Milken Institute Review 2nd Quarter 2016 issue by Milken Institute Review

A Journal Of Economic Policy

taking measure of

The Gig Economy

The Milken Institute Review • Second Quarter 2016 volume 18, number 2 the milken institute Michael Milken, Chairman Michael L. Klowden, President and CEO

the milken institute review advisory board Robert J. Barro

Van Doorn Ooms

publisher Conrad Kiechel

Jagdish Bhagwati

Paul R. Portney

George J. Borjas

Stephen Ross

editor in chief Peter Passell

Daniel J. Dudek

Richard Sandor

Georges de Menil

Isabel Sawhill

art director Joannah Ralston, Insight Design www.insightdesignvt.com

Claudia D. Goldin

Morton O. Schapiro

Robert Hahn

John B. Shoven

Robert E. Litan

Robert Solow

managing editor Larry Yu

Burton G. Malkiel

The Milken Institute Review is published quarterly by the Milken Institute to encourage discussion of current issues of public policy relating to economic growth, job creation and capital formation. Topics and authors are selected to represent a diversity of views. The opinions expressed are solely those of the authors and do not necessarily represent the views of the Institute. The Milken Institute’s mission is to improve lives around the world by advancing innovative economic and policy solutions that create jobs, widen access to capital and enhance health. Requests for additional copies should be sent directly to: The Milken Institute The Milken Institute Review 1250 Fourth Street, Second Floor Santa Monica, CA 90401-1353 310-570-4600 telephone 310-570-4627 fax info@milkeninstitute.org www.milkeninstitute.org Cover: Michael Wertz

Asia Summit | September 15–16

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CONFERENCES Join us for these extraordinary events dedicated to turning ideas into action.

Joel Kurtzman 1947–2016 We mourn the loss of Joel Kurtzman, a managing senior fellow at the Milken Institute and the first publisher of the Review. Joel had a dazzling career as an economist, writer, editor and thought leader, working with organizations ranging from the United Nations to The New York Times to the Harvard Business Review to PricewaterhouseCoopers. We’ll remember him best, though, as an all-around good guy eager to help his friends and colleagues, and always willing to share the credit.

Partnering for Cures | November 13–15

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contents

2 from the ceo 3 editor’s note 5 trends

book excerpt

Refugee economics. by Paul Collier

Between Debt and the Devil Adair Turner explains how Milton Friedman could still save the global economy.

14 charticle

...The new 50? by William H. Frey

95 institute news

16 the gig economy

Paper trail.

Neither fish nor fowl. by Seth D. Harris and Alan B. Krueger

96 lists

26 the elusive promise of

We’re number 21?

structural reform

The trillion-euro misunderstanding. by Dani Rodrik

36 how to – and how not to – manage student debt Depends who’s borrowing. by Susan Dynarski

46 letter from caracas Venezuela hits bottom. by Charles Castaldi

56 p-values vs. patient values When nothing’s left to lose. by Andrew W. Lo

64 housing policy, the morning after 26

Untying the Gordian knot. by Lawrence J. White

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from the ceo

This year’s outbreak of the Zika virus has been a grim reminder of the continuing need for effective programs to protect public health around the world. Some observers have declared the heroic age of public health to be over, comparing today’s complex challenges to decisive breakthroughs such as the elimination of polio in a single generation. But while the battlegrounds have shifted, the fight continues on multiple fronts. Research and coordinated action serve not just to protect public health but also to promote what our founding fathers called “the general welfare” – only this time around, for the whole world. While the Milken Institute has been devoted to health issues since its inception, in recent years the Institute has broadened its attention through our Center for Public Health. In March, these efforts took a big step forward with our first-ever Public Health Summit, in Washington, DC. Held in conjunction with the Milken Institute School of Public Health at George Washington University, the Summit brought together some 450 leaders from industry, government, academia, philanthropy and other spheres. Panels were devoted to cutting-edge global issues, including the rising toll of obesity, the avoidable cost of hypertension (an estimated $4 trillion worldwide) and the challenge of mental illness prevention and treatment. We were honored that key leaders – among them, Tom Frieden (Director of the Centers for Disease Control and Prevention), Francis Collins (Director of the National Institutes of Health) and Robert Califf (the newly confirmed Commissioner of the Food and Drug Administration) – shared their insights. In addition to providing a timely update on the global fight against the Zika virus, Frieden offered a telling anecdote from the time he was first appointed CDC Director. Daniel Inouye, then the chairman of the Senate Appropriations Committee, counselled Frieden on how best to argue for funding from Congress: “Don’t tell us the good things that will happen if we give you the money. Tell us the bad things that will happen to us if we don’t. … I’ve never heard better advice.” The overarching goal of the Milken Institute in this arena is to do for public health what we’ve been doing in medical research through our FasterCures group. We want to bring together stakeholders, spark innovation and foster effective collaboration. We want to make prevention of disease just as important as its cure. I look forward to providing you updates on these ambitious goals.

Michael Klowden, CEO and President

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e d i t o r ’s n o t e

Energized by the film Suffragette, worthy correspondent JG of Passadumkeag, Maine, wonders what we’ve been doing to combat gender bias in the language of

focus features/the kobal collection/hill, steffan

the Review. Another penetrating question, JG. I’m going to leave the classic “Manhattan” versus “Personhattan” dispute to others. But I’ve been turning somersaults over the “his/her” problem – as in “Each student must finish his assignment.” “His” is plainly a no-no. “His or her” is terminally awkward, while randomly alternating “his” and “her” is downright confusing. When possible, I just convert pronouns to plural form so I can write “students must complete their assignments.” But now the Washington Post’s style czar has liberated us, officially blessing “their” as the all-purpose modifier – as in “each student must complete their assignment.” Not to be outdone, The New York Times is upping the ante, experimenting with the made-up “Mx.” as a genderneutral alternative to the titles Ms., Miss, Mrs. and Mr. Get used to it, pedants… Meanwhile, back to what we do best: check out these deep dives into economic policy. Paul Collier, an economist at Oxford and Institute senior fellow, weighs the response to the Syrian refugee problem. “Politicians have paraded their consciences along the spectrum from headless compassion to heartless cruelty,” he writes, while the private sector remains paralyzed. He argues “there is both a pressing need and an unprecedented opportunity for global business to demonstrate that it can deliver solutions. That missing role of

business is not charity; it is business – in a word, jobs. Jobs are central both to the immediate humanitarian duty of rescue, and to the long-term prospects for future stability.” Dani Rodrik, an economist at Harvard’s Kennedy School, examines the misunderstanding about what structural reform of ailing economies can accomplish. While reforms, such as those imposed on Greece by its creditors, are needed to sustain long-term growth, he explains, they’ll do nothing – and

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e d i to r ’s n ot e probably less than nothing – to trigger growth in the near term. Rodrik’s remedy: selective incentives to stimulate exports. Andrew Lo, director of MIT’s Laboratory for Financial Engineering and a senior fellow at the Milken Institute, offers a breakthrough statistical approach for balancing the risks in the FDA’s much criticized process for new drug approval. “One reason for these criticisms,” Lo argues, “is the lack of transparency with which the FDA makes its decisions, and the fact that the drug approval process has several stakeholder groups that do not necessarily share the same values or objectives.” Lo’s approach: “Bayesian decision analysis, by contrast, offers a systematic, objective, transparent and repeatable process for making regulatory decisions that reflects differences in both the impact of diseases and stakeholder perspectives.” Seth Harris, the former deputy secretary of labor, and Alan Krueger, a former chairman of the White House Council of Economic Advisers, tackle the problem of how to protect workers in the so-called gig economy without retarding innovation or market flexibility. “There is something for all sides to dislike (and like) about our proposal,” they acknowledge. “We suspect that both sides will have to lose some important cases before they will be ready to seriously consider a new legal classification for workers who don’t fit comfortably in either status. That is, all sides may need to be shocked into the realization that the 20thcentury (or 19th-century) legal structure is inappropriate for some newly emerging sectors of the contemporary labor market.” Susan Dynarski, an economist at the University of Michigan, takes a hard look at the student loan mess and rejects the arguments that interest rates are too high and that most borrowers can’t pay their debts. “The real

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problem,” she argues, “is the mismatch in the timing of the arrival of the benefits of college and its costs, with payments due when earnings are lowest and most variable. The solution is an income-based-repayment structure, with payments automatically flexing with earnings over a longer horizon than the current 10-year standard.” Larry White, an economist at New York University, steps back from the wreckage of housing finance to ask what we really want from government housing policy and how best to get from here to there. “Housing policy,” he reminds, “is still a mishmash of costly incentives that help the affluent more than struggling households. This is understandable: organized groups representing almost everybody who deducts mortgage interest from taxable income are reluctant to rock the boat.” But in the words of Pogo, Walt Kelly’s long-departed comic strip character, “We have seen the enemy, and he is us.’” Charles Castaldi, a former NPR reporter in Latin America, reflects on the chaos that has engulfed Venezuela and the prospects for restoring both economic growth and a civil society. “What makes Venezuela’s current situation so tragic is that this isn’t your run-ofthe-mill dictatorship whose citizens are helpless in the face of the avarice and indifference of its elite,” Castaldi notes. “But creating a successful market-driven social democracy from the wreckage of socialism’s last hurrah will be a daunting task.” Wait, there’s more: an excerpt from Between Debt and the Devil, the brilliant new book by Adair Turner, the chair of the UK Financial Authority … a charticle by demographer Bill Frey on the state of the Baby Boomers as they approach their 70s … a note by your editor on where the United States really stands in the pecking order of affluent nations. Enjoy. — Peter Passell

trends

b y pa u l c o l l i e r

There are more refugees now than at any time since 1945. Yet to date, public policy responses, both international and national, have been abysmal. Politicians have paraded their consciences along the spectrum from headless compassion to heartless cruelty. Still missing from the public debate is discussion about what the

reuters/yannis behrakis

private sector could do to cope with the looming problem.

I believe there is both a pressing need and an unprecedented opportunity for global business to demonstrate that it can deliver solutions. That missing role of business is not charity; it is business â&#x20AC;&#x201C; in a word, jobs. Jobs are central both to the immediate humanitar-

ian duty of rescue and to the long-term prospects for future stability in crisis-torn regions. Here, I consider these horizons in turn.

the duty of rescue First, letâ&#x20AC;&#x2122;s focus on the need. Half the entire

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trends population of Syria – around 10 million people – has been displaced by the current conflict. Some five million of them are displaced within Syria, lacking the resources or opportunity to get across a border. They are the ones in most desperate straits. Another five million have managed to depart Syria for Turkey, Lebanon and Jordan. Most are still there. They are in the next category of need,

are now out of danger. Most are young professionals from middle- and upper-income families, who are better prepared to look after themselves. Moreover, since they were already safe in Turkey, Lebanon or Jordan before going to Europe, they are essentially migrants rather than refugees. Those who made it to Sweden will be generously assisted at the expense of the global displaced poor whose futures are highly problematic.

As young Syrian men have accumulated in Sweden as well as Germany

without official preparation, they have behaved much as might be expected of young men denied purposeful activity, socialized into violence and released from the restraint of family. safe but with their lives on hold. Finally, a few hundred thousand, mainly young men, have seized on a spontaneous invitation from Chancellor Merkel to migrate to Germany. As these young men have flocked to Sweden as well as Germany without official preparation, they have behaved much as might be expected of young men denied purposeful activity, socialized into violence and released from the restraint of family. This has created rising panic across Europe, accentuated by ISIS, which has taken the opportunity to infiltrate terrorists among them. As a result, they are receiving far more attention than the displaced left behind. For example, Sweden has diverted half of its global aid budget to serve the needs of its new Syrian immigrants. Yet they are in the lowest category of need, and not only because they PAU L COL L I E R, a former director of development research at the World Bank, is professor of economics and public policy at the Blavatnik School of Government at Oxford University and a senior fellow at the Milken Institute. He has been advising the government of Jordan and the WANA Institute in Jordan on policy toward refugees.

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Evidently the focus of need should be switched. Relatively little can be done for the five million displaced still in Syria, beyond reopening closed borders. But much can and should be done for the millions in neighboring countries. To get from here to there, public policy needs a complete rethinking. Ever since 1945, policy toward refugees has been framed as a “duty of care.” The legal responsibility for care is shared between the first country of arrival, which must provide safe haven, and the United Nations refugee agency, the UNHCR. Placing this duty on the first country of arrival is vital, since it is the easiest place for refugees to reach. It is also the easiest place from which to return home once the violence is over. The mandate of UNHCR is exclusively humanitarian: it provides food and shelter. This makes sense if individual refugees are transient, en route to better lives – as was briefly the case with those freed from Nazi death camps at the end of World War II. But these were the exception: most refugees remain displaced for years.

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Both inviting refugees to Germany, on the one hand, and reducing their needs to food and shelter, on the other, radically mistake the condition of the current wave. Refugees are not natural migrants: their goal is not the conventional migrant ambition of uprooting life from a past pattern in order to transform it through new opportunities. On the contrary, most refugees want first and foremost to return to the lives they know, once peace makes it possible. Meanwhile, they aim to preserve as much normality as possible. The normality they have lost is primarily related to community and personal autonomy. To preserve their community while away from home, people need to cluster, like with like, restoring the familiar. But the offer of permanent resettlement in Germany sud-

denly trumped this modest goal. Germany, the United States, Britain and a few other paradise destinations are irresistibly attractive for many poor people around the world. Beyond the comfortable reality, they offer an imagined existence of affluence, glamor and prestige: some arrivals find Porsches parked in the street and send back photos of themselves standing in front of them. Since many refugees share this perception, Chancellor Merkelâ&#x20AC;&#x2122;s invitation effectively changed their aspirations from refugees to migrants. However, that wonâ&#x20AC;&#x2122;t stop those intending to be migrants to try for the best of both worlds â&#x20AC;&#x201C; to cluster together once in Germany to preserve vestiges of normality. And this is the antithesis of what the German government wants to happen: the official mantra

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trends

thatâ&#x20AC;&#x2122;s deeply degrading to the human spirit. But it is unreasonable to expect the neighboring haven countries to provide employment: they are usually themselves quite poor and suffer from serious underemployment. Their governments are naturally reluctant to permit a surge of immigrants to work for fear that this would depress the earnings of their poorest nationals with whom many refugees would be competing in the labor market. Hence, the legal duty of care does not extend to permission to work. But, unsurprisingly, despite the offer of subsistence without effort in the camps and the fact that working in their host societies is illegal, most refugees prefer to take their chances in illegal employment on the margins of the cities. In Turkey this is not a major problem: it has two million Syrian refugees in

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a population of 90 million. But in Jordan and Lebanon the proportions are far higher and far beyond the capacity of the local economy to absorb without disruption. Superficially, the German invitation may seem part of the solution to this problem: Germany has plenty of jobs. But Germany also has labor laws â&#x20AC;&#x201C; ones that are strictly ob-

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is of social integration so that immigrants can learn to be Germans. Then there is the issue of autonomy. To preserve autonomy, refugees need jobs. Without jobs people lose dignity and a sense of purpose. A United Nations system in which people are expected to live in camps for years, being fed by international donations while living in enforced idleness, is a travesty â&#x20AC;&#x201C; one

mandel ngan/afp/getty images

The enormous Zaâ&#x20AC;&#x2122;atari Syrian refugee camp is now Jordanâ&#x20AC;&#x2122;s fifth-largest city.

served. In particular, the nation has very high minimum wages. German workers earn well, but they return the favor with high productivity because most have the benefit of good education followed by long apprenticeships. But this is feasible only for adult refugees who are already skilled and likely to integrate well. Germany may thus prove to be less an

El Dorado than an unemployment cul-de-sac for many.

the jobs agenda The primary focus of enabling refugees to get jobs should not be the thousands in Germany, but the millions in the safe havens of neighboring host countries. Camps, instead of

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trends being the repositories of human tragedy, should be job havens. In effect, they should be portable cities rather than cruel imitations of holiday camps. To see how this might work, consider the Syrians currently in Jordan. Jordan alone has around a million Syrian refugees. Its largest camp, Za’atari, is only minutes away from a virtually empty industrial zone large enough to employ more than the entire labor force of the camp. Jordan has over 40 such industrial zones and many camps across the country, all of which could potentially provide jobs for refugees near temporary housing. The core of the jobs strategy would be to bring new manufacturing to these zones that would employ both refugees and Jordanians. It is, of course, essential that sufficient numbers of these jobs go to Jordanians; otherwise, the host population would have good reason to be resentful and so the Jordanian government would not permit it. Over and above their economic functionality, using zones as the core of the jobs strategy is politically attractive. The process of setting up new firms in the zones and thereby creating new jobs is easily recognizable by ordinary Jordanian citizens as a positive-sum process in which Jordanian workers gain directly and indirectly along with the refugees. Politically, providing jobs in zones is sharply distinct from simply lifting the restriction on refugees competing for jobs anywhere in Jordan. Economists might like to claim that such generosity would be mutually beneficial, but try telling that to the locals. Jordan, like Lebanon and Turkey, has met its international obligations to provide safe haven for unlimited numbers of refugees. But richer nations have not met their corresponding obligation to cover the costs. By 2014, the citizens of many rich nations had lost interest

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in the plight of Syrian refugees: they were safe in these havens and so had become someone else’s problem. For example, Germany halved its contribution to the cost of food provided by UNHCR in the camps. Jordan was left to finance much of the cost of the refugee influx: the government estimates that as a result of this extra burden, the national debt has risen to 90 percent of GDP from 60. The crisis of Syrian migration to Europe has forced all parties to reconsider policy-asusual. And to its great credit, the Jordanian government has agreed that as long as international donor financial support is forthcoming, it will permit very large numbers of Syrian refugees to work. Bringing jobs into zones is critical, which is why business involvement is essential. Only international business has the requisite experience; after all, managing multiple offshore stages of production has become standard operating procedure in manufacturing and some services. For example, over the past two decades German firms have created millions of jobs in the “near offshore” – first in Poland, then in Turkey. What has been done in Turkey could be done in Jordan. Indeed, many firms are already operating there. These firms cannot be expected to commit financial suicide. Hence, production in Jordanian industrial zones using refugee and Jordanian labor must be made financially viable. This is likely to be easier than finding jobs for refugees in Germany because wages can be set to levels appropriate for Jordanian and Syrian levels of productivity. But other elements must mesh – and quickly – to give foreign business adequate incentives to participate. The obvious market for goods produced in Jordan is the European Union. This would require a modest amendment to the rules of market access on the part of the EU. But there is a clear precedent for this in the European

reuters/muhammad hamed

Metalshop trainees at work in the vocational center at Al Za’atari.

Union’s emergency trade response to the earthquake in Pakistan. And make no mistake: the refugee crisis is clearly no less of an emergency. So, given Europe’s evident interest in stemming the influx of refugees, acceptance of refugee-produced goods made elsewhere is highly likely to be part of the overall agreement. Setting up production in Jordan would require firms to bear some initial additional costs, and it is reasonable that these be covered by subsidies from foreign sources. In practice, this would best be implemented by one-time grants proportional to the number of jobs generated. Consider, too, that the policy environment for business in Jordan warrants improvement

– the economy ranked 113th out of 189 countries in the latest Ease of Doing Business Index published by the World Bank. This unique opportunity for Jordon to attract a major influx of international business would be a timely moment for reform. Recognizing this, Amman has already committed to making significant changes. One attraction of international business is that it can move fast. For example, new production jobs in Mexico have been established by American firms in only six weeks. Even before the official donor conference to endorse the new policy package, CEOs of major companies are traveling to Jordan to see what is practical; the subject was also on the agenda at World Economic Forum at Davos this year.

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Direct employment by international firms in zones, it’s worth noting, would be only the beginning. Jobs producing exports trigger a multiplier process through which many other jobs can be created. As refugees get jobs, they get paychecks and hence spending power. This will create a much bigger market for consumer goods and services, providing incentives for enterprising Jordanians and refugees alike to create busi-

nesses (and more jobs) within the zones that serve them. All that is needed for this is straightforward facilitation by the Jordanian government and UNHCR. Currently, the informal shops run by refugees that have sprung up in the camp are excluded from the official system of food distribution. Refugees are given money to purchase food, but the money is a

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restricted token currency that can be redeemed only in one of two official food shops. But that could be easily changed. By the same token, permission to employ refugees in the zones would make it far easier for Syrian businesses to relocate to them. Like the Syrian people, Syrian businesses need safe havens.

the long view Violent conflicts, even those as dispiriting as the civil war in Syria, eventually end – or at least peter out. But they leave wrecked economies in their wake, which are slow to mend. To date, the recovery of economies post conflict and the humanitarian duty of rescue have been treated as entirely distinct challenges, both conceptually and institutionally. Economic recovery has been seen as a development problem and, as such, the bailiwick of the international development agencies like the World Bank only after the conflict subsides. What’s needed is an integrated approach to displacement and recovery. Indeed, by limiting the challenge of recovery to the provision of post-conflict assistance, development agencies have missed distinctive opportunities generated by refugees for incubating recovery during conflict. The refugee economy described above could, if adequately supported, constitute an economy in exile. Once peace is restored, the businesses that employ Syrian refugees could relocate to Syria with their Syrian employees. Obviously, it would be in Jordan’s interest to retain these firms, but, happily, post-conflict location is not a zero-sum game. As long as operations in Jordan remained profitable,

reuters/marko djurica

trends

firms would presumably remain there, but might well choose to start up satellite operations in Syria to take advantage of their knowledge of the market. This would help to stabilize the post-conflict economy and speed recovery. From this perspective, relocation in Germany could slow rather than speed the solution to the refugee problem. Recall that the exodus has disproportionately attracted the youngest, most affluent and most skilled. These are the very people the recovering economy will most need. Yet once in Germany they will probably never return, except as visitors. Many have sold their Syrian property at massive discounts in order to finance the cost of paying the criminals who run the boats to Europe, and return would be humiliating. The exodus to Germany has thus inadvertently deepened the long-term problems of the region. The economic agenda of providing jobs also feeds back to the humanitarian agenda of rescue. Note that current funding for humanitarian relief depends upon ad hoc appeals for donor money. It does not work well for the simple reason that donor support depends upon political support, which in turn depends upon public attention and concern. But this is intrinsically problematic since chronic refugee problems rapidly cease to be newsworthy. Without jobs at the core of a humanitarian strategy, human needs simply cannot be met. There may also be a more subtle feedback mechanism between the economic and humanitarian agenda: the narrative of business incubation can be psychologically supportive. The refugees working in zone enterprises, whether international businesses or relocated Syrian businesses, might get a sense of purpose from rebuilding their normal lives not just individually for the present, but collec-

tively for the future. Finally, by improving the prospects of the country now in conflict, successful incubation of jobs in refugee camps would make the future of the neighboring host economy more secure.

division of labor For decades, governments have devised solutions to international problems that have been cast in terms of government initiatives. But governments are not agile; nor are they especially adept at finding common ground with other sovereign states. Even in the best of circumstances, they arenâ&#x20AC;&#x2122;t much good at productive activities that are otherwise left to the private sector. International refugee pol-

Without jobs at the core of a

humanitarian strategy, human needs simply cannot be met. icy fits this mold all too well: it is essentially an inheritance from the late 1940s, a time when international business barely existed and could hardly be expected to fill the gap. As demonstrated by the World Economic Forum and the United Nations Global Compact (a voluntary group of corporations seeking to advance common societal goals), the leaders of international business are now very much aware that they remain aloof from international public policy at their peril. The refugee crisis is the here-and-now issue, so business is inclined to engage. But it needs to have a well-identified role. Supplying blankets to the refugee camps or offering training to refugees in Germany is best left to public agencies. Multinational business is needed to do what only it can do: integrating refugees in the neighboring havens like Jordan into global production chains.

