HCER-Fall-2009

HARVARD

Should Governments Regulate Sin?

C OLLEGE

Page 5

Policy Challenges and Finance

Economics Review FALL 2009 造 VOL IV ISSUE 1

Finance and

Regulation

Page 7

Prices and Crisis Page 17

Letter From the Editors Dear Reader, EDITORIAL BOARD

Editors-in-Chief Gina He Yuriy Shteinbuk Business Directors Michael J. Ding Athena Jiang Content and Editing Directors Pamela Ban Marianna Tishchenko Xiaoqi Zhu Publication and Layout Director Alee Lockman

Content

Regan Bozman–Content Associate Omar Garcia–Content Associate Han He–Content Associate Kwon-Yong Jin–Content Associate Suhas Rao–Content Associate Channing Spencer–Content Associate

BUSINESS

In this issue, we hope to shed light on the role of regulation in the modern economy.

The financial crisis has brought regulation, or the lack thereof, to the forefront of public discussion. This issue provides a few different perspectives that we hope will help you better understand the issues involved in the debates.

We have also included a number of articles in this issue that span a variety of topics, from the history of recessions to the economics of hip-hop and geochemical engineering. In the Cover Theme section, you will find an interesting argument regarding sin taxes by Jeffrey Miron, as well as a discussion of financial growth policy by Ross Levine.

We have also introduced a new section in this issue focusing on issues relating to International Economics. Additionally, we have as usual included a series of student articles in an effort to engage disparate groups on the Harvard campus.

We hope that you find this edition of the Harvard College Economics Review insightful, entertaining, and educational. As always, please write to us or visit us online at www.harvardeconreview.com.

Best regards,

Jean-Marie Wecker –International Manager Png Zhiheng–International Manager Louis Argentieri–Business Associate Paul Finnegan–Business Associate

IT Director and Webmaster Varun Bansal

Gina He

E-mail: hcer@hcs.harvard.edu Website: www.harvardeconreview.com COPYRIGHT 2010 HARVARD COLLEGE ECONOMICS REVIEW. ISSN: 1946-2042. All rights reserved. No part of this magazine may be reproduced or transmitted in any form without written permission of the Harvard College Economics Review. Opinions published in this periodical are those of contributors and do not necessarily reflect those of the editors.

Yuriy Shteinbuk

Harvard College Economics Review VOL. 4 ISSUE 1 On the Cover:

Economics and Regulation The HCER brings together academics, practitioners, and students to analyze the changing nature of regulation and its implications for policy, industry, and economic growth.

HARVARD

Should Governments Regulate Sin?

CO L L E G E

Page 5

Policy Challenges and Finance

Economics Review FALL 2009 ¤ VOL IV ISSUE 1

Page 7

Prices and Crisis Page 17

Finance and

Regulation

Should Governments Try To Reduce Sin?

Prices and Crises The Forgotten Recession: Lessons from 1937-38 4 6

Ross Levine

9 11

Stephen G. Brooks

The Culprits Behind India’s Income Inequality: Neoliberal Economics and Globalization?

13

Channing Spencer

Latin America Fights Back Omar Garcia

ISSN: 1946-2042 ISBN: 978-0-9823780-1-4

Book Review End the Fed

22

Siddhant Singh

23

Han He

Kiran Gajwani

Has America Lost the Capacity to Lead?

19

Kwon-Yong Jin

Book Review This Time is Different: Eight Centuries of Financial Folly

International Poor People Helping Themselves

16

Hyun Song Shin

Jeffrey Miron

Finance, Growth, and Opportunity: Policy Challenges

Special Focus: Finance

15

Interest

Hip-Hop and the Recession

24

Regan Bozman

Interview with David Keith Interviewed by Regan Bozman

26

Jeffrey Miron

Should Governments Try to Reduce Sin? The costs and benefits of sin taxes

M

ost governments attempt to reduce the consumption of “sinful” goods like alcohol, tobacco, drugs, gambling, and prostitution. The most aggressive approach is prohibition: a ban on the production, distribution, and consumption of the good in question. A less extreme approach is sin taxation, which raises the price of the targeted good but allows legal production and use. Numerous other policies, such as drunk-driving laws or minimum purchase ages, target specific negatives associated with sin.

Economists offer two justifications for policies that target vice. First, that certain goods or activities cause externalities. Second, that some consumers make irrational choices about the goods usually thought of as sins. Each of these views has an element of truth, and well-designed policies aimed at reducing vice might be beneficial on net. In practice, such policies can have significant unintended negatives, so the case for reducing sin is not compelling.

The externality argument for reducing vice holds that consumption of these goods can harm innocent third parties, implying the privately chosen amount of

such goods is socially excessive. For example, driving under the influence of alcohol can cause traffic accidents that injure not only the driver but other cars and passengers, pedestrians, and property. Smoking cigarettes generates second-hand smoke, which bothers many non-smokers. Drug abuse can diminish health, which negatively impacts others through a “fiscal externality” if government pays for health care. Gambling might cause financial ruin, implying more people living on welfare, and prostitution might spread sexually transmitted diseases.

The externality logic for reducing vice is sound, but several caveats apply.

First, while some people consume sin in ways that generate externalities (e.g., driving under the influence), many others do not. The ideal policies discourage consumption only in circumstances that generate externalities. Thus, penalties for drunk driving make sense because they focus on behavior that might harm others, and bans on smoking in public places address an externality directly. Prohibitions and sin taxes, however, impose the same penalty—a higher price—on consumers

who do and do not generate externalities.

The second problem with the externality framework is that determining what constitutes an externality and which ones society should reduce, is difficult.

Washing one’s laundry causes water pollution, a classic externality. Eating too much ice cream can cause heart disease, thereby increasing the costs of publiclyfunded health care. Watching late night TV means less sleep and lower workplace productivity the next day, which can adversely affect one’s co-workers. In other words, a great many activities generate externalities. Since society does not have the resources to control them all, it must figure out which are most significant.

This complicated and subjective exercise, however, often comes with problematic implications. Smoking, for example, causes elevated health costs, some of which are paid out of public funds. Thus, smoking causes a “fiscal” externality, and this might seem to justify policies to reduce smoking. At the same time, many smokers die younger than non-smokers, which means they collect less in Social Security and Medicare benefits. This is a benefi-

HARVARD COLLEGE ECONOMICS REVIEW

cial externality because it reduces taxes on everyone else. The externality reasoning taken to its logical end thus implies that if smoking reduces Social Security and Medicare payments by more than it raises public health costs, governments should subsidize smoking.

Few people would endorse such a policy. Yet, if society is unwilling to apply the externality logic consistently, the concept becomes a tool of special interest groups who use it to promote their own goals.

Academics, for example, emphasize the externalities from education and use these claims to justify government support, but the evidence for such externalities is modest. The externality argument must therefore be applied with caution.

A different argument for targeting vice holds that many individuals make bad decisions when left to their own devices, especially regarding “sins� like alcohol or gambling. This might occur because people are short-sighted, ill-informed, undisciplined, or in some way not rational. Relatedly, it might occur because certain sins are addictive. Thus, according to the paternalism perspective, governments can make such people better off by encouraging or requiring different choices than these people would make on their own.

No one denies that some individuals are not fully rational and do not seem to act in their own self-interest. The paternalistic defense of anti-vice policies, however, is problematic.

To begin, paternalism can seem to justify an enormous range of government intervention. Paternalism might suggest, for example, that government should

discourage not only sins like drug use or prostitution, but also saturated fat, lack of exercise, excessive television, certain books, and particular religious preferences. In each case, a plausible argument exists that some people consume the wrong amount of the good in question, yet most people would be wary of intervention that dictates religious choices, dietary restrictions, or jogging regimens. More broadly, paternalism opens the door for interventions that would horrify those who invoke paternalism in other contexts. Paternalism might suggest, for example, banning abortion because most women prevented from obtaining an abortion nevertheless end up loving their kids.

Even without slippery slopes, government attempts to prevent every bad decision would consume enormous resources.

Thus, politics and prejudice can play a large role in determining which goods come in for paternalistic considerations. Marijuana use, for example, carries health risks, but even heavy, long-term use appears to generate less harm than obesity.

Thus, the standard arguments for policies aimed at vice, while logical as far as they go, are not necessarily compelling.

Whatever the merits of these arguments, a full analysis must examine the costs of the specific policies used to reduce vice.

For prohibition, the costs are enormous.

Prohibition drives markets underground, generating violence between rival suppliers, diminished quality control for users, and corruption of police and prosecutors.

Prohibition enriches those who supply the good despite the law, and the widespread non-compliance teaches everyone that laws are for suckers. Because violations of prohibition do not generate a natural complainant, prohibition diminishes civil liberties as police rely on intrusive tactics such as warrant-less searches and racial profiling. Prohibition, moreover, does not appear to substantially reduce vice.

Sin taxation is a better policy than prohibition for addressing externalities or irrationality, but it generates several adverse side effects. Excessive sin taxation amounts to de facto prohibition, so it creates a black market and all the attendant negatives. Sin taxes do not necessarily reach this level, but the risk is always present.

Even moderate sin taxes have unwanted effects. Sin taxes penalize those who can engage in drug use, prostitution, or gambling without hurting themselves or others, so the net impact on consumer welfare is ambiguous. The choice of which goods to regard as sins is not obvious and in practice reflects politics more than good economics. Watching late night TV, for example, might reduce productivity more than marijuana allegedly does, but demonizing marijuana users is politically than imposing a tax on late-night talk shows.

Similarly, designating some goods as sins might signal that people should not worry about the non-sins, but many of these, like an unhealthy diet, generate real harm. Sin taxation also means that governments promote sin even while trying to discourage it (e.g., by banning private gambling while airing television ads that glamorize government lotteries).

Even mild anti-vice policies do not necessarily generate greater benefits than costs. A minimum purchase age for alcohol, for example, might reduce irresponsible drinking by teenagers. Yet the same policy might encourage binge drinking by teens who decide to consume heavily on occasions when they do get access.

The bottom line is that government efforts to reduce sin are harder to justify than conventional wisdom assumes. A few interventions, such as drunk-driving laws, almost certainly make sense, but overall anti-sin policies can easily generate more cost than benefit. H

Jeffrey Miron is the Director of Undergraduate Studies at Harvard University.

5

Ross levine

Finance, Growth, and Opportunity: Policy Challenges The contributions of financial systems to economic prosperity and what we can do to boost them

T

his article first describes the connections between the functioning of the financial system and both the rate of long-run economic growth and the availability of economic opportunities. The article next discusses how financial innovation affects economic prosperity. The article concludes with an analysis of financial regulation, describing the lessons that have been learned over the last few decades and how those lessons should be reevaluated in light of the recent financial crisis.

1

Finance matters for growth A large and growing body of research shows that the operation of financial markets and intermediaries exerts a first-order impact on the rate of long-run economic growth: (1) Countries with better functioning financial systems grow faster over many decades, and (2) Improvements in the operation of financial systems accelerate the rate of economic growth within particular economies.

