critical role of the Chinese government in housing markets. The demand for urbanization in China is large, so if the government acts to sharply restrict new supply, it can probably maintain prices at close to current market levels. ...
"Yet that path may create significant social costs. Construction employment would plummet. Millions of Chinese may lose the apparent productivity advantages associated with living in Chinese cities. Local governments would lose the financial autonomy from land sales and taxes that has been their institutional basis. The alternative for the Chinese government is to accommodate high levels of construction and housing supply. As we have showed, this will lead to very low or negative expected returns to investment in housing. The welfare of potential new buyers will rise, but current owners will suffer losses. 
"Bursting real estate bubbles have traditionally done great harm when they are associated with financial crises. Bubbles that burst without banking meltdowns, as in 1980s Los Angeles, are temporary events that seem to cause little long-run damage. Going forward, an important step is to secure China’s financial system, rather than focus solely on maintaining high housing costs in Chinese cities." 



Why Does China's Government Allow Critical Social Media? 

China's government has the power to shut down social media accounts, and it doesn't seem to  have many scruples about doing so in certain cases. But China's government allows a fairly lwide array of online criticism and protest. In "Why Does China Allow Freer Social Media? Protests versus Surveillance and Propaganda," Bei Qin, David Strömberg, and Yanhui Wu offer some possible reasons why.

Our primary finding is that a shockingly large number of posts on highly sensitive topics were published and circulated on social media. For instance, we find millions of posts discussing protests such as the anti-PX [a chemical called P-Xylene] event in 2014, and these posts are informative in predicting the occurrence of specific events. We find an even larger number of posts with explicit corruption allegations, and that these posts predict future corruption charges of specific individuals. This type of social media content may increase the access of citizens to information and constrain the ability of authoritarian governments to act without oversight. ... 
However, social media also provide authoritarian governments with new opportunities for political control ...  Social media messages are transmitted in electronic form through an infrastructure that is typically controlled by the government. Recent advances in automated text analysis, machine learning techniques, and high-powered computing have substantially reduced the costs of identifying critical users and censoring messages . Governments can use these methods to track and analyze online activities, to gauge public opinion, and to contain threats before they spread. ...  Most of the real-world protests and strikes that we study can be predicted one day in advance based on social media content. ... Indeed, Chinese government agencies across the country have invested heavily in surveillance systems that exploit information on social media. ...
Another important surveillance function of social media is to monitor local governments and officials. In China, many political and economic decisions are delegated to local governments. These decisions need to be monitored, but local news and internal reports are likely to be distorted because local politicians control the local press and administration. In contrast, national politicians regulate social media. In social media, relentless complaints about local officials are abundant. Posts exposing officials who wore Rolex watches, lived in mansions, or had inappropriate girlfriends have resulted in investigations and dismissals. Not surprisingly, we observe millions of posts with explicit corruption allegations in our data. We find that social media posts related to corruption topics are effective for corruption surveillance. These posts help identify when and where corruption is more prevalent. Furthermore, we can predict which specific politicians will later be charged with corruption, up to one year before the first legal action.  ...
Our findings challenge a popular view that an authoritarian regime would relentlessly censor or even ban social media. Instead, the interaction of an authoritarian government with social media seems more complex. From the government point of view, social media is not only (1) unattractive as a potential outlet for organized social protest but is also (2) useful as a method of monitoring local 120 Journal of Economic Perspectives officials and (3) gauging public sentiments, as well as (4) a method for disseminating propaganda. 

How Much Did the One-Child Policy Reduce China's Birth Rate? 

Junsen Zhang discusses "The Evolution of China’s One-Child Policy and Its Effects on Family Outcomes."  For a feel of the argument, consider this figure comparing fertility rates in rural and urban China to some other countries. Two facts jump out. First, China's fertility rate starts dropping dramatically in the early 1970s, because of a quite stringent family planning policy adopted at that time, before the one-child policy is instituted in 1979. Second, China's fertility rate in recent years is quite similar to other countries in east Asia like Thailand and South Korea that did not institute a one-child policy.


Zhang cited estimates that China's working-age population peaked in 2015, and that China's overall population will peak around 2030. It appears likely that China will get old before it becomes rich. Comparing China's birth rates to those of other countries, and taking into account the strong connection between economic development and fewer children, Zhang writes:
"Although the enforcement of the one-child policy may have mildly accelerated the fertility transition in China, it also brought substantial costs, including political costs, human rights concerns, a more rapidly aging population, and an imbalanced sex ratio resulting from a preference for sons. In retrospect, one may question the need for introducing the one-child policy in China." 