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charticle

by william h. frey

Just when they slipped your mind, Baby Boomers are about to make history again. This year, the first members of the generation that once never trusted anyone over 30 will begin celebrating their 70th birthdays – leading a train of more than 65 million others who will pass that threshold over the next two decades. While eclipsed by the Millennials in media visibility, the Boomers will continue to make their mark, this time around by bringing a new demographic sensibility to what it means to be 70. In part, this is a matter of sheer numbers. But it’s also true that Boomers have a striking propensity to generate socioeconomic change. Early Boomers are not only more racially

diverse than previous generations at this age, but also more diverse than they themselves were in the younger years, thanks to immigration by Latinos and Asians. By the same token, the women’s movement (along with frustration with stagnant wages) has narrowed gender inequity in the workplace to a far greater degree for Boomers than for prior seniors. Fully 30 percent of early Boomer women are

THREE GENERATIONS ENTERING THEIR 70s ATTRIBUTES AT AGE 60-69 FOR: Depression Era (b. 1926-1935) WWII Era (b. 1936-1945) Early Baby Boom (b. 1946-1955)

Percent Non-White

Percent Women College Grads

Percent Women In Labor Force

source: William H. Frey analysis of Current Population Surveys, 1995, 2005, 2015

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Percent Women Professional and Managers

Percent Adults Currently Married

Percent Adults Divorced

now college graduates, a far larger figure than for similarly aged women in the World War IIera and Depression-era generations. And even though they are past peak labor force participation age, they remain far ahead of women of the same age from previous generations. As young adults, early Boomers were notorious for resisting the traditional family structure of the 1950s, delaying marriage, bearing fewer children and, for women especially, placing greater emphasis on careers. And they remain less likely to be married and more likely to be divorced than the two prior generations. Finances are also brighter â&#x20AC;&#x201C; though hardly coming up roses â&#x20AC;&#x201C; for Boomers. Poverty rates are relatively low (at 10 percent) compared to the national poverty rate (15 percent in 2014). And a study by the Pew Charitable Trusts predicts that early Boomer retirees will be able to replace a solid 70 to 80 percent of their preretirement income. Along with economic power, the large number of Boomers (and their inclination to

vote) promises growing political strength. If they turn out at 2012 rates in 2016 (a pretty big if), the Boomers will generate 35 percent of all votes cast, compared with 24 percent from lower turnout Millennials. Republican candidates may see Boomers as their best hope for success because they are whiter and more conservative than younger Americans. But Pew Research Center polls in 2014 in fact show that 49 percent of early Boomers identify or lean Democratic, while only 41 percent identify or lean Republican. Indeed, while their lifestyles may differ sharply from those of todayâ&#x20AC;&#x2122;s youth, the generation gap is likely narrower than in the past. And (I hope) this presages an opportunity for building a majority with common political goals and an inclination to compromise. B I LL FR EY is a senior fellow at both the Milken Institute and the Brookings Institution and author of Diversity Explosion: How New Racial Demographics Are Remaking America. 70%

Percent Adults Never Married

Percent Homeowners Who Are Female Householders

Percent Household Income in Upper 2 Quintiles

Percent Household Income in Lower 2 Quintiles

Percent Persons in Poverty

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Gig The

Economy

How to Modernize the Rules of Work to Fit the Times

by s e t h d. h arris an d alan b. k ru ege r i llustrations by michae l we rtz

Is your

Uber driver an employee or an independent contractor? That isnâ&#x20AC;&#x2122;t a question of semantics. Employees qualify for a host of legally mandated benefits and protections, including rights to organize and bargain collectively, civil rights safeguards, workersâ&#x20AC;&#x2122; compensation insurance, overtime pay and the minimum wage. Indeed, an extensive social compact has emerged in the relationship between employees and employers over the past century. The former cede control over their work lives (and, to some extent, their economic futures) to the latter, and

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the gig economy thereby make themselves economically dependent. In return, employers provide the minimum level of economic security required by law, and often more. Along with redressing the inherent imbalance in bargaining power between individual workers and employers, these laws improve the efficiency of the labor market by correcting market failures, like information asymmetries between worker and employer – as in, “do I need a mask to prevent exposure to chemical X?” – or discrimination that would otherwise deny qualified workers access to more-productive jobs. Independent contractors, in contrast, are expected to use their bargaining power as independent businesses to negotiate their own compacts. The law doesn’t guarantee them a minimum wage, nor do they have much protection against discrimination. But unlike workers formally designated as employees, they have the freedom to work when they want, where they want and how they want. So, whether workers are classified as employees or independent contractors matters a great deal to their ability to call on the law to protect them. There is currently much uncertainty as to whether your Uber driver – or Lyft driver, or TaskRabbit handyman or Thumbtack personal trainer – will be ruled an employee or an independent contractor by regulators and the courts. On the one hand, these workers have some characteristics of independent contractors, including being able to choose when to work and whether to work at all. They typically use their own equipment. They S E TH D. H AR R I S, a former deputy secretary of labor, is a distinguished scholar at Cornell’s School of Industrial & Labor Relations. AL AN B. KR U E G E R, a former chairman of President Obama’s Council of Economic Advisers, is a professor of economics and public affairs at Princeton.

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may also work simultaneously with multiple “intermediaries” (that is, the companies with online apps that connect them with customers) or conduct personal tasks while they are working with an intermediary. On the other hand, they have some of the characteristics of employees. The intermediaries retain some control over the way workers perform their work, such as setting their fees or determining the sort of equipment that must be used, and they may, in effect, fire workers by prohibiting them from using their services. Those workers are thus not independent businesses as that term is usually defined. Labor, employment, and tax law currently only recognize those two traditional legal classifications. Yet increasingly, workers are falling into a gray area between the two, and that is inefficient and potentially unfair for all concerned.

neither fish nor fowl Even if one sets aside the complications introduced by digitally enabled work, the relevant labor and employment law is hardly a model of clarity. In fact, there are multiple laws that apply different tests for determining whether a worker is an employee or an independent contractor. These tests typically involve factors that are weighed against one another, but legal precedents and regulatory interpretation don’t offer uniform guidance regarding how to apportion the weights. No single factor is decisive, courts and administrative agencies warn, and the tests do not require the satisfaction of all factors. It is thus up to judges, juries and administrators to decide. For example, the IRS’s test for tax liability places weight on whether workers receive fringe benefits in determining whether they are employees, while the test mandated by the Fair Labor Standards Act does not.

Wait, it gets worse. The Fair Labor Standards Actâ&#x20AC;&#x2122;s test puts weight on whether a worker exerts independent judgment, while the test used for the Employee Retirement Income Security Act does not. And the amount of weight to place on whether workers exert independent judgment relative to the amount of weight to place on whether they can set their own hours is unspecified. Similar inconsistencies and ambiguities arise in the National Labor Relations Act, the Civil Rights Act and state labor and employment laws. Moreover, when workers simply cannot be classified unambiguously, the United States (unlike some other countries) does not have a

default rule that automatically assigns them to employee status, until proven otherwise. Too often, judges, regulators and employers decide what result they want, and then make their analyses fit the desired outcome. Thatâ&#x20AC;&#x2122;s not how the law is supposed to work, and it risks stifling innovation, undermining efficiency and denying workers and employers a fair deal on the aforementioned social compact. Judges and administrative bodies asked to decide difficult cases are increasingly requesting new rules that would allow them to avoid conflicting decisions on the classification of workers in the gig economy. In a case involving the classification of Lyft drivers under the

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the gig economy Fair Labor Standards Act and state law, for example, Judge Vince Chhabria of the United States District Court for the Northern District of California wrote in May 2015: As should now be clear, the jury in this case will be handed a square peg and asked to choose between two round holes. … Some factors point in one direction, some point in the other, and some are ambiguous. Perhaps Lyft drivers who work more than a certain number of hours should be employees while the others should be independent contractors. Or perhaps Lyft drivers should be considered a new category of worker altogether, requiring a different set of protections. But absent legislative intervention, California’s outmoded test for classifying workers will apply in cases like this. And because the test provides nothing remotely close to a clear answer, it will often be for juries to decide.

The parties in this case reached a settlement in January 2016 (pending Judge Chhabria’s approval), with Lyft agreeing to pay the drivers $12.25 million and to make two concessions. The company agreed to bar drivers only for cause and to pay the costs of arbitration in the future. The drivers remained independent contractors. Shannon Liss-Riordan, the Boston-based lawyer who represented the drivers, said she believed the settlement was fair “given the risks we faced in litigation.” But the case plainly did not resolve the uncertainty surrounding the classification of on-demand workers. Indeed, the fact that both sides were willing to settle rather than take their chances with a jury indicates the risk and ambiguity that they perceive in the current system. A similar suit against Uber Technologies in California, brought by the same lawyer, is pending. Different coasts, different legal interpretations. A ruling by the Department of Economic Opportunity in Florida in December 2015 found that the facts clearly supported

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the case that Uber drivers were independent contractors, and it took issue with rulings in two other states: Uber is a technology platform that, for a fee, connects transportation providers with customers seeking transportation. The agreement between drivers and Uber specifies that the relationship is one of independent contractor, and the actual course of dealing confirms that characterization. Drivers have significant control over the details of their work. Drivers use their own vehicles and choose when, if ever, to provide services through Uber’s software. Drivers decide where to work. Drivers decide which customers to serve. Drivers have control over many details of the customer experience. Drivers may provide services through, or work for, competing platforms or other companies when not using the Uber application. On these facts, it appears that Uber operates not as an employer, but as a middleman or broker for transportation services. Two other jurisdictions – California and Oregon – have in recent months come to the opposite conclusion, finding that drivers using the Uber software are employees under the law of those states. These opinions are not persuasive, as they largely ignore the contract, and misconstrue the actual course of dealings between the parties. To a significant extent, these rulings appear to rest on the fact that Uber could not be in business without drivers. But the same is true of all middlemen. Uber is no more an employer to drivers than is an art gallery to artists.

Other cases like these are seemingly inevitable. No one could sensibly expect much clarity to emerge from this legal process, given the inconsistency and obsolescence of the underlying statutes. The likeliest outcome is conflicting decisions doled out over the course of many years, and the resulting legal morass will likely slow the development of innovative new sectors and services, create inefficiencies for all parties involved in the emerging internetintermediated labor market and impose high transaction costs from extensive litigation.

independent workers Late last year, we proposed a new category for independent workers that gives legal recognition and protections to workers who fall in the gray area between employees and independent contractors (see “A Proposal for Modernizing Labor Laws for Twenty-First-Century Work: The ‘Independent Worker,’” The Hamilton Project). Our goal was to modernize labor, employment and tax law to be more efficient and fair in preparation for the growing number of on-demand workers and perhaps to preempt the coming avalanche of litigation that is likely to leave all sides worse off.

ployees receive. These include the freedom to organize and bargain collectively, civil rights protections, mandatory tax withholding and worker-company shared contributions for the payroll taxes that fund Social Security and Medicare. Economists and business analysts will no doubt squabble over who would ultimately bear the cost, as they do over benefits now provided to traditional employees. We think there is solid evidence that some (even most) of these costs likely will be borne by workers in the form of higher commissions and fees they pay to intermediaries in the long run,

Regardless of whether they work through an online or offline

intermediary, independent workers should qualify for many of the benefits and protections that employees receive. Under our proposed definition, independent workers are distinguished from employees because the independent workers control whether they work, when they work, how long they work, where they work and (for the most part) the manner in which they provide a customer with service and the duration of that service. Intermediaries can have some control over the way independent workers perform their tasks, but less than traditional employers. We propose that these workers receive legal benefits and protections that are appropriate for workers who have this kind of substantial control over their work, but still establish important economic relationships with the intermediaries that differ from the arm’s-length contracts typifying independent businesses. We think that regardless of whether they work through an online or offline intermediary, independent workers should qualify for many of the benefits and protections that em-

just as supply-and-demand pressures in the traditional labor market induce employers to reduce wages to make up for a sizable percentage of the employee benefits and taxes they must cover. If nothing else, requiring intermediaries to provide benefits – such as paying for half the Social Security payroll tax – will make it easier to compare the after-tax compensation of gig work with traditional employment. We also expect that it will significantly increase tax compliance, to the benefit both of the independent workers and the U.S. Treasury. Since it is conceptually difficult to attribute some independent workers’ hours on the job to any single intermediary – and it is often unclear whether they are on the job or not – they would not qualify for hours-based benefits, including overtime pay and the minimum wage. Further, independent workers would rarely, if ever, qualify for unemployment insurance because these benefits are

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premised on a decision by the employer to discharge or lay off a worker without cause rather than a decision by a worker with broad discretion to choose whether to work through an intermediary. As a result, independent workers would not be covered by unemployment insurance and intermediaries would

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not be required to fund that program. Intermediaries would, however, be free to pool independent workers for purposes of providing medical insurance and other benefits at group rates without the risk that their relationship would subsequently be treated as an employment relationship.

Our goal is to find a middle way to ensure that gig-economy workers share America’s workplace social compact without jeopardizing the benefits that come from innovation and flexible work arrangements. We were guided by three principles: • Legally required benefits and protections should be appropriate for workers who control when and whether to work. • Independent-worker status should be neutral with respect to employment status. • Creating a new classification for independent workers should make the labor market operate more efficiently. In particular, companies that use independent workers should survive and grow because they have a better service, not because they take advantage of regulatory arbitrage. A natural concern here is that some employers may restructure their work relationship to convert employees to independent-worker status. That would be very unlikely, however, for two reasons. First, employers would have to give up a tremendous amount of the control they currently exert in order to make the switch. How many employers would be willing to tell their employees that they could come to work whenever they wanted, and only if they wanted, without any advance notice? That would be a great deal of control to sacrifice in exchange for very little, since independent workers would be entitled to virtually all of the legally required benefits that employees receive, save overtime pay, the minimum wage (which is unlikely to be binding anyway) and unemployment insurance. Second, employers can already organize work to classify (and, in too many cases, misclassify) their workers as independent contractors, who receive none of the legal benefits for which independent workers would qualify in the new category. That is, there are greater

cost savings to be had in the current, badly flawed system by rejiggering work to meet the legal definition of independent contractor. Indeed, we suspect that many more workers would gain legal protections than would lose them under our proposed system.

the gig economy by the numbers A variety of estimates suggest that the number of gig workers, defined as those working through an online intermediary, is currently relatively small. Our own estimate, based on the number of Google searches for major online platforms, including Uber, Lyft, Grubhub and others, puts the figure at about 600,000,

Although the number of workers

currently working through online intermediaries is relatively low, the rate of growth is quite high.

or less than a half-percent of total U.S. employment. Lawrence Katz and Alan Krueger estimated that, in the fall of 2015, 0.5 percent of the U.S. work force provided labor services to customers through an online intermediary, such as Uber or TaskRabbit. The McKinsey Global Institute estimated that fewer than 1 percent of all workers are providing services through the online economy. And an estimate by the JPMorgan Chase Institute, based on bank deposits from 30 work-related Internet platforms, such as Uber and TaskRabbit, into individuals’ bank accounts, puts the figure around 1 percent of the U.S. population. This last analysis further estimates that a cumulative 4 percent of the population has worked through an online platform at some point. Although the number of workers currently working through online intermediaries is relatively low, the rate of growth is quite high.

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For example, Uber, which is the largest online intermediary, has doubled the number of its U.S. workers each six months for the past few years. Technological advances are likely to lead to further disintermediation of the workplace that is expected to propel growth in freelancing and gig work in the future. It should also be noted there are hundreds of thousands more workers, like many taxi drivers, Avon direct-sales workers and others who currently work with an offline intermediary. Katz and Krueger, for example, found that twice as many workers work through an offline intermediary as through an online one. Many of these workers would likely be classified as independent workers under our proposal. At current growth rates, the number of independent workers providing labor services through online intermediaries would likely exceed the number working through offline intermediaries within a few years.

a grand bargain Our plan is meant to start a conversation. We recognize that those vested in the current system and those who firmly believe their side will prevail in the legal wrangling would have reason to oppose it. As Sen. Mark Warner of Virginia put it in discussing our proposal when the Brookings Institution rolled it out, “They’ve managed to piss off both sides with their project already, which is a pretty good starting place to be.” There was something for all sides to dislike (and like) about our proposal. Unions and some labor-connected think tanks and academics dislike the exclusion of the minimum wage, as well as the exclusion of some other benefits and protections. Intermediaries, for their part, object to allowing independent workers to organize and to bargain collectively. Of course, we did not offer our pro24

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posal to serve any particular interest. Rather, our objectives are to maximize the size of the economic pie – the joint surplus, as economists would put it – and to ensure a fair distribution of that surplus to those who contribute to creating it. Given that litigation over employee and independent-contractor status for gig workers is still in its early stages, we suspect that both sides will have to lose some important cases before they will be ready to seriously consider a new legal classification for workers who don’t fit comfortably in either status. That is, all sides may need to be shocked into the realization that the 20th-century (or 19thcentury) legal structure is inappropriate for some newly emerging sectors of the contemporary labor market. This circumstance is reminiscent of the situation that existed when the workers’ compensation insurance system was created. Workers’ comp laws were enacted in most states at the beginning of the 20th century, when the legal system for compensating workers and their families for workplace injuries proved inefficient, burdensome and too uncertain for all sides concerned. The goal of our proposal is to suggest a detailed solution to the unnecessary tumult being created by our outdated, uncertain and inefficient legal regime before it frustrates or stifles intermediaries, independent workers and customers alike. Others, perhaps motivated by different principles, may suggest other solutions. We welcome a vigorous debate on these issues. As in any grand bargain, there is room for disagreement and space for compromise once both sides recognize that change can benefit all parties, compared with the status quo.

the gig economy

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The Elusive

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Promise of Structural Reform

by da n i rodri k

Structural reform â&#x20AC;&#x201C; or more accurately talk of struc-

tural reform â&#x20AC;&#x201C; is everywhere nowadays. Every country struggling for economic growth, it seems, is getting the same message from the chattering classes as well as the deep-pocketed multilateral finance agencies like the IMF and the European Central

Bank: half measures are not enough. In practice, structural reform has come to repre-

sent a grab bag of policies meant to enhance produc-

tivity and improve the functioning of the supply side of the economy. These measures aim to sweep away impediments to the functioning of labor, goods and services markets â&#x20AC;&#x201C; to make it easier for firms to fire

unwanted employees, to break business and union monopoly power, to privatize state assets, to reduce regulation and red tape, to remove licensing fees and other costs that deter market entry, to improve the efficiency of the courts, to enforce property rights, to enhance contract enforcement and so on. Indeed, the grab bag is even bigger. Often, for example, structural

reform includes changes in taxes and social security programs with an eye toward fiscal sustainability.

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structural reform The overarching goal is to increase the efficiency with which labor and capital are allocated in the economy, ensuring that these resources go where their contribution to national income is largest. Success comes in the form of increased productivity, more private investment and, of course, more rapid economic growth. Perhaps nowhere in recent years has the gospel of structural reform been promoted with greater vehemence than in Greece. Indeed, Greece’s creditors have made it crystal clear that structural reform, boldly conceived and implemented without slippage, is critical to economic recovery and growth – and most persuasively to Greeks, that bailout funds will not be forthcoming without it. The International Monetary Fund and European public lenders understood that the fiscal austerity they prescribed would be costly to incomes and employment (though a retrospective IMF study later showed they significantly underestimated by how much). But there would be a compensatory boost to the economy, they argued, that would come from the long-delayed and much-needed opening of the Greek economy to competitive market forces. The specifics demanded from Greece ranged from gut-wrenching to mundane. They included (in no particular order) lower barriers to entry in service businesses such as notaries, pharmacies and taxis; reduced scope of collective bargaining; privatization of state assets; a rollback of pensions and the cleanup of Greece’s notoriously inefficient and arguably corrupt tax administration. The IMF’s

DAN I ROD R I K is the Ford Foundation professor of international political economy at the Kennedy School at Harvard. This article is an expanded version of a column written for Project Syndicate.

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then-chief economist, Olivier Blanchard, (among others) argued that such reforms were critical in light of the “dismal productivity growth record of Greece before the program.” Less ambitious reforms wouldn’t do because they would have less impact on growth potential and necessitate greater debt relief.

partial amnesia But the policy prescribers, it seems, suffered from selective memory. Structural reform as a remedy for slow (or no) growth has been around at least since the early 1980s. At that time, the World Bank began to insist on economywide liberalizing reforms as the quid pro quo for developing countries in Asia, Africa and the Middle East in return for “structuraladjustment” loans. These policies were then extended and codified in Latin America during the 1990s under the umbrella of the Washington Consensus. Many of the former socialist economies adopted similar policies (in some cases, voluntarily) when they opened up their economies during the 1990s. Oddly, though, debate over the reforms pressed on Greece and other crisis-battered countries on the periphery of Europe did not benefit from lessons learned in these other settings. A serious look at the vast experience with privatization, deregulation and liberalization since the 1980s – in Latin America, post-socialist economies and Asia in particular – would have produced much less optimism about the benefits of the kinds of reforms Athens was asked to impose. That experience suggests that structural reform yields growth only over the longer term, at best; more often than not, the shortrun effects are negative. One meta-study of 46 different research papers on post-socialist economies found that the impact of structural reform varied across the board. The modal estimate of the impact was statistically

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insignificant, meaning that it was impossible to conclude with any confidence whether the effects were positive or negative. In Latin America, for example, some economies have flourished in the wake of reform (think Chile) and some have lagged (as in Mexico). These results may seem surprising at first glance but are, in fact, consistent with what economic theory teaches. The standard convergence framework that economists use to analyze growth across countries gives us little reason to expect strong short-term growthpromoting effects. Reform works by raising the potential income of the economy in the long run. Take Greece. Opening the regulated professions will eventually lead more productive firms to drive out inefficient suppliers. The privatization of state enterprises will lead to

the rationalization of production (and dismissal of all the excess workers employed through political patronage). But these changes will require years to work themselves through the economy. And in the short run, they may yield perverse effects. For example, the loss of the (however disappointing) output of workers laid off by privatized enterprises will subtract from, rather than add to, national income. Economists have spent significant effort at estimating the speed with which economies tend to converge to their long-run levels of income. The near-consensus of academic studies is that convergence is pretty slow, at a rate of about 2 percent per year. That is, an economy tends to close 2 percent of the gap each year between its actual and potential income levels.

