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HARVARD COLLEG E Economics Review SPRING 2010 造 VOL IV ISSUE 2

Development Economics Monetary Policy for Emerging Market Economies Page 4

UNU-WIDER to Focus on the Triple Crisis Page 23

A Fishy Market Page 30

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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 Roger Hu–Content Associate Casra LaBelle–Content Associate

BUSINESS

Louis Argentieri–Business Associate Paul Finnegan–Business Associate

In this issue, we take on the topic of Development Economics, a dynamic branch of economics that has received a great deal of attention in recent years. The quality of life of billions of people around the world depends on economical research and analysis, which lay the groundwork for the policies that various states adopt and implement. This issue contains articles on a variety of topics. Our Cover Theme section, for example, comprises of articles dealing with food crises, microfinance, women’s rights, and monetary policy in emerging markets, among others. In providing a variety of perspectives on pressing economic issues in the developing world, we seek to aide you in better understanding current debates in the burgeoning field of Developmental Economics. We have, as usual, included a series of student articles in addition to our professional contributors, 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 and/or visit us online at www.hceronline.com.

Best regards,

IT Director and Webmaster Varun Bansal

Gina He

E-mail: hcer@hcs.harvard.edu Website: www.hceronline.com COPYRIGHT 2010 HARVARD COLLEGE ECONOMICS REVIEW. $7.99. 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 2

Special Section: Perspectives from UNU-WIDER Economists

On the Cover:

Economics & Development The HCER brings together academics, practitioners, and students to analyze important findings in developmental economics—a dynamic field of research that has attracted a great deal of attention in recent years.

HARVARD C O L L E G E

UNU-WIDER to Focus on the Triple Crisis

Economics Review SPRING 2010 ¤ VOL IV ISSUE 2

23

Finn Tarp

Development Economics

Entrepreneurship, Global Development, and the Policy Challenge

Monetary Policy for Emerging Market Economies Page 5

UNU-WIDER to Focus on the Triple Crisis Page 23

Wim Naudé

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A Fishy Market Page 16

Monetary Policy for Emerging Market Economies

4

Benjamin M. Friedman

Microfinance and Unexpected Consumption Expenditures

24

9

Global Food Crisis and Food Security in Middle East 26 and North Africa Imed Drine

Trade as Growth Engine for Developing Countries

28

Amelia Santos-Paulino

Richard Hornbeck

Financial Globalization and International Business Cycle Synchronization

11

Elias Papaioannou

Private Sector Agribusiness Investment in Sub-Saharan Africa

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18

The Changing Role of States, Markets, and International Organizations

20

How Well Can Economists Forecast? Federal Reserve’s TALF: A Failure?

33 35

Kwon-Yong Jin

Breaking the U.S. Embargo

37

Maria Carla Chicuen

Book Review Too Big to Fail Athena Jiang

ISSN: 1946-2042 ISBN: 978-0-9823780-2-1

30

Ray C. Fair

Kiran Gajwani

Hassan Y. Aly

A Fishy Market Kathryn Graddy

Nomathemba Mhlanga

Women and Development

Interest

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Benjamin M. Friedman

Monetary Policy for Emerging Market Economies Beyond inflation targeting

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hroughout much of the developing world, both monetary policy and the macroeconomic conditions for which monetary policy is in part responsible have shown a significant, indeed historic, improvement during the past decade and more. In the wake of the Asian financial crisis of the late 1990s (which also engulfed some economies far from Asia), many central banks thought they faced a choice between firmly fixing their exchange rate, thereby foregoing any attempt at an independent monetary policy, and resolutely hands-off floating, which allowed monetary policy to be independent but only by foregoing any influence over the exchange rate at all. Today, evidence based on actual central bank behavior suggests that the 'empty middle of the spectrum' is in fact well populated. The difference is partly due to the enormous increase in many developing countries' holdings of international reserves – for example, from $21 billion to $166 billion in India, from $19 billion to $73 billion in Mexico and from $12 billion to $284 billion in Russia, between 1996 and 2006.1 But part of the

story as well has been, in one country after another, the imposition of a more focused, more rational, and more analytically disciplined approach to monetary policy-making. In some developing economies–nearly a dozen and a half at last count, including the 'transition economies' in Eastern Europe – this change in turn has involved the adoption of one or another form of inflation targeting. But inflation targeting is hardly the whole story either, since countries that have not adopted this specific form of monetary policy-making (India is a leading example) have likewise been part of the more general improvement. At the same time, macroeconomic performance has also improved. For the decade 1987-96, ending just before the strains of the Asian financial crisis occurred, the average rate of consumer price increase among countries that the International Monetary Fund designates as 'emerging market and developing countries' was 56.6 percent per annum. For 1997-2001, the average was 9.4 percent, and for 2002-2006 it was just 5.6 percent. But while output and employment suffered in many of these

economies during the actual years of disinflation (and, of course, during the financial crisis), since then most have returned to robust growth. Among the same group of developing economies, after-inflation economic growth during 1987-96 averaged 3.9 percent per annum. The comparable growth rate was 4.5 percent during 19972001, and 7.0 percent during 2002-2006. Moreover, the year-to-year volatility of both inflation and real economic growth has declined as well.2 Because of their huge populations, together with the prevalence of poverty there several decades ago, this strong economic growth performance has been especially important in China and India. They are the two main reasons why the number of people living in poverty worldwide, while still far too high, is nonetheless falling rapidly. In 1985, China's per capita income, measured in 2005 Purchasing Power Parity (PPP) dollars, was $1300, while India's was $1500. But since then China has achieved an average increase of 8.4 percent per annum, maintained fairly steadily throughout the period, and in 2005 Chinese per


HARVARD COLLEGE ECONOMICS REVIEW

capita income (again on a PPP basis) was $6600. India had a slower start. Growth there began to accelerate in the 1980s, but in an unbalanced form that proved unsustainable. After a near halt at the end of the decade, however, and then a series of reforms in the early 1990s, India's growth pace has steadily increased, within the past few years approaching China's. In 2005, Indian per capita income was $3500.3 Progress in hand is not ground for complacency, however, and especially in the context of the challenges of economic development, a number of key questions surrounding the making of monetary policy remain. One concerns the objectives that monetary policymakers should seek to achieve. A second – which, despite the label, is relevant even if policy-makers seek to achieve objectives beyond just the inflation rate – is whether inflation targeting is the best way to go about making monetary policy. A third, despite the rediscovery of the middle ground between pure currency pegs and pure floating, is what role the exchange rate should play in monetary policy. And it is also important to recognize the limits of monetary policy: not just in order to foster a more realistic assessment of what monetary policy can accomplish, but to highlight the other important tools of public policy that also potentially bear on the ability to achieve macroeconomic objectives. The need for a sound fiscal poli-

cy, and the analytical connections between monetary and fiscal policies, are already well understood. The relationship between monetary policy and financial regulation and supervision has received less attention (perhaps because advocates of inflation targeting and other rule-based approaches to monetary policy-making are often hostile to government interference with the conduct of private-sector profit-seeking activity), but it too is potentially a significant factor in enabling a developing economy to achieve its macroeconomic aims. What objectives should monetary policy seek to achieve? Both theory and evidence indicate that, in developing and mature economies alike, monetary policy can affect output, employment, and other quantitative aspects of non-financial economic activity over at least some significant period of time.4 The relevant question is in what way it should seek to do so. The composition of economic activity also matters as soon as the purview of policy becomes forward-looking. Among economies that have already reached industrial, or even post-industrial status, physical capital formation is plausibly secondary to advances in intangible technology as an engine of further growth in productivity and therefore per capita output. In the developing world, however, not only is capital formation per se important – including

private-sector production facilities such as factories as well as key elements of infrastructure like highways and airports – but much of the ability to import and implement new intangible technology likewise depends on installing new physical capital. It is a mistake to believe that no investment ever takes place apart from government initiative. At any point in time, individuals' economic well-being hinges largely on how much they are consuming, but both individuals and the economy in the aggregate have good reason to consume less than all of current production in order to invest in future productive capacity. To the extent that such forward-looking expenditures involve debt financing (or, equivalently, to the extent that required equity returns vary with interest rates), monetary policy has the ability to affect private economic agents' willingness and ability to undertake productive investment – indeed, judging from historical experience, greater ability to affect the pace of their investment than their consumption. What is less clear is what efficacy monetary policy per se has with respect to financial soundness. To be sure, because of the leveraged positions that most financial institutions normally take, simple reductions in market interest rates can help to shore up balance sheets, and sometimes even ensure survival, when adverse price movements for particular assets place some institutions in jeopardy. But policymakers' main goal is (or at least should be) to prevent crises from happening in the first place. For this purpose, more specialized policy instruments like bank capital requirements, or prudential regulation and supervision, or margin requirements on the purchase and holding of specific assets, are what mostly matter. Therefore, monetary policy can be effective for these objectives only in conjunction with other policy tools. Is inflation targeting the best way to achieve these objectives? Concluding that monetary policy can, indeed should, pursue multiple objectives for the economy's rate of price inflation, for the level and rate of growth of aggregate economic activity, in some settings for the investment rate and perhaps also the exchange rate and the economy's international balance, not to mention issues of financial stability-is easy enough. But under most countries' institutional arrange-

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ments (and, behind those, the fundamental logic of how monetary policy works in a market economy), monetary policy has only one instrument: typically either a short-term interest rate or the level or rate of growth of some measure of the central bank's liabilities, or under a pegging policy the country's exchange rate. Even apart from the inability to predict future economic developments in a setting in which the influence of policy is subject to time lags monetary policy cannot be expected to achieve desired paths for all of the numerous dimensions of economic activity that policy-makers rightly seek to affect. Barring some special coincidence, the best that policy-makers with only one instrument at their disposal can achieve is to keep the economy on the path that represents the optimal compromise among their diverse objectives.5 Considerations of uncertainty only make matters more difficult. In recent years many central banks, both in the developing world and among already mature economies, have addressed this tension between multiple objectives and their unitary monetary policy instrument by resort to 'inflation targeting'. Beginning with Chile in 1991, then Korea in 1998, both Mexico and Brazil in 1999 and Thailand in 2000 (in each case in response to the Asian financial crisis), and continuing on with the Philippines, Peru, Indonesia, Turkey and others as well, many developing countries have chosen to adopt some variant of this path for their monetary policies. So too have many of the 'transition economies' in Eastern Europe, beginning with the Czech Republic (in 1998), and now also including Hungary, Romania and the Slovak Republic. Although the forms of inflation-targeting strategies for monetary policy are many and varied, in current usage of the term the two essential components are (1) the clear public statement of what rate of price increase policy-makers are seeking to achieve over some medium-to long-run horizon, in practice typically stated in terms of a target range, and (2) the formulation, in internal central bank discussion as well as statements to the public, of the economic trajectory intended to follow from the chosen monetary policy in terms of the implied path for inflation. One immediate virtue of this policy rubric, as is the case with most rules-based regimes, is that it imposes a logic and rationality on a country's monetary policy-making process and