Financial markets and intermediaries provide particular services that affect longrun rates of economic growth. They mobilize savings, choose where to allocate capital, monitor the use of that capital once it is allocated, and provide mechanisms for pooling and diversifying risk. To the extent that

the financial system performs these services well, economies tend to grow correspondingly faster. To the extent that a financial system simply collects funds with one hand and passes those funds along to cronies and the politically connected with the other hand, the economy tends to grow more slowly.

Moreover, consistent with the focus of the new growth literature, finance affects longrun growth by altering the rate of technological change and the efficiency with which resources are allocated. Finance is not very strongly linked with savings rates. Rather, finance shapes the rate of economic growth by affecting the flow of capital to more or less efficient ends.

Indeed, recent research shows that financial policy reforms that enhance the competitiveness of the financial system spur entrepreneurship in the non-financial sector.

Better, more efficient financial systems both ease the entry of excellent new firms and also ease the exit of relatively poor old firms.

Because there are winners and losers, not everyone wants a better functioning financial system. Some will fight vigorously against policy reforms that improve the functioning of the financial system and hence the rate of economic growth. Thus, political economy considerations are obviously paramount in reforming financial policies, either for the

better or for the worse.

2

Finance matters for the poor But, who actually benefits from a better financial system? Does financial development induce an increase in per capita GDP only because the very rich get even richer? Or, does finance expand economic opportunities for the bulk of society?

Economic theory suggests that the operation of the financial system could have a major impact on the distribution of economic opportunities.

The financial system influences who can launch a new business venture and who cannot, who can acquire education and who cannot, who can live in a neighborhood that fosters the cognitive and non-cognitive development of their children and who cannot, and who can pursue one’s economic dreams and who cannot.

Thus, the financial system affects the degree to which a person’s economic opportunities are bounded by individual skill and initiative or whether familial wealth, social status, and political connections delineate the contours of one’s economic horizons.

Though much less well-developed than the literature on finance and growth, a growing body of research indicates that more competitive, better functioning financial systems

HARVARD COLLEGE ECONOMICS REVIEW

exert a disproportionately positive impact on relatively low-income families.

With greater competition among financial institutions, banks lower interest rates and are pushed to become better at screening projects and monitoring managers. By boosting competition and efficiency in the non-financial system, financial development spurs economic activity and increases the demand for labor. Empirically, this manifests itself as an increase in the relative demand for lower-income workers. The relative working hours and relative wage rates of lowerincome workers increase as improvements in the financial system accelerate economic growth.

This evidence raises an obvious question: if finance is so beneficial for accelerating the rate of economic growth and expanding economic opportunities, what are the barriers to creating well-functioning financial systems?

I believe the answer is also obvious: some people do not want well-functioning financial systems that give the economically disenfranchised greater opportunities. They do not want to compete on more equal terms.

Thus, generating financial reforms that accelerate economic growth will involve much more than identifying which financial sector policies are good for economic growth.

Financial innovation is indispensable for 3 growth Before turning to a discussion of the types of policies that help in the creation of a growth-enhancing financial system, it is crucial to discuss financial innovation.

The literature on economic growth over the last two decades, if not the last six de-

cades, has placed technological innovation in the starring role. Yet, the literature on finance and growth has largely ignored financial innovation. History suggests that this is a mistake: financial and technological innovations are inextricably linked.

Financial innovations have been essential for permitting improvements in economic activity for several millennia. Whether it was (I) the design of new debt contracts six thousand years ago that boosted trade, specialization, and hence innovation, (2) the creation of investment banks, new accounting systems, and novel financial instruments in the 19th century to ease the financing of railroads, (3) or the development and modification of venture capital firms to fund the development of new information technologies and innovative biotechnology initiatives, financial innovation has been a critical component of fostering entrepreneurship, invention, and improvements in living standards.

The evidence does not imply that financial innovation is unambiguously positive.

Financial innovations are frequently implemented simply to avoid regulations, and they played prominent roles in triggering our current suffering.

At the same time, the evidence does imply that financial innovation is important in fostering economic growth and expanding economic opportunities.

These observations—that (a) finance shapes the rate of long-run economic growth, that (b) finance affects the distribution of economic opportunities, and that (c) financial innovation is a pivotal input into the quality of the financial services provided to the non-financial sector—have at least three

policy implications: 1. Improvements in the financial system will generate winners and losers, suggesting that the political power of particular constituencies will play a central—if not the central—role in determining the degree to which a country selects growth-enhancing financial policies.

2. The financial regulatory regime should not focus exclusively on stability since financial development and financial innovation influence human welfare by shaping economic growth and the distribution of eco4 nomic opportunities .

3. The regulatory regime must adapt to financial innovation or well-reasoned, well-intentioned, and wellstructured regulations will become obsolete and potentially detrimental to economic prosperity as a country innovates.

Existing evidence on which financial regu5 lations work best I now discuss evidence on which financial regulations work best in creating a financial system that boosts economic growth and expands economic opportunities.

First, in the name of economic growth, we should be wary of recent calls for more regulation and greater government intervention in financial systems. We should be very concerned about the form of regulation and the nature of government intervention and not just focus on the quantity.

In particular, an enormous body of research suggests that financial regulations are frequently used to help a small group of powerful elites, not to promote economic welfare in general. Whether it is Brazil or Mexico, India or Pakistan, Italy or the United States, publicly owned, government-controlled, and state-protected banks are associated with slower growth, not more rapid rates of economic development. Moreover, these government-influenced banks do not typically lend much to the poor; rather, they lend the bulk of their funds to politically connected firms.

In terms of official supervision, a large literature finds that official supervisory agencies that exert a direct, powerful influence over banks typically use that power to alter the flow of credit toward political ends.

Around the world, in countries with supervisory agencies that exert an influential hand over the affairs of banks, we observe much

7

8

fall 2009

higher rates of corruption in lending, along with declines in bank efficiency.

The evidence, however, does not advertise the efficacy of a laissez-faire approach to regulating financial systems.

The evidence instead indicates that countries that force financial institutions to disclose information in a transparent, easily comparable manner enhance the functioning of their financial markets. Moreover, the evidence indicates that legal and regulatory systems that both facilitate and compel equity and debt holders to oversee the management of financial institutions create more efficient, competitive financial systems that foster economic prosperity. Or, put differently, growth-promoting financial intermediaries arise with a greater probability when governments refrain from enacting and implementing regulations that interfere with the ability and incentives of shareholders and creditors to monitor financial intermediaries.

The crisis and financial policies: Lessons for promoting growth Does the recent U.S. financial crisis conflict with these policy conclusions?

No. I think it reinforces the earlier findings. A series of regulatory policies in the United States (1) hindered transparency, (2) erected barriers to shareholders and creditors effectively monitoring the activities of financial institutions, and (3) created incentives for financial institutions to take excessive risks. Thus, the United States did not follow the basic lessons about financial regulations that have been learned from the last few decades of research. It is inaccurate and, ultimately, unhelpful to view the crisis as a failure of the market. The United States had and has lots of regulations and very powerful regulators. It is both more accurate and more useful to identify the regulatory and political failures that produced the crisis so that the United States and other countries can enact more growth-enhancing policies.

For example, the U.S. Congress made it difficult for market participants and government regulators to acquire information on exposure to credit default swaps (CDSs).

For many years, the Federal Reserve was very well aware—and very concerned—that it could not assess the counterparty risk of CDSs. Yet, it still let banks dramatically reduce capital through the purchase of CDSs. This was a bad choice, potentially influenced by the political power of bankers.

As a second example, the Securities and Exchange Commission (SEC) and Federal

Reserve knew for over a decade that the Nationally Recognized Statistical Rating Organization (NRSRO) would have overwhelming incentives to sell high credit ratings on securitized mortgages for over a decade.

They knew that the explosive growth of securitization and collateralized debt obligations would dramatically intensify the conflicts of interest inherent in credit rating agencies. Basically, these credit rating agencies might not sell their reputations for a few million dollars, but for many billions of dollars, they energetically produced whatever ratings the banks needed. Yet, the SEC and Fed themselves still relied on the ratings of these agencies in evaluating the riskiness of intermediaries supervised by the SEC and Fed. This was not a lack of regulatory power.

Rather, there was an institutional and political unwillingness to adapt the discretionary implementation of regulations in the presence of new financial innovations.

As a final example, consider the horrible incentives created by the behemoths Fannie Mae and Freddie Mac in conjunction with the policies of the Department of Housing and Urban Development and the Federal Reserve. For a host of political reasons, these institutions pushed banks to participate in sub-prime mortgages. Yet, even though these institutions and Congress knew for over a decade that the situation was deteriorating, politics trumped sound policy.

Over the course of many years, policy-

makers and regulators made choices, bad choices, in the United States. They did not adapt regulations in response to financial innovations to help and induce shareholders and creditors to monitor financial intermediaries and, instead, maintained policies the interfered with the ability and incentives of investors to govern financial institutions effectively. A more publicly responsible—and responsive and accountable—regulatory system could have captured the benefits to economic growth and economic opportunity from securitization, collateralized debt obligations, and credit default swaps, rather than turning them into malignant tools of financial destruction.

Conclusion In conclusion, the operation of the financial system exerts a first-order impact on the rate of long-run economic growth. Moreover, research has produced useful guidelines regarding which financial policies have been most successful at creating growth-promoting financial institutions.

With regard to actually enacting and implementing growth-enhancing policies, however, the greatest difficulty lies in creating regulatory agencies that are powerful enough to facilitate and compel shareholder and creditor oversight of financial institutions while also obliging powerful regulatory agencies to act in the best interests of the H public.

Ross Levine is the James and Meryl Tisch Professor of Economics and Director of the William R. Rhodes Center for International Economics and Finance at Brown University.

Endnotes 1.

2.

3.

4.

5.

The section draws on Ross Levine (2005), “Finance and growth: Theory and evidence,” in Handbook of Economic Growth, ed. P Aghion, S Durlauf, 1A:865--934. Amsterdam: North-Holland Elsevier.

This section draws on the literature review by Asli Demirguc-Kunt and Ross Levine (2009), “Finance and Inequality: Theory and Evidence,” Annual Review of Financial Economics, 1. The literature considers three related, though clearly distinct and potentially contradictory, definitions of inequality. Many researchers stress equality of opportunity. Others emphasize the intergenerational persistence of cross-dynasty relative income differences.

Still others concentrate on income distribution because (1) they use income distribution to proxy for equality of opportunity or intergenerational persistence or because (2) income distribution is an independently worthwhile focus of inquiry, as relative income directly affects welfare. Since my goal is simply to note that a considerable body of research relates the operation of the financial system to various concepts of the distribution of economic opportunity, I do not distinguish among these different views of economic inequality, but see Demirguc-Kunt and Levine (2009).

This section draws heavily on Stelios Michalopoulos, Luc Laeven, and Ross Levine (2009), “Financial Innovation and Endogenous Growth,” National Bureau of Economic Research, working paper, 15356.