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This estimate helps us gauge the magnitude of growth we can expect from structural reform. Let’s be wildly optimistic and suppose that structural reforms enable Greece to double its potential income over three years, which would push Greece’s potential per-capita GDP significantly beyond the European Union average. Applying convergence math, this would produce an annual growth boost of only about 1.3 percent per year on average over the next three years. To place this number in perspective, remember that Greek GDP has shrunk by 25 percent since 2009. So if structural reforms have so far not paid off in Greece, it is not necessarily because the country’s governments have slacked off. Indeed, it is easy – but also largely erroneous – to blame successive Greek governments for unenthusiastic implementation of structural reform and significant slippages. Certainly, Greece has not delivered on every measure it agreed to adopt. Given the magnitude of effort needed, which government could? Yet, remarkably, Greece moved up by nearly 40 positions between 2010 and 2015 in the World Bank’s Ease of Doing Business rankings. The country’s labor markets are more “flexible” – meaning liberalized – today than those of most other eurozone countries. Greece’s “failure” arises instead from the very logic of structural reform: the bulk of the benefits comes much later, not when their creditors (and unemployed Greeks) need them most.

what triggers takeoffs? This leaves us with an apparent puzzle. If structural reforms deliver their growth payoffs so slowly, how are we to explain the numerous instances of abrupt takeoffs in East Asia and elsewhere? If such takeoffs are not the product of conventional structural reform, what does drive them?

A few words first on growth takeoffs. A decade ago, Ricardo Hausmann, Lant Pritchett and I published an article that documented the basic stylized facts about what we called “growth accelerations.” We defined a growth acceleration as an increase in per-capita growth of two percentage points or more (with most of the episodes we identified exceeding this threshold by a wide margin). To qualify as acceleration, the increase in the growth rate had to be sustained for at least eight years, and the post-acceleration rate had to be at least 3.5 percent annually (per capita). In addition, to rule out cases of acceleration purely attributable to recovery from recession, we required that post-acceleration output exceed the pre-episode peak level of income. We were surprised to discover how frequent these episodes of growth acceleration are. We identified more than 80 cases over the 35-year period from 1957 to 1992. This meant the probability that any given country would experience a growth acceleration sometime during a decade was as high as 25 percent. Of the 110 countries included in the sample, 60 had at least one acceleration in the 1957-92 period. More important, we found that standard factors economists think play a role in growth do not do a good job of predicting acceleration. In particular, structural reforms were only loosely correlated with turning points in economic performance. Fewer than 15 percent of significant economic liberalizations produced growth accelerations, and only 16 percent of growth accelerations were preceded by economic liberalization. Some growth accelerations were obviously the result of fortuitous external conditions (such as a rise in the world prices of a country’s major exports) or other changes not directly attributable to economic policy (such as changes in political regime). But in most

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structural reform cases, there was no smoking gun. That got us thinking about what might lie behind these instances when economic prospects suddenly brightened. India’s growth acceleration in the early 1980s is perhaps a paradigmatic case. The country’s growth rate more than doubled, from 1.7 percent in 1950-80 to 3.8 percent in 1980-2000, with a clear turning point in 198182. Yet serious liberalizing reforms in India did not arrive until 1991, when Manmohan Singh slashed trade barriers, welcomed foreign investment and began both privatization and the dismantling of what is derisively called the license raj. In other words, the pickup in India’s growth preceded the 1991 liberalization by a full decade. Arvind Subramanian and I concluded that the trigger to India’s economic growth was an attitudinal shift on the part of the national government in 1980. Until that time, the rhetoric of the reigning Congress Party had been all about socialism and pro-poor policies. When Indira Gandhi returned to power in 1980, she realigned herself politically with the organized private sector and dropped her previous rhetoric. The national government’s attitude toward business went from being outright hostile to supportive. Note that this was a pro-business shift rather than a pro-market shift. It was not supported by liberalizing reforms, which would only come a decade down the road. Indira Gandhi’s switch was further reinforced, in a more explicit manner, by Rajiv Gandhi after his rise to power in 1984. This seems to have been the key change that unleashed what Keynes called the “animal spirits” of the Indian private sector. The moral of the Indian story is that small changes can make a big difference in economies that suffer from multiple distortions.

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The Chinese growth acceleration after 1978 very much bears this out. The Chinese economic takeoff wasn’t the product of economy-wide reforms or a major liberalization. It was the consequence of specific reforms that loosened collective farming rules and allowed farmers to sell excess production – after state quotas were fulfilled – at uncontrolled market prices. The same type of selective, targeted reforms in urban industrial development, trade, foreign investment and finance would unfold over the next three decades, keeping the Chinese miracle going and going and going. Or consider Mauritius, one of Africa’s few growth successes in the 20th century, which experienced its growth acceleration in 1971. The trigger seems to have been the establishment of a largely unregulated export processing zone that led to a boom in garment exports, even as the rest of the economy remained heavily controlled and protected. What is common to these cases is that the takeoffs were associated with a targeted removal of key obstacles to growth, rather than broad liberalization and economywide reforms. India, China and Mauritius all benefited from growth strategies that specifically focused on removing binding constraints on growth. Targeting reforms on areas where the growth returns are the greatest maximizes early benefits. It also ensures that scarce political capital and administrative resources are spent on the battles that really matter.

maximum gain for minimum pain Along with my Harvard colleagues Ricardo Hausmann and Andres Velasco, I undertook to identify the binding constraints to growth in specific settings in a 2005 article. For example, an economy in which the main constraint on growth was poor access to finance should exhibit different symptoms (high in-

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terest rates, strong responsiveness of domestic investment to foreign capital inflows, etc.) than an economy whose main problem was low profitability of private investment (low interest rates, ample liquidity in the banking system, etc.). When entrepreneurship is hampered primarily by market failures rather than government failures, the country may rank high on standard creditworthiness measures like transparency or institutional quality, but private investment will remain low. A focus on binding constraints helps us see why remedies that are not well targeted – broad structural reforms – are ineffective, at best, and sometimes counterproductive. Cut-

ting red tape and reducing regulation does little to spur private economic activity when the constraint lies on the finance side. Improving financial intermediation does not raise private investment when entrepreneurs expect low profits. Successful policy design must rely more on domestic experimentation and local institutional innovations – and much less on “best practices” and blueprints adopted from international experience. Going back to Greece, where is the binding constraint on that economy today? With a quarter of the labor force out of work, I would argue that the quickest way to get the economy back on its feet would be to increase

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Greece and its creditors need to recognize the importance of improving the

the private sector’s demand for workers. Supply-side measures, such as conventional structural reforms, can’t be particularly effective at present because the binding constraint is on demand rather than supply. Deregulating professions does not boost entry when aggregate demand is depressed. Making it easier to fire workers does not induce firms to invest and produce more; it just facilitates laying off workers. As helpful as these measures may be in promoting long-term growth, they don’t do much for the economy in the short run and may even make things worse. However, conventional demand-side remedies like government spending, tax cuts or devaluation are ruled out by both the burden

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of public debt and Greece’s membership in the eurozone. In principle, wage deflation should have been a substitute for currency depreciation, making Greek goods and services cheaper in foreign markets. And Greek wages have come down substantially. But here, too, the absence of a single-minded focus on the binding constraints has proved costly. Different elements in the structural reforms have had conflicting effects on export competitiveness. In manufacturing, for example, the competitiveness benefits of wage cuts were offset by the cost of increases in energy prices resulting from fiscal austerity measures and state enterprise price adjustments. A better prioritized reform strategy could have protected export activities from this adverse effect. The absence of the ability to devalue or depreciate the currency remains a serious impediment. But the experience of other countries provides a rich menu of alternative tools for export promotion ranging from tax incentives to special zones to targeted infrastructure projects. Greece and its creditors need to recognize the importance (and priority) of improving the profitability of sectors that produce tradable goods and services, and to reorganize reforms around that task. Most urgently, the government needs to set up an institution close to the prime minister tasked with fostering a dialogue with potential investors – both domestic and foreign – in export-oriented projects. This institution needs to have the ability to remove obstacles identified in the process, to avoid having its proposals languish in ministries with other priorities. These obstacles are typically highly

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profitability of sectors that produce tradable goods and services, and to reorganize reforms around that task.

specific to the investment – a zoning regulation here, the lack of a labor-training program there – and are unlikely to be targeted by broad structural reforms. Some observers of the Greek economy deride the value of export promotion, arguing that the country is hindered by a lack of diversity in tradable goods and services, and is thus unlikely to respond to incentives. But the experience of other countries makes clear that low export and diversification levels are not destiny. Sizable – and credible – changes in export incentives typically produce robust responses, even where exports are confined to a few traditional crops. It is now forgotten that Taiwan exported sugar, rice and little else before its trade took off in the early 1960s. Closer by, export pessimism was the dominant mood among Turkey’s elites before the reforms in the early 1980s, which mainly consisted of export subsidies, produced a rapid rise in the export-GDP ratio. In Taiwan, Turkey and elsewhere, new exports rather than traditional products have led the way. There’s no straightforward means to predict what these new exports will be before the incentives are put in place. But this opacity should not be grounds for pessimism about their likelihood of emerging.

pay now, pay later Ultimately, the choice of reform boils down to one of two approaches. The conventional structural reform agenda relies on a “big bang” – as many changes as possible, as quickly as feasible. Politically, this approach typically exploits a window of opportunity created by economic crisis that reformers fear will close when normal times return. The costs of bigbang reform – higher unemployment, slower recovery – are tolerated in order to reap what is hoped will be sizable benefits down the line. This kind of reform perhaps works best when

there are external anchors that prevent backsliding as short-term costs mount. Poland in the early 1990s is arguably the model. The prospect of European Union membership – and the promise of becoming a “normal European country” after a half century of isolation from the West – held the reforms together despite high unemployment and serious economic dislocation early on. Elsewhere, in the absence of external anchors there is always a real threat that the backlash will dominate. Bolivia and Venezuela in Latin America fit this latter mold. The second approach is less ambitious, consisting of sequential targeting of binding constraints. The political strategy underpinning this style of reform is the expectation that early wins will create political support for reforms (and reformers) over time. When binding constraints are successfully targeted, the early growth payoffs can be quite spectacular. This is the quintessential model perfected in China, but versions have been at play in South Korea, Taiwan and India at different times. Because the reforms are partial, they never quite do away with the insiders (and their ability to extract gains through market power and political connections), who are typically less than enthusiastic about continuing reforms. So there is always the risk that such reforms will get stuck midway and the early growth benefits will dissipate. Greece has taken the first route – likely less because this was the country’s choice than because its creditors left it with little alternative. If the results have been disappointing to date, it is for reasons that should have been expected at the outset. It remains to be seen whether Greeks’ evident desire to remain in the eurozone (or at least their fears of the alternative) will prove sufficient counterweight to the pain that the country has yet to endure.

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How to – and How Not to – Manage Student Debt by susa n dyna rsk i

i llustrations by yevge n ia naybe rg

If you even casually follow the news, you’ve probably heard that Americans owe a record $1.3 trillion in student loans. These loans are now second only to mortgages as the largest source of household debt. Policymakers are scrambling to respond to what is widely perceived as a debt crisis akin to the mortgage meltdown: seven million borrowers are in default, while millions more are behind on their payments.

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managing student debt Readers – and politicians – often assume that higher debt must lead to increased risk of default. But the fact is, default is highest among those with modest student debts. Of those borrowing under $5,000, a whopping 34 percent end up in default. For those borrowing more than $100,000, the default rate is just 18 percent.

the U. S. Treasury and Constantine Yannelis of Stanford University delved into this link between earnings and student borrowing. They had access to new data on a subject for which figures have been frustratingly incomplete. This new data matches records on federal student borrowing with the borrowers’ earnings from tax records (with identifying details removed to preserve privacy). And it includes

Half of the increase in loans was driven by a surge in borrowing to attend

for-profit and community colleges, where enrollment exploded as workers fled a weak labor market. These borrowers gained little from their investment. What explains this counterintuitive pattern? In a word: earnings. And this should influence the way we think about student debt and government policy that has gone astray.

the link between earnings and default The most indebted student borrowers are likely to be those who attended graduate school or who earned undergraduate degrees at expensive, elite institutions. These borrowers typically spent many years in higher education and so racked up many years of debt. But they also build up a lot of human capital, which typically pays off in higher salaries once they enter the job market. Small borrowers, by contrast, tend to be those who went to for-profit technical schools or community colleges for a year or less. They finished (or dropped out) quickly and so borrowed little. But they also build up little human capital along the way and so do relatively poorly in the labor market. A recent research paper by Adam Looney of S U SAN DYN ARS K I is a professor of education, public policy and economics at the University of Michigan.

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information about the borrowers and the amounts borrowed, the colleges the borrowers attended, their repayment records and their earnings both before and after college. Looney and Yannelis found that half of the increase in loans between 2003 and 2013 was driven by a surge in borrowing to attend forprofit and community colleges, where enrollment exploded as workers fled a weak labor market. These borrowers gained little from their investment: the median income for those exiting these schools in 2010 was a paltry $22,000. The explanation lies in who attended and why. As part of the anti-recession stimulus package, the federal government encouraged unemployed and low-skilled workers to head to college for training. Increases in federal need-based Pell Grants and the new American Opportunity Tax Credit (which was worth up to $2,500 a year for households with annual incomes of up to $160,000) helped workers to take this option. But the huge influx of students taxed the resources and capacity of community colleges. Wait a moment. Shouldn’t an increase in demand make any enterprise better off? In

TRENDS IN NONMORTGAGE CONSUMER DEBT

BILLIONS OF DOLLARS $1200

Student loan 1000

800

Auto loan Credit card

600 HELOC 400

200

20 04 20 Q4 05 20 Q4 06 20 Q4 07 20 Q4 08 20 Q4 09 20 Q4 10 20 Q4 11 20 Q4 12 20 Q4 13 20 Q4 14 -Q 4

private markets, a surge in demand produces additional sales revenue that can be plowed back into expanding capacity. At public colleges, however, tuition covers only a fraction of the cost of educating students. Public colleges thus rely heavily on state aid to supplement tuition revenue. Prices (tuition) at public colleges would resemble prices at private colleges were it not for this substantial government subsidy. During the Great Recession, however, states cut their appropriations to public colleges as part of their efforts to offset falling tax revenues. Cuts in state funding to community colleges created a cascade of consequences. Public colleges, including community colleges, made up part of the loss by raising tuition. In response to this increase in prices, students at community colleges borrowed more. Traditionally, community college students have borrowed little or nothing; this new borrowing therefore reflected a sea change in how these students finance their schooling. The drop in state funding also increased student borrowing at for-profit colleges. How? Community colleges, strapped for funds, could not accommodate the increased demand. For-profit colleges enrolled many of the students that community colleges could not. For-profit colleges have long provided training for the same sort of low-skilled, though ambitious, workers who attend community colleges, but they have always been a small part of this market. This changed significantly during the Great Recession. In 2000, for-profits enrolled just 4 percent of undergraduates in the United States; by 2010, they were enrolling 11 percent. As for-profit enrollment rose, so, too, did borrowing by their students. For-profit colleges charge high tuition and (unlike private,

source: Federal Reserve Bank of New York note: “HELOC” indicates home-equity lines of credit.

non-profit colleges) provide little aid (which are really discounts). As a result, for-profit students – unlike students at community colleges – have always taken on relatively heavy debt. By the same token, defaults among borrowers at for-profit colleges have always been high, especially during economic downturns. The Great Recession continued this pattern, with one key change: instead of representing a tiny minority of college students, for-profit students were now a bigger chunk of undergraduate enrollment and undergraduate borrowing. When the surge in for-profit borrowers left school and were obliged to start repayment, defaults rose rapidly. For those leaving forprofit colleges in 2010, the five-year default rate was a painful 28 percent. The default rate was also high (31 percent) among community-college borrowers, but there were far

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managing student debt fewer of them. While there are many more community-college students than for-profit students, it is still relatively rare for community-college students to borrow. In hindsight, this was almost inevitable. The very poor employment prospects for lowskilled workers make borrowing very risky for them. Indeed, their low earnings make it difficult to support even small amounts of debt.

how much is too much? Borrowing is not risky for all students. Graduates of four-year colleges, especially colleges with selective admission standards, tend to earn good salaries and to pay back their loans. At selective schools, the default rate is only about 6 percent. Graduate students also have little problem repaying their debt and have a similarly low default rate.

Note, too, that student loan debt is lower than is widely perceived. Consider students who first enrolled in college in 2003-4. Six years later (the length of time it takes a typical undergraduate to earn a bachelorâ&#x20AC;&#x2122;s degree), 44 percent had borrowed nothing and another 25 percent had borrowed $10,000 or less. That is, 69 percent of undergraduates borrowed $10,000 or less. Another 29 percent borrowed between $10,001 and $50,000, while just 2 percent borrowed $50,001 or more. Todayâ&#x20AC;&#x2122;s entering college students appear to be on a similar path. Thus, while attention is focused on extreme cases, only a very small share of undergraduate borrowers are liable for the six-figure debts that dominate the headlines. Remember, too, that a four-year college education remains one of the best investments that a young person can make. Median earnings among all young workers (those

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aged 22 to 27) with a 4-year college degree in 2015 was $43,000, compared with $25,000 for those with just a high school degree. Take that difference and multiply the figure across four decades of work, and it is quickly apparent that $30,000 in student loans – the typical debt for a student graduating from a fouryear public college – is a sensible investment.

could free community college solve our student-debt woes?

If we are determined to reduce distress and default among student borrowers, the target should not be the graduates of elite four-year institutions but rather those who dropped out of non-selective programs. Going forward, one way to reduce their debt distress is to keep them from borrowing in the first place. Community colleges are the traditional entry point for low-income students whose

parents did not go to college, and historically they have charged very low prices – a few hundred dollars a semester was not atypical even two decades ago. With a need-based Pell Grant from the federal government, a community college student could get by without borrowing. Students who dropped out could thus return to the labor force without debt. In essence, society took on much of the risk of the college bet by bearing the direct costs. Bringing prices at community colleges back to their historic standard – near zero – would be one way to reduce borrowing and, thereby, debt distress. However, making community college free would not end the debt problems of those who attend for-profit institutions. As noted above, for-profit colleges draw students from the same pool as community colleges. Yet most of them would still need to borrow large sums to attend. Reducing the price of community

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college would presumably draw some students away from their expensive private counterparts. But itâ&#x20AC;&#x2122;s unlikely to shut down the whole sector. So, whether or not we make community college free again, weâ&#x20AC;&#x2122;ll need a well-functioning system for borrowing and repaying student loans.

a flexible system of student loans One simple way to reduce defaults is to lengthen the time frame of loan repayment. In the United States, the standard period is 10 years. Other countries let students pay back their loans over a far longer horizon. In Sweden, students pay their loans back over 25 years. For a loan with an interest rate of 4.3 percent (the current rate), stretching amortization to 25 years would halve monthly payments.