thereby presumably helps to avoid large errors. An economy with an inflation-targeting monetary policy is unlikely to suffer hyperinflation, or an economic crisis with deep and widespread loss of output in the process of ending that inflation experience. Especially in the developing world, assurance of merely avoiding first-magnitude mistakes is clearly of some value. Whether that lesson remains to be learned, however, well into the new century, is less clear. And if not, then the question that arises is how the many other objectives—that are also valid for a developing economy—fit into an inflation-targeting regime. Advocates of inflation targeting, both within central banks and among academic researchers, frequently ground the argument in favor of the way of conducting monetary policy in considerations of transparency and accountability: telling the public which single variable to associate with monetary policy, and also the numerical target at which the central bank is aiming for that variable, makes clear what policy-makers are trying to achieve. When the aim of policy is well known and the results straightforward to monitor, it is also possible for both higher authorities and the public to hold policy-makers accountable for their success or failure. Transparency of the central bank's policy is presumably helpful in that it reduces the uncertainty

that financial market participants, as well as households and firms more generally, face in carrying out their respective economic plans, thereby making the economy as a whole more efficient. Further, especially when the objective is low and stable inflation, transparency of that particular objective also helps to anchor the public's inflation expectations, thereby reducing the real economic costs associated with combating any unexpected increase under circumstances (such as are commonly assumed in today's 'new Keynesian' economic framework) in which price setting behavior at any point in time depends not only on real economic activity relative to full-employment benchmarks, but also on expectations of future inflation.6 Accountability of policy-makers for the efficacy of their decisions and actions is plainly part of what constitutes effective democracy. The argument for the greater transparency of the inflation-targeting strategy fails, however – and with it the argument for the consequently greater accountability of monetary policy – when policy-makers have objectives for output or employment, or the economy's investment rate, or its external balance, or for that matter any other aspect of economic activity other than the stated price target. The essential question is whether monetary policy-makers have objectives for other aspects of their econ-


HARVARD COLLEGE ECONOMICS REVIEW

omy, or not. If they do – if, for example, policy-makers in a developing country are actively seeking to increase the economy's investment rate, or to raise or lower the exchange rate to offset a recent shock to the economy's terms of trade, or to keep the exchange rate systematically low in order to foster export-led economic growth, then inflation targeting is more likely to undermine transparency of monetary policy than to promote it. The chief reason is that under inflation targeting policy-makers normally reveal to the public only one of these multiple objectives: inflation. If the public knew (and were able to use) the economic model on which policy-makers rely in evaluating potential actions, whoever is interested could infer what path for output, or employment, or the investment rate, or the exchange rate, or any other variable of interest would be expected to accompany the targeted inflation trajectory. But few central banks disclose this information, including those that follow inflation-targeting strategies. Moreover, policy-makers in many central banks do not rely on a single economic model for these purposes anyway, and this is especially likely to be the case in developing countries where both the internal structure of the economy (often with a significant 'informal' sector) and the external exposure to hard to model supply shocks in key export markets make such models inherently less reliable to begin with. Inflation-targeting central banks also rarely if ever quantify for the public, or often even for themselves, the relative importance that they attach to their objectives for inflation and for these other aspects of economic activity. Indeed, many inflation-targeting central banks at least appear to go to some effort not to reveal such aspects of their policy-making to the public. Similarly, many inflation-targeting central banks, in the public explanation that they provide of the rationale underlying their monetary policy strategy, avoid any reference to the possibility of tension, even in the short run, between their inflation objective and any real outcome. In light of the presumed favorable consequences for short-run inflation output trade-offs that ensue from keeping expectations of future inflation anchored at a low level, as is explicit in the standard New Keynesian representation of pricesetting behavior, the incentive for policymakers to downplay or even conceal their

objectives for other economic outcomes is clear. But doing so hardly contributes to the transparency of their policy. The same considerations also undermine the argument for inflation targeting on grounds of promoting the accountability of monetary policy. If policy-makers have objectives for both inflation and other economic outcomes, but disclose only their inflation objective, then higher authorities as well as the general body politic can hold them accountable in an explicit way at most for their success or failure in meeting their inflation objective; the rest must rely on inference and guesswork. To be sure, if those other aspects of economic activity are obviously at variance with any reasonable set of objectives, presumably everyone would understand that the central bank had failed to execute its responsibilities and hold it accountable. But the same is true under other ways of conducting monetary policy too. The debate over the potential contribution of inflation targeting to enhancing the accountability of monetary policy is, to repeat, about more than simply avoiding first-magnitude errors. The other possibility, of course, is that policy-makers may not have objectives for real outcomes, but instead may actually direct their policy solely toward the achievement of the state rate of inflation. In this situation, monetary-policy makers would be foregoing their capacity to seek, within the capacities of the instrument at their disposal, to influence the other aspects

of economic activity that also matter for achieving the objectives of public policy. Indeed, one interpretation of the movement toward inflation targeting among so many of the world's central banks is that this is precisely the state of policy-making that inflation targeting is intended to bring about over time. A plausible consequence of constraining the discussion of monetary policy to be carried out entirely in terms of an optimal inflation trajectory is that, in time, objectives for other aspects of the economy will atrophy, or even disappear from policy-makers' purview altogether. This eventuality may also ensure because policy-makers inevitably take more seriously those aspects of their responsibilities for which they expect to be held accountable. Disclosing only the inflation objective, when in fact policy-makers have objectives for inflation as well as other economic outcomes, biases the relative importance that they will attach to these respective objectives by fostering their accountability for inflation and not for the other outcomes. In time, the objectives for other aspects of the economy will devolve into a rhetorical fiction. Adapted from: Friedman, Benjamin M. 2008. Monetary policy for emerging market economies: beyond inflation targeting. Macroeconomics and Finance in Emerging Market Economies 1, March: 1 – 12. Adapted by Pamela Ban and Casra LaBelle, with permission. H

Benjamin M. Friedman is the William Joseph Maier Professor of Political Economy at Harvard University. Endnotes 1. Data are from the IMF, World Economic Outlook, various issues. 2. Data are again from the IMF, World Economic Outlook. 3. Data are from the World Bank, World Development Report, various issues, and the online World Development Indicators. 4. See Friedman (1996). 5. See Blanchard and Gali (2005) for an analysis of just such a 'coincidence'. 6. See, for example, the canonical model analysed in Calrida, Gali, and Gertler (1999). This implication of anchoring forward-looking inflation expectations is also the heart of the analysis in the application of time inconsistency to models of monetary policy, as in Barro and Gordon (1983) and Rogoff (1985). References Barron, Robert J. and David B. Gordon. 1983. Rules, discretion, and reputation in a model of monetary policy. Journal of Monetary Policy 12, July: 101-22. Blanchard, Olivier, and Jordi Gali. 2005. Real wage rigidities and the New Keynesian model. NBER Working Paper No. 11806, November. Clarida, Richard, Jordi Gali, and Mark Gertler. 1999. The science of monetary policy. Journal of Economic Literature 37, December: 1661-707. Friedman, Benjamin M. 1996. Does monetary policy affect real economic activity? Why do we still ask this question?. In Monetary policy in an integrated world economy, ed. H. Siedbert. Tubingen: J.C.B. Mohr Rogoff, Kenneth. 1985. The optimal degree of commitment to a monetary target. Quarterly Journal of Economics 100, November: 1169-89.

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JOHN DUNLOP THESIS PRIZE $500 Award

for the best thesis from a Harvard senior on a public policy issue at the interface of business and government The Mossavar - Rahmani Center for Business and Government at the Kennedy School of Government DEADLINE: May 7, 2010 To apply, go to: http://www.ksg.harvard.edu/m-rcbg/dunlop_prize.htm


HARVARD COLLEGE ECONOMICS REVIEW

Richard Hornbeck

Microfinance and Unexpected Consumption Expenditures Do microfinance organizations help to increase the poor’s access to credit?

Q

uestions in development economics often focus on the poor's limited access to capital and, in particular, on their high interest rate for borrowing. Despite this high price for capital, many poor households borrow substantial amounts for production and consumption. This situation suggests that the poor have access to very productive investment opportunities and face periods when they have a very strong desire to consume more than their current income. Motivated by high borrowing costs among the poor, a large number and wide variety of organizations have made efforts to expand the availability of credit and decrease interest rates. Microfinance organizations are one prominent example, and loans are often also provided by banks, moneylenders, family, friends, and other local associations. Households also finance major expenditures using cash savings, funds from rotating savings groups, the sale or pawning of household items, insurance or entitlement programs, or gifts. Indeed, financial diaries show that the poor simultaneously use a large number of formal and informal financial instruments. It is not clear whether this large number of financial instruments represents an economic success or failure. Assuming that the poor are not simply tricked, each of these instruments is fulfilling some demand that is not met by the other instruments. This reflects a great deal of adaptability in creating and adopting different instruments, but it also reflects the limited capabilities of each particular instrument. Even when each source can supply only a limited amount of capital, borrowers often do not use them to the fullest extent possible, despite seemingly substantial overlap in the services provided by each instrument. Encouraging the creation of new financial instruments to cover unmet demands is a patchwork solution to these problems. It would be useful to understand what underlying rigidities prevent some products from substituting for others. Such an understanding would both help in developing new

instruments and potentially allow for more direct corrections to the underlying financing challenges faced by the poor. For example, in thinking about unexpected consumption expenditures, there is an inherent importance in having fast access to funds. If a household member experiences a sudden illness, accident, or pregnancy complication, receiving immediate hospital care will often require substantial upfront payments. Microfinance clients may be able to obtain funds on a regular schedule for business investments, but not necessarily for immediate health expenditures. In early 2007 a survey was administered to 5,500 SKS Microfinance client households in rural India (Bidar and Gulbarga districts) as part of the author's ongoqwing research with Professors Abhijit Banerjee and Es-

ther Duflo of the Massachusetts Institute of Technology on the bundling of microfinance loans with health insurance. The survey asked about sources of loans used to finance expenditures on particular major health events, special events such as weddings, funerals, and festivals, buying and tending animals, operating a business, and cultivating land. For each category of expenditure, figures below report the fraction of loans coming from banks, microfinance organizations, moneylenders, family and friends, and other sources. When more than one loan source was used, fractions of the loan are allocated based on the proportion of loans from that source. SKS Microfinance clients do not report using microfinance for health expenditures; rather, they report using moneylenders and

figure 1: Major health events

Source: SKS Microfinance client survey, 2007. Note: Total number of loans in this category = 8,007.

figure 2: Weddings, funerals, and festivals

Source: SKS Microfinance client survey, 2007. Note: Total number of loans in this category = 1,068.

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Figure 3a: buying & tending animals

Source: SKS Microfinance client survey, 2007. Note: Total number of loans in this category = 839.