I am not suggesting that crises are unimportant. Indeed, crises are exceptionally costly. In developing economies, the fiscal costs of banking crises in the last two decades of the 20th century were greater than all of the nonmilitary international aid provided to developing countries during the 20th century. In the United States, the IMF estimates the cost of the financial crisis at about $3 trillion, which is about $20,000 per US taxpayer and exceeds educational expenditures by federal, state, and local governments during the last decade. We obviously should care about financial stability. Yet, reducing the risk of systemic crises is not the only goal of financial regulation and therefore is not the only consideration in rethinking the governance of financial regulations.

This section draws heavily on James R. Barth, Gerard Caprio, Jr., and Ross Levine (2006), Rethinking Bank Regulation: Till Angels Govern, New York: Cambridge University Press.

HARVARD COLLEGE ECONOMICS REVIEW

Kiran Gajwani

Poor People Helping Themselves

Membership-based organizations of the poor are an extreme form of decentralization…and a potentially useful development strategy

D

ecentralization of governance—in the sense of shifting power and responsibilities from national to subnational levels of government—has been a popular policy initiative in many developing countries over the past few decades.

The goals of such a policy are generally to fill in the failures of central governments in achieving poverty reduction, public goods provision, and overall provision of basic necessities to some of the poorest individuals in developing countries. In theory, locallevel governments and government officials may better know individuals’ preferences and be better able to target anti-poverty programs. India, China, Brazil, Indonesia, and Uganda are just a few of the many developing countries that have undertaken major decentralization policies in the last few decades.

There are certainly decentralization success stories. For example, decentralization in Bolivia has done well to gear public sector investment towards the needs of municipalities (Faguet, 2004). And, looking across several countries, there is some evidence that decentralization may lead to less corruption (Fisman and Gatti, 2002).

Decentralization policies, however, also have their fair share of problems. In China, fiscal decentralization may have hampered provincial economic growth (Zhang and Zou, 2001). There is also some evidence that decentralization of land use authority in northern Kenya has interfered with some traditional pastoralists’ migration routes, causing them to be more susceptible to drought (Munyao and Barrett, 2007).

The disappointment with decentralization strategies in some developing countries has therefore led to continued efforts to figure out ways to reach the poorest people in some of the poorest countries in the world.

One area that has recently been garnering much interest is membership-based organizations of the poor (MBOPs)—an extreme type of decentralization in a sense, where power and decision-making are put in the hands of poor individuals themselves.

MBOPs are tricky to precisely define, but

generally include any group where a ‘membership requirement’ exists; the vast majority of members are poor individuals, those poor members are largely in control of the group’s organization and governance, and the group is formed around some activ1 ity to improve the livelihood of the poor .

MBOPs have existed in developing countries for years and can be in the form of cooperatives, self-help groups (SHGs), or savings and loans groups, for example. The Uganda Shoe-Shiners Industrial Cooperative Society was started by five shoe-shiners in Kampala in 1975 and has now expanded to roughly 400 members (Birchall, 2003).

They provide access to polish and brushes, as well as training programs and savings and credit services. SHGs are very common in

Kenya, particularly in the form of women’s 2 groups , where they can take on functions ranging from agricultural projects, to childcare, to insurance (Udvardy, 1998; Gugerty and Kremer, 2004).

MBOPs range in size from very small, to hundreds, or even thousands of members.

One very large-scale, successful example of an MBOP is the Self-Employed Women’s Association (SEWA) in India. SEWA is a trade union comprised of women in the 3 informal sector , which are a significant subgroup of India’s population: more than 90 percent of India’s female labor force is in the informal sector (International La4 bour Office, 2002) . SEWA began as a way for informal women workers to organize themselves and to increase their empow-

9

10

fall 2009

erment in society. Members of SEWA fall into four broad informal employment categories: 1) manual laborers and service providers, 2) home-based workers, 3) hawkers, vendors, and small-business women, and 4) producers. Within SEWA, the women are organized into cooperatives based on their trade and are able to access markets for their goods and services that are otherwise beyond reach. From their origins in 1972 with 1,070 members in Gujarat state, SEWA’s 2008 membership stood at close to one million informal women work5 ers, across nine states in India . SEWA is almost entirely governed by its poor, informal working members, who pay an annual membership fee of five rupees (about 11 cents at the time of this article).

As its mission is to empower women as well as to improve their employment situation, SEWA offers many complementary services to its members, such as banking, health care, child care, insurance, legal services, housing, and even a “SEWA Academy” that provides basic education for members as well as leadership and technical training. In addition to organizing the women, SEWA works to influence government policies regarding informal female workers.

SEWA has been crucial in increasing the visibility of informal workers in India and the world: it was a key actor in the recognition of informal workers in India’s census, aided in bringing home-based workers and self-employed persons to the attention of India’s Planning Commission and subsequent goals (Datta, 2000), and participated in a September 2009 meeting of the International Labor Organization on strategies to provide all workers with social security coverage. In fact, SEWA refers to itself as not only a trade union, but a movement towards the empowerment of women and the informal sector of the economy.

SEWA’s achievements have been so profound that they were awarded a “MacArthur Award for Creative and Effective Institutions” in 2009. Such success has made it very tempting to try to replicate this MBOP 6 in other developing countries , and to expand this model to individuals other than informal laborers.

However, development practitioners must think long and carefully about what makes SEWA—and other successful ‘selfstarted’ MBOPs—tick before trying to duplicate them elsewhere. Indeed, attempts by outsiders to start new MBOPs or aid existing MBOPs have led to some disap-

pointing results. The success of self-started MBOPs is one reason for the World Bank’s strong pursuance of “community-driven development” projects (which generally involve creating MBOP-type groups geared at certain aspects of development) in recent years—to the tune of $2 billion in 2003 (Platteau, 2004). However, evaluations of some of these projects indicate disappointing results, such as low achievement of objectives, poor sustainability without World Bank involvement and funding, and individuals acting for their own personal gain (Alsop, 2005; Alsop and Kurey, 2005).

There is also some evidence that provision of funding from a non-governmental

organization (NGO) to women’s self-help groups in western Kenya had the unintended consequence of attracting younger, more educated, wealthier women into the groups and into positions of authority, and potentially alienating older, poorer women who might need the group the most (Gugerty and Kremer, 2004).

Nevertheless, something is definitely working well with SEWA, and with many other home-grown MBOPs. In fact, it’s working so well that it’s worth trying to understand better so that governments and NGOs can fully harness the potential of MBOPs as a successful development stratH egy.

Kiran Gajwani is a College Fellow in the Department of Economics at Harvard University and a part-time researcher with the International Food Policy Research Institute. She received her Ph.D. from Cornell University in 2008. Her area of specialization is in development economics, with a focus on governance, public goods provision, and inequality.

Endnotes 1. A thorough discussion on defining MBOPs can be found in Chen et al. (2007).

2. Regarding the size of Kenya’s SHGs, Udvardy (1998) states that groups typically have 35-45 members (p.

1751).

3. While having a union for informal workers who have no formal employer may seem puzzling, SEWA argues that the purpose of a union is not only about filing grievances with an employer, but also about bringing people together in support of a common cause.

4. Even after excluding agricultural work, more than 80 percent of all women in non-agriculture employment in India are in the informal sector (International Labour Office, 2002).

5. More than half of the members are from Gujarat state (approximately 519,000 in 2008).

6. The Self-Employed Women's Union (SEWU) in South Africa, established in 1993, is one example of a SEWAinspired group.

References Alsop, Ruth. 2005. “Community-Level User Groups: Do They Perform as Expected?” In Martha Chen, Renana Jhabvala, Ravi Kanbur, and Carol Richards (eds.), Membership-Based Organizations of the Poor. Abingdon, UK: Routledge.

Alsop, Ruth and Bryan Kurey. 2005. Local Organizations in Decentralized Development. Their Functions and Performance in India. Washington, DC: The World Bank.

Birchall, Johnston. 2003. “Rediscovering the Cooperative Advantage: Poverty Through Self-Help.” Geneva: International Labour Office.

Chen, Martha, Renana Jhabvala, Ravi Kanbur, and Carol Richards. 2007. “Membership-Based Organizations of the Poor. Concepts, Experience and Policy.” In Martha Chen, Renana Jhabvala, Ravi Kanbur, and Carol Richards (eds.), Membership-Based Organizations of the Poor. Abingdon, UK: Routledge.

Datta, Rekha. 2000. “On Their Own: Development Strategies of the Self-Employed Women's Association (SEWA) in India.” Development, 43(4): 51-55.

Faguet, Jean-Paul. 2004. “Does Decentralization Increase Responsiveness to Local Needs? Evidence from Bolivia.”

Journal of Public Economics, 88(3-4): 867-893.

Fisman, Raymond and Roberta Gatti. 2002. “Decentralization and Corruption: Evidence Across Countries.” Journal of Public Economics, 83(3):325-345.

Gugerty, Mary Kay and Michael Kremer. 2004. “The Rockefeller Effect.” Poverty Action Lab Paper No. 13, April 2004.

International Labour Office. 2002. “Women and Men in the Informal Economy: A Statistical Picture.” Geneva: Employment Sector, International Labour Office.

Munyao, Kioko and Christopher B. Barrett. 2007. “Decentralization of Pastoral Resources Management and Its Effects on Environmental Degradation and Poverty: Experience from Northern Kenya.” In C. B. Barrett, A. G. Mude, and J. M. Omiti (eds.), Decentralization and the Social Economics of Development. Lessons from Kenya. Wallingford, UK and Cambridge, MA: CAB International.

Platteau, Jean-Philippe. 2004. “Monitoring Elite Capture in Community-Driven Development.” Development and Change, 35(2): 223-246.

Udvardy, M. L. 1998. “Theorizing Past and Present Women’s Organizations in Kenya.” World Development, 26(9): 1749-1761.

Zhang, Tao and Heng-fu Zhou. 2001. “The Growth Impact of Intersectoral and Intergovernmental Allocation of Public Expenditure: With Applications to China and India.” China Economic Review, 12(1): 58-81.

Stephen G. Brooks

Has America Lost the Capacity to Lead?

U

ntil very recently, there was widespread agreement that we were living in a “unipolar” world – that is, one with a single superpower. Yet in the past year or so, many American analysts have begun to question whether the “unipolar moment” is about to end, if it hasn’t ended already. In a recent article, Christopher Layne aptly describes this dramatic mood shift: “Until fall 2007, most members of the American foreign policy establishment—policymakers, scholars and pundits alike—still took it for granted that U.S. primacy would last far into the future...By late 2007, however, whispers of American decline...and incipient multipolarity began to creep into the foreign policy debate. As a result of the financial and economic meltdown that hit with full force in autumn 2008— plunging the U.S. and global economies into the worst downturn since the Great

Depression—these sotto voce doubts have given way to open speculation that the era of America’s post-Cold War hegemony is waning.”