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Lengthening the horizon of loan repayment makes economic sense. A college education is an investment that pays off over many decades. With most loans, the length of repayment corresponds to the useful life of the collateral. We take out 30-year mortgages on houses, but just five-year loans on cars. Cities and states sell long-term bonds to fund highways and other infrastructure that will provide services for many decades. A complementary way to make debt manageable is to link payments to income. In an income-based repayment system, payments would rise and fall with earnings, thereby reducing pressure on borrowers. Australia, Chile, New Zealand, Thailand and Britain have all gone this route with student loans. In Britain, for instance, borrowers pay 9 percent of their annual income that exceeds ÂŁ21,000

(about $30,000); any remaining balance is forgiven after 30 years. The federal government does have income- based repayment options for student borrowers, such as the Pay As You Earn program. But PAYE is not the default repayment plan. The automatic option for borrowers is a 10-year mortgage-style fixed payment. Borrowers must proactively apply to the income-based programs before being admitted. Eligibility must be renewed annually. The Consumer Financial Protection Bureau has documented the difficulties that borrowers have in navigating this process. With PAYE, and all the other income-based repayment programs, every change to earnings requires a new application to adjust the loan payment. Even if earnings don’t change, staying in an income-based plan requires an annual round of complicated financial paperwork. Those who most need a helping hand are probably the least able to navigate this bureaucracy. Indeed, the number of borrowers in these flexible repayment plans is much lower than the number in distress and default, which is evidence that the current system isn’t working. Note, too, that while PAYE theoretically limits payments to 10 percent of income, outlays can actually consume a much larger share of a borrower’s earnings in a given year. That’s because, with all the income-based plans in the United States, payments are calculated as a percentage of the previous year’s income. But income can change a lot over the course of a year, especially for the low-skilled marginally employed. For those patching together several part-time jobs, hours and earnings can bounce around weekly. The payment that would have been affordable last year may well be unaffordable this year. To effectively buffer earnings shocks as they arrive, payments need to adjust dynami-

cally with earnings. And this is not beyond the capacity of law and finance. Social Security is a good model. Workers do little paperwork to make Social Security contributions: they complete an initial W-4 form and employers handle the rest. Social Security contributions then automatically rise and fall with earnings. Loan payments could be handled the same way. I’ve written a brief on this idea for the Hamilton Project. There are now several proposals circulating in Washington that would get more troubled borrowers into income-based repayment plans. Some would keep the standard 10-year repayment plan but automatically shift borrowers into income-based plans if they fell behind on payments. Others make incomebased payment universal, as it is in England and Australia.

what about cutting interest rates? In Washington, it is frequently argued that high interest rates are at the root of the student loan mess, increasing defaults and discouraging college attendance. But there are good reasons to doubt that they have much impact on attendance, yet they are an expensive way to reduce defaults. Econ 101 predicts that a lower interest rate would increase college enrollment because it would reduce the lifetime cost of college. A rational decision maker would take this into account, summing the projected lifetime benefits of college and subtracting the projected lifetime costs – including interest due on loans after leaving college. But building on the work of psychologists, behavioral economists have shown that this rational model fails predictably when people have to accept burdens in the present to gain benefits in the future. This applies to a variety of important life decisions ranging from deciding whether

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managing student debt to save for retirement, to exercise for health or to go to college. Strong evidence suggests that, in these situations, tangible incentives that are felt at the moment of decision making are most effective in changing behavior. Interest-rate subsidies fail the tangibility condition: students are handed the same amount of cash now whether the loan’s interest rate is 2 percent, 4 percent or 10 percent. By the same token, they fail the “in the moment” test, since the benefits of reduced interest rates (lower monthly payments) arrive only after students have left college. Lower interest rates might reduce defaults, but the effect is likely to be quite small. The payments students make are determined mostly by principal rather than the interest rate. Most borrowers are enrolled in a 10-year mortgage-style payment program, in which payments are fixed when the students leave college. For a loan of $20,000, cutting the interest rate by 2.5 percentage points would reduce the monthly payment by only about $25 (from $230 to $205). Not only does reducing interest rates have little impact on struggling borrowers, it is hugely expensive. When rates are cut, everyone gets the benefits, including those with high earnings who have no difficulty repaying their loans. An interest subsidy is therefore a poorly targeted, expensive and ineffective tool for reducing loan defaults. If we want to hand borrowers a windfall, with little effect on college attendance or default rates, lowering interest rates on student loans would do the job well. This is a perfectly reasonable policy goal, but we should be clear that this is what we are doing – transferring wealth to borrowers. If our goal is to increase college attendance, grants or lower tuition would do the job more effectively than lower interest rates. If

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our goal is to reduce defaults, an incomebased plan in which payments flex automatically would also accomplish more at lower cost than changing interest rates.

the big picture Governments across the world provide student loans, allowing students to borrow against the expected lifetime income gains created by a college education. While borrowing has risen in the United States, so too has the return from schooling. The typical student holds debt that is well below the lifetime benefits of a college education. To put it another way, the typical student borrower is not “under water,” unlike many homeowners during the mortgage crisis. The real problem is the mismatch in the timing of the arrival of the benefits of college and its costs, with payments due when earnings are lowest and most variable. The solution is an income-based-repayment structure for student loans, with payments automatically flexing with earnings over a longer horizon than the current 10-year standard. As noted above, income-based repayment options are already available in the United States, but the administrative barriers to accessing them are formidable – and especially daunting to the students at greatest risk of default. Further, the existing options do not adjust loan payments quickly enough to respond to the high-frequency shocks that characterize young people’s earnings, especially during a recession. There’s no doubt that Americans view exploding student debt as a problem. And there’s little doubt that many of them would be willing to pay something in order to relieve the debtors’ pain. It would be unfortunate if policymakers wasted this window of opportunity by making changes that did little for those who most need help.

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Pulling into the entrance of the Eurobuilding Hotel, I recognize the lush, palm-lined walkway where the body of one of the assailants came to rest after he was gunned down by hotel security guards. Also killed was his target, a

German citizen who had arrived straight from the airport and whose sojourn in Caracas lasted less than two hours. Now, as I disembark, I recall the stream of articles I read online about this murder and so many others, even as I’m

noting the number of soldiers in full combat gear guarding the door (four). Inside, the dozen or so men dressed in dark colors and sneakers barely try

to hide the fact they’re private security guards. Welcome to Venezuela, which has the unfortunate distinction of having the

Letter from

Caracas by c h a r l e s castald i

highest homicide rate in the world. Venezuela has other dubious distinctions – among them, the highest inflation rate in the world (100 percent last year) and the designation as the most corrupt country in Latin America. On the other hand, it’s blessed with the world’s largest oil reserves (that’s right, more than Saudi Arabia). And it holds the record

for producing Miss Universes and Miss Worlds. What will probably come as no surprise: Venezuela has been mired in political turmoil for years. What might have come as a surprise, though, was the opposition party’s landslide victory in last December’s elections for the National Assembly. Venezuelan politics have, after all, been dominated since 1998 by Hugo Chávez and his successor to the presidency, Nicolás Maduro. Chávez’s “Bolivarian Revolution,” named after the leader of the war of independence against Spain, was anchored on a populist platform of social spending, price controls and expropriations of private businesses. Over the years, the Chavistas’ United Socialist Party (PSUV) won election after election, thanks to support from poor Venezuelans, who remain a majority in spite of the country’s

it’s the economy, stupid But that support now appears on the wane, and it is not hard to see why. When I attempt to change $100 at the black market rate of 800 bolivars to the dollar rather than the official rate of 6.3, I’m laughed at. For one thing, the street bankers say, I won’t be able to find anything I want that’s for sale in bolivars. For another, since the largest bill is only 100 bolivars, it would take

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oil riches and who have benefited the most from the state’s largess.

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letter from caracas a briefcase full to buy anything substantial, provided anyone was dumb enough to make the exchange. I insist, though, and they snap up my greenbacks. My pockets now stuffed with funny money, I’m ready for my first foray on the streets. Exiting the hotel involves running a gauntlet of warnings delivered by concierges and bellboys that I will be kidnapped, shot or mugged unless I use the hotel car service (dollars only, of course). But it’s quitting time for some of the hotel workers, and I fold myself into a small group of them as cover. We cross a bridge, practicing broken-field running through traffic to arrive at the bus stops, where long lines of bedraggled Caraqueños wait for clappedout coaches. Trundling north, my bus passes the Polytechnic University before I step off in downtown Caracas. From there it takes only a few minutes’ stroll to run into a line that snakes around an entire city block. I discover that the object of attention is a store reportedly selling toilet paper without the need to show a ration card. I’m reminded of Nicaragua in the 1980s under the Sandinistas, where toilet paper also disappeared from circulation. Charmin and socialism don’t seem to coexist well. A woman near the front of the line tells me she has been waiting her entire lunch break and then some to buy six rolls, though they’re sure to be more expensive than the pricecontrolled variety, which are hardly ever to be found. In Venezuela, many basic goods are a bargain. At black market exchange rates, gasoline costs a U.S. penny a gallon; meanwhile, a typical utility bill runs a couple hundred bolivars a month (you do the math). Before the woman makes it to the door, C H AR L E S CASTALDI is a former National Public Radio reporter in Latin America, who is now living in Nicaragua.

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the store manager steps out and delivers the bad news: they’ve run out of supplies. The interviewee seems more resigned than angry. “This is what it means to shop in Caracas,” she explains, showing me her empty shopping bag. “I’m supposed to be at work, but if I see another line, I’ll get in it. I might get lucky.” Things aren’t much better in the supermarkets I subsequently visit. In an effort to ensure that everyone can afford staples, the government imposed rationing in 2014 on basics, including milk, rice, coffee, soap and cooking oil. But when rationed products do appear, the shelves are cleaned out in no time. The government has, on numerous occasions, sent soldiers to ensure that fights don’t break out. What’s still available at high uncontrolled prices is generally imported, since a whole host of regulations have nearly brought private domestic production to a standstill. One exception is Empresas Polar, Venezuela’s largest private corporation. Polar’s success as a producer and distributor of food and beverages has made it the Chavistas’ favorite target. The company has been accused of hoarding, while its CEO has been branded a plotter against the Maduro regime. By no coincidence, Polar has been inspected 1,835 times – apparently, somebody’s counting – since the PSUV came to power. I stroll on to the Sambil shopping mall; inside, it’s a parallel universe of glass, marble and consumerism. Nike, Hard Rock Cafe, Tommy Hilfiger are all there. And then I see the line of people standing in front of the Adidas store. A sign in the window announces 30 percent off all store products. But this is no retail discount; it’s the work of the National Superintendency of Fair Prices, a Chavista attempt to limit price gouging. The results are, once again, excess demand. Nevertheless, this mall confirms there is still money circulating among the privileged – mainly those connected with the government,

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the military and the part of the private sector able to buy and sell in dollars. On my way back to the hotel, I stop at a bookstore-cafe to meet Natalia Castañon, the dean of humanities at the private Metropolitan University. Over coffee, she tells me public education has fallen apart in the past few years. “Chávez made education more accessible, which was good,” she says. “But then the system became politicized, the university system lost its autonomy and in the process standards went out the window.” Castañon tells me her salary is frozen at 40,000 bolivars a month – that is, $50. Her daughters (both chemical engineers) have emigrated. Elena Osorio, a 23-year-old college graduate, pipes in that she’s moving to Spain, where she has family, to work and attend graduate school. She tells me that of her graduating class, only a handful have remained in Vene-

zuela. “Lots of people wanted to immigrate here in the 60s and 70s,” she says. “We were the mecca of Latin America. But now those who can, leave. The young, educated middle class has almost disappeared.” Her motives for decamping aren’t just economic; the high crime rate plays a part. “I’ve been mugged five times,” she says. “It used to be that you knew somebody who knew somebody who had been mugged. Now it happens to you multiple times.” She repeats the mantra I’ve heard many times: don’t walk around showing a phone, especially a smartphone. “An iPhone is worth a million bolivars. They don’t even bother to take your cash.” Beyond the rampant violence, she says, ordinary life in Caracas has just become too difficult. “I can only buy certain controlled products like chicken or butter twice a week, but I

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Then, they turned into gangs who got into crime and kidnappings. Nobody wants to mess with them.” The true extent of crime in Caracas is anybody’s guess. The reputable Venezuelan Violence Observatory estimates that there were 82 murders per 100,000 citizens last year, almost twice the rate of the most violent American cities (Detroit and St. Louis). The government would have you believe that the rate is less than half that, but most experts think that, in fact, the numbers are even higher because so many crimes go unreported. In the hotel lobby, statuesque women teeter about on impossibly high heels. The hotel is a respite from the tumult of Caracas. So, on most nights, there are throngs of affluent Venezuelans on view. This night, the aforesaid include contestants in a beauty pageant

top: reuters/jorge silva; bottom: reuters/marco bello

can’t go during work hours and I hardly want to spend half my Sunday in line,” she notes. “So my parents bring me those things. They have a friend who works in the government.” Back at the hotel, I try to chat up a couple of the security guys. They turn out to be retired cops, a bit reluctant to engage at first. But when I tell them that I’m surprised an authoritarian country can have such a high crime rate, they laugh. “Venezuela has a government, and it might be authoritarian, but it doesn’t do much policing,” one of them explains. “Go into the streets at night, and you’ll see almost no police; it’s become too dangerous.” Chávez, it seems, encouraged the formation of paramilitary groups called “colectivos” that received guns, radios and motorcycles to support his Bolivarian Revolution. “At first, they were used to intimidate the opposition.

(hence the heels) and members of the national baseball team. Venezuelans are fanatical consumers of both. One partygoer is a man named Jose in his mid-40s who sells imported foundry equipment in Guayana City, a mining center in southern Venezuela. Business is tough, he says. Production is way down, so his clients aren’t buying much. In any event, demand may not be the binding constraint. “I have to bribe the authorities to get import permits, to get cheaper dollars, to get the merchandise through customs,” he says. “I built my business from nothing, and it’s slowly going back to nothing.” Later, I hear a very different story from a young bartender. “Because of Chávez, they put a school where there wasn’t anything,” he explains. “I got an education. I moved to Caracas, and now I’m studying law at night. … I know many people are going through difficult times, and it’s Maduro’s fault,” he acknowledges. “But you have to understand why so many of us have a deep love for Hugo Chávez.” The following day, I’m on my way to meeting two young Venezuelan journalists for lunch at a restaurant where the arepas, a Venezuelan staple that resembles a smaller, puffier tortilla, are considered the best. Since I’ll be buying, all four pockets of my jeans are bulging with bolivars. And, recalling earlier conversations, I’m keeping my phone hidden in the small of my back. Thanks to the comically low price of gasoline and utter absence of urban planning, Caracas traffic is world class. To get around with speed, there’s either the Metro or the socalled mototaxis, which are just guys on motorcycles carrying extra helmets. I opt for the latter, which are apparently safer as well as faster than four-wheeled vehicles since thieves are more attracted to carjacking and grabbing phones from people stuck in traffic.

After we agree on the price, we’re off. But what seemed like a clever idea a few seconds earlier turns into a near-death experience as the driver accelerates through lines of barely moving cars and darts around a bus with only inches to spare. The upside: I arrive early. Luis Carlos Diaz works for an independent radio program hosted by César Miguel Rondón, the most listened to in Caracas. His wife, Naky Soto, is, among other things, a blogger for ProDavinci, an independent online publication that attracts many opposition intellectuals. We talk about the state-owned media, which pretty much control television at this point. Maduro is constantly on the air signing decrees and approving new projects. “He is a poor imitation of Chávez, who could spend hours on the air but at least had some charisma and sense of humor,” Luis Carlos says. Maduro’s big attraction is his more than occasional malapropism, like his saying that Christ multiplied penes (penises) instead of panes (fishes). “The Chavistas saturate the audience with the same message over and over again,” Naky laments. “People have become so bored with it that they look for other sources. Social media, private radio, all have grown exponentially.” The first lady, Cilia Flores, who is widely considered the real power behind the throne, hosts a program called “With Cilia and Family.” “Unintentionally, it’s become a joke, since she’s given government jobs to 46 family members.” Two of her nephews were arrested in Haiti last year on drug charges and extradited to the United States. I pay the bill (seventy 100-bolivar notes). We head downtown by Metro, packed so tightly that conditions would be considered cruel for sardines. I’m the only light-skinned person in the car – skin color is class identity in Venezuela. Soon we’re on the street again, passing the

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letter from caracas National Assembly, which has now become the battleground between the Chavistas and the newly emboldened opposition. We come to the Plaza Bolivar, where the mayor’s office is located. Except that the mayor, Antonio Ledezma, is under house arrest. After running as an opposition candidate and winning in 2008, Chávez pulled the rug out from under him by appointing a Chavista to run a newly created administrative structure that would actually hold the reins of power in the city. Ledezma went on a hunger strike, becoming one of the regime’s most visible opponents. In 2015, he was arrested after Maduro accused him of participating in an Americanled conspiracy against his government. Much the same thing happened to Leo poldo López, the mayor of the Chacao subdistrict of Caracas. In 2008, he was barred from public office, though not charged with a crime. But his good fortune ran out in 2014 when, as the leader of an opposition party, he called for peaceful protests. He was arrested, charged with inciting violence through subliminal messages and convicted in short order. The lead prosecutor later decamped for the United States, declaring the trial a sham. López remains in jail. At one end of the plaza stands an opensided tent that’s almost deserted. I spot Juan Carlos Dugarte walking through. Dugarte is the de facto mayor of Caracas, holding the office created to trump Ledezma. He’s surrounded by security guards and acolytes, but known to all by his Venezuelan flag-themed jacket popularized by Chávez. I identify myself, and Dugarte invites me to follow him into Expo Productive Caracas, which is intended to show off the products that the Bolivarian Revolution has to offer. There are shoddy-looking knockoffs of American goods with names like Timerland boots,

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doors that look like high school woodshop rejects, and packaged foods that don’t exist yet – mockups of what’s on the Bolivarian agenda. And then there’s a guy selling pool chlorinators, who seems unsure why he was asked to participate. Who says socialists don’t have a sense of humor?

meet the boliburguesia That evening, it’s dinner with Wilmer Ruperti, one of the richest men in Venezuela. We drive in a couple of armored cars with bodyguards to a restaurant in Altamira, an upscale Caracas neighborhood. Ruperti is quick to explain how he started with nothing, the son of Italian immigrants. He worked around ships and became a tanker master. Ruperti’s big break came during the oil strike in 2002 in which anti-Chávez officials of PVDSA, the national oil company, tried to force Chávez to resign. While other ships lay immobilized at anchor, he found a way to break the strike with some Russian tankers – and in doing so, provided Chávez with the economic lifeline to survive. Ruperti made a fortune in oil distribution and became a star in the Boliburguesia (bourgeois, but pro-Chávez) firmament. He has since branched out, starting his own TV network and going into film. “We were the envy of Latin America in the 60s and 70s,” he says. “But we managed to squander our oil riches through corruption and mismanagement. By the time Chávez came along, the situation was desperate for the masses of Venezuelans. Suddenly, someone was speaking for the poor – someone who made them feel like he really cared.” Ruperti is a bit more critical of the regime’s management of the PVDSA. He says the state oil company has added 100,000 employees since the strike, but its output has nonetheless dropped 30 percent. “Nobody’s even remotely suggesting this government is perfect,” he says. “But you have to understand: Venezuelans

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have become so accustomed to government handouts that the sad fact is, they don’t really want to work.” Francisco Monaldi, a professor at the Kennedy School at Harvard and an expert on Venezuela’s oil industry, takes a longer view. “After World War II and into the 80s, oil made Venezuela the Latin American economic miracle, with lower levels of poverty, the highest income per capita, good health and education, and a quite vibrant democracy,” he says. In the OPEC years, however, the country was undone by oil riches, which were squandered on patronage and corruption. By the nineties, Venezuela had become one of the worst economic performers in Latin America. This is when Chávez, an army lieutenant colonel, appeared on the scene. The military coup he led was rebuffed, but he nonetheless was elected president in 1998. It was hardly smooth sailing thereafter, though. Oil prices tanked, and “the popularity of presidents of

oil-producing countries like Venezuela is directly related to the price of oil – it doesn’t really depend on what they do or don’t do,” Monaldi argues. But just when Chávez’s popularity was at its nadir, oil prices took off again, and he made the most of it. “Chávez not only enjoyed a period of boom prices, he was clever at spending heavily on social programs just before electoral cycles; then, post-cycle, he would rein in those expenditures,” Monaldi explains. Chávez seems to have subsequently lost his sense of timing, however. He overran high oil revenues with even higher spending, and attempted (vainly) to control inflation by maintaining a grossly overvalued currency exchange rate. “He created a series of grotesque [market] distortions that pushed Venezuela into recession even before oil prices starting collapsing,” Monaldi notes. After Chávez died of cancer in 2013, his successor, Maduro, continued those profligate

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slumming it The following morning, I head to Petare, one of the largest slums in Latin America and the area of Caracas with the highest murder rate. I stop off at city hall to meet Andrés Schloeter, a charismatic 20-something city councilman from the opposition party, Primero Justicia, who is known by everyone as Chola. The city hall is located on a small colonial square complete with a church painted cotton-candy pink. Children are playing in the square, and I start to wonder if this could possibly be the horrific slum Venezuelans warned me not to set foot in. To get a feel for the place, Chola suggests – 54

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you guessed it – the back of a motorcycle. Only this time, in addition to a slalom race through traffic, we’ll be navigating narrow roads that wind up and down the steep mountain onto which houses cling like badly assembled Legos. As soon as we turn off the main square, Petare shows its true face. The streets are potholed and strewn with trash. The only visual relief from to the grayness and dirt is children walking home in their spankingclean blue-and-white school uniforms. We stop to talk to Victor Barrios, a corpulent fellow in his 40s who is spray-painting a car parked on the side of the road. This is his paint shop, he explains, with a wry laugh. He pauses to hose down the section where he paints to avoid having passing cars raise dust. Barrios paints a car here and there to make ends meet, he says. And he is quick to volunteer that he’s grateful for what Hugo Chávez did for him. His kids are in school, which is free. Moreover, his whole family now receives

©aaron sosa/dpa/corbis

policies, running up budget deficits in excess of 20 percent of GDP and borrowing heavily from China to pay for imports. “Maduro is like a deer in headlights, afraid to do anything that might cause pain in his base,” Monaldi says. “I think he really has no clue as to what to do.”

medical care. But when I ask Victor how he’s going to vote, his face darkens. “I don’t know,” he says. “This Maduro government is unable to run the economy. It seems like they don’t run much of anything these days. We have a lot of crime, no jobs, no money. This can’t go on.” This was by now a familiar refrain: a government that doesn’t govern. And it points to a major problem for the Chavistas. While many Venezuelans venerate Chávez, they seemingly have little regard for Maduro and his handling of the economy – which is why the Chavistas did so poorly in the National Assembly elections. This isn’t to say that Chavismo is dead. Far from it. For even while losing seats in the Assembly, the Chavistas took 40 percent of the vote, which still makes it the largest single party in Venezuela. We pass by a spanking new sports complex that includes a soccer field and a large swimming pool, recently built in the lower part of Petare by the opposition-controlled city council. The emerald green turf and turquoise pool bottom are visible from the neighborhood’s higher reaches. Next stop: the police station in Valle Alto, near the top of the mountain. A couple of uniformed cops guard the entrance as if it were a bank. And for good reason. The police station was attacked three times in 2015 and has since been attacked twice more – once with tear gas, once with grenades. Grenades, incidentally, are becoming the gang weapon of choice, available on the black market for less than $20. Cops are prime targets for gang members who want to rapidly ascend the ranks. One policeman admits that policing has become a secondary goal for the force; they’re just trying to stay alive. Apart from the officers at the station, I see no cops during the entire time that I’m in Petare.

After I get back to city hall, Chola takes me for a walk around the neighborhood. It’s an impressive display of grass-roots politicking to see this young man from an upper-middleclass background work the streets. Everyone seems to know him. People come up to talk about problems or just to shake hands. He listens, his assistant takes notes, he invites people to community meetings. And it’s not just show: Petare boasts a number of improvement projects apart from the sports complex. There’s a theater as well as assorted new schools and playgrounds that is a testament to the fact that the community hasn’t entirely given in to the despair of poverty and violence.

* * * The opposition’s election victory in the National Assembly was clearly a turning point, even if President Maduro will do what he can to prevent the majority from exercising much power. The challenge for the opposition will be to measure how and where to push for change, understanding that their victory was more a cry of pain than a mandate. Indeed, this victory won’t be easy to build on. For while the economy was driven over a cliff by the Chavistas, the low, low price of oil will make it very difficult to placate the poor while sober heads attempt to fix the machinery of production. Many other countries with more mineral wealth than institutional sense or respect for civil liberties have discovered they can’t live with the treasure, yet can’t live without it. What makes Venezuela’s current situation so tragic is that this isn’t your run-of-the-mill dictatorship whose citizens are helpless in the face of the avarice and indifference of its elite. But creating a successful market-driven social democracy from the wreckage of socialism’s last hurrah will be a daunting task.