Figure 3b: Operating own business

Source: SKS Microfinance client survey, 2007. Note: Total number of loans in this category = 1,546.

figure 4: cultivating land

Source: SKS Microfinance client survey, 2007. Note: Total number of loans in this category = 772.

family and friends (Figure 1). SKS Microfinance has an emergency health loan program but most clients report being unaware of this program. Capital may be fungible and reported sources of funds may not reflect the true long-run source of funds for these expenditures. For example, clients may only take a high-interest loan from a moneylender in the short-term, and then repay with a microfinance loan, sales of assets, lower investment, or other sources of funds. Ongoing analysis of the randomized introduction of a health insurance policy will give some insight into how other debts and assets adjust to uninsured major health expenditures. High interest costs for financing health expenditures, at least in the short run, can blur the traditional distinction between credit and insurance. Credit allows consumers to smooth expenditures over time, but it does not reduce the associated loss in permanent wealth. Insurance, on the other hand, is typically thought to reduce this risk of lost wealth. If credit is very expensive, however, then insurance may derive much of its benefit from effectively providing credit: it pays for health expenditures exactly when the consumer places a high value on capital. Indeed, SKS's health insurance policy offered a cashless network option for obtaining healthcare that was much more popular than

upfront payment and reimbursement for clients. Credit and insurance may be much closer substitutes for the poor in developing countries than is typically thought in contexts with developed capital markets. This relationship between credit, insurance, and unexpected consumption expenditures is intuitive, but additional survey results present a more puzzling situation. If microfinance were simply too inflexible to fund unexpected health expenditures, then microfinance might be more commonly used for anticipated consumption expenditures. However, microfinance was only slightly more common among loans used for weddings, funerals, and festivals; loan sources for these uses are similar to those for health expenditures (Figure 2). Perhaps microfinance is simply ill suited for financing consumption expenditures. Microfinance organizations often attempt to fund production rather than consumption, even though the two are closely linked through household financial decisions. Production loans may attract people that are lower risk ex ante, and production may be easier to monitor ex post. When clients take

out loans to buy and tend animals or support their own business, they mostly use microfinance loans (Figures 3 and 4). The group structure of microfinance loans may prevent their use for consumption expenditures. Whereas production decisions have a natural seasonality, large consumption expenditures are less correlated between households, and it may thus be difficult to coordinate group borrowing. If group liability is not particularly important for maintaining microfinance repayment, as some recent research suggests, changing to individual microfinance loans could encourage their use for consumption. Although buying and tending animals is somewhat seasonal, operating a business does not have an obvious seasonality. If borrowers tend to use microfinance only for production because of seasonality and group coordination, then one might expect microfinance to be common among loans for cultivating land. Borrowers, however, use moneylenders more often than microfinance loans for cultivating land. They also sometimes use banks, which could reflect the use of land as collateral. Overall, aspects of the data suggest that microfinance might be used more for health events or other unexpected consumption expenditures if funds were available quickly and without group liability. Other aspects of the data discourage this interpretation, however, and much remains unknown about what factors influence the poor's access to credit. Introducing new financial products (such as insurance) can potentially fulfill unmet demands along some margin and, by changing a variety of borrowers' behaviors, new products also provide an opportunity to learn about what underlying factors influence the availability and use of different credit sources. Understanding the root causes of imperfect credit access would help in the design of future public and private initiatives. For further reading: D. Collins, J. Morduch, S. Rutherford, and O. Ruthven, Portfolios of the poor: How the world’s poor live on $2 a day (Princeton, NJ: Princeton University Press, 2009); X. GinÊ and D. S. Karlan, Group versus individual liability: Long-term evidence from Philippine microcredit lending groups, (World Bank, Washington, DC, and Yale University, New Haven, CT). H

Richard Hornbeck (hornbeck@fas.harvard.edu) is an Assistant Professor in the Department of Economics at Harvard University. This article is reproduced with permission from the International Food Policy Research Institute (www.ifpri.org), 2020 Focus Brief No. 17, which can be found at: http://www.ifpri. org/sites/default/files/publications/focus17.pdf


Elias Papaioannou

Financial Globalization and International Business Cycle Synchronization Is financial market integration synonymous with output synchronization?

W

hile many commentators, academics, and policy makers argue that financial globalization has been a catalyst for the propagation of the 20072009 crisis from a corner of the United States capital markets to the rest of the world, so far the tentative empirical evidence is mixed and inconclusive. Some studies for example show no systematic link between financial linkages to the United States and the transmission of the crisis; other recent works suggest that countries with stronger financial linkages to the U.S. capital markets did not experience sharper recessions as compared to less interconnected economies. Not only does the tentative evidence seems to contradict the conventional wisdom, but also the predictions of most theoretical models in international macro and corporate finance suggests that by facilitating contagion, capital supply shocks will lead to more synchronized cycles among financially integrated economies. This ambiguity is magnified because even before the recent crisis we lacked a good understanding of how financial integration affects the synchronization of the economic activity in regular times. Empirical works show a clear positive association between financial integration and output synchronization using data in the late 1990s and early 2000s.

Yet this result is at odds with standard theory predicting that in the absence of major financial shocks, there will be a negative association between financial globalization and the synchronization of economic activity. In the textbook international business cycle model, following an idiosyncratic country-specific productivity shock, the return to capital and labor increases, workers substitute leisure for work, and foreign capital flows to finance the rising investment opportunities; consequently, output patterns among financially integrated countries diverge. To make a long story short, there is a clear paradox between theoretical predictions and the main data patterns. While in regular times the partial correlation between financial integration and business cycle synchronization should be negative, there is a clear positive association both across country pairs and across time. And while one could reconcile the positive association with financial frictions and shocks to the supply of capital, the tentative evidence from the recent crisis shows no systematic link between linkages in the U.S. capital markets and the spread of the crisis. Moreover even if the data were to match the theoretical predictions, it would be premature to conclude that the simple correlations reflect causal relationships.

In a recent paper, Sebnem Kalemli-Ozcan, Jose-Luis Peydro, and I attempt to identify the one-way effect of financial integration on international business cycle synchronization using a unique dataset of bilateral external positions and a novel instrumental variables method. For our analysis, we exploit a confidential dataset that covers all international bilateral banking activities for the twenty largest economies over the past three decades. The rich structure of our data is essential as it allows us to account econometrically for many sources of heterogeneity and biases. Most importantly, by exploiting the considerable time-dimension, we can investigate whether business cycles among any two countries become more or less synchronized as the two economies become more interlinked. Due to data limitations, previous works could not directly address this question, because most databases on bilateral international positions report statistics only for the past decade. The limitation of our data is that it covers only the international exposure of banks and does not record investments by mutual funds, other than banks institutional investors (such as hedge funds), and other types of foreign investment. Yet banking activities are by far the largest component of total international assets and liabilities,


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accounting for half of the total foreign positions of our group of industrial economies (in comparison the sum of portfolio equity investment and foreign direct investment accounts for roughly a third of total external positions). Moreover, as recent databases reveal a strong correlation between all types of international investment holdings and flows, the banking statistics reflect most likely all external positions. The three-dimensional panel structure of our dataset enables us to control for global trends and shocks common to all countries, such as the increased coordination of monetary policy, outsourcing, and other features of globalization, over a prolonged period of time. Quite importantly, we also account for all (to a first-approximation) time-invariant country-pair factors, related to trust, distance, information asymmetries that previous research shows that crucially affect both integration and output fluctuations. Besides these straightforward technical merits, by exploiting the within country-pair variation of the data we can address directly the relevant policy question: Do increases in bilateral financial linkages makes economic activity more or less synchronized? In the first part of our analysis we show with simple econometric methods (ordinary least squares) that accounting for shocks common to all countries and country-pair fixed-factors are fundamental. Across country-pairs there is a significant positive correlation between financial integration and output synchronization; this comes at no surprise. The business cycle of the US economy is much more synchronized and more financially linked with Canada, as compared to Germany or France, which are themselves more synchronized and also more interconnected. Yet, in sharp contrast to the clearly positive cross-sectional correlation, when we examine the within country-pair response of output synchronization on increases in bilateral financial linkages, we find a significantly negative association. This implies that increases in financial integration within each country-pair (say Canada-US or FranceGermany) are associated on average with less synchronized, more divergent, output cycles. The negative association between bilateral financial linkages and business cycle co-movement is in line with the standard textbook models in international macro that imply that in the absence of capital supply shocks, financial integration should magnify totalfactor-productivity shocks and make output patterns to diverge.

Yet our results may be driven by output divergence leading to a higher degree of financial integration rather than the other way around. Reverse causation cannot be ruled out, because the benefits of international diversification become larger the less synchronized equity returns are. According to the logic of the textbook international meanvariance model, capital should thus move in countries with asynchronous output cycles. A further concern with the panel estimates is that one can not rule out that another factor—not related to financial (or trade) integration—country-pair time-varying is spuriously driving the correlation between financial integration and synchronization. Another open issue is how potential measurement error in the proxy measure of financial globalization is affecting the estimates. While the BIS statistics reflect all on balance-sheet international exposure of banks and thus classical error-in-variables is minor, our data do not include other types of international investment. Moreover, due to the hub nature of international banking, almost all datasets of international investment holdings miss indirect exposures (i.e. a Canadian investment in Austria will most likely occur through New York and/or Luxemburg) and investments through off-shore centers (such as the Cayman islands or the Channel Islands). To account for these endogeneity concerns, in the second part of our paper we de-

velop a novel country-pair panel instrumental variables identification scheme that links legal-regulatory harmonization reforms in financial services with bilateral banking activities in a first-stage empirical model and in turn (in the second stage) with output synchronization. This approach has some nice features. From an econometric standpoint, under instrument validity, this method accounts for all sorts of biases arising from reverse causation, omitted-variables bias, and measurement error. From a policy standpoint, as many countries are currently in a process to redesign the regulatory framework of financial intermediation, our two stage empirical framework enables us to understand how such reforms may affect output synchronization through international financial integration. Our policy instrument for bilateral banking activities reflects regulatory-legislative financial sector harmonization policies in the European Union (EU) economies (our sample of 20 advanced economies includes the initial EU15 countries). In the end of the 1990s, the main legislative bodies of the EU launched a major policy reform package, the Financial Services Action Plan (FSAP). The FSAP aimed to remove barriers to the movement of capital across Europe by harmonizing the regulatory framework of financial intermediation across the EU. The program included 29 major legislative acts, 27 directives and 2 regulations in the areas of secu-