Friday, February 10, 2017

The Middle Income Trap and Governance Issues

The "middle-income trap" is an argument that when countries have emerged from dire poverty to middle-income status, they can become stuck at that point, and stop making progress toward higher income levels. The World Development Report 2017  notes: "Contrary to what many growth theories predict, there is no tendency for low- and middle-income countries to converge toward high-income countries." The overall theme of this year's WDR is  "Governance and the Law," and as usual, the report offers a wealth of examples and insights. Here, I'll just focus on the arguments about the middle-income trap, where the report illustrates its underlying theme by arguing that "the difficulty many middle-income countries have in sustaining growth can be explained by power imbalances that prevent the institutional transitions necessary for growth in productivity."

This figure illustrates the patterns of transition for economies between low-income, middle-income, and high-income status. On the horizontal axis, countries are plotted by their per capita income level in 1970; on the vertical axis, by their per capita income level in 2010.

To get a sense of how the graph works, look at the category of "lower-middle income" countries on the horizontal axis, with per capita GDP between 5 and 15% of the world leaders. Now run your eye up, and see how those countries are faring by 2010. A substantial share of them have fallen into the "low-income" category, although most remain in the same "lower middle" category as before. Only one of thee lower-middle countries from 1970, Korea, had emerged into the high-income category after 40 years. Similarly, if you start by looking at low-income countries in 1970, only two of them had risen as high as "upper middle income" by 2010: Equatorial Guinea (GNQ) and Botswana (BWA), which is a prosperity largely founded on oil and diamonds, respectively.

The World Bank researchers writing the WDR argue that a core problem is that the institutions and strategies that raise a country up to middle-income status are often different from the strategies that would allow taking the next step to high-income status--and entrenched interest groups can make the transition a difficult one. Here's some commentary from the WDR (citations and references to figuress omitted):

"Middle-income countries may face particular challenges because growth strategies that were successful while they were poor no longer suit their circumstances. For example, the reallocation of labor from agriculture to industry is a key driver of growth in low-income economies. But as this process matures, the gains from reallocating surplus labor begin to evaporate, wages begin to rise, and decreasing marginal returns to investment set in, implying a need for a new source of growth. Middle-income countries that become “trapped” fail to sustain total factor productivity (TFP) growth. ... Efficient resource allocation and industrial upgrading require a set of institutions that differs from those that enable growth through resource accumulation. ... 
"The creation of these institutions may be stymied by vested interests. Creative destruction and competition create losers—and in particular may create losers of currently powerful business and political elites.This is a more politically challenging problem than spurring productivity growth through the adoption of foreign technologies, which tends to favor economic incumbents. These political challenges may be particularly great in middle-income countries because actors that gained during the transition from low to middle income may now be powerful enough to block changes that threaten their position. In this sense, the challenges that middle-income countries face go beyond policy choice to the challenge of power imbalances. ... Understanding the policy arena in which elites bargain is essential for explaining the political economy traps faced by middle-income countries.
"One such political economy trap is a persistent deals-based relationship between government and business. Deals-based, sometimes corrupt, interactions between firms and the state may not prevent growth at low income levels; indeed, such ties may actually be the “glue” necessary to ensure commitment and coordination among state and business actors. But they become more problematic for upper-middle-income countries. For example, theory suggests that as markets expand and supply networks become more complex, deals-based relationships can no longer act as a substitute for impersonal, rules-based contract enforcement. ... Combating entrenched corruption and creating a
level playing field for firms imply a need for accountable institutions. At upper-middle-income levels, legislative, judicial, media, and civil society checks become increasingly important." 
The difficulties in moving toward types of governance that can offer a foundation for both representation and growth is an ongoing theme throughout the report. As another example, here are some facts about elections worldwide that raised my eyebrows. The share of countries holding elections is steadily rising, but the the share of elections rates as "free and fair" is steadily falling.

The number of elections is steadily rising (as shown by the bars) but voter turnout worldwide in those elections has been steadily falling.
Governments have become much less likely to censor the media in a direct way in the age of the internet, but they have become more aggressive about regulations that limit the  ability of civil service organizations (CSOs) to organize themselves or to spread their messages.  The report notes:


As the report notes:
"Evidence from the last decade, however, suggests that the global trend may be a shrinking civic space (figure 8.10). Many governments are changing the institutional environment in which citizens engage, establishing legal barriers to restrict the functioning of media and civic society organizations, and reducing their autonomy from the state. For example, in the case of media, governments may award broadcast frequencies on the basis of political motivations, withdraw financial support of media organizations and activities, or enforce complex registration requirements that raise barriers to entry into a government-controlled media market. In the case of nongovernmental organizations (NGOs), governments might resort to legal measures to restrict public and private financing or pass stricter laws that restrain associational rights ..."
In short, economic growth and development isn't just about pulling the right economic policy levers--government budgets, monetary policy, investment in education, foreign aid, and the like. It's also about the extent to which economic forces have flexibility to function within the political and legal institutions of that society.

For some earlier posts on the hurdles in the way of economic convergence, see

"Will Convergence Occur?" (November 25, 2015)
"Dani Rodrik on Economic Convergence: Jackson Hole I" (September 14, 2011)