Second Quarter 2016

The process for approving new drugs is a high-stakes activity fraught with scientific, ethical, political and economic challenges. Regulators charged with that responsibility are under intense scrutiny because of the potential for life-and-death consequences from their actions. Therefore, the FDA and other agencies involved must walk a fine line to avoid approving an unsafe or ineffective drug â&#x20AC;&#x201C; or, the other side of the coin, rejecting a safe and effective one.

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P-Values vs. Patient Values

A New Statistical Approach to the Drug-Approval Quandary

by an d r ew w. lo

At the root of this challenge is the unavoidable trade-off between two objectives: minimizing the likelihood that an ineffective drug is approved and maximizing the likelihood that an effective drug is approved. These two objectives are at odds with each other. We could reduce the chances of approving an ineffective drug to zero simply by refusing to approve any drug. However, such an approach would also eliminate the possibility of approving any effective drug. Therefore, an unavoidable aspect of the drug-approval process is deciding how to weigh the two possible errors that can be committed: rejecting an effective drug (known as type I error in the jargon of statistical analy足 sis) and approving an ineffective one (type II error).

Second Quarter 2016

drug approval quandary Within the traditional framework for random clinical trials, this trade-off is addressed by setting a fixed value for type I error (typically, a probability of 2.5 percent) and then determining the sample size of patients needed to detect the reasonable probability of a positive therapeutic benefit (typically 80 to 90 percent). Then the candidate drug is administered to this size sample of patients, while a matching sample of patients is given a placebo. If the differences in the outcomes of these two groups are statistically significant at the 2.5 percent level – that is, there’s only a 2.5 percent probability that the drug made patients better off than the placebo by chance alone – the drug is approved. This outcome is often summarized by a “p-value”: if this value is .025 or less, the therapeutic benefit is considered “statistically significant.” Note that by fixing the type I error at 2.5 percent across all random clinical trials, this approach implicitly assumes that the damage done by approving an ineffective therapy is the same for all diseases. However, for patients with terminal illnesses that have no effective treatment options, it is only common sense that this level of type I error is too stringent. Such patients may be willing to take a much greater risk of being treated with an ineffective therapy, even if it means a greater risk of receiving an ineffective therapy that has serious side effects. After all, what’s the alternative for these patients? As Prof. Don

AN D R EW LO is the Charles E. and Susan T. Harris professor at MIT’s Sloan School of Management, director of MIT’s Laboratory for Financial Engineering and chief investment strategist for AlphaSimplex Group LLC. Research support from the MIT Laboratory for Financial Engineering is gratefully acknowledged, as are helpful comments and discussion from Alison Bateman-House, Don Berry, Jayna Cummings, Ilan Ganot and Debra Miller.

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Berry, a well-known biostatistician and random-trial expert at the University of Texas, put it, “shouldn’t we be focusing on patient values as well as p-values?” One concrete illustration of the distinction between patient values and p-values is with Duchenne muscular dystrophy, a rare, devastating disease usually affecting boys that causes progressive muscle degeneration starting in infancy. There is currently no approved therapy for either the symptoms or root cause. Most patients are confined to wheelchairs by age 12 and dead by 25. In this particular case, the potential conflict between regulatory and patient perspectives has come to a head with the recent FDA decision to turn down a Duchenne drug candidate, drisapersen, because of insufficient statistical evidence of efficacy and potentially serious side effects. Some parents of Duchenne patients and patients’ advocates strongly objected to these decisions, indicating their willingness to accept a high level of risk for the chance of potential benefits. As Debra Miller, the founder and chief executive officer of the nonprofit advocacy organization CureDu chenne (and the parent of a Duchenne patient), put it in responding to the FDA’s decision: We are disappointed that the FDA did not approve drisapersen, given the significant benefit that many Duchenne boys experienced when they were on an early and consistent treatment protocol of the drug. ... This disease, with its complex genetic roots, is unlikely to be cured by any single drug. Drisapersen was expected to be beneficial to about 13 percent of all patients.

Further complicating matters are the differing perspectives regarding the relative costs and risks of the potential outcomes. A dying patient, for example, may be much less concerned about a potentially dangerous experimental drug than the shareholders of a company that would bear the cost of wrong-

ful-death litigation. Note, too, that there is a utilitarian conundrum in which small benefits for large numbers of patients must be weighed against devastating consequences for an unfortunate few. Can we do better in how we decide whether a drug is approved or not?

the limitations of random clinical trials Clinicians, drug regulators and other stakeholders have long recognized that these competing factors must be accounted for in the

cebo) treatment during the trial (assuming a balanced double-blind random clinical trial) raises an important ethical issue. Indeed, the fact that half the seriously ill patients in a clinical trial will be stuck receiving the placebo is one key reason that sample sizes are not further increased to achieve greater statistical certainty. Although we have seen the emergence of new hybrid designs, including sequential and adaptive tests, none accounts for the severity of the target disease and the ethics of depriving some of the desperately ill a last hope for effective treatment.

Patients with terminal illnesses may be willing to take a much

greater risk of being treated with an ineffective therapy, even if it means a greater risk of receiving an ineffective therapy that has serious side effects. After all, what’s the alternative for these patients? decision making, both when drug trials are designed and when they come up for approval. In fact, regulatory guidelines do allow for deviation from traditional Phase III clinical trials (testing on humans) for designated breakthrough therapies that address unmet needs for severe or rare diseases. But the relaxation of the rules is inadequate. For one thing, it is often done on an ad hoc basis and may require post-approval studies. For another, many compounds are not eligible for the special programs – fast-track, breakthrough-therapy, accelerated-approval and priority-review – that are designed to expedite the approval process. Consider, too, that the seemingly arbitrary nature of the values for the size and power of the statistical test for efficacy raises questions about their justification. As Professor Berry has pointed out, the fact that the classic approach to designing clinical trials ignores the fact that at least half the subjects are exposed to an ineffective (pla-

The classic random-trial framework also does not explicitly account for the potential number of patients who will eventually be affected by the outcome of a trial. It stands to reason that patients suffering from the target disease will experience a positive effect from an approved effective drug or a negative effect from an approved ineffective drug or a rejected effective drug. Thus, the sample size of the trial should depend on the size of the population that will be affected by the outcome of the trial.

enter thomas bayes Professor Berry suggested one approach to incorporating patient perspectives that involves assigning different costs to the different outcomes, and then determining the optimal type I and type II error levels – that is, the levels that minimize the overall expected cost of the decision. In a recent paper I wrote with Leah Isakov (Pfizer) and Vahid

Second Quarter 2016

drug approval quandary Montazerhodjat (MIT), we apply a standard Bayesian decision analysis framework to the drug-approval process in which the costs of type I and type II errors are explicitly specified using historical U.S. burden-of-disease data. Such an analysis is an established decision-making process for determining the optimal action in cases involving multiple uncertain outcomes. Different possible scenarios are considered and the consequences of each are carefully quantified and then combined into a single cost function that can be minimized. The decision that minimizes this function is the Bayesian analysis optimal action. It is important to note that the term “cost” in our context refers to the health consequences of incorrect decisions for current and future patients, not necessarily the financial cost. Moreover, our cost measure is not related to the pharmaco-economic concept of “cost effectiveness.” In the Bayesian decision analysis framework, cost is meant to reflect the consequences of a given decision under specific assumptions about disease prevalence, severity and patient preferences. We first define costs associated with the clinical trial given the null hypothesis (the treatment is ineffective) and alternative hypothesis (the treatment is effective). We assign prior probabilities to these two hypotheses and formulate the expected cost associated with the trial. The optimal sample size and critical value for the test are then jointly determined to minimize the expected cost of the trial. We applied the Bayesian framework only to traditional fixed-sample random clinical trials. But it could also be used for more sophisticated (though still somewhat controversial) adaptive random-trial designs in which information gathered during a trial is

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used to revise the trial midstream. For illnesses with extremely high costs – as measured by a combination of objective costs, such as the total number of years of life lost from a given disease, as well as subjective costs, such as the preferences of patients and their caregivers – the optimal type I error may be considerably higher than 2.5 percent. That is, it may be worth approving such drugs even if there is, say, a 10 or 20 percent chance that the measured benefits only reflected chance. By the same token, mild diseases may warrant lower levels of type I error. We found that the current standards of drug approval are weighted more toward avoiding a type I error than a type II error. That’s understandable, given the FDA’s mandate to protect the public, but it does not necessarily reflect the severity of all diseases or the values of all stakeholders. Take the example of clinical trials for therapies targeting pancreatic cancer, a disease with a five-year survival rate of just 1 percent. We calculated a Bayesian decision analysis optimal type I error of 23.9 percent to 27.8 percent, depending on the assumed power of an efficacious treatment. On the other hand, for clinical trials for prostate cancer therapies, in which the disease’s prognosis is not as grim, we calculated an optimal type I error of 1.2 percent to 1.5 percent. This suggests that the standard 2.5 percent threshold may be far too conservative when applied to potential therapies for terminal diseases and too aggressive in other cases. It depends on the relative costs and severity of the disease.

details, details We categorized the costs associated with a clinical trial into two groups: In-trial costs, which are independent of the final decision of the clinical trial but depend on the numbers in the trial.

RISK VS. BENEFIT

DISEASE

BDA-OPTIMAL VALUES PREVALENCE (1,000S) SEVERITY

SAMPLE SIZE

Ischemic heart disease�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,896. . . . . . . . . . . . 0.12 . . . . . . . . . . . Lung cancer�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290. . . . . . . . . . . . 0.45 . . . . . . . . . . . Ischemic stroke�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,932. . . . . . . . . . . . 0.15 . . . . . . . . . . . Hemorrhagic/other non-ischemic stroke�. . . . . . . . . . . . . . . . 949. . . . . . . . . . . . 0.16 . . . . . . . . . . . Chronic obstructive pulmonary disease� . . . . . . . . . . . . . 32,372. . . . . . . . . . . . 0.06 . . . . . . . . . . . Diabetes� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,695. . . . . . . . . . . . 0.05 . . . . . . . . . . . Cirrhosis of the liver�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78. . . . . . . . . . . . 0.49 . . . . . . . . . . . Alzheimer’s disease� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,145. . . . . . . . . . . . 0.18 . . . . . . . . . . . Colorectal cancer�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799. . . . . . . . . . . . 0.15 . . . . . . . . . . . Pneumococcal pneumonia�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84. . . . . . . . . . . . 0.30 . . . . . . . . . . . Influenza�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119. . . . . . . . . . . . 0.20 . . . . . . . . . . . H influenza/type B pneumonia�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21. . . . . . . . . . . . 0.26 . . . . . . . . . . . Respiratory syncytial virus pneumonia�. . . . . . . . . . . . . . . . . . . . 15. . . . . . . . . . . . 0.07 . . . . . . . . . . . Breast cancer�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,885. . . . . . . . . . . . 0.05 . . . . . . . . . . . Chronic kidney disease�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,919. . . . . . . . . . . . 0.04 . . . . . . . . . . . Pancreatic cancer� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23. . . . . . . . . . . . 0.71 . . . . . . . . . . . Cardiomyopathy�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416. . . . . . . . . . . . 0.17 . . . . . . . . . . . Hypertensive heart disease�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185. . . . . . . . . . . . 0.27 . . . . . . . . . . . Leukemia� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140. . . . . . . . . . . . 0.21 . . . . . . . . . . . HIV/AIDS�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,160. . . . . . . . . . . . 0.10 . . . . . . . . . . . Kidney cancers�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329. . . . . . . . . . . . 0.12 . . . . . . . . . . . Non-Hodgkin lymphoma�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283. . . . . . . . . . . . 0.13 . . . . . . . . . . . Prostate cancer�. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,710. . . . . . . . . . . . 0.05 . . . . . . . . . . . Brain and nervous system cancers� . . . . . . . . . . . . . . . . . . . . . . . . . . 60. . . . . . . . . . . . 0.30 . . . . . . . . . . . Liver cancer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31. . . . . . . . . . . . 0.44 . . . . . . . . . . .

CRITICAL VALUE

283 . . . . . . . . . . . 165 . . . . . . . . . . . 268 . . . . . . . . . . . 263 . . . . . . . . . . . 336 . . . . . . . . . . . 344 . . . . . . . . . . . 156 . . . . . . . . . . . 253 . . . . . . . . . . . 264 . . . . . . . . . . . 205 . . . . . . . . . . . 243 . . . . . . . . . . . 214 . . . . . . . . . . . 278 . . . . . . . . . . . 342 . . . . . . . . . . . 354 . . . . . . . . . . . 117 . . . . . . . . . . . 257 . . . . . . . . . . . 218 . . . . . . . . . . . 239 . . . . . . . . . . . 295 . . . . . . . . . . . 285 . . . . . . . . . . . 274 . . . . . . . . . . . 349 . . . . . . . . . . . 204 . . . . . . . . . . . 165 . . . . . . . . . . .

SIZE (%)

POWER (%)

1.76. . . . . . . . . . . . . 3.9% . . . . . . . . . . . 88.8% 0.99. . . . . . . . . . . 16.1. . . . . . . . . . . . . . 90.0 1.66. . . . . . . . . . . . . 4.9. . . . . . . . . . . . . . 89.2 1.62. . . . . . . . . . . . . 5.2. . . . . . . . . . . . . . 89.3 2.10. . . . . . . . . . . . . 1.8. . . . . . . . . . . . . . 87.3 2.14. . . . . . . . . . . . . 1.6. . . . . . . . . . . . . . 87.2 0.93. . . . . . . . . . . 17.7. . . . . . . . . . . . . . 90.0 1.55. . . . . . . . . . . . . 6.1. . . . . . . . . . . . . . 89.7 1.63. . . . . . . . . . . . . 5.2. . . . . . . . . . . . . . 89.3 1.25. . . . . . . . . . . 10.6. . . . . . . . . . . . . . 90.0 1.49. . . . . . . . . . . . . 6.8. . . . . . . . . . . . . . 89.8 1.30. . . . . . . . . . . . . 9.6. . . . . . . . . . . . . . 90.0 1.93. . . . . . . . . . . . . 2.7. . . . . . . . . . . . . . 84.6 2.14. . . . . . . . . . . . . 1.6. . . . . . . . . . . . . . 87.2 2.21. . . . . . . . . . . . . 1.4. . . . . . . . . . . . . . 86.9 0.63. . . . . . . . . . . 26.4. . . . . . . . . . . . . . 90.0 1.58. . . . . . . . . . . . . 5.7. . . . . . . . . . . . . . 89.5 1.33. . . . . . . . . . . . . 9.2. . . . . . . . . . . . . . 90.0 1.45. . . . . . . . . . . . . 7.3. . . . . . . . . . . . . . 90.0 1.84. . . . . . . . . . . . . 3.3. . . . . . . . . . . . . . 88.5 1.78. . . . . . . . . . . . . 3.8. . . . . . . . . . . . . . 88.6 1.70. . . . . . . . . . . . . 4.4. . . . . . . . . . . . . . 89.0 2.18. . . . . . . . . . . . . 1.5. . . . . . . . . . . . . . 87.0 1.24. . . . . . . . . . . 10.7. . . . . . . . . . . . . . 90.0 0.99. . . . . . . . . . . 16.1. . . . . . . . . . . . . . 90.0

source: Author and colleagues

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Post-trial costs, which depend solely on

the final outcome of the trial and are assumed to be independent of the number of recruited patients. In-trial costs are mainly related to patients’ exposure to inferior treatment, for example, the exposure of enrolled patients to an ineffective and harmful drug in the treatment arm or the delay in treating all patients (those in the control group and the general population) with an effective drug. If the current treatment or placebo is assumed not to be harmful, the patients in the control arm will experience no extra cost. But if the drug is effective, the situation is quite different. In that case, for every additional patient in the trial, there will likely be an incremental delay in the emergence of the drug in the market, which

affects all patients inside and outside the trial. We assume that there is no post-trial cost associated with making a correct decision (rejecting an ineffective drug or approving an effective one) and count post-trial costs associated with type I and type II errors. Specifying asymmetric costs for type I and type II errors allows us to incorporate the consequences of these two errors with different weights in our formulation. Take the case of pancreatic cancer, where patients can benefit tremendously from an effective therapy. The type II cost – caused by mistakenly rejecting an effective therapy – must be larger than the type I cost. In addition, the post-trial costs associated with type I and type II errors were assumed to be proportional to the size of the target population,

Second Quarter 2016

drug approval quandary because the greater the prevalence of the disease, the higher the cost associated with a wrong decision.

numbers, please We used the U.S. Burden of Disease Study 2010 to estimate the cost parameters associated with the adverse effects of the medical treatment and the reduction in the severity of the disease to be treated. One of the key factors in quantifying the burden of disease and loss of health due to disease is the years lived with disability attributed to the study popula-

by the World Health Organization. To estimate the current cost of adverse effects of medical treatment per patient, we used the corresponding values from the U.S. Burden of Disease Study 2010 mentioned above. The Bayesian decision analysis optimal critical values, size and power for the top disease-related leading causes of death for an intermediate value of the treatment effect come from my research with Isakov and Montazerhodjat (see the table on page 61). The table shows that the optimal type I errors (approving an ineffective therapy) vary considerably, depending on the costs associated with each

The formal Bayesian decision analysis framework offers a

systematic, objective, transparent and repeatable process for making regulatory decisions that reflects differences in both the impact of diseases and stakeholder perspectives. tion. In general, that number is computed by first specifying the different outcomes for a particular disease and then multiplying the prevalence of each outcome by its disability weight, a measure of severity for each outcome ranging from 0 (no loss of health) to 1 (complete loss of health â&#x20AC;&#x201C; that is, death). It should be noted that years lived with disability are computed only from non-fatal outcomes. To compute the severity of a disease, we added the number of deaths (multiplied by its disability weight, 1) to the number of years lived with disability and divided the result by the number of people afflicted with, or who died from, the disease. Rather than using the absolute numbers for death, disability years and prevalence, we used their age-standardized rates (per 100,000) to get a severity estimate thatâ&#x20AC;&#x2122;s more representative of the severity of the disease in the population, based on a standard population distribution proposed

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disease. For example, in the case of respiratory syncytial virus pneumonia, the Bayesian decision analysis optimal size is 2.7 percent â&#x20AC;&#x201C; nearly identical to the 2.5 percent threshold used by most random clinical trials. However, for pancreatic cancer, the optimal size is 26.4 percent, an order of magnitude bigger than the conventional threshold. The reason is straightforward: even though the prevalence of pancreatic cancer is in the same ballpark as respiratory syncytial virus pneumonia (23,000 vs. 15,000 cases annually), the severity of pancreatic cancer is an order of magnitude larger (0.74 vs. 0.07). Given the much greater severity of pancreatic cancer, common sense suggests that we ought to be willing to accept a greater risk of approving an ineffective therapy. Bayesian decision analysis provides a formal framework for implementing this intuitively sensible conclusion. However, some of the entries in the table

imply that the conventional 2.5 percent test for type I error may be too aggressive – as in the case of diabetes, where the optimal level is only 1.6 percent. Without providing context by explicitly specifying the burden of disease in terms of costs and benefits for current and future patients, it is virtually impossible to say whether a standard random clinical trial is too conservative or too aggressive. Bayesian decision analysis provides a solid framework for making such determinations.

light at the end of the tunnel The FDA is a highly scrutinized agency charged with tremendously important decisions that are often criticized as too aggressive or too conservative. Efforts to expedite the approval process for drugs targeted at serious conditions and rare diseases – by providing for faster reviews and accelerated endpoints to judge efficacy, for example – have garnered criticism for being too aggressive. At the same time, the FDA’s recent decision on drisapersen has incited a new round of criticism from patients’ families and advocates for being too conservative. One reason for these criticisms is the lack of transparency with which the FDA makes its decisions and the fact that the drugapproval process has multiple stakeholders who do not necessarily share the same values or objectives. The formal Bayesian decision analysis framework, by contrast, offers a systematic, objective, transparent and repeatable process for making regulatory decisions that reflects differences in both the impact of diseases and stakeholder perspectives. The analysis presented here is meant to be illustrative only. Practical implementation would require input from scientists, patient advocates and biopharma and health insurance professionals, as well as construction of an appropriate process for determining the

required Bayesian decision analysis parameters. This may seem daunting, given that part of the input is qualitative information, such as the impact of muscle degeneration on the quality of life of a Duchenne patient and his family. However, at least two initiatives for incorporating such information into the drugapproval process are already under way. Last May, Johnson & Johnson announced a newly formed partnership with the Division of Medical Ethics at NYU Medical School. The partnership will create an external advisory committee to review requests made to a Johnson & Johnson subsidiary, Janssen Pharmaceuticals Companies, for the use of its investigational drugs for so-called compassionate use. Such deliberations may be viewed as narrower versions of the drug-approval process, since they consist of approving or rejecting the one-time use of a drug candidate for just one patient. According to Johnson & Johnson, the Compassionate-Use Advisory Committee “will make recommendations regarding individual patient requests from anywhere in the world” and Janssen clinicians “will make the final decision.” Meanwhile, last September, the FDA announced the formation of the Patient Engagement Advisory Committee. I’ll spare you a recitation of the laundry list of subjects the committee is chartered to examine. Suffice it to say that, although newly launched, both of these committees have mandates that clearly include the implementation of the Bayesian decision analysis framework as an alternate method for regulators to evaluate the statistical evidence from random clinical trials. Cross your fingers. There’s hope that drugs will soon be evaluated in a systematic, consistent, transparent, unbiased, equitable, datadriven manner – one that, in Professor Berry’s words, focuses on patient values and not just p-values.

Second Quarter 2016

g n i s u o H Policy,

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g n i n r o The M After by lawre nc e j. wh it e

“The shapers of the American mortgage-finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.” — David Frum

For better or worse, housing policy is no longer the topic du jour for cable news.

On second thought, make that for better. After falling by about one-third between mid-2006 and 2012, housing prices have generally stabilized, even rebounded a bit. With help from Uncle Sam, the mortgage market has cleaned up much of the debris left by defaults, and the default rate today is relatively modest. But that doesn’t imply anybody’s truly minding the store. Federal housing-finance policy remains in limbo – and nowhere is that more evident than in the fate of Fannie Mae and Freddie Mac, the giant

Second Quarter 2016

housing policy

more is ... more Cutting to the chase, the United States’ current housing policy is easily summarized in a few words: housing is good; more is better. And the way to get more is to subsidize it. Start with the advantages of homeownership. Buyers can deduct the interest paid on mortgages from taxable income, while the state and local property taxes they pay as a consequence of homeownership are similarly deductible. And for most people, any capital gain they realize when they sell is exempt from income tax as well. Meanwhile, Fannie Mae and Freddie Mac indirectly subsidize mortgage interest and reduce down payments by shifting credit risk from borrowers to Uncle Sam. What’s more, they have company; the Federal Housing Administration, the Veterans Affairs Department and the Department of Agriculture all L AWR E N C E J. WH ITE is a professor of economics at NYU’s Stern School, specializing in regulation. As a member of the defunct Federal Home Loan Bank Board, he helped oversee the operations of Freddie Mac.