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rities regulation (e.g. Prospectus Directive), insurance (e.g. Solvency Directive), corporate fraud (e.g. Directive on Insider Trading), corporate governance (e.g. Transparency Directive), and banking (e.g. Directive on Capital Adequacy). In contrast to EU Regulations that become instantly enforceable, directives are legal acts that do not become immediately enforceable across the EU. Instead, member countries are given time to adopt, modify, and eventually transpose the directives into domestic law. Due to bureaucratic inefficiencies, policy considerations, and other frictions, the transposition process is notoriously slow and it is not uncommon for member countries to delay the adaptation of the directives for more than five years. For identification, we thus exploit differences on the transposition timing of each of the 27 directives of the FSAP. Building on our parallel research on the roots of the recent spur of financial integration in Europe, we construct a bilateral time-varying index of legislativeregulatory harmonization policies in financial intermediation that is increasing when both countries have transposed the exact same directive of the FSAP in each year. We then associate this legislative harmonization index in financial services with bilateral banking activities in the first-stage and in turn with output synchronization. This identification strategy is appealing as it links regulatory-legislative reforms in financial intermediation with outcomes (banking integration) in exactly the same sector of the economy and in turn to international output synchronization. The so-called exogeneity assumption for instrument valid-

ity is plausible because legislative reforms are at the country-level, while the outcomes we study are bilateral. The so-called exclusivity assumption for instrument validity is also credible because harmonization policies in financial intermediation should affect the synchronization of economic activity primarily by altering cross-border financial activities. As the FSAP was initiated, designed, and implemented with the explicit goal to integrate capital markets among EU member countries, it is quite reasonable that (conditional on other country-pair time-varying factors) it should affect output synchronization by spurring financial integration. The first-stage specifications reveal that cross-border banking activities increase significantly when countries homogenize the rules governing the function of financial intermediation. The first-stage relationship is strong, even when we condition on the flexibility of the exchange rate regime (i.e. that captures the direct effect of the euro), trade, and other (country-pair time-varying) factors. This suggests that a considerable part of the overall positive effect of the single currency in spurring financial integration in Europe comes from regulatory-legislative convergence. The second-stage estimates show that, conditional on common to all countries shocks and country-pair time-invariant factors, the component of banking integration predicted by legislative-regulatory harmo-

nization policies in financial intermediation tends to make business cycles less alike. We also estimate simple panel specifications that associate output synchronization with the bilateral index of legislative-regulatory harmonization policies in financial services. The so-called “reduced-form” estimates are particularly interesting in our set-up because the harmonization index that we use as an “instrument” for identification in the IV models is a structural measure of financial integration. In line with our simple panel least squares estimates, we find that conditional on common trends and country-pair time-invariant characteristics, convergence policies in financial intermediation are followed by more divergent output cycles. Thus both the LS and the IV results suggest that financial globalization has led to more divergent output cycles. Yet this negative association was masked, because over the past two and a half decades, the spur in financial globalization coincided with an increased degree of business cycles convergence. Yet our results do not imply that financial integration has not contributed to the spread of the recent financial crisis from the US to the global economy. Theory makes sharply different predictions on the effect of financial linkages on the propagation of countryspecific productivity (“real”) as opposed to financial shocks. We have thus intentionally decided to focus on a group of advanced economies in a period of unprecedented financial stability (from the late seventies till 2007) to examine the effect of financial integration on the propagation of productivity driven shocks. As new data will start becoming available on financial linkages and output growth during and after the recent financial crisis, empirical work should reassess the empirical link between integration and the synchronization of economic activity in turbulent times. Our work has hopefully shown that policy recommendations based on simple time-series or cross-sectional correlations can be quite misleading. One needs to carefully bring theory to the data and pay attention to tricky issues arising from the measurement of international financial linkages and the isolation of productivity from financial shocks, and also account for other forms of endogeneity. H

Elias Papaioannou is an Assistant Professor of Economics at Dartmouth College and a CEPR Research Affiliate.

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Nomathemba Mhlanga

Private Sector Agribusiness Investment in Sub-Saharan Africa Trends, challenges, and prospects for scaling-up

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he surge in food prices that began in 2006 and peaked in mid–2008 heightened the urgent need for investment in developing countries’ agriculture. Increased investments in this sector are considered especially imperative in sub-Saharan Africa (SSA), where approximately 70 percent of its people derive their livelihoods from agriculture and hunger and poverty are still prevalent. According to the Food and Agriculture Organization of the United Nations (FAO), net annual investments of approximately $11 billion in agriculture are needed in SSA if the region is to address its food security concerns by 2050 (FAO, 2009). These investment needs far exceed estimated public sector investment and official development assistance for agriculture in the region, hence private sector investments1 (both local and foreign) will have to be harnessed to help narrow the investment gap.2

This article presents a synthesis of trends in private sector investment in SSA, discusses key challenges for increased private sector participation, and identifies mechanisms for tackling some of the noted challenges and scaling up private sector agribusiness investments. Agribusiness Defined Agribusiness is a sector that consists of four main subsystems: (i) input delivery, (ii) farming/ primary production, (iii) postharvest and processing (agro-industry), and (iv) marketing and distribution. For the purposes of this article, the agribusiness sector also includes commercial business activities in forestry and fisheries. Patterns and Trends in Private Sector Agribusiness Investments Here, consideration will be given mainly to foreign direct investment (FDI) and commercial bank lending to the agricul-

tural sector as a proxy for domestic private sector investment. Commercial Bank Lending to Agriculture The share of lending to agriculture relative to total credit from commercial banks is displayed for select countries in Table 1, while Table 2 shows the magnitude of the annual investments in U.S. dollar terms. In most cases, the raw data for commercial bank lending by sector as reported by Central Banks are given in terms of the local currency; thus, a sensible cross-country comparison is the share of the agriculture sector relative to total funds committed. For the countries studied, the bulk of commercial bank lending goes to the sector “other services and personal loans,” followed by “trade credit.” With the exception of Malawi, United Republic of Tanzania and Uganda, commercial banks in SSA lend less than 10 percent of their total


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Table 1: Share of commercial bank lending to the agricultural sector, select countries (percentage of total portfolio) Country Botswana Gambia Ghana Kenya Lesotho Malawi Mozambique Nigeria Sierra Leone Tanzania Uganda

1995 1.40 28.62 8.10 22.54

2000 0.61 9.65 6.57 7.55 4.84 6.30 10.71

2001 0.93 9.56 6.01 8.63 17.87 8.29 9.60 8.57

2002 0.67 9.38 6.07 3.23 15.97 1.12 17.1 11.14

2003 0.76 9.45 6.20 10.40 12.37 5.16 1.75 12.0 9.69

2004 1.42 7.65 6.00 12.11 10.69 4.46 1.93 13.90 11.07

2005 1.42 6.71 6.25 9.90 8.66 2.44 1.97 12.40 10.05

2006 1.13 5.37 5.38 0.31 15.25 6.39 1.96 0.88 13.94 9.13

2007 1.06 7.20 4.41 4.08 1.90 16.27 9.42 3.11 2.49 11.01 6.67

2008 0.68 5.53 4.28 3.60 8.17 14.60 8.05 1.37 2.95 12.35 5.88

Note: Commercial bank lending are loans and advances to the agricultural sector Source: Author calculations based on data from Central Banks

Table 2: Value of commercial bank lending to the agricultural sector, select countries (USD million) Country Botswana Gambia Ghana Kenya Lesotho Malawi Mozambique Nigeria Sierra Leone Tanzania Uganda

1995 6.83 – – – – 22.91 – – – – 55.91

2000 5.90 – 69.03 320.40 – 10.50 – – 0.72 – 40.05

2001 8.74 – 80.28 290.93 – 8.21 100.37 – 1.58 – 30.42

2002 6.99 – 75.95 322.99 – 1.47 94.81 – 0.31 – 40.55

2003 11.18 – 109.42 360.78 – 9.84 72.17 454.95 0.77 – 41.34

2004 25.60 – 108.13 388.83 – 16.89 74.18 511.82 1.04 141.05 60.82

2005 23.42 – 131.71 455.87 – 14.24 74.82 377.90 1.14 152.14 65.61

2006 20.30 – 146.62 465.06 0.19 31.97 64.87 390.43 0.60 231.37 72.90

2007 23.79 9.12 188.38 436.80 2.04 42.76 118.28 1286.16 2.32 289.48 74.11

2008 15.50 7.96 210.19 381.54 9.31 47.17 133.28 814.76 3.33 422.24 103.10

Note: Commercial bank lending are loans and advances to the agricultural sector. The dollar value expressed uses exchange rates prevailing at the reporting time. Source: Author calculations based on data from Central Banks

credit to the agricultural sector. On average, commercial banks in Botswana invest the smallest share of their credit into the agricultural sector. In 2008, they invested less than 1 percent; in fact, credit to the agricultural sector in Botswana has never exceeded 2 percent of the total credit. However, in monetary terms, there are more loans and advances to the agricultural sector in Botswana than in countries like Sierra Leone and Lesotho. Although no clear trends can be discerned, there are indications that credit to the sector is on the rise. On average, Nigeria and Kenya have provided the most credit to the sector.3 The data presented in Tables 1 and 2, however, are not fully indicative of lend-

ing to the broader agribusiness sector, since agro-industries occupy a dominant position in manufacturing activities. Data from the Bank of Uganda show that agro industries received more than a quarter of the lending to the manufacturing sector between 1993 and 2008. Similar data for Mozambique indicate that 40 and 60 percent of total lending to the manufacturing sector from 2003–2007 was to agro-industries. As such, the aggregate figures presented above should be interpreted with this limitation. Based on statistics from the Bank of Mozambique the sub-sectors or crops receiving the largest share of lending to agriculture were fisheries, cotton, sugar, and cashews. Nonetheless, current commercial banks statistics do not offer

much hope that commercial bank lending will increase significantly in the near future, hence the need to explore alternative options for increasing investment in agriculture. This is also the case because the recent financial crisis has caused financial institutions to be more circumspect in their lending. Commercial bank lending is an inaccurate measure of domestic private sector investment as domestic enterprises tend to rely on self-finance and remain informal for the most part. Foreign Private Investment To illustrate trends and patterns in foreign private agribusiness investments, the study uses data drawn from several sources.4 The data shows a significant presence

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of multinational corporations including African companies across the food supply chain. In the input supply segment, companies like BASF, Dow Chemicals, Bayer, DuPont and SASOL have set up subsidiaries in several countries in the region. Companies like Illovo Sugar Limited of South Africa are investing in primary production and engaging small-scale farmers through out-grower schemes. The likes of Nestle, Unilever, Archer Daniels Midland, Tongaat-Hullett, Coca Cola and SAB Miller are involved in food and beverage processing while supermarket chains and fast food retailers such as Shoprite Holdings and McDonald’s are in retailing and service delivery. In terms of the magnitude of the investment, different sources of the data yield varying figures. Data based on announcements and that from investment promotion agencies tends to be inflated compared to data from other sources. For instance, investment data as reported by the Mozambique Investment Promotion Centre (CPI) shows that FDI investment in agriculture increased from $27.2 million in 2003 to $95.6 million in 2007. Yet, the balance of payments statistics for the same period show a small increase in investment from $23.7 million in 2003 to

