Columbia Economics Review Vol. I, No. 1
The Case of the Missing Ally
The War on Terror and the Political Economy of USPakistan Relations I Dream of Gini Income Inequality in the Chilean Neoliberal Model Brain Gain How Empirical Economics can Improve our Schools
Note from the Editor
Columbia Economics Review 2010-2011 Editorial Board Editor-in-Chief Pooja Reddy Managing Editors Michael Mirochnik Kellan Zheng Senior Editors Ben Eckersley Hadi Elzayn Vignesh Subramanyan Dasha Wise John Ng Associate Editors Rakhi Agrawal Davis Xu Rui Yu Art Editor Cindy Pan Layout Editor Kevin Zhang
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Columbia Economics Review
Contents Features 2 } The Case of the Missing Ally | The War on Terror and the Political Economy of US Pakistan Relations 6 | Brain Gain | How Empirical Economics can Improve our Schools 10 | I Dream of Gini | Income Inequality in the Chilean Neoliberal Development Model
Interviews & Events
14 | 10 Questions for Gurcharan Das 16 | Show Me the Treasury Bonds | Discussing the Second Round of Quantitative Easing
Business Economics 17 | Networking and Interviewing | Tips by Columbia Women’s Business Society 18 | Gone in a Flash Sale | How Gilt Groupe is Rewriting the Rules of Retail 20 | The Bright Lights of Silicon Alley | New York City’s Growing Entrepreneurial Sector
Theory & Policy 22 | Seeing the Forest for the Trees | Deforestation and Cost-Effective Regulation of the Timber Industry
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The Case of the Missing Ally
The War on Terror and the Political Economy of US-Pakistan Relations Taimur Malik “Pakistan may be on its way toward an economic milestone that so far has been reached by one other populous country--the United States.” When The New York Times wrote this in 1965, the leonine Field Marshal Ayub Khan was in charge of the country and his agenda of robust development was so promising it enticed South Korea to emulate it. This erstwhile optimism is a far cry from where Pakistan finds itself today: in the midst of a security crisis, internal fissures, and an economy that is in shambles. The contrast is truly sharp given that at many points in its history the Pakistani economy was performing rather spectacularly. Only a decade ago, Pakistan’s economic growth hovered around 7 percent, a stark difference from the predicted growth of 2.5 percent this year--a rate all but nullified by population increases. What is it that went so very wrong for Pakistan? A series of strategic decisions gone awry and an on-again, off-again relationship with the United States contributed to the current state of affairs. In the 1960s, Pakistan was firmly in the anti-communist boat and a member of the U.S.-sponsored Central Treaty Organization that ensured it was on the receiving end of much economic and military assistance. However, a sudden and disappointing stop to U.S. aid halted economic progress and precipitated a change in political regime. The surge in anti-American feeling led to the rise of a socialist government under the charismatic Zulfiqar Ali Bhutto, whose policies unfortunately left Pakistan in economic malaise for years. But when the Soviet Union occupied Afghanistan in the 1980s, Pakistan once again became the “front-line” ally of the U.S. in its fight against communism.
While the junta of General Zia-ulHaq during the 1980s saw a boom in U.S. aid to Pakistan and rapid GDP growth, the 1990s is often referred to as Pakistan’s “lost decade.” Politics in this era was essentially a game of musical chairs between a string of democratic governments with short shelf lives and even shorter policy deliverables. Aside from the incompetence of governments under Benazir Bhutto and Nawaz Sharif, however, Pakistan suffered from a cornucopia of regional and international problems that compounded and perhaps even initiated its misery. Abandoned yet again by the U.S. and “sanctioned to the eyeballs,” as General Colin Powell put it, by its former chief ally, Pakistan was left too financially disadvantaged and politically alienated to effectively deal with the rather messy fallout of the Afghan situation, which is where much of this sordid story begins. According to Hassan Abbas, professor at Columbia University’s School of International and Public Affairs (SIPA) and Senior Fellow at Harvard University’s Belfer Center for Science and International Affairs, the decision to abandon Pakistan is one that American policymakers now recognize as a colossal mistake.
Politics in this era was essentially a game of musical chairs between a string of democratic governments. Great Games in Greater Central Asia The disintegration of the Soviet Union in the early 1990s ushered in a wealth of opportunities for Pakistan to forge economic ties with newly-formed states looking to open up their markets. About Columbia Economics Review
the same time that Turgut Özal inspired Turkey to move closer to its post-Soviet Turkic neighbors, Pakistan’s industrialist Prime Minister, Nawaz Sharif, sent his Minister for Economics Affairs, Aseff Ahmad Ali, and a team of businessmen to examine the prospects for trade in Turkmenistan, Uzbekistan, Tajikistan, Kazakhstan, and Kirgizia. There seemed to be enormous potential in these new Central Asian republics, whose people share historical ties with what is now Pakistan. For Pakistan, Central Asia provided an ideal destination for its exports; for the new republics, Pakistani seaports held out the promise of world trade, given that much of Central Asia is landlocked. But the warring state of affairs in Afghanistan during the 1990s presented Pakistan with an unsavory strategic choice. Abandoned by the U.S. – which lost no time in disengaging from the region after using Pakistan as a proxy to fight the Soviets – and faced with woebegone economic conditions, the pursuit of trade in Central Asia became a keystone of Pakistan’s national security calculus. At the same time, the postSoviet power vacuum in Afghanistan led to the rise of the infamous Taliban regime under Mullah Omar and his band of disciplined Madrassah students, who won overwhelming support among many Afghanis as the only disciplined force able to instill justice and order amidst endemic chaos. Under the circumstances, Pakistan reluctantly recognized the Taliban, becoming one of only three countries in the world to do so. This was a move it thought would lead to unparalleled access to the Central Asian economies. The move backfired. Recognizing the obscurantist Taliban gave Pakistan much less influence over the recalci-
Features trant regime than it had hoped for. For instance, Pakistan tried arduously to persuade the regime not to destroy the Buddha statues in Bamyan, but it all came to no avail. Nor did Pakistan gain any economic traction in the region. Instead, it began to be perceived as a state going rogue and a sponsor of terrorist entities. The sword of Damocles finally fell on Pakistan’s head with the U.S. invasion of Afghanistan after September 11, 2001. The fallout from the war meant that militants fleeing from the U.S. escaped across the porous Durand line and established sanctuaries in Pakistani territory. Paying for the Sinews of War To this day Afghanistan’s situation negatively affects Pakistan and its economy in Brobdingnagian ways. Pakistan’s internal security has been significantly affected by the rise in terrorism and suicide bombings. More than 3,500 terrorist incidents have occurred in the country since 2007, killing an average of 84 people per month last year. Paki-
stan has also lost over 2,500 troops in the war over the last decade, including no less than four high-ranking generals – significantly more than the coalition forces in Afghanistan. But Pakistan has also had to deal with millions of internally displaced persons who have been forced to flee from the large scale fighting in certain parts of the northwest region bordering Afghanistan. Further burdening the already fragile exchequer have been the more than two million refugees from Afghanistan who arrived during the Soviet occupation and never left. In this gloomy climate Pakistan’s foreign direct investment (FDI) has been greatly affected. At a recent conference in Washington arranged by the U.S.-Pakistan Business Council, political analyst Shuja Nawaz laid out the effects of the War on Terror on Pakistan’s investment environment. “There is a nexus between security and governance that is critical to the economic climate,” he said. “You need long-term stability to encourage economic growth. Com-
3 panies need a five-year time frame to make investment plans, not six months or so.” Doubts about the nation’s longterm security stemming from its role in the War on Terror have led to a decline in FDI from a decade height of approximately $8 billion to less than $2.5 billion in the last fiscal year. Concurrently, the insurgency in and around Afghanistan has forced massive capital flight from Pakistan to the Persian Gulf. The IMF estimates that the cost of the war, including direct costs of resource movements and indirect costs of lost exports, foreign investment, industrial output, and tax collection amount to more than $30 billion. In addition, since 2008 Pakistan’s economic outlook has taken a dramatic turn for the worse due to domestic financial troubles. The Economist reckons that inflation has been about 20 percent since this time, and the Pakistani rupee has gone from 60 rupees to U.S. dollar in 2007 to over 86 rupees. This currency depreciation has seriously corroded confidence in the country’s economy, resulting in capital flight and – by making imports even more expensive – further increased inflation. Combined with high global commodity prices, the impact has shocked Pakistan’s economy with gaping trade deficits, high inflation, and a crash in the value of the rupee. For the first time in years, Pakistan had to seek external funding as balance of payments support. With the IMF’s $7.5 billion bailout package Pakistan’s overall debt has soared. Feeding the Rentier State One thing the War on Terror did for Pakistan was to bring it back into the ambit of U.S. economic assistance; in an all too familiar pattern, the country’s foreign debt got rescheduled and economic aid began to trickle in once Washington decided it needed Pakistan again. But the Pakistani economy has over the years developed a heavy reliance on U.S. aid in times when the latter is in need of Pakistan’s services. As a “strategic partner,” the U.S. uses the carrot it waves best – civil and military aid. But this aid could never be sufficient to cover the losses that Pakistan continues to incur. Moreover, tied aid – in the form of pro-
Features uses for patronage purposes. The result is that incentives for competition within the economy are significantly reduced. General Pervez Musharraf seemed to have realized the limited and temporary panacea that is aid and on one of his last trips to the EU, begged the West to “please give Pakistan trade, not aid!” Columbia University professor Hassan Abbas echoes the same sentiment against the current U.S. aid regime, which is comprised of a multitude of small-scale projects addressing vague issues like “democratization and civic engagement.” Stalin may have found that “quantity has its own kind of quality,” but in an interview with this author Professor Abbas stated his belief that thinking big is the solution. “I told Holbrooke and Hillary Clinton in my meetings with them that this aid regime is flawed – what you need is a few massive scale projects.” There is therefore a need to fundamentally change the nature of the Pakistan-U.S. relationship, transitioning from meager aid to robust trade and from small gestures to big investments.