This is not the first time that American analysts have been pessimistic about the country’s global standing. The current American decline scare is actually the fourth since 1945—the first three occurred during the 1950s (Sputnik), the 1970s (Vietnam and stagflation), and the 1980s (the Soviet threat and Japan as a potential challenger). In all of these cases, real changes were occurring that suggested a redistribution of power. But in each case, analysts’ responses to those changes seem to have been overblown.

Multipolarity—an international system marked by three or more roughly equally matched major powers—did not return in the 1960s, 1970s, or early 1990s, and each decline scare ended with the United

States’ position of primacy retained or strengthened.

Will things be different this time? No one knows how rapidly the U.S. will recover from this crisis and what its economic prospects will be over the next decade. America might spiral downward for many years—like Japan in the 1990s.

Or it could muddle along with lackluster growth—like Europe in the 1990s. Finally, America might rebound and achieve impressive economic growth—like it did in the 1990s. It is unclear which of these three pathways America will follow, but given America’s past 150 years of impressive economic performance and its penchant for remaking itself, it would seem premature—and unwise—to assume that America will flounder economically in the years ahead.

What we do know for certain is that America’s lead over its competitors is

12

fall 2009

very, very large. The latest figures from the International Monetary Fund show that the U.S. economy is three times as large as the next largest economy (Japan) and is almost as large as the second, third, fourth and fifth largest economies combined. The picture presented by military data is even starker, where the United States continues to account for about half of the world’s defense spending. Relative power is the bread and butter of international politics, and it shifts slowly. The significance of trends depends greatly upon the starting point; because the U.S. now has such a dramatic lead over other states, it will not be replaced as the sole superpower for a very long time.

Consider China, which is generally seen as the country best positioned to emerge as a superpower challenger to the United States. Yet given where China is now relative to the United States—somewhere between a slightly less than 30% the size of the U.S. economy (if you measure GDP using market exchange rates) and a little more than half of the size of the economy (if you measure GDP using purchasing power parity)—it still has a very long way to go before it can come close to equaling America in economic terms, let alone military and technological capacity. Of course, China in recent decades has been growing at around 10% per year. But no country in history has been able to sustain anywhere near this kind of growth rate once it becomes wealthy (right now, China’s GDP per capita is less than 10% of the U.S. level now, regardless of how you measure China’s GDP). China will not be in position to be a peer competitor of the U.S. if it does not become wealthy (and thus lags in terms of technological capacity). But if China does eventually become rich, it is hard to see how it will continue to grow as quickly as it does now—even if all goes well.

Of course, whether all goes well over the next decades in China is hardly a given. Although the United States certainly will confront many significant long-term vulnerabilities, those American analysts who portend a rapid U.S. decline often seem to overlook that this is true of China as well. Consider demography. It has become commonplace for U.S. analysts to bemoan that U.S. fiscal prospects are gloomy in the years ahead due to the expected high costs associated with an aging U.S. population. Yet population aging

will have an even greater negative effect on China in the upcoming decades. As Mark Haas argues in a recent comprehensive analysis, “Although the U.S. is growing older, it is doing so to a lesser extent and less quickly than all of the other great powers. Consequently, the economic and fiscal costs for the United States created by social aging (although staggering, especially for health care) will be significantly lower for it than for its potential competitors.”

The bottom line is that the world is and will long remain a “1 + X world” with one superpower and X number of major powers. Of course, being the sole superpower hardly makes the U.S. omnipotent and it would be a mistake to overestimate what it can accomplish on the world stage. The early part of the 2000s were certainly marked by irrational exuberance among analysts and policymakers

about the degree to which the U.S. could shape outcomes in the system. Yet today many analysts seem to err in the opposite direction: understating the U.S. capacity to influence world politics as much as it was exaggerated just a few years ago. The financial crisis notwithstanding, America remains in a strong position to act as the leader of the system. It is hardly insignificant that President Obama concurs with this position. As he stressed in a recent news conference, “We remain the largest economy in the world by a pretty significant margin. We remain the most powerful military on Earth. Our production of culture, our politics, our media still have... enormous influence. And so I do not buy into the notion that America can't lead in the world.” Obama then noted further that although America should not dictate to the world, it “can continue to show H leadership for a very long time.”

Stephen G. Brooks is an Associate Professor of Government specializing in international relations and globalization at Dartmouth College.

Channing Spencer

The Culprits behind India’s Income Inequality: Neoliberal Economics and Globalization?

A

s the second-most populous country in the world, with a population of over 1.3 billion, India is a vast country with an economic structure that has undergone various transformations. In the 1980s, the Indian economy mirrored that of a socialist economy crippled by strict protectionism and extensive governmental regulation. It was characterized by a slow growth rate and agricultural dominance.

Today, many would say that India is the picture-perfect image of a developing country.

It now has a market economy with a GDP of $1.2 trillion and a labor force that is sec1 ond only to China's . What lies beneath the surface of the Indian economy, however, is an image that contrasts starkly with common perception. Closer observation paints a picture of a country with large income inequality and more poverty. Because of the complexity of the Indian economy, this article will approach the title question— “What are the ‘culprits’ behind India’s income inequalities?”—by undertaking a multifaceted approach that examines: (i) India’s past economic policies, (ii) present economic policies, (iii) current indicators of growth, inequality, and poverty.

1980’s: Regulation and Protectionism As a result of socialist-based policies in the 1980s, economic growth in India was largely dependent on government expendi-

tures for fiscal stimulus. Government spending accounted for 26.3 percent of GDP in the period from 1980-1981 and a staggering 2 32.3 percent in the period from 1986-1987 .

These government expenditures, which were not coupled with increases in taxes, were financed through foreign loans (investment -WC)—leading to high demand and, ultimately, inflation. To control inflation, the government liberalized trade to allow for

imports. However, rather than allowing the exchange rate of the rupee to be determined by the market, the government administered the exchange rate to avoid price fluctuations and maintain a degree of economic stability.

India’s imports have consistently exceeded their exports (Figure 1).

These imports, which were largely technological products, allowed for the production of many goods geared towards the upper

figure 1

!

14

fall 2009

class. Despite the apparent “betterment” of the upper class in the 1980s, the poor also reaped the benefits of increased government expenditures in the form of projects intended to reduce poverty. A substantial amount of government expenditures were in the form of subsidies and transfer payments to rural households in India and largely benefited the poor. The increase in transfer payments led to an increase in employment and overall growth of the Indian economy. It therefore stands that the socialist policies of the 1980s contributed to some degree of growth, although slow, as well as economic benefits to 3 all segments of the population .

1990s: A period of Reform The 1990s saw unprecedented changes in the Indian economy in the form of economic reforms. Beginning in 1991, neoliberal economic theory, which asserts that giving greater freedom towards the private sector leads to more efficient economic outcomes, was heavily implemented. These reforms included: • Allowing market forces to influence investment decisions • Permitting international competition and the resulting prices to prevail • Reducing the role of the government in production and trade • Reducing regulations on teh banking system to permit foreign entrance into the financial market The reforms of the 1990s have also resulted in an Indian economy that relies much less on government spending. Government expenditures as a percentage of GDP have fallen substantially to around 15-17 percent over the period from 1995 to the present (Figure 2).

While the economic growth of the 1980s was due to the fiscal stimulus, that of the 1990s was a result of an expansion of goods and services. The increase in the variety of services led to an increase in consumption by the top quintile of the population and, ultimately, to a consumer-driven economic 4 boom . It should also be noted that unlike the economic growth of the 1980s in which both the highest and lowest quintiles of the population benefited, the growth of the 1990s benefited only those who were “wellto-do.”

Globalization Let us now turn our focus towards the second “culprit” responsible for India’s economic disparities: globalization. Proponents

figure 2

!argue that globalization has many benefits that range from economic prosperity to a wider variety of goods within the market.

For some, however, the term "globalization" conjures images of sweatshops, exploited 5 workers, and overworked child laborers .

Examination of India’s embracement of globalization has painted a picture much like the latter. Globalization has had unfortunate ramifications for India’s poor. Analyzing the impact of India’s shift towards globalization on the poor proves that the saying “the rich get richer while the poor get poorer” is truly timeless. Globalization has largely benefited certain businesses and contributed to the growth of the middle class. As a result, the purchasing power of the country has increased, which has lead to an overall increase in prices—a fact that does not bode well for India’s impoverished. Price increases have made it difficult for the poor to afford basic necessities, such as education. Because the poor are not even able to invest in education for their children, an unfortunate cycle in which the poor remain at the bottom of the economic pillar persists.

!

Conclusion So, where does the responsibility for India’s income inequalities and lack of progress in the reduction of poverty lie? Indeed, culprit number one is neoliberal economics.

The implementation of this economic theory in the early 1990s decentralized India’s economy and led to a spike in consumption. Although this sounds like the perfect economic remedy, it most certainly was not because the spike in consumption resulted in consumerdriven price increases. These price increases had consequences that exacerbated inequalities inasmuch as they widened the income gap. Culprit number two, globalization, has also had rather unfortunate consequences for the Indian economy. With the acceptance of globalization, India’s labor force has become increasingly divided as some areas benefit while others are exploited and their income gaps widen. Perhaps the most pressing question is whether or not there is an imminent solution to these problems. Unfortunately, this is a question that only time and the Indian government can answer. H

Channing Spencer is a freshman Government concentrator at Harvard College.

Endnotes 1. United States CIA 2. Panagariya, Arvind: India: The Emerging Giant, USA: Oxford University Press,03-31-2008, p.353.

3. Chandrasekhar, C.P and Ghosh, Jayati, “Macroeconomic Policy, Inequality and Poverty Reduction in India and China,” The IDEAs Working Paper Series (05/2006):1-17 4. Ghosh, Jayati, Income Inequality in India, People’s Democracy, 02-17-2004, http://www.countercurrents.org/ eco-ghosh170204.htm 5. Globalization Income Inequalities and Regional Disparities in India <http://business.mapsofindia.com/globalization/income-inequalities-regional-disparities-india.html>

HARVARD COLLEGE ECONOMICS REVIEW

Omar Garcia

Latin America Fights Back

In the midst of an American recession, nations in Latin America are making a strong rebound to prosperity

I

t is said that when America catches a cold, Latin America catches pneumonia, but this time around it’s different: Brazil, Argentina, Chile, and Bolivia are rebounding from the global economic recession while America struggles. Annual Gross Domestic Product has shrunk by 2.5 percent, caused by a decrease in exports (1.5 percent) due to the fallen price of commodities including copper, oil, soy beans, and agricultural products. According to the IMF, Brazil’s GDP is expected to grow by 3.5 percent, Argentina 's by 1.5 percent, Chile's by 4 percent, and Bolivia's by 3.4 percent. These South American countries have been able to ride smoothly through this economic recession partly by decreasing their dependence on U.S. trade.