$27.9 in 2007. What is interesting to note is that these figures are below the value of commercial lending reported above. The World Investment Report (UNCTAD, 2009), which focused on transnational corporations in agriculture production, likewise shows that the share of FDI in agriculture in total FDI flows or stocks is low at less than 1 percent for most of the countries in SSA. However, FDI flows are relatively significant in Tanzania at approximately 10 percent, and agriculture’s share in total FDI stock is approximately 16 percent in Swaziland, 13 percent in Malawi and almost 12 percent in Zambia. FDI is not evenly distributed among SSA countries. Countries that have traditionally received large volumes of FDI flows such as South Africa and Nigeria tend to host a larger number of MNCs in agriculture hence more FDI. At the country level, the number of enterprises by sub-sector reveals interesting patterns. For example, according to the UNIDO survey data, almost a third of the surveyed agribusiness enterprises were in the horticultural subsector, a reflection of the recent developing floriculture in the country. Also relevant to this topic is the recent wave of interest in purchasing farmland in SSA countries that has largely been

controversial. Cotula et al (2009) found that well structured deals could guarantee employment, better infrastructures and better crop yields. The rising land-based investments have emanated from both domestic and foreign private investors. Overall, the general indication is that domestic private sector participation and foreign investment in agribusiness are still low but have been increasing in recent years. Challenges to Private Sector Agribusiness Investments In general, private sector investments are motivated by expected returns relative to perceived risk and uncertainty, which in turn are shaped by both external and internal factors. In the recent past, a number of external and internal factors have worked in concert to enhance expected returns to investment. Over the past decade, many countries in SSA have embarked on reforms to improve their business climate and attract private investment into their respective countries. The reforms coupled with recent upward trends in food prices have increased interest of the private sector in the agricultural sector, which anticipates higher returns to their investment. Far reaching changes in consumption


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patterns in industrialized countries and other developing countries, particularly pertaining to increased demand for processed foods are creating opportunities for farmers and agribusiness entrepreneurs in SSA through higher-value exports and agro-industries development. Furthermore, investor country factors such as the need to secure its long-term food security play a major role in driving investments in agriculture and related activities, while increased globalization has led to increased competition resulting in some investors seeking alternative markets in SSA countries. However, the agriculture sector has remained relatively risky compared to other sectors. Specific risks related to agriculture are production risk due to inability to have entirely control for quantity and quality of output, market risk resulting from input and output price volatilities, credit and financial risk from long production cycles, lack of collateral and solid repayment histories, and institutional risk from changes in regulation or trade policies. Therefore, to meet the need for scaling up private sector agribusiness investment in SSA, it is key to address the challenge of dealing with the relatively high risk, both real and perceived, in the sector. Prospects for Scaling-up Private Sector Agribusiness Investment As discussed above, the most daunting challenges to private sector investments in SSA are the high levels of real and perceived risk and the large gap such investments are expected to cover. Agricultural or agribusiness investment funds are likely to be an important modality for financing agricultural projects because of their capacity to tackle both the high risks of doing business in the agricultural sector and the large scale of investments required. Agribusiness investment funds allow investors to pool together their capital so as to maximize profits, thus taking advantage of larger investment opportunities than are possible for an individual investor. Moreover, the fund structure allows for diversification of the investor’s portfolio through multiple projects. The risks facing private investors can be further mitigated by structuring funds as public-private partnerships (PPPs), whereby national governments and international public funders such as bilateral or multilateral agencies and development finance institutions come aboard to create an en-

abling environment and finance technical assistance of projects being funded. Indeed, a recent study by FAO’s Rural Infrastructure and Agro-Industries Division in collaboration with ConCap Connective Capital shows a rising trend in the set up and use of agricultural investment funds (Miller et al, 2010). The study identified 31 agricultural investment funds targeting sub-Saharan Africa, Eastern Europe and Central Asia, 58 percent (18 funds) of which were established between 2007 and August 2009. The funds’ profiles include public funds, public-private partnerships and purely private funds. The same study finds that most existing funds are under professional management, whose tasks among others are to provide careful risk analysis of projects and administer the

investment portfolio. Examples of agricultural investment funds currently operational in SSA are Actis Africa Agribusiness Fund, African Agribusiness Fund (AgriVie), Aventura Rural Enterprise Fund, and Phatisa African Agri Fund.5 SSA countries can also increase private sector agribusiness investment, particularly foreign investment by targeted investment promotion for the agribusiness sector. Investment promotion is necessary for the region because information about business conditions for potential host countries is less readily available, a factor which has contributed to high levels of perceived risk. The type of investment promotion offered should go beyond providing fiscal incentives as commonly practiced to actually facilitating investments. H

Nomathemba Mhlanga is an Agribusiness Economist, working as a consultant for the Food and Agriculture Organization of the United Nations (FAO) in Rome, Italy. She received her Ph.D. in Applied Economics and Management from Cornell University with a specialization in development economics. Endnotes 1. Private sector investment refers to commitments of capital by individuals or private institutions such as companies with the anticipation of realizing a future return. Private investors could be residents or entities incorporated in the host country, in which case they are “domestic private investors” or they could be resident in another country, thus “foreign investors”. 2. The capacity of SSA countries to significantly increase their investment in agriculture is very limited. Currently less than a third of AU-member countries have allocated 10 % of their national budget to agriculture in compliance with the 2003 Maputo declaration (NEPAD, 2008). Concerning official development assistance (ODA), the share of ODA to agriculture as a percentage of total ODA to SSA decreased from 13.4 percent for 1991-93 to 5.4 percent for the 2003-05 period. Moreover, aid data shows that aid to agro-industries including forest industries has been almost negligible (OECD, 2008). However, in 2009, the G8 at its L’Aquila Summit committed USD 20 billion for African agriculture. 3. The Botswana economy is less agricultural based and Nigeria is large and has a history of subsidized interest to agriculture. 4. Sources include the UNIDO Africa Foreign Investor Survey (2005); BusinessMap Foundation data on investment announcements by foreign individuals or enterprises; Investment Promotion Agencies; and various publications including the 2009 UNCTAD World Investment Report. 5. Other FAO efforts to increase private sector agribusiness investments in Africa (in collaboration with partner organizations) include the recent High Level Conference on the Development of Agribusiness and Agro-Industries in Africa, under which there are plans for a financial facility. For more information, visit www.hlcd-3a.org or www.fao.org/ag/ags References Cotula L., Vermulen, S., Leonard, R. & Keeley, J. 2009. Land grab or development opportunity? Agricultural investment and international land deals in Africa. London, UK and Rome, Italy IIED/FAO/IFAD. Food and Agriculture Organization of the United Nations (FAO). 2009. How to feed the world in 2050. Based on Schmidhuber, Bruinsma & Baedeker. 2009. Capital requirements for agriculture in developing countries to 2050. Presented at the Expert Meeting on “How to feed the world in 2050”. FAO, 24–26 June 2009. Rome, Italy. Available at www.fao.org/fileadmin/templates/wsfs/docs/expert_paper/How_to_Feed_the_World_in_2050.pdf Mhlanga, N. 2010. Private sector agribusiness investment in sub-Saharan Africa. FAO Agricultural Management, Marketing and Finance Working Document No. 27. Rome, Italy. Miller C., Richter, S., McNellis, P. & Mhlanga, N. 2010. Agricultural investment funds for developing countries . Food and Agriculture Organization of the United Nations, Rome, Italy. New Partnership for Africa’s Development (NEPAD). 2008. National compliance with 2003 African Union-Maputo Declaration to allocate at least 10% of national budget to agricultural development. Mimeo prepared by the NEPAD Secretariat-Agriculture Unit, Midrand, South Africa. Organisation for Economic Co-operation and Development (OECD). 2008. Business for development 2008: promoting commercial agriculture in Africa. Paris, France. United Nations Conference on Trade and Development (UNCTAD). 2009. World investment report: transnational corporations, agricultural production and development. New York, USA and Geneva, Switzerland.

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Kiran Gajwani

Women and Development

Are political reservations for women a good way to address the wellbeing of women in developing countries?

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ore than 80 percent of the world’s population live in developing countries. About 25 percent of people in developing countries live on less than $1.25 per day (in 2005 PPP-adjusted USD), and about 56 percent live on less than $2.50 per day.1 Excluding China from these statistics reveals an even starker situation: nearly 30 and 62 percent living on less than $1.25 and $2.50 per day, respectively. Among the poorest individuals in developing countries, however, women are particularly worse-off. In many countries, they have—relative to men—lower income, lower quality of health, fewer freedoms, fewer rights, fewer job opportunities, less political representation, and the list goes on. Aside from any feelings of inequity one might have from these facts, the particularly poor status of women in developing countries is worrying for another reason: the well-being of women strongly influences the well-being of others, especially their children. Women with lower levels

of education are more likely to have less educated children; the children of women with poorer health are more likely to have a lower quality of health; overburdened women (particularly those in poor, rural, subsistence households) are more likely to keep kids home from school to help with household labor; and so on.2 Thus, improving the well-being of women plays a large role in improving the well-being of their children. This, in turn, may go a long way towards improving development and poverty in a country overall. Referring to policies to improve the status of women, Former Secretary-General of the United Nations, Kofi Annan, stated "there is.. [n] o other policy… as likely to raise economic productivity… reduce child and maternal mortality [and] improve nutrition and promote health.” 3 There are many possible policies developing countries can (and do) consider to address this situation: incentives to improve girls’ school enrollment rates, literacy programs targeted at adult women, bene-

fits for a country’s informal sector (which is comprised largely of women in many countries), campaigns to promote women’s empowerment, to name a few. In fact, many of these aspects are addressed in the Millennium Development Goals, and gender empowerment is high on the agenda of the World Bank.4 One increasingly common—and often contentious—policy in recent years is that of political reservations for women. Representation of women in government is quite low: about 18 percent of parliament seats worldwide are held by women.5 Political reservations directly aim to increase the representation of women in government, with the hope that this leads to pro-women policies and gives women greater status and respect in society. Today, 57 countries have quotas for women specified in their constitution; this figure jumps to 94 when counting countries with voluntary political party quotas.6 India provides a particularly interesting example of women in government and women’s reservations:


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it has historically had female political leaders in top positions, it was one of the earlier developing countries to adopt reservations for women by requiring one-third of all local government seats to be reserved for women in the early 1990s, and it is currently undergoing intense debate over reservations for women at national and state levels.7 One major reason for support of women’s reservations is that a ‘critical mass’ of women’s representation in politics may be needed to represent the interests and viewpoints of women, and advance pro-women policies.8 Since change may be slow in terms of improving women’s status in society and their ability to win seats in political office, women’s reservations aim to speed up this process. Many studies have shown positive effects of women’s reservations in developing countries. Women in political office are less likely to engage in corrupt activities, and corruption indices seem to decline as women make up a greater share of national political seats.9 And—in at least some places—women have achieved one of the key goals reservations set out to accomplish: the advancement of pro-women policies. In two areas of India, for example, women leaders in reserved seats at the village level have been shown to provide more “womenpreferred” public goods, such as access to drinking water.10 However, there is no shortage of arguments against women’s reservations; indeed, many of the arguments surrounding any affirmative action policy are ever-present in the debate over women’s reservations. There are issues of equality: women’s reservations violate principles of equality for all by giving women an advantage over men. Some argue that reservations are unfair, in that they restrict the possible candidate choices of constituents and may lead to less-qualified representatives in office that would have otherwise been chosen in the absence of reservations. One oft-cited downside of reservations is that women may end up merely serving as puppets for powerful men. Additionally, if society is not supportive of women leaders, women can be ridiculed or even ostracized by their community and family if they run for office. If women’s colleagues in government aren’t yet ready to have women leaders, women elected to reserved seats may be harassed or ignored while in office.11 Further compounding the difficulty of

women’s reservations is that, even if a highly qualified woman takes a reserved seat in office, they may still be perceived as less effective than men. For example, a study of several states in India revealed that women in reserved village seats provided more public goods than men, and the goods were of at least as high quality.12 However, constituents were consistently found to be less satisfied with the public goods of their village. This bias and low expectation of women politicians, though, does seem to diminish as individuals are exposed to women leaders.13 This issue is by no means resolved. As mentioned above, India is currently heated up over this debate: in March of this year, 14 years after first being proposed, India’s

upper house passed historic legislation calling for the reservation of one-third of seats in Parliament and state assemblies for women.14 And the typical excitement and worries continue: will this be a momentous step for India, where women currently hold only 10 percent of seats in Parliament? Or will this lead to wealthy and powerful men having their wives in office so they can pull the strings? No one can say for sure how this will play out in India, and elsewhere. One thing is for sure, however: the especially poor status of women in developing countries is a very real and important issue that developing countries will have to address in order to fully realize their potential and aid their society as a whole. H

Kiran Gajwani is a College Fellow in the Department of Economics at Harvard University. Endnotes 1. The $1.25/day measure is the standard international poverty line used by the World Bank as of 2008. For complete details on measuring world poverty and the different poverty lines that have been used over time, see Chen and Ravallion (2008). 2. For an in-depth discussion of these issues, see UNICEF (2006). 3. UNICEF (2006), p. vi. 4. World Bank (2001). 5. From http://www.quotaproject.org, which contains a database on quota policies across countries. 6. From the database available at http://www.quotaproject.org. These statistics include countries with quotas at either national or sub-national levels. Political party quotas are only used in places with a proportional representation system, as opposed to a first-past-the-post system. These numbers, however, do not account non-compliance issues which do indeed arise in some places. 7. Women in India have actually historically opposed the notion of reservations; only in the latter part of the twentieth century did this change. For an interesting summary of women’s reservations in India, see John (2000). 8. Tinker (2004). 9. Dollar et al (2001); Tinker (2004). 10. Chattopadhyay and Duflo (2004). 11. Tinker (2004). 12. Duflo and Topalova (2004). 13. Beaman et al (2008). 14. Before the bill can become law, India’s lower house must also pass the measure, followed by approval from a majority of India’s states. References Beaman, Lori, Raghabendra Chattopadhyay, Esther Duflo, Rohini Pande and Petia Topalova. “Powerful Women: Does Exposure Reduce Bias?” MIT Poverty Action Lab Working Paper, July 2008. Available at: http://econ-www.mit. edu/files/3122. Chattopadhyay, Raghabendra and Esther Duflo. 2004. “Women as Policy Makers: Evidence from a Randomized Policy Experiment in India.” Econometrica, 72(5): 1409–1443. Chen, Shaohua and Martin Ravallion. “The Developing World is Poorer than We Thought, But No Less Successful in the Fight Against Poverty” World Bank Policy Research Working Paper 4703, August 2008. Available at: http:// ssrn.com/abstract=1259575. Dollar, David, Raymond Fisman, and Roberta Gatti. 2001. “Are Women Really the “Fairer” Sex? Corruption and Women in Government.” Journal of Economic Behavior & Organization, 46(4): 423-429. Duflo, Esther and Petia Topalova. “Unappreciated Service: Performance, Perceptions, and Women Leaders in India.” MIT Poverty Action Lab Working Paper, October 2004. Available at: http://econ-www.mit.edu/files/793. John, Mary E. 2000. “Alternate Modernities? Reservations and Women's Movement in 20th Century India.” Economic and Political Weekly, 35(43/44): 3822-3829. Tinker, Irene. 2004. “Quotas for Women in Elected Legislatures: Do They Really Empower Women?” Women’s Studies International Forum, 27(5-6): 531– 546. UNICEF (United Nations Children’s Fund). 2006. State of the World's Children 2007: Women and Children: The Double Dividend of Gender Equality. New York: UNICEF. World Bank. 2001. “Engendering Development Through Gender Equality in Rights, Resources, and Voice.” World Bank Policy Research Report 21776.

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Hassan Y. Aly

The Changing Role of States, Markets, and International Organizations Does globalization warrant a reevaluation?

A

s a result of the current economic and financial crises, the role of the government in economic activities has expanded. Gone are the days of Ronald Reagan when he declared that “government is not a solution to our problem; government is the problem.� Moreover, international organizations are also going through an era of fast growth and expansion and having much bigger influences on national economies. Currently, the role of the government in market economies, as described in traditional public economics textbooks, is under major reexamination and questioning. Recent trends in international trade and global financial markets have added more ambiguities to this role and called for a second look at what the government should or should not do in order to secure sustainable growth and development. Moreover, international organizations (the IMF, the World Bank, and other regional entities) are asked to lend a hand to economies that suffered major setback due to the re-

cent economic turmoil. And since there is no free lunch, the assistance of these organizations is coming at the expense of the countries complying with certain international regulations and standards that are put forward and designed by the international organizations. Thus, in this brief, I will first explain the traditional functions of the government in a market economy as postulated in public economies literature. Second, I will elucidate the paramount functions that international organizations are performing now to assist national economies (developed and less developed). Third, I will go over why these functions are changing and what are the factors that call for a new and fresh look at the expanding roles of both the government and international organizations. Finally, I will pose some basic questions on the way forward with policy implications that may assist in understanding the limits of such expanded roles.

The Role of the Government in a Market Economy: In the public economics literature, the government is thought of as performing the following functions: 1) Providing the economy with a legal structure: This function requires the government to ensure property rights, provide enforcement of contracts, act as a referee, and impose penalties for foul play. In order to perform this function, the government should furnish the economy with regulations, legislations, and means that ensure product quality, define ownership rights, and enforce contracts. 2) Maintaining competition: Since competition is the optimal and efficient market mechanism that encourages producers and resource suppliers to respond to price signals and consumer sovereignty, the government ought to fight monopoly power and promote competitive behavior. 3) Providing a safety-net: The government should strive to provide the pro-


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tection for the poor, dependent, handicapped, unemployed, and others who cannot sustain themselves due to external factors with a social safety net. The safety net is usually composed of programs that are built on transferring income from the high income groups or the state monopoly of certain resources to the limited income ones, through progressive taxes and other means of redistribution (examples are price support programs, low interest loans, rent subsidy, etc.). 4) Provision of public and quasipublic goods: When the markets fail to provide the needed goods or the correct amounts of certain goods or services, the government fills in the vacuum. Examples of public goods that the markets do not provide are defense, security, police protection, and the judicial system. Education, health services, and the financing of scientific and technological research that cannot be sufficiently or efficiently supplied by private investors are examples of quasi-public (merit) goods that the gov-

ernment intervene to supply enough of. 5) Promoting growth and stability: The government -assisted by its central bank and other economic administrative entities- promote macroeconomic growth and stability (by increasing the GDP and fighting inflation and unemployment) through changes in its fiscal and monetary policies. Current factors that call for changing the role of the state and expansion of international organizations influences. In the recent years, the role of the state along with the influences of international organizations has enlarged, in many tangible ways, due to the following factors: 1) Globalization: As the rate of globalization increased and hastened, it became apparent that the role of the state will not diminish. Actually, it has gone the other way. Government’s role has definitely expanded. This is mainly due to the ability of laborer, capital owners, and entrepreneurs, among other movable

factors, to attain more freedom on deciding where to locate, nationally or internationally. Thus, the role of the state as the eventual supplier of "complementary assets" in attracting mobile factors to a national economy becomes more imperative. The state also is the one negotiating bi-lateral and multi-lateral agreements, legalizing and defining property rights for citizen and non-citizens, in addition to controlling flows of labor and capital across its border. 2) The Emergence of “Global Externalities”: Public economics literature talks about three kinds of goods and services that are produced and consumed in a market economy: private, public, and quasi-public. Public (or social) goods produce national externalities to everybody in the country collectively. Thus, private producers will not be able to produce it and the government is the major supplier in this case. However, due to the recent trends in international trade and international finance, certain transactions produce externalities (positive or negative) at the international level. Examples are insolvent foreign banks, money laundering, sudden inflow/outflow of foreign fund to/ from certain countries, the movement of migrants, and their remittances (legal and illegal) across borders. As the current crises taught us, all these transactions call for an expanded role of not only the government, but also international organizations, in order to control such “global externalities.” In a pre- globalized, precrises world, Greece’s recent financial problems- stemming from irresponsible government fiscal discipline that used creative accounting to hide its irresponsibility- would have mattered only a little due to its small-sized economy.1 However, Greece’s predicament is becoming a European problem, largely because it is producing “global negative externalities” for much bigger economies. And accordingly, the whole euro zone is suffering. The call for regional (EU) and/or international (IMF) organizations to intervene in order to control such externalities has started. As such, the expanding role of states or non-national organizations is seen now as normal and sometimes necessary for the survival of the market system. 3) The Rise of Sovereign State Funds (SSF): The significant rise of governmentcontrolled funds is hard to miss, especially given their role in the recapitalization of