curement of goods and services sourced from the donor country – reduces the net benefits to the recipient country. The USAID is particularly notorious in this respect: it is popularly believed that as many as 70 cents per aid dollar ends up in the hands of U.S.-based private contractors, consultants, administrators, and suppliers. This form of assistance hardly creates a significant number of jobs in the local economy. Because of a general mistrust of government agencies in developing countries, flows of aid often bypass them. This has created more distortions in the economy. Instead of strengthening the capacity of government institutions in charge of delivering basic services to the people, NGOs are permitted to act as intermediaries in the execution of projects. They hire technocrats and professionals on very high compensation packages, depleting the human resource reservoir available to the government and
impairing its capacity. In an interview, Columbia University professor Akbar Zaidi said that the USAID money going to NGOs run by family members of the old entrenched elites does nothing to alleviate the suffering of Pakistanis. Zaidi advocates a complete halting of such aid, not least because he believes it contributes to poor governance and economic inefficiencies by providing shortterm, stop-gap arrangements of cash flow. This leads to another drawback of aid: the much dreaded “Dutch disease,” in which appreciation of the domestic currency from an infusion of foreign money discourages exports and makes investments in non-traded goods relatively more attractive. The overall effect is to exacerbate inefficiency and noncompetitiveness among local exporters. The economy becomes a “rentier state,” receiving rent (in the form of aid) for services merited to its foreign donor, in this case the U.S., which the rentier state then Columbia Economics Review
A New Pakistan-U.S. Partnership What Pakistan needs is a multipronged, multi-year engagement which the U.S. must deliver. The U.S. needs Pakistan’s help in the Afghan end-game and the U.S. has a moral responsibility to help its vital ally as it suffers acutely from U.S. boots on the ground in the region. Americans must invest in long-
General Pervez Musharraf seemed to have realized the limited and temporary panacea that is aid and on one of his last trips to the EU, begged the West to “please give Pakistan trade, not aid!” term and large-scale projects in Pakistan that are high-impact and high-visibility, and they should do so by targeting several key areas, beginning with energy generation. As Pakistan hungers for energy with shortages running into thousands of
Features megawatts, Central Asia could potentially provide a solution. Tajikistan is ready to export electricity to Pakistan, while Turkmenistan is eying the Turkmenistan-Afghanistan-Pakistan-India (TAPI) pipeline. However, both options would require grids to pass through Afghan territory, something impossible to achieve without complete cessation of military hostilities there. In order to diversify its energy mix, Pakistan has repeatedly asked the U.S. for a civilian nuclear energy deal along the lines of what Washington is offering its neighbor and fellow Nuclear Non-Proliferation Treaty (NPT) non-signatory, India. So far the U.S. has refused to even consider the possibility of such an arrangement. Many analysts, such as Michael O’Hanlon of the Brookings Institution, question the wisdom of this intransigence. In fact, in some quarters there is now clear recognition of the need for investments in energy. The previous U.S. ambassador to Pakistan, Anne Patterson, was working on a U.S.-sponsored economic package that would help mitigate the resentment created by the U.S.’s “12-year divorce” from the region after the Red Army’s exit from Afghanistan. “We are trying to get people to see that we’re committed by helping with investment,” Patterson told Forbes magazine, “because you meet older people and they will say to you, ‘Oh, I remember dam such-and-such, and the Americans built that.’ That is the kind of synergy we look for, because it builds goodwill for both of us.” A dam is not a bad place to start. With nuclear energy an apparent stumbling block and the situation in Afghanistan not warranting energy access through the Central Asian corridor, the U.S. should make amends by investing in a mega-dam in Pakistan. Such a dam would be of immense value to the Pakistani people. It would help minimize the energy shortfall, counter dwindling water resources caused by glacial melting, and bring new life to Pakistan’s stagnant agricultural production, which will in turn greatly benefit poor farmers. In fact, the consultancy Weidemann Associates prepared a report commissioned for a USAID study on Pakistan’s agriculture that suggests that 3.5 times
more employment is generated by agriculture and its spillovers within the rural non-farm sector as in the urban sector. Thus, a dam would be especially effective in alleviating rural poverty. Add to this open access of U.S. markets to Pakistani exporters and we have a Pakistan that is better integrated into the global economy, with entrepreneurs and industry doing well. The U.S. has so far refused to sign a free trade agreement (FTA) with Pakistan, thus limiting the country’s greatest export, textiles, which in 2008 alone brought $8 billion to the national kitty. However, there is potential for much more robust growth, especially since Pakistan’s industries are suffering heavily from acute competition from China and Bangladesh. As a Least Developed Country (LDC) desig-
Pakistan’s burgeoning middle class aches for high standard education and the U.S. can win both urban and rural support with investments in insitutions of higher learning. nated by the U.N., Bangladesh receives preferential access for its exports while Pakistan gets neither free trade nor any guaranteed quota. Greater access for Pakistani textiles would provide a major fillip to the industry and also employ many workers who have lost their jobs since the downturn. Another U.S. trade-related scheme that has been kept on the back burner has been the creation of “Reconstruction Opportunity Zones (ROZ)” in the troubled and impoverished northwestern regions of Pakistan. Under the proposed plan, any goods assembled or made within ROZs would reach the U.S. market without any tariffs or barriers. The aim of the program was to generate employment in least developed regions that are most susceptible to the recruitment efforts of terrorist groups. Unfortunately, the U.S. seems to have balked at this Bush-era promise. Closely linked to the integration of Pakistan’s economy with that of the U.S. is the rise of an emerging Muslim Fall 2010
5 middle class. This will tremendously dampen extremism and will lead to social and economic reform in the Muslim world, bringing the region much closer to democratic and capitalist governance than any other forced-down-the-throat pill that Langley or Foggy Bottom could concoct. In his book Forces of Fortune, Council on Foreign Relations fellow Vali Nasr makes an excellent case for courting a pious but entrepreneurial Muslim middle class. The area where large investment is needed is in top-quality universities, which this country of 175 million has a paucity of. Every year hundreds of thousands of Pakistanis graduate from good high schools with British A-Level diplomas but have limited options when it comes to quality Pakistani universities. An American University of Karachi or Lahore would be a fantastic starting point. If Iraq has an American University then Pakistan surely deserves one. Pakistan’s burgeoning middle class aches for high standard education and the U.S. can win both urban and rural support with investments in institutions of higher education. This will drastically reduce anti-American sentiment among ordinary people, reassuring them that Uncle Sam is a sincere friend and is not merely running with the hare and hunting with the hound – a major security bane for the U.S. Time for a Media Make-Over The last and most important prong of this strategy is perhaps hardest to implement, and has to do with how Pakistan is presented in the Western, and most importantly, U.S. media. Harvard professor Michael Porter and his team at AllWorld Network, a global growth initiative, developed the theory of “visibility economics.” The idea is simple: entrepreneurial endeavors in the developing world can be enhanced by bringing successful companies which the media otherwise takes little note of to the world stage and creating a brand image for them. The image of Pakistan as a nation is similar; while it gets more than its fair share of mention in the media these days, the overwhelming majority of it is negative. The visibility economics approach
6 of Professor Porter seeks to find hidden entrepreneurs, credential them, and put them on the world’s radar; markets, Porter believes, will do the rest. The U.S. must aim to do this with Pakistan as a country. To start with, the American government must make an effort to appear in the U.S. media with a focus on non-negative aspects of its “strategic alliance” with Pakistan. The good cop-bad cop routine that American politicians play in their statements on Pakistan, while apposite to the ear canals of their domestic audience, is widening the gap between the two countries and is hardly endearing to Pakistanis. An interesting example of this dichotomous game can be seen in diametrically opposed statements
Features from two important US figures. Richard Armitage in a new task force report asks the U.S. government to up the ante against Pakistan and demand that it do more against terrorist groups like the Haqqani network by threatening U.S. surgical strikes against Pakistan in the event of an attack on U.S. soil. In antipodes to this view is Colin Powell’s recent interview urging the U.S. government to provide more money, hardware, and intelligence to the Pakistani army, which does not have the wherewithal to go after the Haqqanis. Pakistanis are deeply hurt by this mudslinging and saberrattling, whether due to domestic U.S. politics or other factors. The image of Pakistan currently peddled by the U.S. media also ends up badly compromis-
ing Pakistan’s economic potential. Pakistan’s economy has followed a unique trajectory since the 1950s, one in which the U.S. has played a most crucial role; its temperamental relationship with the country auguring both good times and bad. Pakistan has always sought out the U.S. to enhance its economic machine, which has suffered in times when U.S. strategic objectives no longer required Pakistan’s cooperation. As a strategic ally, however, Pakistan needs a deeper economic partnership with the U.S., not least to offset many of the costs incurred during the last time Pakistan was drawn into Afghanistan. The steps outlined here provide a blueprint for the solution to Pakistan’s economic woes.
How Empirical Economics Can Improve our Schools Skanda Amarnath The recent release of “Waiting for Superman,” a documentary about the pitfalls of the American school system, as well as ongoing television coverage on the subject, such as the somewhat farcical “Teach: Tony Danza” and MSNBC’s week-long “Education Nation” special, have been the latest in the continuing attempt to emphasize the issue of education in the nation’s spotlight. Yet whenever there is genuine discussion over potential reforms, the debate quickly boils down to liberals supporting increased spending for the established system and conservatives antagonizing unions and promoting vouchers as the best and only alternative. If we wish to make any serious progress on education policy, we will need to focus on more rigorous analysis of the underlying problems within the system. All sides in the debate invoke vague terms like “better schools.” What exactly are “better schools” though and how do they – if they do at all – improve student achievement? The answers can be found
in empirical studies, which convincingly capture the meaning of this ambiguous term and support an affirmative answer. Clearing the debate of ambiguity where it is possible will help achieve the progress America needs.
It we wish to make any serious progress on education policy, we will need to focus on more rigorous analysis. Given that conservatives often tout the value of switching to an education system that relies more on vouchers in order to empower consumers with the option to choose their own schools, it is helpful at the outset to investigate what that sort of system would entail. The argument hinges on the idea that if we subsidize all education, rather than just public education, the private sector would no longer become crowded out such that there would be sufficient Columbia Economics Review
demand for quality education among all income levels. Better schools would then attract more students and, hence, become more profitable. There are many counterarguments to this stance, but one that typically gets overlooked in this debate is whether going to a so-called “better” school will actually lead to improved individual academic achievement. The answer seems obvious at first. Going to a “better” school should intuitively improve one’s academic achievement. Yet by simply observing higher education in America, it is difficult to determine whether students with nearly identical academic and extra-curricular achievements would accomplish or earn more if they went to an “elite” school rather than a less prestigious university; in fact, Dale and Krueger (2002) found that “students who attended more selective colleges earned about the same as students of seemingly comparable ability who attended less selective schools.” Cullen, Jacob, and Levitt (2005) exploited the randomization that occurs in
Features charter school lotteries in determining that students who transfer to higherachieving high schools do not actually show any demonstrable improvement in test scores or academic achievement. Hence, existing empirical evidence has not simply confirmed our intuition. Much of this elusive empirical evidence was finally captured when Miguel Urquiola and Cristian Pop-Eleches, professors of economics at Columbia University, published their findings in “The Consequences of Going to a Better School” in 2008 and “Going to a Better School: Effects and Behavioral Responses” in 2010. Their research was largely based on statistics from Romanian schools, utilized because the process of choosing schools in Romania is so systematic that it largely resembles a controlled experiment. At the end of eighth grade, for example, all Romanian students take a test and are then asked to state their preference for their choice of secondary school as well as the academic track they wish to pursue. Students rank the schools and tracks they wish to attend, and the higher a student scores on the test, the more likely that student is to attend their first-choice school. Given that all of these schools are subject to limits with respect to capacity, each school has a de facto cutoff score to limit the number of students who attend their school. Since Urquiola aand Pop-Eleches had access to the cutoff score for each school, they could then rank the schools based on each school’s score. Using these cutoff scores as well as each student’s scores on the eighth grade exam and the 12th grade baccalaureate exam, Urquiola and Pop-Eleches utilized a regression discontinuity design to test their hypotheses on school quality and student achievement. The regression discontinuity design centers on determining whether students who scored just above the cutoff score and thus were able to attend a more highly ranked School A performed significantly better than students who scored just below the cutoff score and could only attend a lower ranked School B. There is a positive relationship between student scores on the eighth grade exam and one’s score on the baccalaureate
exam. However, if the school one attends makes no difference to the academic achievement of a student, this
Even in the United States, where concerns of income inequality often take a back seat to economic growth, public education is provided in the hopes that it will help create equal opportunities for all. positive relationship and trend should be continuous through the cutoff score. In contrast, if School A had some positive effect on the academic achievement levels of its students relative to School B, we would see a break at the cutoff score with students who scored above the cutoff doing significantly better on the baccalaureate exam than the students attending School B. The vast amounts of data that Urquiola and Pop-Eleches were able to collect allowed them to test their hypotheses numerous times, and they found, quite consistently, that there existed discontinuities when analyzing student performance at each cutoff. Thus, it seems clear that students visibly benefited from attending a better school.