Brazil is the first G20 country to come out of the global recession. Over the last few years President Luiz Ignacio Lula da Silva has expanded its diversity of exports to include transportation equipment, iron ore, and soybeans, accounting for total revenue of $197.9 billion. As a result, Brazil has decreased its dependence on foreign markets. Its decisions to resist buying and selling mortgages in the secondary market have strengthened its political credibility—which allowed it to attract greater Foreign Direct Investment (FDI) and sustain strong domestic demand. As a result, Brazil has amassed $200 billion in international currency reserves, allowing it to continue current economic polices of investing in railroads, housing, and transportation as it envisions supporting an industrialized nation and providing new jobs, while many nations face record unemployment rates.

Mexico has not fared as well as Brazil has. Its strong ties to the United States have caused it to experience more economic hardship than other Latin American countries.

Maquinas, Mexican factories that import raw materials to be converted into exports to the United States, have been hit hard by the reduction in America's demand.

The Mexican economy has endured further damage due to the 2009 flu epidemic.

The Mexican government has reported that tourism—its largest source of revenue— has decreased drastically. To add to its mis-

fortunes, escalating violence in Mexico has caused fear among foreign investors, making them even more reluctant to channel their funds into the troubled country.

Although it appears that 2009 has not brought any good news to Mexico, the IMF has approved the first flexible credit line of over $48 billion to be given to Mexico.

The flexible credit line is a fund that will be used to prop the current economic situation against the global recession. As many economists begin to speculate when the recession will end, many Latin American countries are

starting to change their economic policies as they see fit and reject the principles of the Washington Consensus, a set of major economic policy prescriptions penned by representatives of major multi-national organizations like the IMF and World Bank.

As of 2009, Latin America has outperformed the market in comparison with Eu1 rope . This can be attributed to the nations' conservative economic policies. As a result, he IMF expects a moderate economic growth in Latin America in the areas of agriculture, 2 oil, and mineral production in 2010 . H

Omar Garcia is a freshman at Harvard College.

Endnotes 1." M&A Outperformed Market in 2009." The Wall Street Journal. January 18, 2009. http://online.wsj.com/article/SB10001424052748704541004575010690772470332.html?mod=WSJ_Bonds_ RIGHTMoreInMarkets 2. "Chile expect 2010 GDP 4.4 % growth." The Latin America Post. January 10, 2010.http://www.latinamericanpost. com/index.php?mod=seccion&secc=2&conn=5903 References "Brazil out of Recession - New Records in Brazilian domestic Tourism ." Brazil out of Recession - New Records in Brazilian domestic Tourism : 2. Web. 31 Oct 2009. <(http://www.propertybrazil.com/news/brazil-out-of-recession---newrecords-in-brazilian-domestic-tourism-12)>.

"Brazil ." October 28 209: n. pag. Web. 31 Oct 2009. <https://www.cia.gov/library/publications/the-world-factbook/ geos/br.html>.

"Brazil Pushes for bigger G20 role." March 26 2009: n. pag. Web. 31 Oct 2009. <http://news.bbc.co.uk/2/hi/7963704. stm>.

Gould, Erik, and Hugh Collins. "Mexico Violence Sap 3 % as Gangs Flourish." Bloomberg n. pag. Web. 31 Oct 2009. <http://www.bloomberg.com/apps/news?pid=20601087&sid=ad1bsEmsnLqw>.

"IMF Approves 47 billion Credit line for Mexico." IMF. April 17, 2009. IMF, Web. 31 Oct 2009. <http://www.imf.org/ external/pubs/ft/survey/so/2009/car041709a.htm>

15

Hyun Song Shin

Prices and Crises

The double-edged sword called price

F

inancial crises are often accompanied by large price changes, but these large price changes by themselves do not constitute a crisis. Public announcements of important macroeconomic statistics, such as the monthly employment report, are often marked by large discrete price changes at the time of announcement. But the market typically finds composure quite rapidly after such discrete price changes, which are arguably the signs of a smoothly functioning market that is able to incorporate new information quickly.

Stung by criticism that they failed to warn of the financial crisis, many economists have clung to the mantra that in a well-functioning financial system, price changes cannot be predicted beforehand. They see the financial crisis in the same terms as the one-off shock that results from the announcement of new employment numbers. The market adjusts to the news, prices quickly incorporate the new information, and life goes on as before.

With this sleight of hand, the economists have turned the failure to predict the crisis into a virtue. You may not have known it, but the apparent failure is actually a success, and the failure to see the crisis coming is the sign of a well-functioning price system.

If you feel short-changed by this sleight of hand, you are in good company. Indeed many economists share the sense of unease

at the glib brush-off. One source of the unease is that the analogy with the one-off jump in prices associated with macroeconomic announcements does not capture the key features of a financial crisis. The distinguishing feature of crisis episodes is that they seem to gather momentum from the responses of the market participants who themselves run for cover. Rather like a tropical storm over a warm sea, a financial crisis appears to gather more energy as it develops. Financial crises could almost be defined as episodes where the allocational role of prices breaks down.

Crises highlight the dual role of prices.

Not only are prices the reflection of underlying economic fundamentals, they are also an imperative to action—they make people “do stuff.” Some actions induced by price changes are desirable, not only from the point of view of the individual, but also from the system’s perspective. Bottom fishing where buyers enter the market to buy under-priced securities will be a stabilizing influence. However, some actions borne out of self-defeating constraints or actions that exert harmful spillover effects on others are undesirable when viewed from the perspective of the group. When markets turn hostile and prices move against you, prudence dictates shedding exposure and selling the loss-making position instead. The question is which group holds sway. When markets

turn hostile, is it the bottom fishers who hold sway or are those the ones who run for cover?

One of the consequences of financial development is that those who run for cover are becoming increasingly important in dictating the course of market events. When balance sheets are marked to markets and loans are packaged into securities and traded in the market by highly leveraged players, the self-reinforcing nature of shocks injects an additional, endogenous element of market fluctuations. The prudent shedding of exposures by the creditors to Bear Stearns is a bank run, when viewed from Bear Stearns’ point of view. As financial conditions worsen, the willingness of market participants to bear risk seemingly evaporates. Such episodes have been dubbed “liquidity black holes.” The terminology is perhaps overly dramatic, but it conveys the sense of freefall. As prices fall or measured risks rise or previous correlations break down (or some combination of the three), previously overstretched market participants respond by cutting back, giving a further push to the downward spiral.

It is when the action-inducing nature of price changes holds sway that the doubleedged nature of prices comes into its own.

It is as if the reliance on market prices distorts those same market prices. The more

HARVARD COLLEGE ECONOMICS REVIEW

weight is given to prices in making decisions, the greater are the spillover effects that ultimately undermine the integrity of those prices. When prices are so distorted, their allocational role is severely impaired. Financial crises could almost be defined as episodes where the allocational role of prices breaks down. The global financial crisis of 2007-8 has served as a live laboratory for many such distress episodes, but the mechanism is universal and impacts every financial crisis.

Imagine an emerging market country defending a currency peg in adverse circumstances in the face of deteriorating macroeconomic conditions and hostile capital markets. Defending the peg is often dictated by political goals more than economic ones, such as eventual accession to the European Union, the adoption of the euro, or keeping the peg in tact in order to shield domestic borrowers who have borrowed in dollars, euros, Swiss francs, etc.

However, defending the currency also entails raising interest rates and keeping them high. The costs of defending the currency bear many depressingly familiar symptomsâ&#x20AC;&#x201D;collapsing asset values and a weakened domestic banking system that chokes off credit to the rest of the economy.

Regardless of the perceived political benefits of maintaining a currency peg and regardless of their official pronouncements, all governments and their monetary authorities have a pain threshold at which the costs of defending the peg outweighs the benefits of doing so. Speculators understand well that their job is almost done when the finance minister of the stricken country appears on evening television vowing never to devalue the currency.

Facing the monetary authority is an array of diverse private sector actors, both domestic and foreign, whose interests are affected by the actions of the other members of this group, and by the actions of the monetary authority and the government. The main actors are domestic companies and households, domestic banks and their depositors, foreign creditor banks, and outright speculatorsâ&#x20AC;&#x201D;whether in the form of hedge funds or the proprietary trading desks of the international banks.

Two features stand out. First, each of these diverse actors faces a choice between actions that exacerbate the pain of maintaining the peg and actions that are more benign. Second, the more prevalent the actions which increase the pain of holding the

peg, the greater the incentive for an individual actor to adopt the action that increases the pain. In this sense, the actions that tend to undermine the currency peg are mutually reinforcing.

Imagine that we are in Thailand in the early summer of 1997 just prior to the onset of the Asian financial crisis. Domestic financial institutions or companies that had borrowed dollars to finance their operations can either attempt to reduce their dollar exposures or hang tough. The action to reduce their exposurâ&#x20AC;&#x201D;of selling baht assets to buy dollars in order to repay their dollar loans, for example, is identical in its mechanics (if not in its intention) to the action of a hedge fund, which takes a net short position in baht in the forward market. For domestic banks and finance companies that have facilitated such dollar loans to local firms, they can either attempt to hedge the dollar exposure on their balance sheets by selling Baht in the capital markets, or sit tight and tough it out. Again, the former action is identical in its consequence to a hedge fund short-selling baht. As a greater proportion of these actors adopt the action of selling the domestic currency, the greater is the domestic economic distress, and hence the greater is the likelihood of abandonment of the peg.

Everyone understands this, especially the more sophisticated market players that have access to hedging tools. As the pain of holding on to the peg reaches the critical threshold, the argument for selling baht becomes overwhelming.

The action-inducing nature of price changes turns up in this scenario through balance sheet stress. The precipitous decline in the exchange rate means that the baht value of foreign currency debts balloons past the value of baht assets that were financed with these loans. At the same time, the higher domestic interest rates put in place to defend the currency undermine the baht value of those assets. Assets decline and liabilities increase. Equity is squeezed from both directions. As the Thai baht collapses, the mutually reinforcing nature of price changes and distressed actions gathers momentum.

As domestic firms with dollar liabilities experience difficulties in servicing their debt, the banks that issued these loans attempt to cover their foreign currency losses and improve their balance sheet by contracting credit. For foreign creditor banks with shortterm exposure, this is normally a cue to cut off credit lines, or to refuse to roll over short term debt. Even for firms with no foreign

17

18

fall 2009

currency exposure, the general contraction of credit increases corporate distress. Such deterioration in the domestic economic environment exacerbates the pain of maintaining the peg, thereby serving to reinforce the actions which tend to undermine it. To make matters worse still, the belated hedging activity by banks is usually accompanied by a run on their deposits, as depositors scramble to withdraw their money.

To be sure, the actual motives behind these actions are as diverse as the actors themselves. A currency speculator rubbing his hands and looking on in glee as his target country descends into economic chaos has very different motives from a desperate owner of a firm in that country trying frantically to salvage what he can, or a depositor queuing to salvage her meager life savings.

However, whatever the motives underlying these actions, they are identical in their consequences. They all lead to greater pains of holding to the peg and hence hasten its demise.

The action-inducing nature of market prices is most dramatic during crisis episodes, but is arguably most damaging during economic booms when it operates away from the glare of the television cameras. Financial crises don't happen out of the blue.