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the U.S. financial system. The enormous role governments now play in the global flow of capital is unprecedented. The IMF estimates total government asset growth by nearly two times the size of the U.S. external deficit. Moreover, a roughly $900 billion current account surplus in emerging markets has been used to finance developed nations deficits. This has given the inevitable role to the states in leading the market, rather than the reverse, toward an active process of globalization.2 With the advent of the global financial crisis, however, more and more governments used their SSFs to either invest domestically or to fill in the gap of falling export revenues to stabilize the domestic markets. For instance China, Russia, Qatar, Kazakhstan, and Kuwait are among countries that used SSFs to take advantage of the falling domestic equity prices to buy shares of domestic companies or banks. Also, Korea and Saudi Arabia were among others who increased their purchases of domestic equities. Moreover, most oilrich countries with SSFs have utilized some of their savings for stabilization purposes in the face of a revenue shortfall to avoid spending cuts. This means that SSFs have expanded the role of the government in the markets to a degree that is unprecedented in recent history.3 4) The recent changes in the international financial architecture: As a consequence of the 2008 global financial crisis, radical reforms of the international monetary and financial system have been called for and set in motion. For instance, the G20 was elevated to the status of the premier forum for international economic and financial cooperation. Also, the Financial Stability Forum (FSF) was transformed into the Financial Stability Board (FSB), with enhanced membership and a greater mandate, and potentially much greater influence. Moreover, the financial resources of the IMF have been increased to assist countries in crisis, with pressure on the Fund to play a more effective role in crisis management and calls for governance reforms of the institution. As such, the G20 proposed measures for improving global regulatory coordination to provide early warning on risks and improving oversight of cross-border financial institutions. What this means is a much greater role for the IMF, the G20, the World Bank, and all other regional development banks and entities in order to oversee interna-

tional transactions with some supervisory role over the state. 5) Blurring the line between the state and private enterprises: As a result of the huge growth of state funds and the bailing-out of some major private enterprises by the states, it became more and more difficult to distinguish the private venture from the public ones. Sometimes, that was done intentionally, as in the case of Dubai to raise funds for certain ventures. However, the signs are there now that more and more government owned enterprises are playing pivotal role in economic activities and will be very difficult for these entities to disintegrate or go private soon. As examples: a) State banks are now among the world’s largest banks, and rather than shrinking in their home markets, they are expanding globally. China’s state banks are best example. They are expanding abroad even though their home market is tightly regulated; b) Global oil production is increasingly dominated by the national oil companies of the oil-exporting states; c) China is now embarking on import-substitution strategy – for chemicals, steel, autos, even aircraft – where many of the leading players in this process are owned by various parts of the Chinese state; d) Private fund managers are scrambling to manage state money, blurring the line between state and private money. Also, state funds are increasingly acting like private funds, blurring the line in another way (as Dubai’s latest crises revealed). Is there a Balance (Equilibrium)? While the market system is still thought of as the best resource-allocative mechanism, the current debate on the global financial architecture is raising the apparent conflict between sovereign states and international organizations to a higher level. Some analysts believe that the proposed changes to the global financial framework are not sufficient and the IMF should have more access and exert

more influences in order to build an efficient global macro-financial surveillance for the purpose of providing an early warning system of future global crisis. This entails agreement among member states of the international community on many issues, such as restructuring the external sovereign debt or the crossborder resolution of insolvent but internationally active financial firms. Others think that international organizations are already intruding into sovereign state’s affairs, sometimes in clear conflict with the economic interests of these states. An example from the recent crisis is the apparent tension between the United States and the World Bank/IMF. While the World Bank and the IMF wanted to inform the international community truthfully about the hard facts of the current global crisis, including the status of the United States economy, the solvency of the financial system, etc., the main shareholders of these international organizations—the United States. and larger European countries—did not want to hear predictions that are inconsistent with their own preferred (optimistic) baseline. Thus, it is rather obvious that the United States and other major World Powers are rather too influential to be contained or constrained by the international organizations. The balance of power here might come in the form of international organizations dealing directly with regional entities rather than individual states. The G-20, the NAFTA countries, the EU, the African Union, etc are examples. Also, giving more leverage and delegating more authorities, and power (funding) to the Regional Development Banks. For instance, South Asian, Latin American, and African states might be more amenable to working closely with their own Asian Development Banks, Latin American Development Banks, and African Development Banks respectively. Thus, regionalism rather than individualism might be the H new world order.

Professor Hassan Y. Aly is the Chief Research Economist at the African Development Bank and a Professor of Economics at The Ohio State University. Endnotes 1. Paul Krugman, The Making of a Euro-mess, Op-Ed piece, NY Times, February 14, 2010 downloadable from http://www.nytimes.com/2010/02/15/opinion/15krugman.html?th&emc=th 2. Brad Setser, State-led globalization, Jan 31, 2008, downloadable from the RGE site at: http://www.roubini.com/ analyst-monitor/241125/state-led_globalization 3. RGE, Sovereign Wealth Funds Domestic Investments on the Rise, February 11th, 2010. downloadable at: http:// www.roubini.com/briefings/66890.php#96659


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finn tarp

UNU-WIDER to Focus on the Triple Crisis A new research program's focus on finance, food, and climate

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he world is going through a “triple crisis.” The impact of the financial crisis has been deep, its effects are not over, and recent signs of recovery remain tentative. At the same time, over one billion people face hunger, and any recovery in the global economy will once again push up food prices, leading to another spike that will hit the poor hard. If global economic growth does resume, then emissions of greenhouse gases will accelerate once again, while cropland previously used to grow food is now being turned over to biofuel crops, adding to the pressure on global food prices. These crises interact, they demand coordinated solutions, and they potentially threaten peace and stability. Hence our use of the term the “triple crisis.” As a United Nations institute, and the only UN research institute in economics located in the Nordic region, UNU-WIDER is giving priority to the Triple Crisis in its new program, building on its longstanding and international reputation for foundational work in the areas of poverty, inequality, and human development. Climate change is on everyone’s mind in the aftermath of the United Nations Climate Change Conference (COP15) last December. Of particular urgency is the need to understand the implications of development policy of the regional and country-level effects of climate change. To do that, we will be working with the natural sciences to integrate the very best climate change research with our understanding of the economies and societies of poor countries—thereby providing better guidance to strategies and investments for sustainable growth and poverty reduction. Our initial focus in this work will be on sub-Saharan Africa as well as the Middle East and North Africa. We will undertake a thorough analysis of food policy—in particular the responses to the huge and recent run-up in food prices—and propose a new global food architecture to protect the most vulnerable people and meet the challenge of climate change. Our work on finance will focus not only on the regional impact of the crisis—including its implications for policy advice in development economics—but also on the

large changes now underway in global financial flows, both official and private. Of great concern are the implications of the financial crisis for aid policy. Tighter aid budgets will demand sharper priorities to raise the effectiveness of aid, while the climate and food crises will demand new modalities of financing and assistance that are yet to be developed. This is a very demanding agenda. Each crisis is complex in its own right, the crises interact in ways that require innovative thinking, and policymakers face considerable uncertainty and very hard choices—which can be reduced, but certainly not eliminated, by cutting-edge research. We believe that UNU-WIDER can make a significant contribution. UNU-WIDER takes a global perspective, drawing upon its extensive network of researchers from both the developing and developed worlds ranging from Nobel Laureates to young early-career researchers. Our UN status has made us as much an institute of the South as one of the North. We have a track record in the range and depth of the Institute’s research that began 25 years ago when UNU-WIDER was established with the generous support of the Government of Finland. Over the years, Finland, Denmark, Norway, and Sweden have continued to contribute resources and sup-

port, and UNU-WIDER has been able to draw upon the Nordic research community. These give us the capacity and the credibility to help the global community face the Triple Crisis. But we do not underestimate the difficulties of the challenge. When UNU-WIDER began, the world was a very different place: the Cold War was still underway, the Internet was unheard of, and climate change was on nobody’s agenda. The level of interaction in flows of trade and finance, as well as technology and people—which eventually became the present era of globalization—was still in its early stages. Yet, many of the problems we see today were also central to the development debate of a quarter of a century ago: the need to end hunger and poverty and the need to manage economic crises and their social fallout were very much on the minds of the Institute’s founders and researchers at the time. And within UNU-WIDER’s first decade, issues of environment and development came to the forefront, making UNU-WIDER one of the world’s first research institutes to seriously address what has become today the most serious problem facing humanity—how to ensure rising prosperity and diminishing poverty in the context of an increasingly fragile environment. H

Finn Tarp, a Danish citizen, became Director of UNU-WIDER, Helsinki Finland on September 1, 2009. He is also Professor of Development Economics, University of Copenhagen. This article is based on UNU-WIDER Working Paper No. 2010/01 ‘The Triple Crisis and the Global Aid Architecture’ by Tony Addison, Channing Arndt, and Finn Tarp, available at www. wider.unu.edu.

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Wim NAUDÉ

Entrepreneurship, Global Development, and the Policy Challenge The strength and weaknesses of economic entrepreneurship

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lobal disparities in income and wealth are staggering. Almost one and a half billion people are extremely poor in terms of income (Chen and Ravallion, 2008). Global income inequality between countries is high, with the world Gini-coefficient exceeding 0.6 according to all estimates (Hillebrand, 2008). Wealth is even more unequally distributed, with almost half of the richest 10 percent of adults in the world (owning 85 percent of the world’s wealth), living in only two countries: the United States and Japan (Davies, 2008). Vulnerability to man-made and natural disasters is seemingly on the rise (Naudé et al., 2009). More than 120 financial crises have been documented since the 1970s, and the number of natural disasters reported almost doubled between 1990 and 2000. After an initial decline at the end of the Cold War, the number of armed conflicts in the world has also risen in recent years. And climate change casts a long shadow over the prospects of many of the poorest countries, who will according to predictions, suffer the most. In this context, the role of the private sector, and in particular entrepreneurship in global development and vulnerability is receiving increasing attention. There are many good reasons for this. With the fall of communism, the failure of state-led industrialisation in Africa, and the significant albeit gradual reforms towards a private economy in China over the past three decades, de-

velopment and growth are widely seen to be dependent on private entrepreneurial innovation, investment, and risk taking. Of course, economists and other social scientists, going back to Joseph Schumpeter a century ago, have build up a strong conceptual case for why entrepreneurship can matter for economic development. Entrepreneurs provide essential roles in driving the structural transformation from a lowincome, traditional economy to a modern economy by creating new firms outside of the household, absorbing surplus labor from the traditional sector, providing innovative intermediate inputs to final-goods producing firms, permitting greater specialization in manufacturing, and raising productivity and employment in both the modern and traditional sectors (Naudé, 2010; Gries and Naudé, 2010). Unfortunately, entrepreneurship will not always result in these beneficial outcomes. As William Baumol (1990:894) pointed out, “at times the entrepreneur may even lead a parasitical existence that is actually damaging to the economy. How the entrepreneur acts at a given time and place depends heavily on the rules of the game—the reward structure of the economy—that happen to prevail”. Thus, while entrepreneurs may provide useful innovations, such as bringing penicillin to market, they may also provide innovations that retard development, such as inventing and spreading weapons

of mass destruction or collateralized mortgage obligations (Naudé, 2009). Also, while entrepreneurs may contribute to growth by re-allocating production factors to more productive use, they may often re-allocate resources to less-productive use, as was recently illustrated by the extent to which resources flowed into financial assets, creating bubbles and drawing resources from more productive use. Furthermore, although entrepreneurs can provide a “cost-discovery function” to show what an economy is good at producing, they can also illustrate how and where rent-seeking and corruption can pay (Naudé, 2008). And in many contexts, entrepreneurs benefit from conflict and crime and act in ways to maintain their sources of rents and entrench the undesirable status quo (Naudé, 2007). To limit the adverse consequences of entrepreneurship and to tilt the allocation of entrepreneurial talent towards activities with generally beneficial societal consequences require us to know how the reward structure of the economy, as put by Baumol, shapes the opportunities perceived by entrepreneurs and provides incentives and means for them to utilize those opportunities. Given this realization, it is not unreasonable to conclude that the global disparities in income and wealth and the apparent rise in vulnerability to various hazards, may largely reflect the fact that the current reward structure in many countries and the world econo-