7 Some point out that this result could be the product of students of similar academic achievement levels learning and spending more time in school together in a phenomenon known as the “peer effect,” hence leading to greater academic stratification. However, many of the cutoffs that Urquiola and Pop-Eleches used were not necessarily for attending different schools but rather for different tracks within the same school. As noted in Pop-Eleches and Urquiola (2010), the students in each track “take all their classes together and do not take courses with members of other tracks, although they share inputs like facilities and a principal.” Therefore, Urquiola and Pop-Eleches were able to control, at least in large part, for peer-quality effects and conclude that, even if a student went to the same school, his or her academic achievement level would dramatically improve if he or she were in a “higher” track. These powerful new findings beg a new question: how do we increase the quality of education for more people, given the existence of positive school effects? As an additional concern, how do we increase the quality of education for lower-income students? Most societies spend on education as a means to combat excessive income inequality. Even in the United States, where concerns of income inequality often take a back seat to economic growth, public education is provided in the hopes that it will help create equal opportunities for all, although none will claim that public education is successful in creating equal outcomes. Americans would ideally prefer a system in which any intelligent and hard-working person could achieve nearly the same results regardless of his or her socioeconomic status as a student. The reality is that the idea of equal opportunity, while reflecting a desire for more equal outcomes in academic achievement, merely translates more often than not to a redistribution of wealth through the subsidization of education. Given Urquiola and Pop-Eleches’s conclusion, it is safe to say that there are two potential solutions: one would focus on expanding school choice to create a marketplace where profit mo-
8 tives catalyze improvements in school quality, while the other would be more concerned with enhancing the direct mechanisms by which school quality can be improved. Those who hold the conservative view that vouchers are the solution would claim that we would then empower all consumers. Families and students would have the necessary income to be able to choose the best available school, thereby encouraging competition between schools and, presumably, improving the quality of education. Ostensibly, such competition would then spur schools to improve the value they add to each student’s aca-
Schools with excellent reputations might be more inclined to screen for higher quality students, rather than focusing their efforts on increasing the value added for each student. demic achievement level. However, this notion is not entirely rooted in reality if we once again look at recent empirical research, which demonstrates how the existence of fixed capacities and an “anti-lemons effect” can create major problems for vouchers. The empirical evidence and analysis found in Emiliana Vegas and Jenny Petrow (2007) examines the role of vouchers in Chile, a country where the private education sector is substantially larger that its public counterpart and subsidized much more heavily than that in the United States. The study showed that Chilean educational performance is below the Organization of Economic Cooperation and Development (OECD) average and more comparable to that of other Latin American countries with lower relative income per capita. Much of this seems to stem from the inability to expand a school’s capacity to educate more students. The best schools in Chile typically must limit the number of students they admit by raising the cost of tuition. Thus, school choice actually leads to increased stratification and income inequality. This is not to say that a voucher-based system is significantly
Features worse either, but the costs involved in switching to a system that produces insignificantly different outcomes make such a transformation unwarranted. Many argue, however, that a voucher system would benefit lower-income areas such as inner cities where the existing public education system can be corrupt. This claim is rooted in empirical evidence, as W. Bentley Macleod and Urquiola (2009) found in their paper that “subsidizing for-proﬁt schools via vouchers is shown to be particularly beneficial to lower income students… it also raises the likelihood that high productivity schools enter the market to serve them.” However, there are still limits to the effectiveness of vouchers for lower-income students; this approach has not shown success across all income levels. With regard to income levels, a key problem that typically goes ignored in policy discussions is the “anti-lemons effect.” The lemons effect alludes to the occurrence of adverse selection in markets; the uninformed consumer typically chooses the “lemon” because the owner of the lemon, or defective good, is willing to sell at a lower price than the owner of the well-maintained good. Thus, the lack of information for the consumer leads to the selection of a lower quality car. The anti-lemons effect, as Macleod and Urquiola define in their paper, refers to schools’ knowledge of a student’s test scores, leading to the selection of students with higher test scores. The problem lies in that test scores are highly correlated to socioeconomic status; McEwan, Urquiola, and Vegas (2008) note in the specific case of Chile that “schools’ average test scores are a very good proxy for average student income.” Thus schools with excellent reputations might be more inclined to screen for higher quality students, rather than focusing their efforts on increasing the value added for each student. Such a system does not represent that of a true market in which firms (schools) are competing to improve the quality of their product (value added with respect to academic achievement). A good way to view the potential anti-lemons effect is through the American higher education system and the specifColumbia Economics Review
ic case of Columbia University, a university with a considerable reputation in academic and professional circles. What exactly does the Columbia University brand name represent? A student who attends Columbia University has proven that he or she is intelligent and diligent enough to gain admission to this selective university. In addition, a student at Columbia University has lived and studied with other smart, hardworking students for four years, which has had some beneficial effects as well. Consequently, Columbia University has an incentive to select high-achieving students and high-achieving students have an incentive to choose Columbia. But is there any way to test whether Columbia University actually improves student achievement level beyond peerquality effects? If Columbia University truly added significantly more value to a given student’s achievement level than other universities, then even a relatively uneducated person should be able to significantly improve his academic achievement level by attending this school. However, Columbia University does not accept the uneducated so there is no way to put this question to the test. This largely explains why, even though going to a better school can improve academic and financial outcomes, there exists limited evidence that in-
“Is there any way to test whether Columbia University actually improves student achievement level beyond peer-quality effects?” troducing voucher-based school choice leads to improved academic outcomes or that elite schools significantly outperform less prestigious schools. Yet the earlier question still remains: how can we deliver higher quality education to more students than what the established system currently provides? As mentioned earlier, the other solution that has been frequently proposed is to focus on enhancing the precise mechanisms by which school quality is determined. Pop-Eleches and Urquiola
Features (2008) highlight how “more selective schools might be able to attract better teachers, be run by better administrators, or even receive favorable treatment from national or regional authorities.” With regards to teacher quality specifically, Eric Hanushek and Steven Rivkin (2003) aptly point out that there exists a mystery with respect to teacher quality, since there exists “both the large impact of teachers on student learning and the lack of explanatory power of traditional quality measures.” According to the teachers’ union, teachers’ experience and educational background are key inputs in improving teacher quality. Accordingly, they reason, teachers should be paid based on their seniority and university degrees. As Hanushek points out, however, empirical analyses have shown that “the amount of experience in the classroom--with the exception of the first few years – also bears no relationship to performance” and “that master’s degrees bear no consistent relationship with student achieve-
ment.” The evidence in Pop-Eleches and Urquiola (2010) seems to support this viewpoint since students who finished below and above the cutoff had teachers of similar experience and educational background. In fact, the only input they
Knowing that schools matter is crucial to future reforms: no longer can we accept the notion that student achievement is solely the product of a student’s actions and characteristics. found to significantly differ between teachers of students above and below the cutoff was the amount of homework assigned. Nevertheless, it remains safe to assume that the given background characteristics are not the source of positive school effects. Thus, while we know that raising the quality of teachers can have a strong positive effect on student achievement, we are not aware of what precisely makes a great teacher. The easiest way to get around this problem of insufficient teacher compensation is to pay based not on inputs, such as experience and one’s higher education, but on outputs, namely gains in student achievement. This might seem rather intuitive since it directly incentivizes teachers and administrators to improve the academic outcomes of students. The best teachers would earn the most since everyone is paid for what he or she produces and the students gain from receiving a better education. Such a system, however, does not take into account the fact that a student’s incomelevel is a great predictor of how much more he or she can achieve in a given year. Yet, suppose we control test scores for differences in socioeconomic status. Shouldn’t a teacher’s value-added then be revealed? The simple answer is yes, but that would be misleading. McEwan, Urquiola, and Vegas (2008) demonstrate that “test-score volatility is even more pronounced when we use measures that arguably do a better job of controlling for student socioeconomic status,” and thus a teacher’s value-added becomes incredibly volatile from year-to-year. Fall 2010
9 Some might champion such a system wherein a teacher or administrator’s salary is largely tied to the value he or she adds, when differences in socioeconomic status are controlled. Yet which might a teacher find more attractive, a highly unstable but higher-paying salary on average, or a slightly lower salary that stays constant from one year to the next? When we consider liquidity constraints and the tendency towards risk aversion, the latter offer might very well be more attractive than the former. One way to mitigate this problem is to make only a fraction of a teacher’s salary directly tied to the test scores of his or her students. Given that under the status quo, salaries are almost entirely determined by inputs such as teacher education and experience, moving toward basing salaries on a more balanced mixture of inputs and outputs would seem most appropriate. In some private sectors, such as finance, there often exists a tendency to overemphasize output over input, leading to issues with limited liability and excessive risk. Yet to place almost zero weight on output, as is the case for nearly all teachers at American public schools, seems equally foolish. There are no simple solutions for improving school quality, but when salaries are based at least in part on output, even if poorly measured, we will be able to create some direct incentive for enhancing potential mechanisms that determine school quality. When we incorporate output into the incentive system there will be an impetus to create better measures of teacher output and methods for testing. Through gathering more data, we will also be able to find stable but effective proxies that more accurately estimate teacher quality. Knowing that schools matter is crucial to future reforms: no longer can we accept the notion that student achievement is solely the product of a student’s actions and characteristics. The teachers and administrators matter as well and the sooner we move to better evaluate and incentivize performance, albeit in a responsible and appropriate manner, the faster we can move towards a future in which all students can truly enjoy equal opportunity.