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provide similar subsidies in their own niches of the mortgage market. Renters get a piece of the action, too – though here, the goodies are spread around less widely. Federal, state and local programs provide vouchers so low-income households can rent from private landlords. And government agencies still shelter 1.2 million lowincome households in public housing built in earlier times. Billions here and billions there still add up to real money. The mortgage-interest deduction alone currently translates into forgone federal tax collections of about $70 billion a year. The property tax deduction and the cap-

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government-sponsored enterprises that pumped credit into the housing bubble until it burst and then became wards of Washington in September 2008. At the time, pretty much everybody expected that these enterprises would be wound down and replaced with some new institutional arrangement designed to stabilize the residential mortgage market and make it more efficient. But that hasn’t happened. Indeed, they have become even more important market-makers for home mortgages than they were in the frenzied years of the bubble. What could and should be done about housing policy? It’s best to add some perspective before asking what we’ve got now and how we got here.

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ital gains exclusion together lead to another $50 billion in forgone federal revenues. And the credit guarantees offered by Fannie Mae, Freddie Mac and the FHA probably have an implicit cost of another $20 to $30 billion. On the rental side, the annual Department of Housing and Urban Development budget – which consists mostly of rent subsidies – is currently around $45 billion. Note, too, that none of these estimates includes unrelated state and local policies that favor housing. One result of making homeownership more affordable may be a modest increase in the number of people living in their own dwellings. But there’s a less-celebrated conse-

quence: people buy more house. In 1950, the average new house provided about 1,000 square feet of living space; by 1980, the figure had reached 1,700 square feet. And in 2014, the average new house was over 2,600 square feet. Although much of this increase surely reflects higher incomes, some of it also reflects the impact of subsidies. That’s good, right? Not necessarily. Buying more housing because it’s cheaper sucks capital from other investments. Thus, money that might have gone to repairing bridges, developing cures for cancer or financing higher education is devoted to larger great rooms, central air-conditioning and patio fire pits.

Second Quarter 2016

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form of attachment to community that creates support for good government, public education and other socially desirable goals. There is also an element of opportunism on the part of antipoverty advocates, who believe that if they support subsidies for the middle class, low-income renters will be asked along for the ride. Moreover, the focus on housing creates natural allies with the construction unions, which remain a force in urban areas, where many poor people live. In this context, itâ&#x20AC;&#x2122;s also worth noting that voucher-based subsidies may be the path of least political and social resistance to achieving increased neighborhood diversity. Whatever the origins of subsidy-based housing policies, theyâ&#x20AC;&#x2122;ve amassed an interestgroup juggernaut to defend them. The for-

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Arguably as important, ill-targeted housing subsidies have contributed to suburban sprawl and led to the loss of open space, even as that sprawl exacerbated traffic congestion, air pollution and greenhouse gas emissions. So, why is house ownership such a priority? One reason: it was touted as the symbol of the American Dream after World War II and hasnâ&#x20AC;&#x2122;t been rethought since. Actually, there are also more tangible reasons. Ownership allows households to escape the whims of landlords and encourages investment in maintenance and improvements. And it is widely seen (largely too optimistically) as an opportunity for long-term wealth accumulation and a hedge against inflation. Moreover, there is some evidence that ownership generates broader societal benefits in the

take the standard deduction are out of luck. And among households that do itemize, the value of the tax breaks rises along with their incomes. Consider, too, that higher-income households are far more likely to carry disproportionately large mortgages, meaning they will be able to deduct more dollars as well as get more of a tax break per dollar of interest paid. High-income households are favored in subtler ways, too. The government-sponsored enterprises have historically tended to favor more expensive houses. Although the median existing house in the United States in 2015 sold for around $220,000, Fannie Mae and Freddie Mac will guarantee mortgages as large as $417,000 in most areas and up to $625,500 in the high-cost coastal regions. So the subsidies strongly favor higher-income households, who would likely buy anyway. Rental subsidies, by contrast, are more narrowly targeted. Old-fashioned public housing sets tough income limits, while rental vouchers are distributed solely to lowerincome households. tunes of tens of thousands of businesses, along with tens of millions of workers, are affected. Obviously, that includes the construction firms and mortgage intermediaries. But it also includes enterprises ranging from heavyequipment manufacturers to appliance makers to insurance companies – enterprises that are not strangers to organized lobbying.

where the windfalls land How effective are subsidies? As was mentioned above, they certainly encourage households to occupy more house. But do we get much bang for a buck in terms of broader ownership? Hardly. The tax preferences are sharply biased to favor higher-income households. First, they are structured as tax deductions. Thus, middle-income households that

mortgage finance for dummies Well, OK; you’re not dummies, and you may already know much of this. But a refresher will set up the meatiest part of this article. Lenders face two sorts of risks: credit risk – the chance that the loan won’t be repaid in a timely fashion – and interest-rate risk – the chance that interest rates will rise, making the loan less valuable in the secondary market. To protect themselves against credit risk, lenders must do their homework, evaluating the prospective borrowers’ ability to meet their obligations, a process that goes by the name of underwriting. Lenders often require borrowers to collateralize loans with an asset that can be seized to cover a default. In real estate, it’s a matter of course; with residential

Second Quarter 2016

housing policy mortgages, the houses serve as collateral and the down payments reduce the prospect that the collateral will prove inadequate. Indeed, lenders typically do even more to protect against credit risk. They may require a guarantor (a co-signer) as a backup, especially if the loan collateral is problematic. And they typically require home mortgages to be self-liquidating, with monthly payments that return a small but growing bit of the principal along with the interest.

fer the certainty of a fixed interest rate. And since the 1930s, American housing-finance markets have tilted toward fixed-rate mortgages, in part because those mortgages were championed by federal policymakers. But one additional contract provision made fixed-rate mortgages irresistible to borrowers: the discretion to repay the loan before the due date without any fee for doing so, which frees those loans of interest-rate risk. So when market rates decline, borrowers can refinance at lower fixed rates, effectively de-

Beginning in the late 1990s, the growing belief that housing prices would

always increase eroded normal underwriting precautions. Meanwhile, the growth of the secondary market for mortgages and the securities created by bundling them made it easy to unload risky loans. In the postwar years, underwriting was generally quite conservative, in part because the loans were typically of very long duration (30 years), and in part because repayment guarantees could be obtained from the FHA or government-sponsored enterprises only if mortgages conformed to conservative standards. However, beginning in the late 1990s, the growing belief that housing prices would always increase eroded these normal underwriting precautions. If housing prices would always increase, the quality of underwriting hardly mattered: sufficient collateral would always be there to make the lenders whole. Meanwhile, the growth of the secondary market for mortgages and the securities created by bundling them made it easy to unload risky loans. Lenders (and the buyers of mortgage securities) generally prefer adjustable-rate loans, with the rate floating along with some measure of general interest rates. This pushes the aforementioned interest-rate risk on to the borrower. By contrast, borrowers usually pre-

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nying the lender any benefit. But when interest rates rise in the economy, they can sit tight, paying below-market rates. Heads I win, tails you lose.

so what could possibly go wrong? Before the 1990s and the creation of a national (and then global) market for residential mortgage-backed securities, lenders put to work the money of their own depositors, profiting from the difference between the interest rates they paid and the interest they collected on the mortgages. Their success thus depended on how well they assessed the creditworthiness of borrowers and how efficiently they serviced the loans. Banks paid for their own mistakes unless they received a guarantee from a government-sponsored enterprise or the FHA, which protected themselves by insisting on conservative underwriting standards. But one factor was beyond the lendersâ&#x20AC;&#x2122; control: their income was limited by the fixed

rates collected on long-term mortgages (typically for 30 years), while their interest expenses for deposits fluctuated with the market. This was an especially severe problem for savings institutions, which were often prevented by their charters from diversifying their port-

could be sold to third-party private investors. The interest and principal repayments of the underlying mortgages were passed through to the security holders by a servicing agent. Note that the once vertically integrated housing-finance industry quickly fragmented

folios into other kinds of assets or even from originating adjustable-rate mortgages. When interest rates rose sharply – as they did in the late 1970s and early 1980s – these institutions were caught between the proverbial rock and hard place. Thereafter, Washington gave the savings-and-loan industry the discretion to diversify investments. The savings-and-loan associations gradually withdrew from the businesses of holding and servicing mortgages. However, an alternative mortgage-finance structure filled the gap: securitization. Here, an originating institution bundled hundreds or even thousands of mortgages into a security – really, a bond – that

into specialized services: one institution marketed and originated loans to homebuyers, another bundled mortgages into securities and sold them and yet another serviced these mortgages on behalf of securities owners. In large part, this was and still is good news. Mortgages can be financed by a far broader range of institutional lenders, many of which (think of insurance companies and pension funds) are uniquely suited to holding fixedrate mortgages because their liabilities are both long term and highly predictable. Another advantage is that specialization allows for greater efficiency and may encourage economies of scale. It may be mildly unpleasant

Second Quarter 2016

housing policy for borrowers to deal with faceless computers and with call centers in the Philippines, but it’s a lot cheaper than dealing with the beancounting banker in It’s a Wonderful Life. However, there’s also a major drawback to de-integration: each handoff – from originator to packager to investor – puts more distance between the lender and borrower, and thus puts a greater premium on truly understanding the risks involved. In particular, how can the investor or lender be sure that the originators have properly screened and vetted the borrowers and have issued mortgages only to creditworthy borrowers? Consequently, it was no accident that the initial securitization of residential mortgages in 1970 was arranged by the Government National Mortgage Association – friends call her Ginnie Mae – an agency run by the Department of Housing and Urban Development. The mortgages being securitized were insured by the FHA (another government agency) while Ginnie “wrapped” FHA’s insurance with its own promise of prompt payment to investors in the event that the underlying mortgage borrower defaulted. Investors in these securities thus didn’t need to know much about the creditworthiness of borrowers – that was Uncle Sam’s problem. It was also no accident that the next enterprises to arrange mortgage securitizations were Freddie Mac (1971) and Fannie Mae (1981). Unlike Ginnie, their debt securities were not formally the liabilities of the U.S. government. But investors didn’t believe Washington would ever leave either of them twisting in the wind (correctly, it turned out). Indeed, by the end of 2007, the government-sponsored enterprises’ mortgage-backed securities accounted for over $3.5 trillion (no misprint) in mortgages when the overall face value of residential mortgages outstanding was around

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$12 trillion. In addition, because they could borrow cheaply (again, because everybody believed Uncle Sam would back them in a pinch), they had bought another $1.5 trillion in mortgages and held them as direct investments on their balance sheets. Although there had been sporadic initiatives to arrange private-mortgage securitizations starting in the mid-1980s, these efforts did not gain momentum because of market concerns about credit risk. In the late 1990s, however, the market took off when the mortgage-bond securities were structured in “tranches,” in which the senior creditors would have first dibs on the cash flow. Creditrating agencies were corralled into giving the senior tranches the top ratings that insurance companies and other regulated institutions needed in order to buy them. That left the owners of junior tranches at the end of the line. But these junior securities were successfully marketed like high-yield bonds, with bundlers playing down the risk and touting the promised returns. Or they were recombined into new bundled securities – collateralized loan obligations – and the slicing and dicing could begin anew. Sometimes there were as many as 15 to 20 tranches carved from the same bundle of mortgages, with each tranche (starting with the most junior) providing a buffer for the next-most-senior one. The risks buried in such complex securities were hard to analyze. And, apparently, few buyers (typically institutions) bothered. Once again, the conviction that housing prices would always increase led most market players to complacency. Mortgage originators took advantage of this belief to extend credit to ever-shakier borrowers, making the pitch that borrowers would always be able to refinance or sell their houses for a profit. Even mighty Fannie Mae and Freddie Mac – which had previously

Second Quarter 2016

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housing policy maintained tight creditworthiness standards with respect to the mortgages that they would securitize or hold in their own portfolios – succumbed around 2004 and lowered their underwriting standards as well. Of course, the music eventually stopped, with housing prices peaking in mid-2006 and sliding thereafter. Delinquencies and then defaults followed, while the annual flow of private-label mortgage securitizations that lacked a government guarantee fell from hundreds of billions of dollars’ worth annually as late as 2006 to zilch in 2008. There has been almost no revival of private-label securitization since. Although government-sponsored enterprises’ securitizations continued largely unhindered (thanks to the comforting backstop of Uncle Sam), by the summer of 2008 Fannie Mae and Freddie Mac were rumored to be insolvent. Thereafter, their governmentconnected status was not sufficient to convince private investors to buy their IOUs. And in early September 2008, the two cash-short entities were put into government conservatorships, where they remain. They’re still in business, though, thanks to their access to federal guarantees for their securities. Indeed, they are the primary suppliers of residential mortgage credit in the country.

housing policy 2.0 It’s hard to create a coherent housing policy without a clear sense of what we’d like to achieve. My own first priority would be to reduce subsidies – especially the subsidies that are defended as promoting ownership. Yes, there are societal benefits to homeownership that go beyond the benefits to the homeowners. But there are also social costs, not the least of which is putting the savings of the struggling middle class at the mercy of the 74

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nice folks who brought you the mortgage crisis of 2007. Equally to the point, there are better ways to spend the hundreds of billions of taxpayer money that is now tossed into the maw of the housing behemoth each year. If politics requires that some form of ownership subsidy remain in the tax code, at the very least we should transform the interest deduction into a refundable tax credit given to anyone who owns or rents. Or if one believes that ownership has positive spillovers worth the price, one could limit the subsidy to a first-time-buyer’s tax credit – say, $5,000 per year for each of the initial five years of ownership. In either case, the tax break would have an equal net value to low-income and high-income households. By the same token, my second priority is that renting should be seen as a respectable alternative to ownership, and not just a refuge for the young and the poor. Indeed, once one realizes that housing has not been nearly as good a long-term investment as the stock market – the figures are startling – it’s obvious that homeownership is not for everyone. Houses are volatile, illiquid investments with outrageously high selling costs. Moreover, ownership impedes the ease with which households can move to take advantage of job, school and lifestyle opportunities. And rent subsidies? As a general matter, unrestricted cash transfers are likely to be the most efficient way of making low-income households better off. Indeed, Brazil and Mexico have made big inroads in poverty with cash handouts conditioned only on an insistence that children in the household are vaccinated and go to school. But Americans have long preferred in-kind transfers – food, housing, preschool education, medical care – to cash. And some of the recent findings of behavioral economics support the idea that targeted subsidies may yield beneficial out-

comes for low-income households. So, let there be rental subsidies, but in the form of vouchers that give renters maximum flexibility and narrowly target low-income families. There would still be ways to help the struggling middle class. For starters, regulations that raise house prices should be examined with an eye to comparing costs and benefits.

should not be a vehicle for internalizing the external societal benefits of homeownership. In this spirit, the FHA, a government agency whose budget is part of the overall federal budget, ought to be the locus of efforts to make it easier for low- and moderate-income households to become homeowners. For example, the FHA should provide explicitly un-

Renting should be seen as a respectable alternative to ownership, and

not just a refuge for the young and the poor. Once one realizes that housing has not been nearly as good a long-term investment as the stock market, it’s obvious that homeownership is not for everyone. Some are no-brainers: restrictions on lumber imports from Canada ought to be dismantled, as should restrictions on the import of cement. More important, local building codes that increase costs without commensurate benefits in safety or reliability should be dismantled. Most important, suburban land-use zoning restrictions that prevent the construction of rental housing (or small-lot singlefamily houses) ought to be eliminated. The third leg of housing policy reform is, of course, finance. Addressed in very broad terms, policy should encourage efficient allocation of capital in which mortgage rates accurately reflect risk and the opportunity cost of diverting resources from other productive uses. Unfortunately, the discussion usually revolves around code words with imprecise meanings – in particular, affordability and accessibility. We certainly want adequate housing to be affordable and accessible, and we want to create potent incentives to encourage neighborhood diversity. But too often those words serve as code for requiring lenders to reduce credit standards or to cross-subsidize low-income households by providing credit at belowmarket rates. The housing-finance system

derpriced guarantees on their mortgages. But allowing people in this group to buy with only small down payments is not a good direction for policy because it puts them at greater risk of default. Down payments of 20 percent – or at least 10 percent – ought to be the target, as compared to the 3 to 4 percent currently allowed under FHA programs. Then there is the question of limiting the size government mortgage guarantees. Currently, the FHA can guarantee mortgages as large as $625,500 in high-cost areas. A ceiling of 90 percent of the national median value of houses sold (currently around $220,000) seems like a reasonable target for FHA guarantees, regardless of whether an area is a high-cost one or not. Next, we have to confront the conundrum of the 30-year fixed-rate mortgage. It’s clear that this is an extremely popular financing instrument – both politically and in the marketplace. But it is also clear that the 30-year fixed-rate mortgage exposes lenders to a lot of interest rate risk. If banks and other depository institutions provide the credit, there is the severe maturity mismatch between their long-maturity mortgage loan assets and their

Second Quarter 2016

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mercial loan arrangements, including com mercial real estate mortgages. They should become normal in residential real estate mortgages as well. And the word “penalty” should be banished from the lexicon of mortgagefinance policy discussions. Then there’s the question of the role depository institutions play in a market that remains dominated by fixed-rate mortgages. In 2007, banks and other deposit takers directly or indirectly held 30 percent of outstanding residential mortgages. That percentage is smaller today. But it would be reasonable to expect a return to that level if these institutions find a way to hedge against the risk of the maturity mismatch between deposits and mortgages. Recall that insurance companies (especially life insurance companies) and pension funds have long-lived predictable obligations. It would seem a natural for them to profit by

istock

short-maturity deposits. On the other hand, if bond investors provide the finance through mortgage-backed securities, the door is opened to the sorts of problems that brought such private-label securities crashing down in 2007. Further, under either model, allowing the borrower to have a fee-free option for refinancing exacerbates the interest-rate risk of the lender. The popularity of the 30-year fixed-rate mortgage and its costs needs to be acknowledged. Let’s start with an easy way to reduce those costs. If lenders were permitted to charge fees for prepayment, the competitive rate of interest would fall by an estimated half a percentage point. Unfortunately, prepayment fees have generally been termed “prepayment penalties,” which has made them seem unfair to borrowers. But they are a normal element in com-

taking on some of the mismatch risk by selling derivatives to the banks – options, futures, swaps and the like – that can limit risk for the buyer. And it would be in the interest of regulators focused on the stability of the capital markets to encourage the development of these instruments. Indeed, it ought to be a priority. The remainder of mortgages will have to be securitized. And a simple two-part tranche structure – a senior tranche that is protected by a junior tranche and by a minimum size, last-to-be-paid equity slice added by the securities packager – would seem to be a natural. Investors who seek safety (and are not afraid of long-maturity assets) would gravitate toward the senior tranche; again, this would seem to be the domain of insurance companies and pension funds (which are a ripe market, since they currently invest far less than 10 percent of their assets in mortgage securities). Hedge funds and mutual funds specializing in high-risk securities would be the likely investors in the junior tranche. Memories of what went wrong in the 2000s (along with greater regulatory oversight) should help keep the parties honest. A big puzzle today is why private-label securitization hasn’t made a comeback. Right now, the only securitization games in town are run by Fannie Mae, Freddie Mac and Ginnie Mae. After 2008, it initially seemed that they were underpricing their guarantees and thus making competition from the private sector difficult. Prior to the crash, they had charged guarantee fees of approximately 0.2 percentage points per year on the unpaid balance of mortgages. Since the interest-rate differential between mortgages backed by governmentsponsored enterprises and those of equal quality that were too large for those enterprises to securitize was around 0.25 percentage points, it seemed that a small increase in the guarantee fees would level the playing field

and lead to expanded private-sector securitization. But fees charged by the GSEs have since been raised by an even larger amount – they are now around 0.6 percentage points annually – and yet the private-sector securitization has not revived. Perhaps the current policy uncertainty has created a chicken-and-egg problem. The private sector doesn’t want to invest in securitization platforms that might be legislated out of existence in some future reform of mortgagemarket regulation. But until a private-sector alternative is clearly viable, policymakers are

Until a private-sector alternative is

clearly viable, policymakers are unlikely to reduce the borrowing power of the government-sponsored enterprises; doing so would risk hobbling the mortgage market. unlikely to reduce the borrowing power of the government-sponsored enterprises; doing so would risk hobbling the mortgage market. Or perhaps potential institutional investors in private-label mortgage-backed securities have learned the lessons of the 2008 debacle too well – that originators and private securitizers (and the credit-rating agencies) are simply not to be trusted. In any event, we seem stuck with a federalized Fannie Mae and Freddie Mac for now. And we don’t seem to be paying much of a price, since they are tightly regulated and are not engaging in the slack underwriting that helped to inflate the bubble and drove them into the arms of the government. Indeed, they have become quite profitable. One very real danger in letting them operate as usual, though, is that they could be

Second Quarter 2016

housing policy used for politically inspired efforts to subsidize housing. In that vein, at the end of 2015, the Federal Housing Finance Agency proposed regulations imposing a “duty to serve” on the government-sponsored enterprises with respect to low- and moderate-income households. If the new regulations prove to have bite, these enterprises will be obliged to serve those market segments even if they can’t cover their costs. And since they are currently highly profitable (with their profits going entirely to the U.S. Treasury) the government would end up funding this subsidy without Congress’s assent. Now, this may prove to be a good use of the people’s money. But it is a bad precedent to fund the program by robbing Peter to pay Paul within the budgets of the GSEs, and thus not subject to routine oversight by Congress. One positive post-crisis development has been a directive from the Federal Housing Finance Agency requiring Fannie Mae and Freddie Mac to share some of the credit risk on their mortgage-backed securities with the private sector. In essence, Fannie and Freddie must buy insurance against limited amounts of the credit losses on the pools of mortgages that underlie their mortgage-backed securities. In a few instances, they really have bought insurance. But over 90 percent of these transactions nowadays involve the governmentsponsored enterprises’ issuance of so-called catastrophe bonds in which creditors would receive less than all their money back in the event that the mortgages underlying a specific government-sponsored-enterprise’s security take a big hit. The cost of managing credit risk this way is reflected in mortgage interest rates (unless the government-sponsored enterprises are persuaded to dip into another pocket to cover

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it). But that is the point: mortgage rates should reflect the full costs of the system that supports housing finance. With time, one can hope that investors become more comfortable with mortgage credit risk, which would open the door to privatelabel mortgage-backed securities that provide some competition for Fannie Mae and Freddie Mac. This process would be aided by a phase-down in the maximum size mortgage that the entities can buy or securitize. These are hardly radical changes. But they would push the needle in the right direction, making housing policy more transparent, as well as better aligning mortgage interest rates with costs and encouraging the private sector to compete with the government-sponsored enterprises.

yes, we might Housing markets have largely healed from the deep wounds left by the crisis. But housing policy is still a mishmash of costly incentives that help the affluent more than struggling households. And the mortgage market is still largely dependent on federal guarantees to function. All this is understandable: organized groups representing almost everybody who deducts mortgage interest from taxable income is reluctant to rock the boat. In the words of Pogo, Walt Kelly’s long-departed comic strip character, “We have seen the enemy, and he is us.” But another aphorism, originally attributed to Winston Churchill (and more recently to Rahm Emanuel), is still worth remembering: “Never let a good crisis go to waste.” The sense of urgency for change created by the 2008 meltdown is rapidly fading. It would be a pity if we failed to use the residual room for maneuvering to create a fairer and more efficient system for financing housing.

b o o k e x c e r p t

Between Debt and the Devil i l l u st r at i o n s b y james turner

Sometimes the best ideas in economics hide

in plain sight. And to his great credit, Adair

Turner, the former chairman of the UK

Financial Services Authority who now heads the board of the New York-based Institute for New Economic Thinking, has rediscovered one that is usually consigned to a footnote in macroeconomics textbooks. ¶ Turner’s new book, Between Debt

and the Devil,* offers a convincing argument for the use of “helicopter drop” money (Milton Friedman’s coinage back in 1948) to manage the rubble left by the collapse of the global debt bubble. Most likely, you’ll initially be inclined to dismiss Turner’s case as fiscal sleight-of-hand, a technique that promises too much gain for too little pain to be realistic. But keep reading, and just as likely your skepticism will morph into dismay that an idea this good could have been ignored for so long. — Peter Passell

Second Quarter 2016

Seven years after the 2007-2008 financial crisis, the world’s major economies are still suffering its consequences. Eurozone GDP has not yet returned to pre-crisis levels; unemployment exceeded 10 percent at the end of 2015 and inflation is far below the European Central Bank’s closeto-2 percent target. Japan continues to struggle with low growth and relentlessly rising public debt. The United Kingdom has begun

“The current phase of the official policy approach is predicated on the assumption that debt sustainability can be achieved through a mix of austerity, forbearance and growth. ... This claim is at odds with the historical track record of most advanced economies.” – Carmen Reinhart and Kenneth Rogoff to grow and create jobs, but GDP per capita is still below the 2007 level and average real earnings are still some 6-8 percent below the pre-crisis peak. The U.S. recovery has been more robust, but the employment rate remains far below 2007 levels. Inequality has continued to increase. Across the advanced economies, many people are no longer confident that capitalism will deliver rising prosperity generation after generation. There could be supply-side explanations for this slowdown in economic growth. Working-age population growth has slowed and has turned negative in Japan. Some economists argue that the attainable rate of productivity growth has also declined. But long-term developments in supply-side factors cannot possibly explain the sudden switch from robust growth in many countries before 2008 to slow or nil growth for seven years thereafter.