They invariably follow booms. As the central banker Andrew Crockett puts it, “The received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and mate1 rialising in recessions."

During a boom, the action-inducing nature of market prices does its work through the increased capacity of banks to lend.

When asset prices rise or measured risks fall, less capital is needed to act as a loss buffer for a given pool of loans or securities. At the same time, higher bank profits also add to the bank's capital. In boom times, banks have surplus capital.

When balance sheets are marked to market, the surplus capital becomes even more apparent. In the eyes of the bank's top management, a bank with surplus capital is like a manufacturing plant with idle capacity.

Just as good managers of the manufacturing plant will utilize surplus capacity to expand their business, the bank's top management will expand its business. If they fail to expand their business, they know that the ranks of bank equity analysts will start to castigate them for failing to achieve the 20

percent return on equity achieved by some of their peers.

For a bank, expanding its business means expanding its balance sheet by purchasing more securities or increasing its lending. But expanding assets means finding new borrowers. Someone has to be on the receiving end of new loans. When all the good borrowers already have a mortgage, the bank has to lower its lending standards in order to lend to new borrowers. The new borrowers are those who were previously shut out of the credit market, but now suddenly find themselves showered with credit. The result is the ballooning of subprime mortgage lending.

The pressure on the bank's managers to expand lending reveals an important feature of the capital constraint that banks face. As with any meaningful economic constraint, the capital constraint binds all the time—in booms as well as in busts. Binding capital constraints during bust phase is (by now) well understood. However, less appreciated is the binding nature of the capital constraint during booms. In boom times, the constraint operates through channels that appear more benign, such as the pursuit of shareholder value by raising return on equity.

The action-inducing effect of market prices derives their potency from the apparently tangible nature of the wealth generated when asset prices appreciate. Consider the following passage from a commentary published in the Wall Street Journal in May 2005, at the height of the housing boom in 2 the United States .

“While many believe that irresponsible borrowing is creating a bubble in housing, this is not necessarily true. At the end of 2004, U.S. households owned $17.2 trillion in housing assets, an increase of 18.1 percent (or $2.6 trillion) from the third quarter of 2003. Over the same five quarters, mortgage debt (including home equity lines) rose $1.1 trillion to $7.5 trillion. The result: a $1.5 trillion increase in net housing equity over the past 15 months.”

The argument is that when the whole U.S. housing stock is valued at the current mar-

ginal transactions price, the total value is $17.2 trillion (although it was subsequently to rise much more). Although household debt had increased by over a trillion dollars in the meanwhile, this still left them an increase in net worth of $1.5 trillion.

One can question how tangible this increase in housing wealth is in the face of a possible downturn. But for banks and other financial institutions that mark their balance sheets to the market continuously, the increase in marked-to-market equity is very tangible. The surplus capital generated by asset price appreciation and greater profits weighs on the bank's top management and induces them to take on additional exposure. Risk spreads fall, and borrowers who did not meet the necessary hurdle begin to receive credit. The seeds of the subsequent downturn are thus sown.

The action-inducing nature of asset price booms is strongest for leveraged institutions such as banks and securities firms since leverage magnifies the increase in marked-tomarket equity. Thus, the reasoning quoted above in the Wall Street Journal commentary ripples through the financial system through the actions of leveraged financial institutions. John Cassidy, in his recent book 3 How Markets Fail , does a magnificent job in sketching the forces at work.

The action-inducing nature of market prices during booms operates away from the glare of the television cameras and away from the chorus of politicians complaining about the effects of mark-to-market accounting rules. But the insidious effects of marking to market are at their most potent during the booms. Andrew Crockett's statement that risks increase in booms and materialise in busts is an important lesson that is relearned after each financial crisis.

The challenge for economists and policy makers is to reduce the frequency with which we relearn these lessons. The most important lesson is that prices are doubleedged in crises and in the boom that precedes them. Crises and prices are inseparable, but not always in the ways one reads in the textbooks. H

Hyun Song Shin is the Hughes-Rogers Professor of Economics at Princeton University.

Endnotes 1. Andrew Crockett (2000) "Marrying the micro- and macro-prudential dimensions of financial stability" <http:// www.bis.org/speeches/sp000921.htm> 2. “Mr. Greenspan's Cappuccino” Commentary by Brian S. Wesbury, Wall Street Journal, May 31, 2005. The title makes reference to Alan Greenspan's comments on the "froth" in the U.S. housing market.

3. John Cassidy, How Markets Fail, November 2009.

Kwon-Yong Jin

The Forgotten Recession: Lessons from 1937-38

I

n many respects the current recession is without precedent in modern United States history. For one, it is one of the worst, if not the worst, recession in the last half century, surpassing the grim conditions of the recession of 1980s in many areas. Furthermore, never before have America’s fiscal and monetary authorities implemented such innovative measures to revive the slumping economy. Reaching the limits of the traditional monetary and fiscal policy, the Federal Reserve and the Treasury have resorted to extraordinary measures—lending facilities, massive asset purchases to name a few—that have tested the limits of their authority, more than doubling the Federal Reserve’s balance sheet to over two trillion dollars, and leading the Administration to execute one of the largest fiscal stimulus plans in American history.

That is not to say, however, that history cannot teach us lessons regarding this recession. Many have turned to the study of the Great Depression for guidance on how to rescue our economy from stagna-

tion. But a majority of these studies have focused heavily on the years leading up to and immediately following the Stock Market Crash of 1929. As important as these studies are, most do not model the period

of recovery after the recession. Since the United States economy is showing signs of a potential, albeit not definite, recovery, it is time to examine a model describing the recovery period. In particular, the double-

figure 1

!

20

fall 2009

dip of 1937-38, dubbed the “Roosevelt Recession,” provides valuable lessons on the dangers of fiscal and monetary authorities’ premature exit from the economy.

The Recovery and the Double-Dip One common misconception about the Great Depression is that the American economy languished throughout the 1930s and returned to vibrancy only after 1939. In actuality, however, the recovery from the economic collapse in 1929 occurred far before World War II. Supported by extraordinarily expansionary policies in both the fiscal and monetary spheres, the American economy grew at a fast pace after the trough in 1933. From 1929 to 1933, real GDP tumbled by 27 percent, but from 1933 to 1937, it grew at an astonishing annual rate of 9.4 percent, surpassing its 1 1929 level by 1936. Other indicators kept pace with the GDP during the recovery of 1933-1937; the Dow Jones Industrial Average tripled and industrial production 2 doubled during this period . By 1937, it seemed as if a full-fledged economic recovery was in place and the Great Depression was ostensibly over.

With rapid recovery came discussions of the fiscal and monetary authorities’ exit strategies. The federal deficit had ballooned from 1932 to 1937 owing to the Roosevelt Administration’s large expenditures (see Figure 2), and ending the Administration’s expansionary fiscal policy seemed necessary to balance the budget. The Administration’s top priority, promoted by Treasury Secretary Henry Morgenthau, became balancing the federal budget, even if that meant reducing government expenditures.

In his speech to the Congress in April of 1937, Roosevelt expressed this view clearly, saying, “I am convinced that the success of our whole program and the permanent security of our people demand that we adjust all expenditures within the limits of 3 my Budget estimate” . As a result, in 1937, the Administration sharply cut its expenditures, and this step, along with implementing the Social Security Tax in 1936, led to a drastic reduction in the government’s contribution to total expenditures.

The triumph of economic hawks was not limited to the fiscal sphere. The Federal Reserve, concerned about the rising level of excess reserves, also implemented a highly contractionary policy as well. Excess reserves rose from $35 million in early 1932 to $3 billion in late 1935, thanks to a

figure 24

!

5

rapid inflow of gold from abroad . To curtail this exponential rise in excess reserves, the Federal Reserve, over the course of ten months from August 1936 to May 1937, raised reserve requirements by 100 percent, reducing the supply of credit in the market.

The end result of contractionary policies in both the fiscal and monetary spheres was a sharp downturn in the economy in 1937.

From 1937 to 1938, the economy retreated back to its 1934 level, undoing three years of recovery. Many indicators saw a sharper drop during this period than they did during the four years immediately following the collapse in 1929. The Dow Jones Industrial Average fell by 30 percent, real GDP by 3.5 percent, and industrial production by 21 percent–all in just a year–leaving a pain6 ful mark on the American economy .

Responsibility for the Double-Dip: Fiscal Policy and the Business Cycle There is no doubt that the contractionary policies by the Federal Reserve and the Roosevelt Administration contributed to the sharp downturn in 1937. The question, then, however, is not whether the government’s contractionary policy contributed to the recession, but the question is by how much. On the fiscal side, debate rages over the effect of sharp reduction in government expenditure in 1937 on personal income and total expenditure. There is no doubt, despite this fierce debate, that fiscal policy is not entirely to blame for the recession in 1937. Six months elapsed between the

reduction in government spending in early 1937 and the drop in personal income in mid-1937. According to Roose (1954), this is proof that the decrease in government expenditures affected the economy “only 7 indirectly” .

Therefore, there must be another accomplice to the recession of 1937: the business cycle. In order to capitalize on the recovery from 1933 to 1937, businesses invested heavily in inventory, becoming more and more unprofitable in the process. As wages and prices of commodities galloped far ahead of the price of finished goods, corporate profits fell to dangerously low levels, prompting a downturn in early 1937. Furthermore, the majority of the investment spending in the years preceding 1937 had been on short-term projects, compounding the cyclical nature of the downturn.

Investment stagnated in long-term projects such as construction, which are key to sustainable growth; even in 1937, total private construction expenditure remained at 8 one-third of its 1929 level . Thus, it is this unfortunate overlap between the reduction in government expenditure and the downturn in the business cycle that compounded the effects of both and precipitated the catastrophic double-dip.

Monetary Policy as a Cause of the 1937 Recession The debate over how much contractionary policy is to blame for the recession of 1937 is no less fierce in the monetary sphere. Those who downplay the effects of

HARVARD COLLEGE ECONOMICS REVIEW

contractionary monetary policy argue that even after the Federal Reserve raised reserve requirement, credit was still plenty.

Hardy (1939) wrote, “even immediately after [the Federal Reserve’s increase in reserve requirement] the margin of excess reserves was far greater than it ever was 9 before 1932” . While it is true that excess reserves of financial institutions remained ample, the effect of the Federal Reserve’s actions was not uniform across regions.

Banks in major cities, such as New York and Chicago, faced the need to raise more capital in order to meet the increased reserve requirement and resorted to reducing loans for investment and selling their government securities. Even the banks that did not need to raise more capital wanted to hold on to a significant quantity of excess reserves for cushion and thus 10 reduced lending . The sudden increase in the supply of Treasuries in the market had the effect of depressing the price of government securities, in turn lowering the price of corporate bonds. Corporations found it harder to raise capital through the issuance of bonds, and coupled with a reduction in loans for investment, this newfound difficulty in raising capital led to a decrease in overall expenditure and output.