I Dream of Gini
Income Inequality in the Chilean Neoliberal Development Model Ross Bruck “Deeply involved in the preparation of the coup, the Chicago boys, as they are known in Chile, convinced the generals that they were prepared to supplement the brutality, which the military possessed, with the intellectual assets it lacked.”--Orlando Letelier, Chilean Minister of Interior under Salvador Allende, in an article published in The Nation (1976). Introduction One of the most contentious debates in economic development theory centers around the successes and failures of Chile’s neoliberal experiment, carried out by a group of Chilean economists trained at the University of Chicago under the likes of Milton Friedman and Arnold Harberger. The economic reforms, carried out by this legion of economists, shifted the course of Chile’s economic history towards the free market: trade
barriers were eliminated, industries were denationalized, and social goods like health care were privatized. Scholarship on this period has largely fallen into two distinct categories: one views the effects of the reforms as miraculous while the other maintains that the policies resulted in economic and social catastrophe. However, such polarized views of the period from Pinochet’s coup in 1974 to the transition to a democratically elected government in 1990 are inconsistent with original source economic and social data from this era, which demonstrate that the neoliberal reforms were successful at accomplishing certain economic and social goals, such as taming inflation and boosting exports, while failing to meet others, such as abating domestic inequality. The mid-1980s through the 1990s saw a major expansion of national in-
Figure 1: National Investment Rate of Return
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come, although the shares of this newly created wealth were by no means evenly distributed. Should a Chilean-style, free market approach to development be applied to current or future advancing nations, it is quite likely that a similar inequality versus overall growth conundrum would arise. What range of inequality, then, is optimal for positive economic and social outcomes? A discussion of Chile’s growth between 19741990 leads us to how we might begin answering this difficult question. The late 20th century Chilean economic experiment, an archetypal implementation of Chicago-style neoliberal theory, is complex, nuanced, and an experiment which should be deconstructed and adapted rather than simply wholly embraced or wholly rejected. Similar nuance is required when considering the advancement paths of today’s and tomorrow’s developing nations. Chile Prior to 1974 Before 1974, Chile faced enormous economic difficulties, including the highest inflation rate in the world, which stood at over 600 percent in 1973. Various presidents of the country had made attempts at economic reform, and immediately prior to the neoliberal experiment was Salvador Allende’s “Chilean Path to Socialism.” Furthermore, the country was confronted with a fiscal deficit of 20 percent of GDP along with low domestic savings and investment rates of 6 percent and 7.9 percent, respectively. For comparison, in 2009, the United States ran a fiscal deficit of around 12.3 percent and Greece, which suffered a near-catastrophic debt crisis, only had a deficit of around 15.4 percent. Figure 1 compares Chile’s investment rate in 1974 to the average investment rates from 1960 to 2000 of the United States, Japan, and Venezuela. Even by the rela-
Figure 2: Fluctuations in Chile’s GDP Growth (1971-2008)
tively lower regional standards of South America, Chile’s domestic savings and investment rates were inadequate. With regard to economic growth, the years between 1940 and 1970 show a cumulatively modest, though certainly not abominable, record with real GDP growing at an average rate of 3.7 percent per annum and real per capita GDP growing at 1.7 percent per annum. On average, between 1959 and 1973 the bottom 40 percent of Chilean society received 10.5 percent of GDP, the middle 40 percent received 32.4 percent, and the top 20 percent received 57.3 percent, and it was this inequality that was the impetus for Allende’s policies. For much of this period, the Chilean government followed an import-substitution development strategy that intervened significantly in the economy; especially in the socialist overhaul, there was a strong egalitarian social agenda that sought to equalize Chilean society and expand public welfare services. Healthcare and education sectors were nationalized, as were different industries, while agriculture was collectivized; protectionism was a general economic policy. The initial results were positive but gains were quickly reversed. In addition to loss of economic efficiency the ire of the United States increased to the point where it applied pressure and convinced other nations to cut off Chilean credit as it had immediately following Allende’s election. This pressure culminated in the
support for Pinochet and the military to overthrow Allende in a coup in which the democratically-elected socialist president was removed from power and in fact committed suicide. The Pinochet Era On September 11, 1973, the Chilean Armed Forces overthrew the elected government of Salvador Allende and installed in its place a junta led by Augusto Pinochet. Almost immediately after taking power, Pinochet, his advisors, and his crony government technocrats began to lay the groundwork for pioneering neoliberal economic reforms. The coup d’état ended the previous constitutional republic and radically reoriented policy from the “Chilean Path to Socialism” to free-market economics; in doing so the regime faced opposition from political and economic leftists that it overcame through oppression and “forced disappearances” of civilians. There is no question that these ideas were implemented on the country by force or that the social consequences of oppression were dire, but the consequences of political change must be separated from the effects of the economic transformation. Policies such as the privatization of most state-owned enterprises, reduction of government expenditures on social services, limitations on organized labor, affirmation of secure property rights, and the promotion of foreign capital inflows were implemented. AdditionFall 2010
11 ally, Chile became much more open to foreign trade, lowering tariffs and eliminating other trade barriers. Essentially, the country adopted most of the 10 economic policy prescriptions of the Washington Consensus. These reforms represented a nearly complete overhaul of the nation’s economic institutions and regulations, and the relative rapidity of their implementation in just a few short years led to the dubbing of this practice as “shock therapy.” Certain policies, however, such as the subsidization of several export industries, particularly fruit and lumber, bailouts of financial institutions, and the pegging of the Chilean peso to the U.S. dollar demonstrated that the regime was willing to break from neoliberal dogma when pragmatism dictated a state-specific solution to an economic difficulty. To clarify nomenclature, the Chilean model refers to a generally orthodox adaptation of neoliberal policies with the above exceptions. Economic and Social Effects of Reform As illustrated in Figure 2, the early economic effects of the neoliberal reforms can best be described as erratic and not exceedingly successful. Between 1950 to 1972, the Chilean annual GDP growth rate stood at 3.9 percent, falling to just 1.4 percent from 1974 to 1983. Years of economic catastrophe due to external shocks in 1975 and, according to Friedman, the implementation of a fixed currency in 1982, saw year-to-year GDP declines of 13 percent and 14 percent respectively, while 1977 to 1980 saw average annual GDP growth of 8.5 percent. Figure 3 shows the dramatic fluctuations in real wages during the Pinochet era. Furthermore, the unemployment rate rose dramatically after the coup to a peak of 21.9 percent in the crisis of 1976, settling to a still high 15.1 percent in 1981. While the transition period in which structural adjustment dismantled socialist policies led to erratic growth in the early years, later economic growth was substantial. From the mid-1980s onward output grew by an average of six percent per year. This growth trajectory continued through the 1990s and, in 2009, Chile had the highest GDP per capita in South America with $14,700. Whether or not the growth that occurred
after Pinochet’s rule can be attributed to his neoliberal policies is a fundamental question in assessing the successes and failures of the implementation of neoliberal theory in Chile. If the scope of analysis is strictly limited to Pinochet’s rule, the economic consequences of his reforms seem less successful. The historical record, however, suggests that the advancement of the Chilean economy after Pinochet left office can be ascribed to neoliberal theory since most of the regime’s policies and ideology carried over into subsequent administrations and the constitutional reform of July 1989 permanently established many of his administration’s policies in the longstanding economic policy of the nation. One of the primary criticisms of Chile’s neoliberal period is that it was responsible for dramatically increasing domestic income inequality. Indeed, many of the statistics regarding inequality during the mid-1970s through the 1990s are concerning. Chile presents an enormous disparity between the income share of the top 20 percent and the income share of the bottom 20 percent of households. According to the Gini Index, which measures income inequality on a scale from zero (perfect equality) to 100 (perfect inequality), Chile ranked 14th worst in the world in 2003. Certainly, the result of the Chilean development model has been an imbalanced growth with far greater gains going to the top quintile.
The privatization of state owned enterprises allows for investors and entrepreneurs to amass great wealth, as does the deregulation of major markets. Those benefiting are often those with access to greater wealth and social capital, and it is for this reason that some increase in inequality is to be expected. Cuts in education and healthcare spending, similarly, make upward mobility by the lowest classes much more difficult. While greater income and wealth disparity is certainly troubling, the economic growth that has accompanied the reforms of the 1970s and 1980s has increased the absolute income of the bottom quintiles of Chilean society. Combining data on national GDP and income shares by quintile reveals that the annual absolute incomes of the bottom two quartiles were higher in 1974-1989 than in 1971-1973 by $13.1 million and $18.5 million respectively (1970 PPP$). This represents absolute income gains of about five percent for the bottom quintile and three percent for the second quintile. By contrast, the top quintile averaged an income $1640.3 million per year higher during 1974-1989 versus 1971-1973, representing a gain of about 35 percent. More importantly, the modest gains in income for the bottom quintile were accompanied by substantial gains in quality of life. According to the United Nations Development Programme
Figure 3: Fluctuations in the Chilean Real Wage* (1970-1990)
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(UNDP), the year Pinochet stepped down from power, 1990, was the year Chile ranked first in South America on the Human Development Index (HDI). The HDI, measured on a scale from 0 to 1, is a composite of several measures of well-being including income, literacy rate, infant mortality, and others. Chile notably enjoyed a life expectancy at birth of 72 years, an adult literacy rate of 98 percent, 97 percent of its population having access to health services, and an average daily calorie supply of 106 percent of necessary daily intake, among other high statistics. This was the result of an upward trend from when the HDI was first defined in 1980 over the remainder of the rule of Pinochet’s junta, and this trend continued in the years after his policies were constitutionally enshrined. Even leading in 1980, Chile bested the Latin American average with an HDI of .607 to the average .578, and expanded its lead to the present, enjoying a score of .783 over the average .706. It seems, then, that the welfare of the citizenry is determined more by overall wealth than by income distribution; most likely, qualities calculated in the HDI like education, life expectancy, and social welfare are more easily improved by increases in total wealth. Nonetheless, one of the major economic shortcomings of the Pinochet era unevenly distributed income growth. A tremendously disproportionate amount of GDP growth went to the richest 20 percent and the bottom 40 percent was left with very modest increases in absolute overall income. Although no real-world economy can be manipulated to deliver strictly equal growth rates for the full spectrum of a society (and whether this is the correct goal is debatable), starkly unequal societies suffer both economically and socially (due to greater overall instability, higher crime rates, more drug and alcohol abuse, lower education attainment, among a litany of others ills). While balanced growth remains the ideal, the case of Chile allows us to question what level of inequality can or should be tolerated. To begin, it is essential to understand that inequality and growth are not isolated economic issues but are actually closely linked. Traditional thinking has
seen such an imbalance as inevitable, with the majority of growth for the poor following the growth of the rich akin to trickle-down theory; recently there have been calls for a focus on “pro-poor growth” to mitigate the effects of inequality. Thus, the question at hand is not how much growth should be sacrificed to achieve greater equality. Rather, it is what level of inequality promotes the highest growth rates while avoiding the aforementioned social and moral issues that arise with large income disparities. As discussed by Giovanni Andrea Cornia and Julius Court in their United Nations Policy Brief, there exists an “efficient inequality range” above or below which growth tends to suffer. If inequality is too high, the economy suffers from incentive traps, the erosion of social cohesion, social conflicts, and uncertain property rights. If inequality is too low, however, incentive traps, free-riding, labor shirking, and high supervision
costs diminish growth. These particular authors found that this efficient range lies roughly between a Gini Index of 25 and 40. As mentioned above, in 2003 Chile had a Gini Index of 54.9. While attempting to quantify a target range of inequality is always somewhat arbitrary, the empirical evidence gathered and analyzed by Cornia and Court seems to suggest that their conclusion is fairly accurate. Clearly, inequality in Chile is greatly above that range and thus presumably, the nation will realize lower long-run growth rates than would be possible given more a more condensed income spectrum. Conclusion While not perfect, Chilean neoliberalism created high overall growth rates that raised the wealth and quality of life of most segments of society and eventually led to a free, democratic political system, accomplishments which should not be Fall 2010
13 dismissed lightly. The model also demonstrates that significant problems often arise when large-scale economic transformation occurs, even when the transformation is to a vastly improved framework. Policy should aim to minimize these issues as best as possible, but they must be endured until the society acclimates to the new environment since the goal of real economic growth is the only means to significantly and perpetually increase the wealth, and consequently the welfare, of a society. Finally, after examining the Chilean case study, it seems that the model enacted by Pinochet should certainly not be implemented wholesale in today or tomorrow’s developing economies. Income gains of 35 percent by one quintile and only 3 percent by another quintile are not symptoms of a perfectly ordered economic model. Despite these shortcomings, the period 1974 through 1990 should be viewed as a qualified success in that it was able to stabilize the chaos of the fiscal budget while still delivering income growth for virtually all segments of Chilean society. The model did, in fact, accomplish important economic goals. Pinochet’s policies successfully stabilized the Chilean government’s fiscal situation while delivering, by the mid-1980s, relatively high growth rates. The major disadvantage of these policies, however, was their failure to evenly distribute income growth. Countries which, in the future, choose to adopt neoliberal policies must be conscientious of this phenomenon and realize that inequality higher than the “efficient range” described above may lead to an array of social issues as well as diminished overall growth rates. In transitions from state-run economies to free-market economies, an attempt should be made, through policies including progressive tax structure, relatively high minimum wage, and expanded welfare and education services, to mitigate the inevitable shock that will come with the transition. In such a manner, gains in income may be more equally distributed across the social spectrum and the society may avoid the worst excesses of inequality, as experienced by Chile under Pinochet, while preserving its growth-inducing effects.