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Low rates of inflation and nominal GDP growth meanwhile make it clear that inadequate demand has played a major role. For advanced economies to grow in line with potential and with about 2 percent inflation, we need nominal demand to grow at something like 4-5 percent per year. Since 2008, actual nominal domestic demand growth has been less than 3 percent per year in the United Kingdom and the United States, around zero in Japan and less than 0.5 percent in the eurozone. Thus we will never get out of the current malaise, return inflation to target or reduce debt levels unless we increase demand in our economies. Faced with this malaise, it can seem that all policy levers are ineffective. Indeed, many central bankers are keen to stress the limits to what they can achieve. But inadequate nominal demand is one of very few problems to which there is always an answer. Central banks and governments together can create nominal demand in whatever quantity they choose by creating and spending fiat money. Doing so is considered taboo – a dangerous path toward inflationary perdition. But there is no technical reason such “money finance” should produce excessive inflation, and, by excluding this option, we have caused unnecessary economic harm. This chapter describes why money finance of fiscal deficits is technically feasible and desirable, and why it may be the only way out of our current problems. Here, I offer some specific ways in which we should now use this potentially powerful tool.

we never run out of ammunition The fundamental reason recovery from the Great Recession has been slow and weak is

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the debt overhang described in detail elsewhere in the book. Collapsing credit supply played a crucial role in driving economies into recession in 2009. But thereafter, debt overhang was the dominant factor, driving reduced private credit demand. Excessive private debt creation before the crisis left many households and consumers overleveraged and determined to pay down debt. Reduced private consumption and investment then depressed economic growth, producing large fiscal deficits and a rising public debt-to-GDP ratio. Leverage has not gone away, but simply shifted around the economy, from private to public sectors, or among countries. German deleveraging, for instance, has only been possible because Chinese leverage has soared. Overall, developedeconomy leverage, public and private combined, has continued to increase slowly, and total global leverage has increased significantly as emerging economy private credit grows at a fast pace. Attempted deleveraging has thus depressed economic growth, but no overall deleveraging has actually been achieved. And none of our traditional policy levers seem able to overcome this dilemma.

is austerity inevitable? After the crisis, fiscal deficits increased substantially as tax revenues fell and social expenditures rose. In the United States, the fiscal deficit rose from 3.2 percent of GDP in 2007 to 13.5 percent in 2009; in the United Kingdom, from 2.9 percent to 11.3 percent. In the eurozone, the aggregate deficit grew from 0.7 percent to 6.3 percent. Those increased deficits helped prevent still deeper recession, providing powerful stimulus to nominal demand in the face of private deleveraging. Indeed, there is no doubt that if governments run fiscal deficits – spending more 82

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than they tax and borrowing the money to cover the difference – the immediate direct effect is increased nominal demand. But in some circumstances, that direct effect can be stymied by the offsetting factors. If short-term interest rates have already been set by the central bank at an optimal level, increased fiscal deficits will provoke rate increases that slow the economy down. If the increased issue of government bonds produces a rise in long-term interest rates, a similar “crowding out” effect may result. And if taxpayers rationally anticipate that fiscal deficits today mean higher taxes in the future, they may save more today, refusing to spend the tax cuts or reducing their private expenditure by as much as public spending rises (the so-called Ricardian Equivalence effect). Pre-crisis macroeconomic theory therefore tended to the conclusion that fiscal policy had little potential to stimulate even nominal demand, let alone to produce an increase in real output. The counterargument, powerfully put by Brad DeLong (Berkeley) and Lawrence Summers (Harvard), is that in the special circumstances of post-crisis recession, the offsetting factors do not apply. With central banks determined to keep interest rates close to zero, increased fiscal deficits will not provoke rate increases. There is underemployment and spare capacity, so the direct stimulus effect will produce additional real growth as well as price inflation; fiscal deficits might therefore pay for themselves, generating faster growth in GDP than in the stock of debt, and thus actually reducing the future debt-to-GDP ratio. As a result, rational individuals and companies will not worry about how increased public debt can be repaid. A strong case can therefore be made that fiscal policy stimulus should have been deployed even more aggressively in the aftermath of 2008. Some estimates suggest that

United Kingdom GDP was depressed by 3 percent as result of unnecessarily aggressive fiscal consolidation after 2010. And there is no doubt that in the eurozone, where the aggregate fiscal deficit has averaged 1.6 percent between 2008 and 2013 versus 7.2 percent in the United States and 6 percent in the United Kingdom, fiscal austerity has significantly depressed growth. But the constraints on our ability to use fiscal stimulus must still be recognized. Even if, in some circumstances, incremental fiscal stimulus might reduce future public leverage relative to a no-action alternative, the large deficits actually run up have been accompanied by big increases in public debt-to-GDP – up from 72 percent to 105 percent in the United States, from 51 percent to 91 percent in the United Kingdom, and from 40 percent to 90 percent in Spain, for instance. And while huge Japanese public deficits after 1990 may, as Richard Koo (the chief economist at the Nomura Research Institute) has argued, have helped offset the deflationary impact of private deleveraging, Japan is still left with the question of how its relentlessly rising public debt can be repaid. In the eurozone, fears that rising public debt burdens in peripheral countries might provoke default or eurozone exit did result in rising interest rates, exacerbating the danger that debts would become unsustainable and increasing the cost of credit to the private sector. Thus there are limits to our ability to use traditional fiscal stimulus to escape the debt trap. Carmen Reinhart and Kenneth Rogoff ’s analysis suggests that if public debt levels rise above about 90 percent of GDP, adverse consequences for growth are likely to follow. Controversy over their calculations shows that we must not overstate the importance of any one specific threshold. But their overall conclusion that high debt-to-GDP ratios will

inevitably constrain the scope for fiscal policy stimulus is valid. It is important not to misinterpret this finding. It most certainly does not mean that fiscal austerity is costless because of some socalled confidence-inducing effect. Indeed, the best interpretation of Reinhart and Rogoff ’s empirical results is that the adverse effect on growth that they observe derives primarily from the fiscal tightening that high levels of accumulated debt appear to make necessary. That makes it crucial to constrain public debt levels in the good years – and also crucial to restrict excessive private credit creation, reducing the danger that excessive debt will shift to the public sector in the aftermath of crisis. But it also means that we need to find ways to stimulate nominal demand that do not result in rising public debt.

ultra-loose monetary policy and adverse side effects For seven years, central banks have tried to use ultra-loose monetary policy to stimulate the economy. Short-term interest rates have been close to zero in the United States and the United Kingdom since 2009, in Japan for much longer, and in the eurozone since 2013. Quantitative easing – central bank purchases of government or other bonds – has been used in Japan, the United States and the United Kingdom to drive down long-term interest rates; in March 2015, it was also finally deployed in the eurozone. And central bank liquidity and funding schemes – such as the Bank of England’s Funding for Lending Scheme and the ECB’s Targeted Long-term Repo Operation – have sought to ensure that real economy households and businesses, as well as financial market traders and investors, can borrow at low interest rates. Those policies have almost certainly generated faster nominal demand growth than

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would otherwise have occurred and helped prevent either still-lower inflation or stilllower real growth. But they have suffered from two deficiencies. First, they have proved insufficient to deliver robust growth, with recovery still anemic and inflation falling below target in all major economies. Still lower (that is, negative) rates would have delivered more stimulus, but if central banks set rates at a more than marginally negative level, individuals and companies would convert bank deposits into currency notes and the stimulus effect would be undone. Kenneth Rogoff has argued that we should overcome this problem by abolishing paper currency, with all money held in deposit form. Central banks could then set interest rates at significantly negative levels. But that option is not available today. And if it were available and used, it would exacerbate the second deficiency of ultra-loose monetary policy – its adverse side effects. Quantitative easing works because low long-term yields drive up asset prices and wealth, and thus stimulate asset holders to consume or invest more. It is therefore bound to increase inequality. Sustained ultra-low interest rates, meanwhile, are likely to encourage risky and highly leveraged financial speculation long before they stimulate real demand. And they can only stimulate real demand by encouraging a return to the private credit growth that first created the debt overhang problem. The United Kingdom’s Office of Budget Responsibility forecasts that UK private leverage, having declined slightly over the past five years, will by 2020 have risen to its highest-ever level. The IMF was therefore right to warn in its October 2014 Global Financial Stability Report that “the extended period of monetary accommodation and the accompanying search for yield is leading to credit mispricing

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and asset price pressures and increasing the danger that financial stability risks could derail the recovery.” But in its simultaneously published World Economic Outlook, the IMF also warned that increased nominal demand is needed and that “in advanced economies, this will require continued support from monetary policy.” With fiscal policy blocked, ultra-loose monetary policy thus seems both dangerous and essential. Fortunately, however, there is an alternative.

helicopter money with fractional reserve banking Milton Friedman explained most clearly why inadequate nominal demand is one problem to which there is always a possible solution. If an economy was suffering from deficient demand, he suggested, the government should print dollar bills and scatter them from a helicopter. People would pick them up and spend them. Nominal GDP would increase, and some mix of higher inflation and higher real output would result. The precise impact of any given size of helicopter-money drop would depend on how much people spent rather than saved of their newfound financial wealth. But it would clearly be somewhat proportional to the value of bills printed and dropped. If they were only worth a few percentage points of current nominal GDP, the stimulus to either real growth or inflation would be quite small. If the currency were worth many times nominal GDP, the effect would be large and primarily take the form of increased inflation, since the potential for real output growth is constrained by supply factors. While Friedman’s example is very simple, it illustrates three crucial truths. We can always stimulate nominal demand by printing fiat money. If we print too much, we will generate harmful inflation; but if we print only a

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small amount, we will produce only small and potentially desirable effects. The money drop from Friedman’s helicopter is fiat money in currency note form – actual dollar bills. And there are historical examples of governments that used printed currency to stimulate nominal demand without generating dangerously high inflation. The Pennsylvania colony did so in the 1720s, and the Union government paid its soldiers with printed greenbacks in the American Civil War. However, most money today is held as bank deposits, not paper currency.

late demand with more certainty and with less adverse side effects than either pure fiscal or pure monetary policy. Compared with funded fiscal stimulus, it is bound to be more stimulative since there is no danger of either crowding-out or Ricardian Equivalence effects. As Ben Bernanke put it in 2003, if consumers and businesses received a money-financed tax cut, they would certainly spend some of their windfall gain since “no current or future debt servicing burden has been created to imply future taxes.” And compared with a pure monetary

It works through putting new spending power directly into the hands of

a broad swath of households and businesses, rather than working through higher asset prices and induced private credit expansion. But the essential principle of the helicopter money drop can be applied in the modern environment. A government could, for instance, pay $1,000 to all citizens by electronic transfer to their commercial bank deposit accounts. (Alternatively, it could cut tax rates or increase public expenditure.) The commercial banks, in turn, would be credited with additional reserves at the central bank, and the central bank would be credited with a money asset – a perpetual non-interest-bearing bond due from the government. The “drop” is of electronic accounting entries rather than actual dollar bills, but the operation is in essence the same – as would be the first round impact on nominal demand. The extent of that stimulus would be broadly proportional to the value of new money created. Printing money in its modern electronic form is thus without doubt a technically possible alternative to either pure fiscal or pure monetary policy. It is, indeed, essentially a fusion of the two. It entails monetary finance of an increased fiscal deficit, and it would stimu-

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stimulus, it works through putting new spending power directly into the hands of a broad swath of households and businesses, rather than working through the indirect transmission mechanism of higher asset prices and induced private credit expansion. It does not rely on regenerating potentially harmful private credit growth. Nor does it commit us to maintaining ultra-low interest rates for a sustained period. Our technical ability to stimulate nominal growth with money-financed deficits is therefore not in any doubt. A formal mathematical paper by Willem Buiter, the chief economist at Citigroup, confirms the commonsense arguments of Friedman and Bernanke. His paper title: “The Simple Analytics of Helicopter Money: Why It Works – Always.” Indeed, the crucial issue is not whether money-financed fiscal deficits are feasible and potentially beneficial in the short term, but whether we can contain their long-term impact in a modern economy with fractional reserve banks. For though the first-round

impact of an electronic deposit drop is determined simply by its size, the exercise creates additional commercial bank reserves at the central bank and thus makes it easier for banks subsequently to create additional private credit, money and spending power. Thus the danger exists that the initial stimulative effect of money finance will be harmfully multiplied by subsequent private credit creation, producing more demand stimulus than desired. That danger would not arise in a system of 100 percent reserve banks of the sort that Irving Fisher and Henry Simons supported in the 1930s, and that Milton Friedman recommended in 1948. In such a system, the monetary base is the money supply, private credit and money creation play no role and the final long-term stimulative effect of money finance is bound to be broadly proportionate to its initial size. For Fisher, Simons and Friedman, 100 percent reserve banks and overt money finance of small fiscal deficits were thus a logically linked package. The latter made it unnecessary to rely on unstable private credit creation to grow nominal demand; the former both made private credit creation impossible and ensured that the long-term stimulative effect of money finance could be precisely controlled. Fractional reserve banks complicate the implementation of money finance. But the model of 100 percent reserve banks also suggests the obvious solution: any dangers of excessive long-term demand stimulus can be offset if central banks impose reserve asset requirements. These requirements would force banks to hold a stipulated percentage of their total liabilities at the central bank and thus would constrain the banksâ&#x20AC;&#x2122; ability to create additional private credit and money. Those ratios could be imposed on a discretionary basis, with the central bank increasing them if inflation threatened to move above target. But

they could also in theory be deployed in an immediate and rule-driven fashion, increasing the required reserves of commercial banks at the same time as the electronic money drop and by precisely the same amount. This would essentially impose a 100 percent reserve requirement on the new fiat money creation. We can, in effect, treat the banking system as if it were in part a 100 percent reserve system and in part a fractional reserve: we do not have to make an absolute either-or choice. The precise consequences of reserve requirements would also depend on whether the central bank paid interest on them, and at what rate. Central banks can choose to pay whatever rate they want on required reserves, but the rate would have to be zero on at least some reserves to ensure that money finance today did not result in an interest expense for the central bank in the future or in central bank losses that would need to be paid for by government subsidy and ultimately by taxpayers. Setting a zero interest rate for reserve remuneration might, in turn, seem to impair the central bankâ&#x20AC;&#x2122;s ability to use reserve remuneration as a tool to bring market interest rates in line with its policy objective. But central banks could overcome this problem, for instance, by paying zero interest rates on some reserves, while still paying the policy rate at the margin. Reserve requirements remunerated at a zero interest rate in turn effectively impose a tax on future credit creation. But taxing credit creation might be a positively good thing. Our challenge is to find a policy mix that gets us out of the debt overhang created by past excessive credit creation without relying on new credit growth. Money-financed deficits today plus implicit taxes on credit intermediation tomorrow might well be the optimal combination.

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Friedman was right: governments and central banks together can always overcome deficient nominal demand by printing and spending money. That is just as well since, without the option of money finance, there may be no good way out of our debt overhang predicament.

deleveraging – no other good way out? Total economy-wide leverage in advanced economies, public and private combined, is now at levels only previously seen in the after math of major wars. Analysis of how deleveraging from previous peaks was achieved illustrates just how difficult it will be from today’s levels. The United Kingdom came out of the Second World War with public debts of 250 percent of GDP, but was able to reduce these to 50 percent by 1970. That reduction was not achieved by paying down absolute debt levels; instead, it resulted from 25 years in which nominal GDP grew at about 7 percent per year, while interest rates averaged much less. That nominal GDP growth rate, in turn, reflected both average inflation of more than 4 percent (well above current central bank targets) and a real growth rate of almost 3 percent, made possible both by significant de-

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mographic expansion and by technological catch-up toward U.S. levels of productivity. Moreover, a falling public debt ratio was accompanied by private debts rising slowly from low levels and constrained by quantitative credit controls. Residential mortgages were only provided by building societies (mutual savings and loans institutions), not by banks, and consumer credit availability was limited by rules on minimum down payments and payback periods. In 1964, total private-sector bank debts, household and company combined, were still just 27 percent of GDP rather than the 120 percent reached by 2007. The same pattern of rapid nominal GDP growth, low interest rates and low-but-rising private leverage also lay behind the United States’ success in cutting public debt from 120 percent of GDP in 1945 to 35 percent in 1970. Across continental Europe, meanwhile, wartime debts were in many countries eroded by high inflation or debt write-off in the immediate aftermath of the war. The historical experience thus illustrates that public deleveraging is possible, but it also indicates how difficult simultaneous public and private deleveraging will be in today’s changed circumstances. Demographic and technological factors will not allow the real

growth rates observed in many advanced economies in the 1950s and 1960s. And if 2 percent inflation targets are considered sacrosanct, nominal GDP growth in many advanced economies is unlikely to exceed 4 percent. In some, it will be lower still: the Bank of Japan estimates that Japan’s potential growth rate is no more than 1 percent. Thus, even if it achieves its 2 percent inflation target, nominal GDP will grow at only 3 percent. Growing out of debt burdens will be far more difficult than in the post-war period. Indeed, in some countries the mathematics make it impossible. The IMF Fiscal Monitor illustrates that Japan would need to turn today’s primary deficit of 6.0 percent (that is, its fiscal deficit before interest expense) into a surplus of 5.6 percent by 2020 and to maintain that surplus for an entire decade to reduce net public debt to 80 percent of GDP by 2030. This will not occur; if attempted it would push Japan into a deep deflationary depression in which public debt leverage, far from falling, would almost certainly rise. Japanese government debt will simply not be repaid in the normal sense of the word. Italy’s public debt burden, at 132 percent of GDP and rising, is also now so high and the country’s potential long-term growth so low that there is no clear austerity-plus-growth path to fiscal sustainability. Indeed, across the eurozone the Fiscal Compact requirement that all countries should reduce their debt stocks to a maximum of 60 percent of GDP by running primary budget surpluses is not credible. To achieve this objective, Greece would have to run a primary budget surplus of 7 percent of GDP for more than a decade; Ireland, Italy and Portugal would require 5 percent surpluses and Spain 4 percent. As Barry Eichengreen of the University of California has pointed out, there are close to no historical examples of such

large continued primary surpluses. They could only be compatible with robust growth if offset by rapid and potentially dangerous private credit growth either within the countries involved or in their export markets. And if, as is more likely, they produced low growth and sustained high unemployment, debt burdens would not, in fact, be reduced. In the face of such austerity, moreover, talented young people would be likely to leave their countries, reducing the tax base and walking away from their share of the inherited debts. Sometimes debts simply cannot and will not be fully repaid. Other ways out of the debt overhang will have to be found.

inflation and financial repression As the UK post-war experience suggests, one option might be to accept many years or even decades in which interest rates are held below nominal GDP growth rates and probably below inflation. One variant of this policy approach – floated by both Kenneth Rogoff and Olivier Blanchard – would entail accepting a higher inflation target than today’s 2 percent. Another would be to sustain interest rates close to zero for many more years. But, in essence, this policy would simply be a continuation of today’s ultra-loose monetary approach, reflecting a realistic assessment that it can only erode debt burdens significantly if maintained for far longer than currently hoped. It would therefore suffer from the disadvantages already discussed. It would help erode the value of existing debts, but could only do so by stimulating new credit growth, and it would create incentives for risky financial speculation.

default and debt write-off If debts cannot be eroded away by either real growth or inflation, they could be reduced by

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default and debt restructuring. Rather than creditors receiving an undiminished nominal value degraded in real terms through inflation, the nominal value of debts could be reduced. Such debt write-offs could certainly play a useful role, but they cannot be a sufficient solution. The extreme version of this option suggests that all we need is fiscal, monetary and free-market discipline. Governments should make their own debts sustainable by cutting expenditures or raising taxes; interest rates

The more realistic alternative involves negotiated debt write-downs and restructurings to reduce debts to sustainable levels while avoiding the disruptive effect of bankruptcy and default. It can be applied to either private or public debts. But in neither sector can debt restructuring alone be sufficient to cope with the scale of today’s debt overhang. Atif Mian (Princeton) and Amir Sufi (Chicago) argue that the United States should have implemented a large-scale program of coordinated mortgage debt restructuring

Achieving sufficient private debt write-down to fix the debt overhang

problem is made difficult by the dilemma that even lending that is “good” from a private perspective can have an adverse macro effect. should return to normal levels. And in the face of subsequent recession, individuals, companies and governments unable to pay their debts should default, providing a useful signal to creditors to be more careful about lending money in the future. This policy is essentially the one proposed by U.S. Treasury Secretary Andrew Mellon in 1931: “liquidate labor, liquidate stocks, liquidate farms, liquidate real estate. … It will purge the rottenness out the system.” And its consequences would be similar to those that followed in the early 1930s. For as Irving Fisher described in his theory of the “debt deflation” cycle, default and bankruptcy on a large scale drive a self-reinforcing cycle of collapsing nominal demand, as bankruptcy provokes fire sale reductions in asset prices, and as creditors facing unexpected losses themselves cut consumption and investment. The policy of applying pure free market discipline amounts, indeed, to a rejection of the consensus that it is desirable by one means or another to achieve a slowly growing level of nominal demand.