Conclusion: Lessons from 1937 In order to examine the lessons we can learn from the Roosevelt Recession of 1937, we must first understand the mis-

takes made by fiscal and monetary authorities. Perhaps the greatest mistake that the United States government made was contracting the economy based on a false illusion of recovery. The economic growth from 1933 to 1937 was mainly driven by massive government spending and shortterm investments on inventory and could not be sustained. Although industrial production and overall output rose, long-term investment remained low and unemployment hovered at 14 percent. The recovery was not based on improvements in the fundamentals of the economy—a bullish outlook from entrepreneurs or low unemployment—but on short-term business cycle movements. Thus, it is no surprise

that when the government pulled out in early 1937, expecting investors in the private sector to take the baton, the latter— feeble and already in a downturn—could not do so.

On the monetary side, the critical mistakes lie in the Federal Reserve’s underestimation of the financial market’s fear of illiquidity. With the memory of the 1929 Stock Market Crash still fresh in their minds, banks were unwilling to lend out their excess reserves, and money velocity remained low. The Federal Reserve overestimated the bullish nature of the market and prematurely contracted the money supply, driving the economy back into a recession.

Of course, comparing the 1937 Recession to the current one, we must keep in mind that our economic situation has changed drastically over the past seventy years. New financial instruments have emerged and the American economy has become much more dependent on its foreign counterparts, altering the economic landscape of the nation. Yet the current situation is strikingly similar to that of 1937.

The current economy is showing some signs of a recovery, but unemployment remains high and the business outlook is bearish. In the monetary sphere, excess reserves have reached a historic high of $800 billion, but money velocity and the multi11 plier remain depressed. As promising as the current situation may look, the fiscal and monetary authorities must keep in mind that we still have a long way to go before achieving a full recovery. Until private investment and consumption are ready to take the baton from the government sector, premature exit would only prolongHand

Kwon-Yong Jin is a freshman Economics concentrator at Harvard College Endnotes 1. Bureau of Economic Analysis 2. Dow Jones & Company (DJIA); The Board of Governors of the Federal Reserve System, “Industrial Production,” Federal Reserve Bulletin (1941): 934.

3. “Message to Congress on Appropriations for Work Relief for 1938”, American Presidency Project, University of California at Santa Barbara.

4. United States Office of Management and Budget, Historical Tables, Budget of the United States Government, Fiscal Year 2009 (Washington, D.C.: U.S. Government Printing Office, 2009), 24.

5. Federal Reserve Bulletin (1932): 274; Federal Reserve Bulletin (1936): 130.

6. Bureau of Economic Analysis; Dow Jones & Company; Federal Reserve Bulletin (1941): 934.

7. Kenneth D. Roose, The Economics of Recession and Revival: An Interpretation of 1937-38 (New Haven: Yale University press, 1954), 71.

8. Ibid, 47.

9. Charles O. Hardy, “An Appraisal of the Factors (“Natural” and “Artificial”) Which Stopped Short the Recovery Development in the United States,” American Economic Review 29, No. 1 (1939): 171.

10. Christina Romer, “The Lessons of 1937,” Economist, 18 June 2009.

11. Federal Reserve Bank of St. Louis, “M1 Multiplier,” U.S. Financial Data.

21

22

fall 2009

Book review

End the Fed

â&#x20AC;&#x153;T

o the young people who powered my presidential campaign and who are the heart of the anti-Fed movement. In your hands is the hope of a free and prosperous society."

Thus reads the dedication of Representative Ron Paulâ&#x20AC;&#x2122;s End the Fed, a book aiming to achieve exactly what its title suggests: doing away with powerful central banks and bringing back the gold standard.

In his latest offering, Ron Paul angles for the bestseller shelves with his fierce critique of the U.S. Federal Reserve. Consistent with Dr. Paul's firm adherence to a policy of putting every aspect of the government through the "Constitution filter", a policy that earned him the sobriquet of "Dr. No." in Congressional circles, his newest book pulls no punches. Following a trajectory that his supporters must be familiar with, the book touches upon basic economic analysis, constitutional precedent, Dr. Paul's personal experiences, and--most enlightening--his interactions with the barons of the Federal Reserve.

The book owes its title to the chant adopted by students protesting at the University of Michigan in 2007. The book deals broadly with three subjects: the first five chapters serve to introduce the system of central banking and the gold standard, interspersed with the author's anecdotes. Paul lays out his intellectual cards right at the beginning, giving the reader the opportunity to see the argument in the context of the author's ideologies and influences. There is a distinct emphasis on Paul's desire for tangibility when it comes to economics. Simplifying banking theory down to his experiences as a child hoarding coin, Paul deals extensively with gold and silver: the imagery of solid money as opposed to a fiat currency. There is little confusion as to which he prefers. Bringing in the Founders, Paul quotes verbatim their objections to "paper money" as the foundation for his argument against debased currency. He thus begins to outline his quest for a return to the gold standard and his skepticism for the goals of the Federal Reserve.

Having laid a broad base from which to mount his attack, Paul moves on to a systemic analysis of the Federal Reserve in his next five chapters, detailing his conversations with Volcker, Greenspan and Bernanke, three prominent Fed chairmen. He lays out the processes involved in fractional reserve banking, the very premise of which Paul seems to find unethical. His exchanges with Bernanke are interesting, Paul's characteristic probing and the Fed Chairman's mollifying rhetoric leading to somewhat nervous interactions.

The final part of the book deals with Paul's recommendations for banking reform. Relying heavily on the Austrian school of thought, which he champions throughout the book.

Paul extols the gold standard and urges a return to it. He mounts a blistering assault on the opacity of the Fed and Congress' intellectual and moral disinterest in regulating it.

Thereby rounding off his critique, Paul asserts that his call is not for hyper-regulating the Fed, but doing away with it to enable an absolute free market, where currency too is subject to the price equations a "truly capitalist" market imposes.

The doctor is earnest and sincere, and most of his arguments carry strong academic weight. The touches of personal and national history imbue the book with personality, but some arguments rely too heavily upon such anecdotes. Paul seems too quick and eager, with minor disclaimers, to idealize the economic acumen of the founding fathers, and fails to convincingly dissociate pre-Fed economic crises from the boom-and-bust cycle he claims is a purely central banking phenomenon.

There are, without a doubt, strong basic inquiries to be made of the Federal Banking System of the United States, and the book serves to outline and explore them with admirable focus. Paul's passion for the subject is infectious and his research diligent. The book should prove highly useful to everyone invested in the nation's economy. â&#x20AC;&#x201D;Reviewed by Siddhant Singh, a sophomore Economics concentrator at Harvard College

HARVARD COLLEGE ECONOMICS REVIEW

Book review

This Time is Different: Eight Centuries of Financial Folly

T

he economy was cruising: the Dow reached an all-time high of over 14,000, unemployment was below 5 percent, and credit was easily accessible and plentiful. We had reached a new era of prosperity, but suddenly, everything changed.

The Dow dropped below 7,000 and the unemployment rate rose above 9 percent. President Obama warned us that this could become the worst recession in our nation’s history.

While most people thought this recession was unprecedented, the authors of This Time is Different: Eight Centuries of Financial Folly differ.

In This Time is Different, Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard University) conclude not only that many countries have experienced similar crises before, but also that well-informed economists could have predicted and controlled the current situation well before it turned into a crisis.

The two professors state, “Our basic message is simple: We have been here before. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experiences from other countries and from history.”

Their claim is backed by a detailed analysis of eight centuries of financial data from across the globe, inflation rates, banking crises, and international capital flow. In fact, the majority of the book is a case-by-case analysis of this data and its impact

on history. This approach provides a compelling argument that nothing new can ever occur in the economic world and makes it painfully obvious that the current crisis could have been prevented.

As enticing as it may be to cover eight centuries of economics turmoil, the two academics produced a work that may be difficult to understand for the general public. However, to those with experience with economics, the legalistic and economic terms will not prove to be detrimental. The book carefully displays its mountain of data. The last two parts (chapters 13-17) neatly tie the past cases to today’s crisis in a concise and approachable way. In these self-contained chapters, Reinhart and Rogoff use past recessions to predict how things are likely to pan out in the next few years for both the American and global economies.

Overall, This Time is Different provides a systematic and organized explanation of why recessions occur, the events following recessions, and measures that can be taken to prevent them. While the book may be a bit difficult to understand for some, it provides a good deal of depth and information for both policy makers and economic enthusiasts.

—Reviewed by Han He, a freshman aman Applied Mathematics concentrator at Harvard College

23

Regan Bozman

Hip-Hop and the Recession Superpower, hegemony and the recession

I

f you were to open the newest issue of The Source or XXL, two of the biggest publications in the hip-hop industry, you probably would see very few references to the economic crisis. Aside from a few mentions of rappers wearing less and smaller jewelry, the financial crisis has been largely absent from discussions of the hip-hop industry. Even when the downsizing of jewelry is mentioned in hip-hop publications, it is almost always overshadowed by news like Florida rapper T-Pain’s new 10 lb, 197 karat necklace, which cost an estimated $410,000 (Hip Hop RX).

In actuality, however, hip-hop has been hit hard by the recession. Sales of hip-hop records declined nearly 20 percent between 2007 and 2008, more than most other genres (CNN) Between July 2008 and July 2009, the top 20 earners in the industry made $300 million, down 40 percent from the previous 12-month period.

It’s a difficult time, even at the top. For instance, Jay-Z, the top earner in the industry, recently felt the financial crisis’ sting when his $66 million hotel venture stalled due to a lack of funding (U.S. News).

The hip-hop industry isn’t generally

known for thriftiness. In fact, many hiphop artists have lost fortunes because they simply couldn’t manage their money.

Case in point is Scott Storch, a hugely successful hip-hop producer who reportedly spent $30 million in six months (Hip Hop Chronicle). Purchases included a 90 foot boat and a car collection worth over $5 million. In early 2008, Rolling Stone estimated his worth at $70 million (Rolling Stone); today, Storch is in bankruptcy (Hip Hop Chronicle).

But this time is different. It’s not just a few artists who are going bankrupt. The entire industry is downsizing. One accurate bellwether for the industry has been the size and quality of rapper’s jewelry.

Indeed, since the beginnings of rap music, artists have worn jewelry to “signify that they have risen above humble origins to become ghetto royalty (Bustillo)." When times were good, rappers were able to purchase spectacularly large diamonds. In 2006, when the industry was doing well, Lil Jon, a rap producer, bought the largest diamond pendant on earth (Bustillo). Today, as the industry faces difficult times, the quality and quantity of jewelry is de-

clining. Rappers are having chains built with less-precious stones and metals, including cubic zirconia, a synthetic diamond stand-in (Bustillo).

The history of obsessive consumerism in hip-hop spans decades. Since the 1980s, when hip-hop legends Eric B and Rakim released their album “Paid in Full,” rappers have been concerned with money. However, it wasn’t until the late 1990s when a large majority of rap artists consistently started producing works about consumerism and materialism. Not coincidently, hip-hop became the most popular genre of music in the United States during the late 1990s (Perry). A focus on material goods that the rest of American society was familiar with allowed a broader audience to relate to hip-hop. Rappers weren’t subtle about their obsession with money. As California rapper Snoop Dogg boasted, “I got my mind on my money and my money on my mind.” The industry, as a whole, seemed to echo his sentiments.