Interviews & Events
10 Questions for Gurcharan Das
Photo courtesy of The Deccan Chronicle
Gurcharan Das is a noted public intellectual, best-selling author, and management expert. He is the author of The Difficulty of Being Good: On the Subtle Art of Dharma, a recently published book about the ethics of capitalism in India, and has written many other fiction and non-fiction works including the international bestseller India Unbound. After graduating from Harvard Business School, Das worked as CEO of Procter & Gamble India and Managing Director of Proctor & Gamble Worldwide. Das currently authors a weekly column at The Times of India and has been a guest columnist at The Wall Street Journal, Foreign Affairs, and The Financial Times. The Columbia Economics Review sat down with Das to discuss his thoughts and opinions on India’s unique brand of economic and business policy. Columbia Economics Review: In a 2006 report on India’s growth in Foreign Affairs you assert that Prime Minister Manmohan Singh’s government is not doing enough to educate voters about the benefits of economic reforms. You state “it is not too late for Singh and the reformers in his administration (Chidambaram1 and Ahluwalia22) to start appearing on television to conduct lessons in basic economics.” What would lesson one of Indian Economics 101 look like? Gurcharan Das: It is essentially what every person instinctively knows in his head as common sense but needs to be reminded about: that markets should be competitive, that competition ensures honesty, that competitive markets perform far better than state monopolies, and that people need to be reassured that some 1. Former Finance Minister and current Union Minister of Home Affairs. 2. Deputy Chairman of Indian Planning Commission, which sets economic policy.
of the state monopolies that we have can be wound up and, really, that opening up [to the free-market system] has helped us as an economy. Foreign investment is also good. For example, in the area of retail trade, we do not yet allow companies like Walmart. But you have to show that it is exactly these kinds of companies that have the capability of creating a core change for Indian farmers. You have to show that cold storage and cold transportation in trucks that are air-conditioned will solve the problem of 25 percent of our produce rotting in the fields. Also, the farmer right now cannot sell directly to a customer but if he were allowed to do so, there would be competition so farmers would be helped--but also consumers because large chains always give you more competitive prices than the mom-andpop stores do as this country, and everywhere else, has shown. At the same time, the employees of the retail stores are helped because if you’re working for the Walmarts and the Reliance Freshs of today, you need employees who are much better educated--so they educate them, they train them in computers, etc. You earn more as an employee than you would at a neighborhood store. And ultimately, you actually create more jobs than you destroy. So these are the kinds of things: our agriculture desperately needs investment, and whether it is private or public investment, both investments are good, but in the end we need investment. If the government is not investing, the private sector will--if you give them the chance. So these are the things that I would have these people talk about. CER: Professor Aravind Panagariya at Columbia University’s School of International and Public Affairs (SIPA), lists in his acclaimed book, India: The Emerging Giant, priority sectors for future reform in which the government is the principal supplier. These areas include power, education, health, water and sanitation--sectors that the Indian government has historically proven extremely weak. Based on your experience with corporate India, can private entrepreneurial actors fill this large void and, if so, to what extent? Das: Well, yes, the answer is yes. And I think the answer lies in enlightened regulation because what you don’t want is crony capitalism. India, because of the poor capacity of the state, will produce a new governance model for the world. There are lots of things you associate with delivery by the government--in India it will be delivered by the private sector, and not for any other reason other than [that] the government is not capable of doing this. The corruption is just a symptom of incompetence. Ironically, some of our state institutions were quite good 40-50 years ago. We were quite proud of them then, but they have frayed very badly and those institutions now need to be reformed. Today, I think that is what the government is trying--struggling, I would say--to do now through public-private partnerships, and things are improving. For example, the recent airports in Delhi
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Interviews & Events and Hyderabad. I believe we can do this in lots of areas, including schools. The government has a responsibility to ensure that all children get a decent education, but it doesn’t have to produce it, it doesn’t have to run schools by civil servants. CER: Talking about your experiences at Proctor & Gamble India in the Harvard Business Review you say “I…began to think of my work as a part of nation building, especially training and developing the next generation of young managers who would run the company and the country.” What specifically would you teach Indian bureaucrats about management, given your experience at Proctor & Gamble? Das: Ultimately, the main thing that the Indian government needs to learn from the private sector is accountability. It will not only make it more efficient, but also raise the level of happiness in our society. When the bureaucrat is more accountable (accountable for results), it will improve governance. We have very good bureaucrats but 80 percent--well, nobody knows what percentage--are bad and it seems like everything you want from the state is, as I said in my book [The Difficulty of Being Good], is morally flawed. I need to get a new driver’s license and I am already worried: will I have to pay a bribe in order to get that license? But behind that, about 20 percent of bureaucrats work very, very hard and it’s not fair to them because they don’t get any reward; in fact, they are punished. So we need to create a system where good people are rewarded and bad people are punished, and that’s what the private sector does very well. CER: Given your experiences, what can India do to train its civil servants, who are known to be among the brightest in the country but lack managerial skills, with a better understanding of supervisory techniques that work in local settings? Das: The whole system in which they are operating is rotten. As you said yourself, these are the brightest people in the country but they very quickly lose that sense of purpose because the system is rewarding bad behavior and not rewarding good behavior or hard work. A starting point? When people are waiting in line for you to give them their passport, talk to them and ask them how you can make their life a little bit better, make the line shorter, make the line more orderly. Just pay attention to your customers. That’s the heart of the market, it rewards you--those companies--that listen to the customers-- they’re rewarded through higher market share and so, it pays to be good. CER: Regulatory capture has often hindered the work of Indian bureaucratic institutions. One situation that comes to mind is the plight of India’s struggling railways which lost $4 billion last year, and yet cannot increase fares. Has the promised provision of public goods damaged the collective good? Das: I do not believe so but, again, our institutions must change to keep up with the times. If we had clear titles on land in our system, for example—that is one of the defects in our system--if the poor had a clear title then they could actually go to a lending institution and collateralize it to start a business. I wrote a
column about this [in the Times of India] titled “Give People Titles, Not Cakes.” The whole idea is to make it easier for people. In India today, the vast majority of people are in the informal economy, and actually the informal economy is actually a very entrepreneurial economy. To survive on such a low income you have to be entrepreneurial. But what the states can do is to make it easier for them. Today, a fellow who sells on the street constantly has to pay a hafta [bribe] to the police--it is extorted from that poor fellow. So give hawkers spaces from where they can legitimately sell their wares: we have a nation of entrepreneurs so we must make it market-friendly to these entrepreneurs. See, when we think of entrepreneurs, we think of Mukesh Ambani, but every Indian is really an entrepreneur. Unfortunately, the License Raj still exists for these poor entrepreneurs very strongly. Every year the World Bank does a study called “Doing Business” and we rank among the lowest because we are so unfriendly and this especially hurts the poor. The number of days it takes to start a business, the number of people you have to bribe to start a business--if all that can be made easier, think of the possibilities! In some countries, you can just start your company on the Internet; all the forms are there and you are in business the next day. If we can do that, then we make it easier for people. They will have titles, they will have security. CER: Indian entrepreneurs claim that they are hardier because they have had to fight not only their competitors, but also state inspectors. In China, however, local communist boards create everything from co-op boards to entire R&D divisions to help their industries flourish. Do you think this short-run disadvantage will help India’s companies compete with their Chinese counterparts in the long run global marketplace? Das: Well, theoretically, if you start the entrepreneurial game early, you have a first mover advantage. Because the Chinese entrepreneurs are in the government, meaning that they are state-owned enterprises but very cleverly they have aligned the interests of the party and the state functionaries, there is a reward for entrepreneurial behavior and so that is why those enterprises are doing well. So in effect what you have done is created millions of Chinese communist party or state entrepreneurs because they have a cut, a kind of benefit from those state enterprises. And maybe those state enterprises will slowly begin to resemble private companies and everything will work out very well, one doesn’t know what will happen to those enterprises. In reality, in some ways today, the Chinese system is a lot more market-friendly because the regulators and the state officials have a vested interest in the success of their enterprises and, thus, are more market friendly to investment and growth. But how that will play out in the end, I do not know, it is hard to say. As I said, the race between India and China will be won not by who creates prosperity faster but by whether India fixes its governance before China fixes its politics, and it is hard to forecast either. To read the remainder of this interview, please visit our website at ColumbiaEconReview.com.