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after 2008. By cutting mortgage debts to affordable levels, this would have reduced the severity of the household consumption cuts that drove the country into recession. Even without such a coordinated program, household debt write-offs have been greater in the United States than elsewhere, helping achieve a more rapid pace of household deleveraging. But Mian and Sufi are surely right to argue that a more extensive and officially mandated program of debt forgiveness would have spurred economic recovery. But achieving sufficient private debt writedown to fix the debt overhang problem is made difficult by the dilemma that even lending that is “good” from a private perspective can have an adverse macro effect. Overleveraged households and companies can act in ways that depress nominal demand even if they can and do repay their debts in full. Indeed, it is the consumption and investment cuts they make to repay their debts that depress the economy. For private debt restructuring to be a com-

plete solution it would therefore have to involve the write-down of debts that from a private perspective look sustainable. Orchestrating such a resolution in a fair, politically agreed-on and non-disruptive fashion would be extremely difficult. Public debt write-offs might potentially play a larger role. In 2011, Greek public debt was reduced by a write-down of privatesector claims without significant market disruption, and public-sector claims on Greece could be and almost certainly will be written down as well. Indeed, public debt writedowns can be used as an indirect way to deal with excessive private leverage. Excessive private credit creation produces crisis, debt overhang and post-crisis deflation, and as a result, rising public debt burdens. Leverage doesn’t go away, it simply shifts from the private to the public sector. But once it has shifted to public debt, it may be easier to negotiate restructuring and write-down without harmful shocks to confidence. The absolute size of the write-downs is crucial, however. The restructuring and writedown of Greek government debt was easily absorbed by financial markets because the total value written off was trivial in global terms. Write-downs of Japanese or Italian government debt sufficiently large to make the remaining debt clearly sustainable would be far more disruptive.

a combination of levers Given the scale of the debt overhang created by past credit growth, there are no certain and costless routes to deleveraging and no one policy that will ensure an optimal result. A combination of policy levers is needed in response, varying by country. In Japan it would not be possible to reduce public debt substantially as a percentage of GDP through the normal processes of growth plus fiscal

consolidation. In the United States, starting with smaller debt-to-GDP than Japan’s and with faster potential growth rate because of a still-growing population, a combination of continued loose monetary policy, growth and market-driven debt write-down may prove sufficient without more radical policy action. But whatever the mix of policies deployed, the money finance option should not be excluded as taboo. Indeed, in some countries it will be essential if we are to achieve adequate debt reduction and reasonable growth.

overt money finance – three specific options Three specific uses of overt money finance should be considered: Bernanke’s helicopter, one-off debt write-off, and radical bank recapitalization. Bernanke’s Helicopter

In 2003, Ben Bernanke proposed that Japan execute a modern version of a helicopter money drop, paying for either tax cuts or increased public expenditure with centralbank-created fiat money, making it clear that no new fiscal debt had been incurred and thus that no additional debt-servicing burden had been created. If Japan had followed that advice, it would now have higher nominal GDP, some mix of higher real output and a higher price level, and a lower ratio of debtto-GDP. Ideally, the major advanced economies would have implemented Bernanke-style helicopter money drops in the immediate aftermath of the 2007–2008 crisis. If we had done so, the recession would not have been so deep, and we would now be further along in escaping the debt overhang. We would also almost certainly be further advanced in returning to normal interest rate levels. In the United Kingdom, for instance, the Bank of England

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has conducted quantitative easing asset purchases to the tune of £375 billion (about $535 billion). These have stimulated the economy by pushing down long-term interest rates and increasing bond, equity, and property prices. If instead the UK government had devoted a fraction of that money (say, £35 billion or about $50 billion) to tax cuts or expenditure increases funded with permanent fiat money, the likely effect would have been a stronger, more equitable, and less risky recovery. In the United Kingdom and the United States, the time for such policies may now have passed. For good or ill, we have used ultra-loose monetary policy to achieve at least some economic recovery. But in Japan and the eurozone the case for money finance has become stronger over the past few years, given accumulating evidence of chronically deficient demand.

At the Federal Reserve’s annual Jackson Hole conference in August 2014, European Central Bank President Mario Draghi noted that without some fiscal as well as monetary stimulus, recovery in the eurozone could not be assured. But any fiscal stimulus funded with new public debt issues would raise questions about how the debt could be repaid. Ideally, the eurozone should now consider policies of the sort put forward by the Italian economists Francesco Giavazzi and Guido Tabellini, who argue for a simultaneous threeyear tax cut in all eurozone economies, funded by long-term bonds, which the ECB would buy and hold in perpetuity. But the political difficulties may well make this ideal policy unattainable in practice. Public Debt Write-offs

The Japanese did not follow Bernanke’s advice in 2003. Instead they offset private deleveraging with large funded fiscal deficits, making a relentless rise in public debt-toGDP inevitable. But they could now write off some of that accumulated debt, putting

themselves in the position they would have been if they had accepted Bernanke’s advice. In an attempt to counter deflation, the Bank of Japan has conducted very large quantitative easing operations, buying government bonds that by the end of 2014 amounted to 44 percent of GDP. It is now buying government bonds at the rate of ¥80 trillion per year (close to $700 billion), a figure substantially larger than the fiscal deficit and net new debt issue, which is running at about ¥50 trillion (about $420 billion) per year. As a result, the amount of government debt not owned by the Bank of Japan is falling, and by 2017 net government debt owned neither by the Bank nor by other government-related entities (such as the social security fund) could be down to just 65 percent of GDP. This seems like a form of money finance. But the stated objective of these quantitative easing operations is not to fund the government deficit but to stimulate the economy through the classic transmission mechanisms of loose monetary policy – very low longterm interest rates, rising asset prices and cur-

rency depreciation. And the stated intent is that, at some time, the Bank of Japan will sell its government bond holdings back into the market and that the government will repay these bonds out of future fiscal surpluses. Official figures for Japanese public debt therefore include the debt that the Japanese government owes to the Bank of Japan, an institution that the government owns. That debt could be written off and replaced on the asset side of the Bank of Japan’s balance sheet with an accounting entry – a perpetual noninterest-bearing debt owed from the government to the bank. The immediate impact of this on both the bank’s and the government’s income would be nil since the interest that the bank currently receives from the government is subsequently returned as dividends to the government as the bank’s owner. So in one sense a write-off would simply bring public communication in line with the underlying economic reality. But clear communication of that reality would make it evident to the Japanese people, companies and financial markets

that the real public debt burden is significantly less than currently published figures suggest and could therefore have a positive effect on confidence and nominal demand. The equivalent operation could also be used to cut stated debt levels and to reduce the apparent need for fiscal consolidation elsewhere, too. The Bank of England owns government bonds worth 23 percent of GDP. Writing off some of them would not entirely remove the need for further improvement in public finances, but would reduce the required pace and severity of fiscal consolidation. Bank Recapitalization

The third possible use of fiat money creation would not deal with the inherited debt overhang but would facilitate rapid progress to a sounder financial system without exacerbating the deleveraging problem. I have argued that bank capital requirements should be set far higher than those established by Basel III. But rapid progress to higher capital ratios could increase the pace of private-sector deleveraging: banks could meet the higher ratios by cutting loans rather than increasing capital. A possible answer is to require banks to increase ratios by raising new capital and to give banks a short period to raise it from the private sector, but with the backstop of government equity injection if private capital is not forthcoming. Government stakes could then be sold off over time. The problem is that if the government equity injection is actually required, government debt-to-GDP increases. So if public debt is already at troubling levels, we solve one problem but exacerbate another. Concerns about the impact that public recapitalization would have on already-high fiscal deficit and debt levels undermined the effectiveness of the European bank stress tests in 2011. With Spain, Ireland and Italy already struggling

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with high public debts and increasing government bond yields, they could not promise to put new capital into the banking system for fear of exacerbating market concerns about sovereign debt sustainability. It was impossible to promise a credible public backstop to private equity raising. If, however, public recapitalization were financed by the central bank through a permanent increase in central bank money, the problem of future debt sustainability would not arise. Even for those who worry a lot about debt monetization, this option might be acceptable. Bernankeâ&#x20AC;&#x2122;s helicopter money drop may be unacceptable if it took the form of tax cuts or public expenditure increases: the medicine might taste so sweet that the temptation to use it to excess would be overwhelming. But a helicopter money drop used solely for bank recapitalization would be more likely to be treated as a one-off.

the taboo As Milton Friedman made clear, deficient nominal demand is one economic problem to which there is an obvious and always possible solution in the form of money creation by government fiat. We have tools, moreover, that can ensure that the demand stimulus is appropriately modest rather than dangerously inflationary. If money finance is excluded, escaping the debt overhang will be far more difficult and economic growth unnecessarily depressed. But using central bank money to finance fiscal deficits or to write off past public debts remains a taboo policy, and for some good reasons. For if we first admit that money finance is possible, how will we ensure we do not use it to excess? The risks of money finance are thus not technical but political â&#x20AC;&#x201C; and the subject of another chapter of this book.

institute news

Last year, some 14,000 people participated in Milken Institute events, ranging from big (nearly 4,000 participants at the Global Conference) to not so big (working sessions on a single issue gathering 20 key stakeholders). Yet Institute researchers and policy specialists also find time to produce a variety of publications. A recent sampling, all available on the Institute’s website.

The Science of Patient Input Across biomedical research and care, there’s been an accelerating trend toward patientcentered approaches – and the Institute’s FasterCures group is helping drive the shift. A key component in spurring better outcomes for patients is getting more data in timely fashion; to that end patient registries are playing an increasingly important role. These registries are organized systems for collecting uniform data for a population defined by a particular disease or condition, making them useful across broad scientific, clinical and policy endeavors. With federal policy now promoting data collection, and computing advances that make data analysis ever more robust, the need for some rules of the road are greater than ever, however. Hence the purpose of FasterCures’ recently published study, based in part on a survey of scores of patient organizations. The report, “Expanding the Science of Patient Input: Building Smarter Patient Registries” is a timely primer for both patients and policymakers.

Nutrition in Southeast Asia Malnutrition remains an issue in a dismayingly large number of countries. And it ranks as a true public health disaster across Southeast Asia, which suffers from a dual burden: a rise in both under-nutrition and over-nutrition. Many families in the region lack access to enough food, leading to high infant mortal-

ity, delayed development and impaired cognition. By the same token, rapid urbanization and rising incomes are contributing to an obesity epidemic. Overtaxed public health systems are having a hard time responding adequately to this dual burden. The Institute’s Asia Center is seeking ways to engage new forms of capital willing to support effective intervention programs. Last June, the center hosted a Financial Innovations Lab that gathered researchers, academics, philanthropists and policymakers to examine what’s worked in other regions and how those solutions could be applied to Southeast Asia. The summary of that event, “Innovative Finance to Address Nutrition in Southeast Asia,” was published in January.

Latest and Greatest in FinTech Innovation in financial technology is tough to keep up with. The Institute’s Center for Financial Markets is working to close the knowledge dissemination gap with FinTech in Focus, a compilation of must-read stories about the role technology is playing in financial services. The newsletter curates a selection of the week’s top domestic and international articles about this innovative, fast-growing sector. Topics include digital and electronic currencies, digital payment systems, online investment and finance platforms, and big data and machine learning. FinTech in Focus is accessible (at no cost) on the Institute’s blog, Currency of Ideas.

Second Quarter 2016

lists

Numbers games We’re number one…! It may only be my imagination, but I think I’m hearing this less in America these days – a welcome trend in a country inclined to rest on its laurels. So, who really is numero uno? That depends, of course, on what you’re measuring. To avoid comparing apples and oranges, I’ve limited the comparisons to 21 high-income countries that are both members of the Organisation for Economic Co-operation and Development (OECD) and bigger than a bread box. (Sorry, Luxembourg and Iceland.) Note, by the way, I’ve included some measures (military expenditures, income equality) in which being first is not necessarily best.

INC0ME PER CAPITA

LIFE EXPECTANCY

INFANT MORTALITY

INCOME EQUALITY

GENDER EQUALITY CORRUPTION

MATH SKILLS

MILITARY EXPENDITURES

ECONOMIC FREEDOM

Australia . . . . . . . . . . . 7 . . . . . . . . . . . . 4 . . . . . . . . . . . . . 17. . . . . . . . . . . . 12 . . . . . . . . . . . 2. . . . . . . . . . . . . . 9 . . . . . . . . . . 10. . . . . . . . . . . . . 6. . . . . . . . . . . . . . . 2 Austria . . . . . . . . . . . . . 6 . . . . . . . . . . . 11 . . . . . . . . . . . . . 10. . . . . . . . . . . . . 5 . . . . . . . . . . 18. . . . . . . . . . . . . 16 . . . . . . . . . . . . 9. . . . . . . . . . . . 19. . . . . . . . . . . . . . 16 Belgium. . . . . . . . . . . 12 . . . . . . . . . . . 14 . . . . . . . . . . . . . . 8. . . . . . . . . . . . . 4 . . . . . . . . . . 16. . . . . . . . . . . . . 12 . . . . . . . . . . . . 7. . . . . . . . . . . . 16. . . . . . . . . . . . . . 18 Canada. . . . . . . . . . . . 10 . . . . . . . . . . . . 7 . . . . . . . . . . . . . 20. . . . . . . . . . . . 14 . . . . . . . . . . . 9. . . . . . . . . . . . . . 9 . . . . . . . . . . . . 6. . . . . . . . . . . . 13. . . . . . . . . . . . . . . 4 Denmark. . . . . . . . . . 11 . . . . . . . . . . . 21 . . . . . . . . . . . . . 16. . . . . . . . . . . . . 1 . . . . . . . . . . . 4. . . . . . . . . . . . . . 1 . . . . . . . . . . 13. . . . . . . . . . . . . 9. . . . . . . . . . . . . . . 6 Finland . . . . . . . . . . . . 13 . . . . . . . . . . . 15 . . . . . . . . . . . . . . 3. . . . . . . . . . . . . 6 . . . . . . . . . . 19. . . . . . . . . . . . . . 3 . . . . . . . . . . . . 5. . . . . . . . . . . . . 8. . . . . . . . . . . . . . 11 France . . . . . . . . . . . . . 13 . . . . . . . . . . . . 8 . . . . . . . . . . . . . . 5. . . . . . . . . . . . 10 . . . . . . . . . . 17. . . . . . . . . . . . . 17 . . . . . . . . . . 14. . . . . . . . . . . . . 5. . . . . . . . . . . . . . 20 Germany. . . . . . . . . . . 9 . . . . . . . . . . . 17 . . . . . . . . . . . . . . 9. . . . . . . . . . . . . 8 . . . . . . . . . . . 6. . . . . . . . . . . . . 10 . . . . . . . . . . . . 8. . . . . . . . . . . . 11. . . . . . . . . . . . . . . 9 Ireland. . . . . . . . . . . . . . 4 . . . . . . . . . . . 16 . . . . . . . . . . . . . 14. . . . . . . . . . . . 16 . . . . . . . . . . . 7. . . . . . . . . . . . . 14 . . . . . . . . . . 11. . . . . . . . . . . . 21. . . . . . . . . . . . . . . 5 Israel. . . . . . . . . . . . . . . 21 . . . . . . . . . . . . 3 . . . . . . . . . . . . . 11. . . . . . . . . . . . 19 . . . . . . . . . . 14. . . . . . . . . . . . . 18 . . . . . . . . . . 23. . . . . . . . . . . . . 1. . . . . . . . . . . . . . 17 Japan . . . . . . . . . . . . . . 16 . . . . . . . . . . . . 1 . . . . . . . . . . . . . . 1. . . . . . . . . . . . 20 . . . . . . . . . . 15. . . . . . . . . . . . . 13 . . . . . . . . . . . . 2. . . . . . . . . . . . 17. . . . . . . . . . . . . . 12 South Korea. . . . . . 17 . . . . . . . . . . . 19 . . . . . . . . . . . . . 15. . . . . . . . . . . . 11 . . . . . . . . . . 13. . . . . . . . . . . . . 20 . . . . . . . . . . . . 1. . . . . . . . . . . . . 3. . . . . . . . . . . . . . 15 Netherlands. . . . . . . 5 . . . . . . . . . . . 12 . . . . . . . . . . . . . 12. . . . . . . . . . . . . 3 . . . . . . . . . . . 5. . . . . . . . . . . . . . 7 . . . . . . . . . . . . 4. . . . . . . . . . . . 12. . . . . . . . . . . . . . 10 New Zealand. . . . . 18 . . . . . . . . . . . 13 . . . . . . . . . . . . . . 9. . . . . . . . . . . . 18 . . . . . . . . . . 10. . . . . . . . . . . . . . 2 . . . . . . . . . . 12. . . . . . . . . . . . 15. . . . . . . . . . . . . . . 1 Norway. . . . . . . . . . . . . 1 . . . . . . . . . . . . 9 . . . . . . . . . . . . . . 2. . . . . . . . . . . . . 7 . . . . . . . . . . . 1. . . . . . . . . . . . . . 5 . . . . . . . . . . 16. . . . . . . . . . . . 10. . . . . . . . . . . . . . 14 Spain . . . . . . . . . . . . . . 20 . . . . . . . . . . . 10 . . . . . . . . . . . . . . 7. . . . . . . . . . . . 17 . . . . . . . . . . 20. . . . . . . . . . . . . 19 . . . . . . . . . . 18. . . . . . . . . . . . 18. . . . . . . . . . . . . . 19 Sweden . . . . . . . . . . . . 8 . . . . . . . . . . . . 6 . . . . . . . . . . . . . . 4. . . . . . . . . . . . . 2 . . . . . . . . . . 11. . . . . . . . . . . . . . 4 . . . . . . . . . . 22. . . . . . . . . . . . 14. . . . . . . . . . . . . . 13 Switzerland . . . . . . . 2 . . . . . . . . . . . . 2 . . . . . . . . . . . . . 13. . . . . . . . . . . . . 9 . . . . . . . . . . . 3. . . . . . . . . . . . . . 6 . . . . . . . . . . . . 3. . . . . . . . . . . . 20. . . . . . . . . . . . . . . 3 UK . . . . . . . . . . . . . . . . . 15 . . . . . . . . . . . 18 . . . . . . . . . . . . . 18. . . . . . . . . . . . 15 . . . . . . . . . . 12. . . . . . . . . . . . . 11 . . . . . . . . . . 15. . . . . . . . . . . . . 4. . . . . . . . . . . . . . . 8 U.S. . . . . . . . . . . . . . . . . . 3 . . . . . . . . . . . 20 . . . . . . . . . . . . . 21. . . . . . . . . . . . 21 . . . . . . . . . . . 8. . . . . . . . . . . . . 15 . . . . . . . . . . 19. . . . . . . . . . . . . 2. . . . . . . . . . . . . . . 7 sources: Income per capita (PPP, 2014): CIA Factbook; Life expectancy at birth (2015): CIA Factbook; Infant mortality under one year (2015): CIA Factbook; Income equality (Gini Index for household income): CIA Factbook (latest available dates); Gender equality Index (2014): UN Human Development Report; Corruption Perception Index (2014): Transparency International; Math Skills Index (2012): Program for International Student Assessment; Military expenditures as a % of GDP (2014): CIA Factbook; Economic Freedom Index (2015): Heritage Foundation

The Milken Institute Review

The Milken Institute Review • Second Quarter 2016 volume 18, number 2 the milken institute Michael Milken, Chairman Michael L. Klowden, President and CEO

the milken institute review advisory board Robert J. Barro

Van Doorn Ooms

publisher Conrad Kiechel

Jagdish Bhagwati

Paul R. Portney

George J. Borjas

Stephen Ross

editor in chief Peter Passell

Daniel J. Dudek

Richard Sandor

Georges de Menil

Isabel Sawhill

art director Joannah Ralston, Insight Design www.insightdesignvt.com

Claudia D. Goldin

Morton O. Schapiro

Robert Hahn

John B. Shoven

Robert E. Litan

Robert Solow

managing editor Larry Yu

Burton G. Malkiel

Asia Summit | September 15–16

MILKEN INSTITUTE California Summit | Fall

CONFERENCES Join us for these extraordinary events dedicated to turning ideas into action.

Partnering for Cures | November 13–15

London Summit | December 6

milkeninstitute.org

paul collier

On rethinking refugee policy. Global business to the rescue?

seth harris and alan krueger On managing the Gig Economy. A grand compromise.

dani rodrik

On structural reform. The Eurozone at the brink.

susan dynarski On student debt. Loans without tears.

andrew lo

On FDA drug testing. Match the risks with the rewards.

charles castaldi

On Caracas as crazytown. No laughing matter.

larry white

On housing reform. Breaking interest-group gridlock isn’t easy.

adair turner

On helicopter money. No pain, much gain?

The Milken Institute Review • Second Quarter 2016 • volume 18, number 2

In this issue

A Journal Of Economic Policy

taking measure of

The Gig Economy