It’s easy to underestimate the economic significance of hip-hop, but while not often recognized, hip-hop has a huge influence on the consumption patterns of a large

HARVARD COLLEGE ECONOMICS REVIEW

majority of youth. The materialistic element of most modern hip-hop urges youth to “get money at any cost” and flaunt it at every opportunity they have (Peterson).

Corporations have also managed to influence hip-hop with marketing techniques.

Indeed, many rappers reference products in their songs. Some of the products mentioned most often include Cadillac cars, Cristal champagne and Rolex watches.

Rappers can have quantifiable influences on markets. Indeed, the popularity of Air Force Ones, sneakers manufactured

by Nike, between 2000 and 2006 was attributed largely to Jay-Z and Nelly—two popular rappers (Bierman). Jay-Z wore the sneakers in almost all of his concerts, while Nelly recoded a song titled “Air Force Ones,” which detailed his obsession with the sneakers. Air Force Ones have become the best selling athletic sneakers ever, selling more than 10 million pairs a year (Bierman).

So, has the recession killed the consumerism in hip-hop? It seems unlikely. While it may have dampened the ability of many rappers to purchase expensive things, most rappers seem to have opted to make themselves look richer than they are, rather than to admit their loss of wealth.

For example, a rapper who, two years ago, wore a large diamond necklace but can now no longer afford it would choose to wear the same size pendant with less expensive stones rather than wear a smaller diamond chain. Johnny Dang, a jeweler in Houston who caters to rappers, notes, “The look is still big…bling, but people are going with…lower-karat gold” (Bustillo).

Moreover, while many rappers acknowledge the recession, their main concern seems to be sustaining their lifestyle during it, rather than cutting back on their excessive ways. Beating out the recession has become a bragging point among rappers. As Virginia hip-hop duo Clipse brags in their latest single, Kinda Like a Big Deal, “It’s a blessing, to blow a hundred thousand [dollars] in a recession, without second guessing.” Earlier this year, rapper 50 Cent accused his adversary, Miami rapper Rick Ross, of wearing fake jewelry (Bustillo). Rick Ross has denied the claims.

The hip-hop industry isn’t the only sector of the economy trying to tighten its belt. Indeed, claims of a newfound American frugality are everywhere. These claims do have some basis. Indeed, consumer spending is down sharply, and the nation-

al savings rate has increased substantially.

However, past predictions that frugality will endure have proven incorrect. Towards the end of the 1991 recession, Fortune announced the “death of conspicuous consumption” (Surowiecki). After the Internet bubble and 9/11, many predicted that American frugality was here to stay. Both were wrong. Indeed, there seems to be little evidence of recessions permanently altering American consumption patterns. Some contend that this recession is much longer and more severe than any other since the Great Depression. However, the numbers simply don’t stack up. For example, during the Great Depression, unemployment numbers were more than twice as high as they are now (Surowiecki). Moreover, even the Great Depression did not kill consumerism beyond revival. Less than a decade later as the 1940’s began, American consumerism soared (Surowiecki).

Similar claims about frugality are be-

ing made about the hip-hop industry. Tamara Connor, a stylist to a host of rappers, claims that “conspicuous consumption is gone” in the hip-hop industry, a quote eerily similar to Fortune’s after the 1991 recession. Connor believes, “We're still going to see some bling, but it's just not going to be as much (CBS News)." However, just as claims about a new era of frugality for consumers are unfounded, claims about the “Death of Bling” in hip-hop aren’t really based on the evidence.

While temporary declines in finances have made it difficult for rappers to sustain their previous lifestyles, there’s no reason to think that as soon as the economy rebounds and rappers (presumably) have more money, they won’t immediately go back to the hyper-materialistic lifestyles they once enjoyed. Rappers, it seems, aren’t too different from the average consumer, and for both, conspicuous consumption is a habit that’sHhard to kick.

Regan Bozman is a freshman Social Studies concentrator at Harvard College.

References Bierman, Fred. "The Nike Air Force 1 Sneaker Turns 25 Years Old." New York Times 23 Dec. 2007. Web. 31 Oct. 2009.

Bustillo, Miguel. "Culture of Bling Clangs to Earth as the Recession Melts Rappers' Ice." Wall Street Journal [New York] 26 May 2009. Wall Street Journal. Web. 31 Oct. 2009.

Castro, Kimberly. "Jay-Z's J Hotels Construction on Hold." US News & World Report. 31 Dec. 2008. Web. 31 Oct. 2009. http://www.hiphoprx.com/2009/06/10/t-pain-and-his-big-ass-chain/ Peterson, James. "Dead Prezence: Money and Mortal Themes in Hip Hop Culture." Callaloo 29.3 (2006). Project Muse. Web. "Scott Storch Goes Bankrupt." The Hip Hop Daily Chronicle. 11 June 2009. Web. 11 Oct. 2009.

"Scott Storch's Outrageous Fortune." Rolling Stone, 29 June 2006. Web. 11 Oct. 2009.

Sulter, John. "Will recession dull hip-hop's bling?" CNN. 29 Jan. 2009. Web. 31 Oct. 2009.

Surowiecki, James. "Inconspicuous Consumption." The New Yorker 12 Oct. 2009. Web. 31 Oct. 2009. <http://www. newyorker.com/talk/financial/2009/10/12/091012ta_talk_surowiecki>.

"T-Pain And His Big Ass Chain!" HipHopRX. 10 June 2009. Web. 31 Oct. 2009.

"Where's the Bling?" CBS News. 16 Apr. 2009. Web. 31 Oct. 2009.

25

26

fall 2009

interview

David Keith

HCER talks with a leading expert in climactic geo-engineering

D

avid Keith, a climate scientist and environmental engineer who holds professorships in the Department of Chemical and Petroleum Engineering at the University of Calgary and the Department of Engineering and Public Policy at Carnegie Mellon University, is one of the foremost experts in the field of climactic geo1 engineering. Geo-engineering, as defined by the British Royal Society, is “the deliberate large-scale intervention in the Earth’s climate system, in order to moderate global warming.” The two forms of geo-engineering that Keith advocates are (1) carbon dioxide removal techniques, which remove CO2 from the atmosphere, and (2) solar radiation management techniques, which reflect a small percentage of the sun’s light and heat back 2 into space.

Keith spoke to the HCER about geo-engineering and some of its economic implications.

HCER: Since 1992 you’ve argued that governments need to fund geo-engi3 neering research. In 2008, you published an editorial that made the same 4 argument. Has funding for research increased since you published the article?

DK: There is funding but not from America. The UK government has announced substantial funding. There’s a million euros of EU funding. That’s surprising because if one had the view that this is not a politically correct thing to do, then your first assumption would be that Europeans would be more bound by political correctness, and do it after the Americans.

HCER: Are you saying that the U.S. needs to take a lead on this issue?

DK: I don’t know about a lead, but the U.S. needs to get active on this issue. There’s a very strong argument for the U.S. government funding of a broad research portfolio on geo-engineering.

HCER: Why exactly do we need to fund geo-engineering research now?

DK: I don’t think it makes sense to say that we need to geo-engineer now. Indeed ,no methods are well enough understood to justify their use today, but we need the capabilities to do so in the future. However,

given the uncertainty as to how bad the climate impacts might be, an uncertainty that’s not going to go away anytime soon, and the huge inertia of CO2 in the atmosphere, we need a way to manage the climate risk. Cutting emissions is a crucial part of that, but it’s not sufficient to manage the climate risk, because even if you cut emissions completely, a substantial risk remains. Geoengineering is the tool to manage the risk of CO2 that is already in the air.

HCER: What needs to be done in terms of developing the capabilities for geo-engineering?

DK: You need to do work on a variety of scales. You have to develop the engineering capability and the regulatory governance capability. That’s what it would mean to have the capability to do it. Realistically, it could take decades to develop that capability.

HCER: Does the financial crisis make it less likely that geo-engineering research will get funded?

DK: Not at all. It’s completely de-coupled.

Geo-engineering actually appears to be a cheaper way to manage the problem, and, in any case, the finding needed now is very small compared to total funding on climate science and technology.

HCER: You’ve admitted that there are probably going to be some negative side effects from the use of geo-engineering.

How should countries be compensated for those side effects?

DK: In a perfect world, the winners would compensate the losers. The reality is that that doesn’t happen very often, and we don’t have a system of global governance to make that happen.

HCER: Most economists agree that climate change is a problem of economic externalities. Specifically, the costs of carbon dioxide aren’t calculated in economic transactions. Does geo-engineering help internalize carbon dioxide

emissions?

DK: I don’t think it does. Geo-engineering doesn’t help internalize the externalities involved in carbon dioxide emissions. It helps to manage and cap the risks. It does reduce the worst-case risk from CO2 emissions. The way to internalize these externalities is to tax emissions.

HCER: Is there a set date by which we must geo-engineer the climate?

DK: I’ve never said that we must implement geo-engineering. I’ve said that we must have the capability to do it. This is a crucial distinction. We don’t know how sensitive the climate is to CO2 emissions. Let’s say that we wanted to hold carbon dioxide levels under some limit. Given the uncertainty in climate sensitivity, you can’t do it by reducing CO2 emissions alone. If you’re trying to reach a specific cap, you need the ability to geo-engineer in case that climate sensitivity is high.

HCER: Do you realistically see any real regulations on carbon dioxide emissions in the next decade?

DK: Yes. It’s very hard to call. On the one hand it’s been 40 years since we’ve had enough knowledge about climate risk so as to start regulating. On the other hand, we’ve been successful in solving other environmental problems over the past decades.

Air pollution regulations were a stunning success. Nobody knows when we’re going to do it, and I don’t think there’s going to be any action at Copenhagen [Climate Conference], but I think there’s a good chance we will regulate. For all previous environmental regulations, securing the said regulation always looked harder before we got the deal than after. Companies have an incentive to overestimate costs. There’s also evidence that government and NGO estimates of the cost of regulations tendHto be biased high before the regulation passes compared to the actual cost afterwards.

Endnotes 1. The Royal Society. "Geoengineering the climate." Sept. 2009. http://royalsociety.org/geoengineeringclimate/.

2. Ibid.

3. Keith, David W. and Hadi Dowlatabani. “A Serious Look at Geoengineering.” Eos, Transactions, American Geophysical Union Vol. 73, No. 27: 289, 292-293.

4. Homer-Dixon, Thomas and David Keith, “Blocking the Sky to Save the Earth,” New York Times (Sep. 19, 2008).

Join

HARVARD C O LLEGE Economics Review

Write | Edit | Design | Fund

Three Boards

Content • Business • Layout Email hcer@hcs.harvard.edu for more information.

The Harvard College Economics Review would like to thank

The Institute of Politics The Center for International Development and

The Undergraduate Council for their generous support of this issue.