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E C O N O M I C S
F O R U M
Show Me the Treasury Bonds Discussing the Second Round of Quantitative Easing In November 2010, Sally Davidson, an adjunct professor of economics, and an intimate group of concerned students sat down in Lerner Hall for a discussion of the causes and consequences of the Federal Reserve’s second round of quantitative easing. Over hot pizza and the cold objective geometry of economic models, the first Economics Forum of the year touched on a slew of issues in central banking ranging from inflation expectations to interest rates. As it stands today, economic indicators widely believed to track fluctuations of the business cycle have performed quite well, even pointing to an uptick in economic activity in the spring of 2011. However, there are still major drags in the economy, and the largest of which is the housing sector. When asked if housing prices are likely to dip again, Davidson replied that due to “shadow inventory,” another dip is not out of the question. This shadow inventory includes houses in foreclosure that have yet to be sold and houses that owners have yet to put on the market as they wait for a resurgence in the housing market. According to Davidson, “if that shadow inventory comes into the market, there may be a temporary stabilizing in housing prices, but we could have another dip.” This state of affairs is primarily why the Fed finds itself implementing its second round of quantitative easing, or QE2. On August 23 last year, when Federal Reserve Chairman Ben Bernanke first broached the possibility of implementing QE2, expected inflation was hovering at around 2 percent, slightly above the established federal target. Prior to the financial crisis, the Fed’s policy tools for such a situation were limited to open market operations, which include lowering the discount rate and federal funds target rate and issuing “moral
suasion” via public statements. When the federal funds rate reached the lower bound of zero on December 18, 2008, market-watchers became concerned about the possibility of further dips. With interest rates at zero percent, Davidson noted that the Fed certainly “cannot ease in a traditional way.” To tackle the economic slump, the Fed utilized all the aforementioned policy tools; it tinkered with the federal funds rate, adjusted the discount rate, and repeatedly issued official statements to sway market expectations. However, none of these has sufficiently reinvigorated “animal spirits.” Enter quantitative easing. The first round of quantitative easing, QE1, began in 2009 with a plan to purchase $1.5 trillion of mortgagebacked securities to bolster financial institutions. QE2, which commenced in November 2010, is a process wherein the Fed plans to inject up to $600 billion of liquidity into the economy through the purchase of treasury securities. Put another way, the Fed uses the size of its balance sheet to affect credit conditions. Between the start of the financial crisis in mid-2007 and the failure of Lehman Brothers in September 2008, the size of the Fed’s balance sheet remained largely unchanged. Most research found that the effective long-term rates dropped at most 100 basis points thanks to the Fed’s first round of quantitative easing. However, Davidson remarked that QE2 is “a little bit different” since its main goal was presumably to lower mortgage lending rates. After the Fed announced that it was going to implement QE2, it publicied its plan to purchase over $600 billion worth of long-term treasuries by late 2011. This amounts to $75 billion of treasury securities per month. As an indicator of QE2’s potential, consider the moral suasion effects of its announcement: when Bernanke first started talkColumbia Economics Review
ing about QE2, long-term treasury rates declined around 20-25 basis points. What, then, is the downside to QE2? “The liability side of the balance sheet has to increase along with the increase in assets,” Davidson stated. The major problems lies in the accumulation of excess reserves. Banks are holding trillions of dollars in reserves on deposit at the Fed. If the Fed does not tighten monetary policy in time, the excess reserves could result in high inflation if and when banks start to loan this into the economy, causing the Fed to lose credibility. Although the Fed has several exit strategies, none is ideal. “You could try to shrink the balance sheet by letting things [long-term treasuries] mature,” Davidson said, “but that takes time.” Instead, the Fed must find a way to shift the money from excess reserves to another category where the banks cannot immediately lend it out. Repurchase agreements, or repos – the practice of temporarily selling securities with an agreement to buy them back – are one possible option; the Fed could then move funds out of excess reserves and pay interest to a small group of banks known as primary dealers. What is most troubling, however, is the dire situation we might see ourselves in if all other options fail. Davidson ruminated on the possibility in which the Fed not only fails to remit profits to the Treasury but also experiences a shortfall. As she sees it, if the Fed has to go to Congress hat in hand, pleading for money, the central bank will lose credibility and possibly even a fair degree of independence. This could be the end of central banking as we know it. Monetary policy, it seems to Davidson, can only do so much. To subscribe to the Economics Forum listserv, please send an email to email@example.com
Tips for Networking and Interviewing By Lucia Manzo and Gabrielle Berg
Focus Research the firms and industries you find appealing and relevant to your background. Ask yourself, do I see myself growing at this company and improving or gaining skills sets? Does this firm value young employees and their careers? Prepare Position your resume and cover letter with your best attributes; apply your experiences to justify how your qualities will benefit each employer. This brainstorming will help prepare you for articulating your skill set in interviews. Be Yourself Ask yourself: am I coming across as me? Am I genuinely interested? Take some time to investigate the qualities and attributes you value in yourself and your firm. Remember, you will be devoting much of your life to your career, so choose a path that represents yourself! Be Confident Have faith in your preparations. Remain focused and know yourself. Balance your confidence with humility. Connect Be sure to gain exposure to your desired firms through information sessions and campus events. Listen to the firm’s employees, who have taken the time to share their views. Be prepared to ask intelligent questions. Reconnect Reconnecting is crucial. Continue to reach out to those with whom you have made a connection. Though you will not be able to connect with everyone, focus on the individuals you feel you have made an impression on. A concise email with a few good questions can lead to more conversations. Keep up with your network; after all, even an occasional email can help maintain relationships.
Interviewing Have an answer prepared Every interview begins with some form of the question, “Tell me a little about yourself.” This question, usually one of the first asked, is one of the few times in the interview where you can take control. Keep your self-introduction brief and relevant; condense your answer to four to six key “bullet points” to present in one or two minutes. To avoid digressing, script your response and practice aloud beforehand. Know your resume Think of ways in which you can relate your activities to the skills required of the job. If your resume lists high school activities or awards, make sure you can still explain them. Resist the urge to inflate your resume; if you took two years of elementary Spanish but can barely compose a sentence, do not write “fluent in Spanish”. The last thing you want is for your your interview to begin with “¿Cómo es usted?” Know the company Research the company and the role you applied for. Information on corpoate websites can provide invaluable background knowledge for the interview. In particular, read through the company’s “About Us,” “Careers” and “Our Team” sections. Moreover, keep up with current news of the company. Have examples ready Interviewers love asking for examples of experiences that demonstrate skills relevant to the job. For example, if you are applying for a job that entails collaboration, the interviewer might ask about your past teamwork. Ponder experiences that can illustrate your work ethic, determination, creativity, or ability to work well with others. Ask a question or two: Every interview concludes with, “Any questions for us?” Have at least one question prepared, perhaps about the content of the interview or the company itself. This is your chance to demonstrate to the interviewer your interest and initiative.
Everyone gets a little nervous and it is easy to become quiet and reserved, but avoid appearing disinterested or lacking in personality and passion. When you describe an activity on campus that you are involved with, let your enthusiasm for that activity shine through. After all, who wants to associate with someone with a monotone, melancholy aura? Remind yourself that connecting with someone involves merely a conversation. Above all, remember to be upbeat and enthusiastic. Fall 2010
Gone in a Flash Sale
How Gilt Groupe is Rewriting the Rules of Retail Caroline Casey, Benjamin Eckersley, Hadi Elzayn, and Dasha Wise In the 1990s, when e-commerce first appeared on the business scene, websites were little more than mail order catalogues transplanted onto the Internet. Today, however, second-generation websites arriving in the wake of the social networking hype of the mid-2000s make full use of technology in order to achieve a high level of consumer customization and access to target niche markets. In doing so, these new websites have revolutionized the traditional model of retail sales and, in particular, the business of online luxury retail. According to Bloomberg Businessweek in 2009, while specialty retail chains suffered a 5-7 percent decline in sales, top private-sale sites actually experienced a fivefold increase in sales per year. Gilt Groupe, a particularly successful online luxury retailer, through its use of “flash sales,” a precisely targeted and highly effective marketing strategy and an inventory model that is quickly changing the way even traditional brick-and-mortar retailers do business, has piqued the interest of industry leaders, fashion designers, and customers alike, even going so far as to alter consumer demands and expectations. Founded in 2007 by an innovative group of entrepreneurs, Gilt Groupe offers members a range of luxury merchandise, such as men’s and women’s clothing and accessories, high-end home products, and extravagant vacation packages. Although Gilt’s flash sales are a derivative of traditional in-store sample sales, Gilt’s model is unique not only due to the steep discounts offered (as large as 70 percent off retail price) but also the limited-time sale format, typically lasting only 36 to 48 hours. Although membership can be requested through Gilt’s website, it is generally by invitation only and most members
Exploiting human psychology lies at the heart of Gilt’s social e-commerce model. join as a result of having been invited by friends or acquaintances who receive a gift card from Gilt when one of their invitees makes a purchase. Apart from exclusivity, these sites also employ a sense Columbia Economics Review
of urgency in order to induce sales. The flash sales and their interface (the clock and the members’ carts) reduce the anonymity and convenience of Internet shopping. In terms of competition, this atmosphere is more akin to physical shopping with a deadline that employs some aspects of auctions. Exploiting human psychology lies at the heart of Gilt’s social e-commerce model. Gilt’s marketing strategy, then, is non-traditional insofar as it focuses more on interpersonal connections rather than direct advertising to build brand awareness. This low-cost strategy appears to have been nevertheless effective, as membership in this pseudoexclusive and chic club currently stands at approximately two million and has grown exponentially from the date of its establishment. Given its customized shopping structure and product offerings, Gilt attains its success largely by catering to the interests and demands of a precisely targeted customer base. According to data, most visitors to Gilt. com are childless Caucasians and college graduates with incomes of more than $100,000 who typically browse from work. In addition to its sales strategy, Gilt, along with other retail reselling sites, also utilizes a unique model of inventory management by buying the excess inventory of wholesalers at discounted prices and reselling them at lower prices for consumers. With its flash sales, Gilt is able to maintain a quick rollover time between products. The countdown clock, the expiration of items from shoppers’ carts, and the air of competition all work to ensure that customers act quickly to lock down scant items; altogether, this minimizes inventory risk, and, unlike the wholesalers the company buys from, Gilt manages to empty nearly
Business Economics all of its inventory. However, while its sales format and service offerings have certainly translated into significant revenue for Gilt and allowed the nascent company to weather one of the worst economic downturns of our times, Gilt’s success may, in the long-term, come at the expense of the luxury goods industry.
Gilt Groupe, alongside other second-generation e-commerce business models, is forcing onsite luxury retailers to rethink many of their traditionl operating paradigms. Andrew Rice, writing for New York magazine puts forth exactly this question: if Gilt continues to expand its membership base and its ubiquity within the market for luxury goods, will customers still be willing to pay full price for the same brands that they can otherwise purchase through Gilt at an enormous discount? If they are not, then perhaps the very brands that currently partner with Gilt have a reason to actually worry about the exposure that they take on through the partnership. While it is still too early to gauge the extent and magnitude of such an effect, it is reasonable to believe that consumers accustomed to Gilt’s deep discounts may significantly reduce their estimations of the fair value of the featured luxury merchandise or, perhaps, luxury products in general. Thus, while in the past three years we have witnessed tremendous growth and financial success from Gilt Groupe and similar online retailers, it remains to be seen how such platforms will affect the demand and profitability of traditional sales of luxury brands as well as the inventory management models of traditional department stores. There are some indications, however, that the stunning success enjoyed by these sites may not last. According to Steven Dennis, a marketing consultant with 25 years of experience, the overall decrease in demand seen during the economic downturn left wholesalers with excessive inventory, and it is largely due
to this reason that resale sites like Gilt have been able to provide such hefty discounts on high fashion items. As the economy has begun to emerge from the recent recession, wholesalers are left with less excess inventory, and sites like Gilt have already begun offering smaller discounts. In addition, Gilt has begun to expand to other areas beyond its initial market, such as travel bookings, wine, and spa packages, and this suggests a somewhat saturated market in the initial niche; Dennis says it “smacks of desperation.” At the least, there will have to be some sort of evolution in this trendy model if it is to continue growing with the same robustness it has shown in the past. Although the concept of online retailing is an extension of the traditional brick-and-mortar store model, the success of Gilt and similar sites has reflected influence in the opposite direction, pressuring conventional retailers and department stores to modify their marketing and distribution practices. Many have experimented with similar strategies: Neiman Marcus, for example, has incorporated in-store sales just two hours in length, hoping adrenaline-frenzied consumers will flock to stores and make purchases essentially on impulse. Saks Fifth Avenue has launched its own
The business of luxury retail has drastically changed for customers, fashion designers, and retailers alike. version of a flash-sales website, “Fashion Fix,” with exclusive invitation by e-mail for 36-hour sales, while eBay, noting the success of this trend, has introduced a “Fashion Vault” section with similar flash sales and designer merchandise to boost diminished sales brought on by the recession. In another twist in the ecommerce model, Nordstrom Rack partnered with the site Groupon to provide 50 percent discounted coupons to online customers, a venture that resulted in the sale of thousands of such coupons a day, vastly increasing turnout in the physical store. It appears that Gilt Groupe, alongside other second-generation e-comFall 2010
merce business models, is forcing onsite luxury retailers to rethink many of their traditional operating paradigms. Conclusion The success of Gilt certainly emphasizes the growing importance of the Internet in the business of retail. Through its flash sales format, unique and highly targeted marketing strategy, and distinct inventory model, Gilt has not only made luxury goods more affordable but also increased awareness and demand for these same goods. During its weekday sales, for example, Gilt logs well over 100,000 site visits by eager shoppers in the immediate hour after the sale commences. “For that time, it might as well be the most crowded store in New York,” posits New York magazine. This competition has encouraged traditional retailers to expand their efforts onto the online realm, where they will likely borrow the same innovative sales techniques that Gilt and other such online retailers have instituted. The business of luxury retail has drastically changed for customers, fashion designers, and retailers alike: how much further these second-generation e-commerce websites can expand in this market however, is a question that remains to be answered.
The Bright Lights of Silicon Alley New York City’s Growing Entrepreneurial Sector Raphaela Sapire With over 45 startups, six venture capital firms, and five entrepreneurial working hubs, New York City’s startup scene is booming and shows no sign of slowing. A multitude of factors, such as a favorable economic environment, private and public funding initiatives, historical business leadership, and an overall decrease in startup costs all help to explain the burgeoning entrepreneurial landscape in New York that has come to be known as Silicon Alley. At a technology conference in rival Silicon Valley, Mayor Michael Bloomberg highlighted New York City’s leadership across several industries and the resulting advantages, emphasizing, “When you want to start a business, you don’t have any choice. This is where the best and the brightest are.” Despite the current economic climate, the evolution of Silicon Alley places New York City at the heart of a technological convergence that revives its historic entrepreneurial leadership.
the lucrative fur trade. This culture of openness and innovation sets the stage for a thriving entrepreneurial mindset throughout the 21st century, particularly in the financial, fashion, and media industries. In 1792, the New York Stock Exchange played an indispensable role in the growth of New York City as a commercial center. Edward Glaeser, professor of economics at Harvard University, comments that in the 1960s, financiers’ “more sophisticated approach to risk and return” enabled entrepreneurs to expand the volume trades on Wall Street such that by 1972, 32 million Americans owned securities, compared to only 12.5 million in 1965. Additionally, the garment industry exploded in New York City after the Civil War when newly arrived Jewish
[New York] pulled itself from the ashes of the dot-com crash and has risen back to the upper echelons of the top tech cities. Unique social and historical factors define the culture of entrepreneurship in New York City, setting it apart from that of any other city in the country. Unlike other colonial cities such as Boston or Philadelphia, New York was founded on the premise of entrepreneurship. The Dutch East India Company arrived in New York Harbor on September 3, 1609, and by 1624 the Dutch West India Company established New Amsterdam for the sole purpose of capitalizing on Columbia Economics Review
immigrants formed small businesses specializing in the clothing industry. Manufacturing played an essential role in New York’s economy during and after the Industrial Revolution and today, New York is one of the fashion capitals in the world. Since the creation of the Penny Press in 1833, New York has served as the media center of the country, with most leading magazines, influential newspapers, and broadcast networks headquartered here. Historical leadership in the financial, garment, and media industries positioned local entrepreneurs in these industries with distinct competitive advantages in relationships, resources, and public relations. Beginning with the Dutch emphasis on innovation and continuing to the inventors and entrepreneurs
Business Economics responsible for today’s groundbreaking technologies, New York City’s technology startup space can be explained as an extension of the city’s historic entrepreneurial success onto the online platform. Dubbed “Silicon Alley” in reference to its competitor Silicon Valley in the San Francisco Bay Area in California, New York City is “now on its way to cementing its reputation beside Silicon Valley as a driving global force in the industry,” according to Chris Cameron, a writer for ReadWriteWeb, one of the largest technology blogs in the world. Just as it had led the way in finance, fashion, and media, New York in the late 1990s was on the cutting edge of web innovation during the dot-com bubble. For example, Prodigy, the first online service to provide access to the World Wide Web, emerged in 1993 in White Plains, New York. New York Internet companies such as Razorfish, DoubleClick, and Pseudo followed suit and with them came Union Square Ventures, a venture capital firm run by Fred Wilson. According to Wilson, in 1999 alone, over 500 startups were founded in New York City. The dot-com crash of 2001, however, resulted in the decline of venture-backed technology startups in generating economic activity in the city. Yet, as Cameron points out, in the decade after the Internet bubble burst, New York “pulled itself from the ashes of the dot-com crash and has risen back to the upper echelons of the top tech cities.” Today, New York City boasts an impressive variety of successful startups and entrepreneurial resources. According to CBInsights, a comprehensive database of private companies, New York City is uniquely specialized in Internet startups compared to California and Massachusetts. Between July and September of 2010 alone, New York City reaped 31 Internet-related funding agreements garnering $126 million, while Silicon Valley acquired 21 deals bringing in $174 million. According to TechCrunch, six of the top ten startups with the most funding in New York City are in the finance, fashion, or media industries, and all of them are web-based. Internet startups in finance include SecondMarket, an online portal for trad-
ing shares, Fynanz, a private student loan platform, and Seeking Alpha, a stock market news community. Tech
With New York City’s historical leadership in finance, fashion, and media, it is easy to see why the city has become a favorable environment for startups in these industries. startups specializing in fashion consist of Gilt Groupe, an online designer retailer, while social media sites such as Gawker and Thrillist also call New York City their home. The advent of the Internet necessitated that companies in every industry—from education to restaurant—establish online capabilities, and with New York City’s historic business leadership, it is easy to see why the city has become a favorable environment for startups in these industries. Other trends explain New York City’s explosive startup scene. One explanation for the proliferation of Silicon Alley is the ever-decreasing costs of starting web-based businesses, a fact that has enabled entrepreneurs to launch companies without venture capital backing. Entrepreneur Paul Graham cites four reasons for the low costs of establishing a startup: “Moore’s law has made hardware cheap; open source has made software free; the web has made marketing and distribution free; and more powerful programming languages mean development teams can be smaller.” Startups simply do not need legions of investors the way they did ten years ago.
Mirroring the environment in the city, the entrepreneurship community on campus is gaining momentum. In addition to existing resources, public funding has also contributed to the rejuvenation of Silicon Alley. In a Fall 2010
21 2009 press release, Mayor Bloomberg, along with the NYC Economic Development Corporation, announced 11 initiatives totaling $22 million to help support business innovation and entrepreneurship. Two such initiatives fund an incubator to help startups obtain office space at affordable rates. In addition, a $3 million investment in a program called the Angel Fund will provide financing to 250 New York-based startups over the next eight years. Small businesses create jobs, and in a city with a 9 percent unemployment rate, these initiatives will help spur job creation. The 2008 financial crisis has created a legion of talented, eager students looking for employment who otherwise would have gone to established banks and corporations. Universities such as Columbia University play an increasingly significant role in New York City’s emerging tech-based economy. According to the Association of University Technology Managers, in 2007, 21 startups emerged out of the city’s major universities. Over half of these originated from Columbia University, which spun off 12 startups – up from eight in 2002. David Lerner, director of the Columbia Venture Lab, calls student entrepreneurship an “emerging colossus” that is increasingly a part of Columbia University’s educational mission. Mirroring the environment of the city, the entrepreneurship community on campus is gaining momentum and more and more becoming a career of interest to students who have come to realize the vast opportunities available in the industry. A city’s past informs its future; the most significant quality in New York City throughout its history has been its ability to reinvent itself. During a 2010 conference hosted by Union Square Ventures, there was wide consensus that New York City had an “unprecedented opportunity to emerge as a global center for tech and media innovation and that technology startups could be the largest part of the New York City economy in 10 to 15 years.” As a rapidly growing industry, New York’s technology sector is an increasingly attractive option for bright college students with interests in industries as widespread as finance, fashion, and media.
Theory & Policy
Seeing the Forest for the Trees
Deforestation and Cost-Effective Regulation of the Timber Industry Ellen Liu, Danni Pi, and Dasha Wise In 2009, Elinor Ostrom received the Nobel Prize in Economics for her groundbreaking research regarding a localized and highly decentralized solution to the “tragedy of the commons” problem. This problem, as originally posited by ecologist Garrett Hardin in 1968, arises due to the fact that the use of common property cannot be restricted and that in such circumstances an individual’s marginal benefit always exceeds his marginal private cost (although not necessarily marginal social cost). This results in overexploitation of natural resources and net social welfare loss via economic inefficiency. Commonly advocated solutions to the commons problem include the privatization of common resources or extensive federal regulation. Ostrom proposes an alternative solution – that of local self-governing institutions. In her 2003 article “The Struggle to Govern the Commons,” co-authored with Thomas Dietz and Paul Stern, Ostrom posits that when certain conditions hold (including easy monitoring of resources, verifiable information, moderate rates of change, effective communication, dense social networks, ability to exclude outsiders, and user monitoring plus enforcement) local communities are the most effective agents in preventing the overexploitation of common resources. This is because local communities have not only greater information about the importance and most effective utilization of a given resource, but are also able to effectively monitor and regulate overexploitation of such resources at much lower cost through mechanisms such as social pressure. This process is what Ostrom refers to as adaptive governance, for it takes into great consideration local needs, resources, and abilities. Ostrom’s theory of adaptive governance may be employed in the global
forest reserve, an important example of a common resource whose excessive exploitation through deforestation remains one of the most important environmental issues facing today’s international community. Among the chief harms of deforestation are the emission of carbon dioxide and other greenhouse gases, contributing significantly to global warming and climate change, and the loss of the very flora that serve as an invaluable carbon dioxide sink. Deforestation, then, is inextricably linked to the largest environmental concern of the 21st century. Other direct harms include the loss of biodiversity, extinction of marginal species through the destruction of natural habitats, the disruption of ecosystems, the desiccation of soil, the opportunity costs of potential future uses of forest resources, the aesthetic damage, the loss of tourism value, and the disruption of local villages and communities.
The need for greater participation and consensus remains a key next step for the international community to undertake. Hence, it is in the interest of all countries to protect their natural forest reserves since it is only through protecting these reserves that countries can implement a sustainable development strategy, attaining an optimal level of economic and social welfare while balancing imminent concerns for the environment and natural resources. In this analysis, we will specifically examine the issue of deforestation in light of the commons problem and the efficiency and cost-effectiveness of employing a Columbia Economics Review
local, decentralized regulatory approach in achieving sustainable practices for forestry regulation similar to the adaptive governance suggested by Ostrom. Specifically, we will focus on the regulatory policies of India and China, two of the most important decision makers on the global stage of timber industry regulation and sustainable development, which have demonstrated effective implementation of a highly localized enforcement regime with respect to the regulation of their lumber industries. Case Study 1: Republic of India In the span of the past several decades, India’s economy has become the world’s fourth largest on the basis of purchasing power alone. In relation to the rest of the world, India has 2.5 percent of the world’s geographical area, 1.8 percent of the world’s forest area, and, as of 1996, 16 percent of the world’s population. For a landmass that was once 31.24 percent covered by forests and greenery, India is currently only 22.6 percent covered by forests, 12.9 percent of which are dense forests. This decrease occurred despite precautionary and regulatory legislations that have been in place since the 1920s – a consequence of illegal logging on the part of commercial interests looking to fulfill demand in neighboring countries as well as ineffective oversight and management on the part of the government. Under the Indian Forestry Acts, forests were divided into three categories: reserve, protected, and village forests. Forests deemed “reserved” are those in which people have no rights unless specifically recorded. Protective forests are those on hill slopes and riverbanks, where forest cover is dictated by physical considerations of erosion, conservation of moisture, and potential floods; in
Theory & Policy such areas, all rights are expressly forbidden. Village forests are fuel forests intended to meet the needs of the surrounding population. In accordance with the National Forest Policy, the main goals of management were based on paramount national needs as opposed to local needs. The major national needs included developing a system of balanced and complementary land use, ensuring an increase in supplies of grazing, small wood, and firewood, and establishing a sustained supply of timber and other forest produce for industry. However, as a result of loopholes in legislation, not only was the state government prohibiting villagers from accessing their own communityâ€™s resources but was also approving vast mega-projects involving large-scale destruction of large forest areas. From 1952 to 1980, over 4.3 million hectares of forestlands were lost to various purposes as a result of these loopholes (World Rainforest Movement). Over 2.3 million hectares of these lands were used for other agricultural activities, and over 130,000 hectares were diverted to industries and townships. The 1988 Amendment to the earlier Forest Conservation Act of 1980 further limited the authority of state governments to turn over any land to private individuals, groups, or corporations, thus optioning the authority back to higher levels of government. Despite the shortcomings of this legislation, the central authority with respect to forest management was the National Forest Policy of 1988. The National Forest Policy introduced the scheme of Joint Forest Management (JFM) which at the most basic level is a forest management strategy wherein the Forest Department and the village communities jointly protect and manage forestland. In return for this responsibility, the villages share in the profits of their management. To date, JFM has been implemented on more than 17 million hectares of degraded forest through over 63,000 Village Forest Committees and spanning 27 states of the Indian Union. Under JFM, the village community receives greater access to a number of Non-Timber Forest Products, or NTFPs
(products such as nuts, roots, and other valuable plants that can sustain the village without impacting the trees), and a share of timber revenue in return for increased responsibility for their protection from fire, grazing, and illicit harvesting. For many poor villages, this is extremely important to economic welfare. In the state of West Bengal, forest communities derive as much as 17 percent of their annual household income from NTFP collection and sales. Furthermore, as of the late 1990s, over 50 percent of national forest revenue and approximately 70 percent of national forest export revenue comes from NTFPs. The strategies of JFM are reminiscent of the self-governing institutions proposed by Ostrom, who would consider this strategy most effective given the conditions of practicability, cohesion, and social pressure. For example, after the initial conflicts with timber thieves of neighboring villages, residents of Behroonguda, a small village in India, Fall 2010
collectively prepared themselves for change by forming a forest protection organization to address the conflict. The village induced rule compliance by expanding participation in an effort to include a majority of the villagers; the perceived participation of the entire village is paired with an individualâ€™s responsibility to uphold the expectations of JFM. These techniques fit squarely with the characteristics of adaptive governance outlined by Ostrom: conflict management, rule compliance, infrastructure, and preparation for change. Indeed, while at the beginning of 1990 the area surrounding Behroonguda was barren, by 1998 the 250 hectares of forestland that had received silvicultural protection and treatment were lush again, increasing their value to 147,897 rupees per hectare compared to the neighboring Chintapally, which did not employ JFM and held a forest value of 45,613 rupees per hectare. Due to the access afforded to the villagers via JFM
24 and the positive actions of the Protection Committee, many of the NTFPs have reemerged, revitalizing an entire economy. In 1998, about 20 tons of NTFPS worth 144,959 rupees (approximately $32,441.73 in current U.S. dollars) were extracted from the forest, allowing villages to obtain higher standards of living. So far, the JFM program has been both successful and cost-effective. In the village of Behroonguda alone, the total cost (including village patrolling, forest department salaries, silvicultural treatments, and other expenses) of the program is $5,574.52, while the total benefits (including additional wages for forestry employees, NTFP sales, and the sale of poles from thinning) amount to $14,288.95 per year. Thus, in this small village alone the net gain from the policy of JFM is in excess of $8,714.43 per year. When such a cost-effective policy is implemented on a national scale and properly applied to other Indian villages and communities, the total net gain to social welfare per year will greatly increase.
Residents of Behroonguda, a small village in India, collectively prepared themselves for change by forming a forest protection organization to address conflict. Case Study 2: China As China continues along its doubledigit growth trajectory, policymakers must decide the optimal balance between economic growth, increased social welfare, and the sustainable use of resources. In a statement made in 2007, China’s State Forestry Administration spokesperson Mr. Cao Qingyao stated that “[under the current national forest policy,] China’s forests are expected to cover nearly one-quarter of its land mass by 2020 and the country does not foresee any major problems in meeting its paper and timber needs. In fact, China’s forestry coverage rate has risen from 8.6 percent to 18.2 percent in the past 58 years…and has planted 53.3 million hec-
Theory & Policy tares of forestland, more than any other country in the world.” While the current expansion rate of forest resources in China may sound highly optimistic, these figures should be examined with caution. It is essential to remember that China is in a unique position of resource usage due to its population and current economic growth. Despite forestry coverage of approximately 175 million hectares, ranking it fifth in the world for forest coverage, and a standing timber stock of 12.5 billion square meters, China is still considered forest-deficient. This is because, apart from China’s growing population, which intensifies the stress placed on the country’s natural lack of forest resources, another source of tension is the country’s rapid economic growth. China’s GDP growth in the last two decades has had significant negative effects on its forest resources. Domestically, China is now experiencing a number of serious social and environmental crises related to the overexploitation of its forests. Facing the ecological consequences of the overexploitation of forest resources and the growing pressures from “the demand side for products to be created in a sustainable manner,” the Chinese government has drastically reoriented its forest policy since the 1980s, moving from a timber-production strategy to an ecosystem conservation and resource restoration strategy. For these reasons, China has introduced the Six Key Forest Projects (SKFP) and new policies to “expand its forest growing and manufacturing base, improve degraded land, and provide more sustainable livelihoods for millions of forestry-dependent communities.” Perhaps the most important provisions of the SKFP are the Natural Forest Protection Program (NFPP) and the Conversion of Cropland to Forest Program (CCFP), both of which can be labeled as devolution agendas. In these programs, village committees, rather than a centralized bureau, undertake much of the decision-making. Committees are active in deciding when and where to establish forest plantations on their collective land and what species to plant. In many cases, the committees are also able to enter into contracts that lease their land to either villagers or outColumbia Economics Review
siders to reforest in exchange for profit. In terms of the CCFP program, the government has taken the initiative to provide farmers and households with the necessary stipends, tax cuts, and seeds needed to replant the land as the community leaders deem appropriate. What is crucial to note is that these village committees are able to make their own regulations that adapt national policy to local conditions. Currently, the SKFP is widely regarded as an effective plan by which to reforest China. Under the NFPP, 95 million hectares of forestland have come under effective protection. In addition, the government has successfully reforested five million hectares of barren land, banned logging in natural forests, and reduced timber harvesting from 18.24 million in 1997 to 11.26 million square meters in 2005. Similarly, under CCFP, the country has successfully converted 18 million hectares of unnecessary croplands (created during the “Great Leap Forward”) back to forestlands. In total, approximately 120 million hectares of forest, or 12.5 percent of China’s land area, are now protected within 1,699 Wildlife and Forest Reserves. It is both necessary and instructive at this point to assess whether SKFP has been efficient. In other words, do the monetary benefits of restricting logging, timber harvesting, and reforestation extend beyond the costs of implementing the SKFP? In terms of the NFPP, while it is difficult to assign a value to the economic losses accrued to China due to the ban in logging and timber harvesting in many areas, we can state with certainty that it affects the present economic growth of the country negatively. Beyond the economic loss, the ban has also contributed to the displacement of approximately 670,000 forestry workers with $300 million in unpaid salaries. In an effort to assist the workers, the government has become burdened with stipends paid to unemployed forestry workers. Upon combining all of the economic impacts, the grand total cost to the government in establishing the SKFP is $85 billion, in addition to the amount spent on stipends and other social welfare programs for displaced workers. On the other hand, the banning of
Theory & Policy logging and timber harvesting has decreased pollution and soil erosion problems, while creating a booming national forest tourism industry which has provided the country with 1.6 million jobs and $300 billion in revenue. Thus, while China has decreased its economic benefits by restricting its use of resources, it has created a very valuable tourism industry that will increase overall net social benefit in the years to come. However, it is necessary to remember that such costs of stipends are typically one-time costs and were used to initiate the program and help farmers switch from crops to reforestation. On the other hand, China has built a strong tourism industry on top of its reforestation program that brings in revenue of approximately $300 billion yearly. China also now effectively manages 12.5 percent of its landmass under Wildlife and Forest Reserves. On the basis of the large increases in protected forest resources over the last three decades as well as the cost-benefits analysis of the NFPP and CCFP programs, the SKFP program is relatively efficient and cost-effective. Nevertheless, even effective and efficient programs have certain flaws. In terms of China’s SKFP program, there are still issues, like illegal logging, that the central government is struggling to address. Both illegal logging and fuel wood gathering are the result of a failure to enforce the NFPP in certain areas of the country. However, the overall NFPP program still seems to be the best current solution, as the amount of illegal activity associated with the program is limited and the NFPP minimizes the cost of state regulation and enforcement through its “collective management” foundation, where village committees are responsible for preventing the illegal logging undertaken by members of their villages. Conclusion It is clear from the above case studies that a highly localized regulatory approach similar to that advocated by Ostrom has indeed been an effective means to regulate deforestation and ensure sustainable forest industry practices. The locally focused programs of JFM in India and SKFP in China have been suc-
cessful for two primary reasons. First, the localized approach has allowed the federal government of each nation to cater most effectively to local needs and tailor its policies so as to provide local communities with the ability to achieve the greatest level of productivity while utilizing their forest and local resources to full capacity. Such locally minded policy formulation has played a key role in achieving many of the economic welfare benefits presented in the
above case studies. Second, focusing on a more local, albeit federally organized, subsidized, and supported enforcement mechanism has proven highly successful, as well. Local community members not only have more at stake in protecting their surrounding forest reserves but also have more localized and specialized knowledge, applicable skill sets, and the ability to utilize social pressure (similar to the means explained by Ostrom and her co-authors) to induce more effective compliance. It is evident that, at least with respect to particular commons problems, namely those that are more amenable to local community management, Ostrom’s local adaptive governance methods are highly applicable and her proposal should at the very least be taken into consideration by federal authorities aiming to construct efficient and cost-effective regulatory policies. Nevertheless, it is also important to keep in mind the role played by the federal governments of India and China in overseeing the localized systems of regulation. Although the enforcement was highly localized and the policies catered to specific community needs, the authority was still delegated in a top-down manner and the policy was nevertheless centrally administered. We believe that with large nations such as Fall 2010
25 India and China, but especially within the context of the entire global community, a top-down (and hence somewhat centralized) approach is vital to the sustainable collective management of all of the world’s reserves of a particular common resource. Although efforts have been made to date , and with some success, to develop international bodies that collectively determine appropriate deforestation levels for particular nations as well as effective international enforcement policies, the need for greater participation and consensus remains a key next step for the international community to undertake. In order to achieve truly sustainable timber industry practices and limit deforestation (as well as other commons-related harms), an effective localized enforcement regime must be coupled with a strong centralized authority. Such an authority should certainly tailor its policies to best meet local needs and make the most efficient use of local resources. Through this ability to set the most effective and welfare-maximizing policies, the centralized authority would also be able to achieve sustainability and regulatory success on a global scale in a way that local institutions cannot due to the lack of both comprehensive information and even private and communal benefit incentives. A centralized structure is most economically efficient chiefly because it has the ability to craft effective international policies as well as to serve as an agent of ultimate legal enforcement; such an authority provides local communities with the assistance, incentives, and local governing power that they require to effectively carry out a system of localized adaptive governance. Thus, as seen by the analyses of the forest commons in China and India as discussed in this paper, Ostrom’s theory of local adaptive governance appears vindicated, especially since modified versions have proven successful. In order to mitigate similar commons problems elsewhere in the world, it would behoove policymakers around the world to pay closer attention to this theory of environmental management, as it would prove enormously beneficial to the goal of sustainable economic development.
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