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my, as a whole, is not conducive for inclusive, global prosperity. For instance, the global financial crisis has been caused by a whole host of inappropriate incentives that affect behavior throughout the US economy—from house buyers to mortgage retailers to investment banks and rating agencies, not to mention extraordinary high rewards in finance drawing talent towards financial speculation. Natural disasters, such as drought, often wreak more havoc in the form of famine in poor countries, where the incentives are stacked against entrepreneurial farmers to produce and distribute food—these include taxes, inadequate insurance and infrastructure, and exorbitant subsidies enjoyed by farmers in rich countries. Also, while many fatalities from earthquakes can be prevented through building standards, these are often not enforced due to the fact that the reward structure allows entrepreneurs in the building industry to bribe officials and thus circumvent regulations. And armed conflicts and corruption are fuelled not as much by poverty as by natural resource abundance (“lootable” resources, such as oil and diamonds), aid and government expenditure programs, which tempt entrepreneurs to try and expropriate easy rents from these rather than add new value. As far as climate change is concerned, the global reward structure has been such that rich countries have received the most benefits from carbon-intensive growth; however, they have the innovative capacity to reduce emissions and are less likely to suffer to the same extent as poorer countries. As a result, climate change-induced crises may exacerbate global disparities. Thus, the challenge for shared global development and a reduction in vulnerabilities requires us to better understand how institutions, that determines reward structures, relates to entrepreneurship. This has partly been of the objective of a two-year United Nations University World Institute for Development Economics Research (UNU-WIDER) project on “Promoting Entrepreneurial Capacity” (see http:// www.wider.unu.edu/research/projects-bytheme/development-and-finance/en_GB/ entrepreneurship-and-development/). This project studied entrepreneurship and its relationship to development in various institutional contexts, from high-growth innovative economies to economies in armed conflict and stagnation. In a forward-looking paper for the project, Jurgen Brauer and

Robert Haywood argue that, critically for global development, we need to go beyond the narrow confines of the nation-state. As they emphasize, “it is imperative that we recognize that dependence on sovereign states is no longer meeting the needs of diverse societies on Earth. It is not meeting peoples’ needs within the state, nor is it maintaining appropriate relations between and among them, nor does it facilitate effective governance of crucial global issues” (Brauer and Haywood, 2010). Accordingly, they call for non-state “sovereign” entrepreneurs (NSE) that can respond to demands for various (global) goods and services, and have the ability to make and enforce rules globally. Would such NSEs be able to make progress

in providing more effective governance of global challenges? They provide intriguing examples of ICANN and FIFA and ask how and under what conditions such entrepreneurship can arise, how it can be promoted and by whom, and what the relationship between NSE and sovereign states would involve once the former start to pose threats to the perceived “internal matters” of latter. Moreover, the call for NSE implies that institutions not only influence entrepreneurship through its reward structure, but is itself influenced by ‘institutional’ entrepreneurs. Entrepreneurship can be the cause, cure and consequence of global development crises. An exciting and important research agenda remains. H

Wim Naudé is a Senior Research Fellow at the World Institute for Development Economics Research of the United Nations University (UNU-WIDER), based in Helsinki, Finland. References Baumol, W.J. (1990). ‘Entrepreneurship: Productive, Unproductive and Destructive’, The Journal of Political Economy 98(5): 893-921. Brauer, J. and Haywood, R. (2010). Non-state Sovereign Entrepreneurs and Non-territorial Sovereign Organizations, UNU-WIDER Working Paper 2009-09. Chen, S. and Ravallion, M. (2008). ‘The Developing World is Poorer than We Thought, But no Less Successful’, World Bank, Washington DC. Davies, J.B. ed. (2008). Personal Wealth from a Global Perspective. Oxford: Oxford University Press. Gries, T. and Naudé, W.A. (2010).’Entrepreneurship and Structural Economic Transformation’, Small Business Economics Journal, 34 (1): 13-29. Hillebrand, E. (2008). ‘The Global Distribution of Income in 2050’, World Development, 36 (5): 727-740. Naudé, W.A(2007). Peace, Prosperity and Pro-Growth Entrepreneurship, WIDER Discussion Paper WDP 2007/02, United Nations University, Helsinki, Finland. Naudé, W.A. (2008). ’Entrepreneurship in Economic Development’, UNU-WIDER Research Paper no. 20/2008, United Nations University, Helsinki, Finland. Naudé, W.A. (2009). ‘Fallacies About the Global Financial Crisis Harms Recovery in the Poorest Countries’, CESifo Forum, Dec, 4 : 3 – 12. Naudé, W.A. (2010). ‘Entrepreneurship, Developing Countries and Development Economics: New Approaches and Insights’, Small Business Economics Journal, 34 (1): 1-12. Naudé, W.A., Santos-Paulino, A. and McGillivray, M. (2009). Vulnerability in Developing Countries. Tokyo: United Nations University Press.

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Imed Drine

Global Food Crisis and Food Security in Middle East and North Africa Lessons from the 2008 global food crisis

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he food crisis now—and perhaps for many years to come—is foremost among the concerns of the world in general, as well as among all developing countries and the Middle East and Noth African (MENA) countries in particular, as these have a very low sovereignty in terms of food supply. Food prices increased dramatically in 2006 and 2007. This increase was more marked during 2008 when prices reached their highest levels. According to the Food and Agriculture Organization (FAO), the average increase in food prices between 2005 and 2006 was almost 8 percent but peaked at about 24 percent during 2006-2007.

Net cereal imports and food aid in MENA countries (% total consumption) 98-00 Algeria

76.10%

Bahrain

39%

Comoros Djibouti

100%

Egypt

33.70%

Jordan

97%

Kuwait Lebanon

99.60% 88.40%

Libya

89.20%

Food prices, during the first quarter of 2008, were 53 percent higher than the 2007 level. This sharp increase in food prices has had considerable effect on many countries faced with the food deficit problem. Price hikes in the MENA region during 20062007 were, on average, between 21 and 115 percent. Yemen, Bahrain and Tunisia recorded price increases for certain products of 140 percent, 125 percent and 25 percent, respectively1. In the MENA region, rising food prices have taken on a dimension that is quite particular given, first, that a large share of the household budget is devoted to food consumption and second, that food consumption, on average, accounts for more than 50 percent of the household budget (in Morocco, for instance, this share exceeds 60 percent, according to FAO in 2007). In addition, a high proportion of the region’s population lives on the threshold of poverty. The MENA region is one of the most disadvantaged regions of the world with regard to food self-sufficiency. The region is among the world’s most arid areas; diminishing water resources for agriculture and inefficient management of water resources have limited the capacity to feed the region’s own

population. The region is largely dependent on the import of grain, meat, milk, sugar, and oils to meet the consumption needs of its population of 300 million. Food deficits are increasing and reliance on external food sources has become a real constraint for most MENA countries. Consequently, any variations in food prices will have an impact, with possible social instability ramifications. Many countries in the region have already witnessed massive protests following food price mark-ups. In Egypt, for example, where 40 percent of the population live on less than $2 per day, the 500 percent increase in bread prices started riots in April 2008, after which the government allocated US$2.5 billion in new subsidies on bread, banned rice exports, and distributed bread to the poor. Public sector wages also rose by 30 percent. In Jordan, the cost of basic foods increased 60 percent in one year, but luckily the country has not seen a repeat of the 1996 riots, and protests have been more peaceful. In early 2008, the Jordanian government decided to increase public sector wages and to abolish taxes on commodities. Violent demonstrations in Morocco, protesting the higher price of bread, prompted

Mauritania Morocco Oman

54.10% 98%

Qatar

95.60%

Saudi A

72.90%

Sudan Syria

12.80% 21.60%

Tunisia

56.90%

UAE

100%

Yemen Average

76.30% 70%

Source: FAO 2008, World Resources Institute

The region is one of the most food-import dependent in the world


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Distribution of major land uses for the MENA region

Source: FAO (2008)

the government to cancel a 30 percent price increase. Yemen witnessed violent riots after mark-ups on wheat, rice and cooking oil and it is estimated that with rising food prices, poverty could increase on a national level by 6 percent in Yemen. Increases in poverty are also projected for Djibouti (14 percent), Egypt (12 percent) and Morocco (4 percent). Food safety is a recurring problem that is related, in part, to the geographical characteristics of the region. Indeed, according to World Bank, MENA is one of the world’s most water-scarce regions. The region has a total area of about 14 million km2, of which more than 87 percent is desert. It is characterized by a high dependency on climatesensitive agriculture and a large share of its population and economic activities are located in flood-prone urban coastal zones. Furthermore, most people are city dwellers, not desert pastoralists. Despite the overall similarity in climate, the MENA states when examined in detail reveal enormous diversity: there is the frequent juxtaposition of a harsh desert environment and intensively cultivated agriculture land. The Mediterranean countries rely on sparse winter rainfall and short rainy seasons to grow cereals, legumes, and lowyield arboriculture, as well as raise sheep and goats on fragile grazing land. Pasture degradation due to over-grazing, associated with the increasing demand for meat and milk from expanding urban populations has forced farmers to import larger quantities of food and fodder. In the Nile valley, agriculture is based on intensive irrigation. Huge population pressures and lack of rainfall force this region to rely heavily on maxi-

mizing food production per unit of land, which, in turn, increases the risk of salinization, water pollution, and water scarcity. The extremely arid Arabian Peninsula depends almost entirely on crop irrigation but is devoid of any major river systems like the Nile system. Instead, they utilize groundwater from wells, but this water source is being depleted much faster than can be replenished by the limited rainfall. Although this region is sufficiently rich to consider desalinated seawater, it is too costly an option for agriculture. Indeed, the region annually exceeds its supply of water from rainfall and river flows, depleting groundwater resources. Accordingly, the availability of water and subsequent agriculture production are expected to diminish2. By 2025, 80-100 million people in MENA will be exposed to water stress3. By 2050, water availability per capita will fall by 50 percent and there is high potential for food crises due to increasing demand (population) and declining supply factors (precipitation and yields). Indeed, the growing competition for water is expected to reduce the share of agriculture to 50 percent by 2050.

Increased water competition and low productivity have added to the region’s difficulties to feed its growing population. In addition to the harsh environment, the region needs to deal with inefficiency with regard to food crops and productivity that result in particular from impractical farming methods, and weak training and education. Limited opportunities for financing and lending, as well as misguided agricultural policies, have resulted in declining farm output. On the other hand, harsh living conditions in rural areas, due to the paucity of agricultural and rural development, have triggered massive rural–urban migration. As one of the world’s most water-scarce regions with a high dependency on climatesensitive agriculture, the situation in MENA is likely to deteriorate in the future. With less groundwater available for agriculture, the region's dependency on trade deepens. Agriculture in the region, in general, faces difficulties and yields are expected to fluctuate more radically. Accordingly, scarcity of water resources and food security risk are among the future challenges of the MENA region. Agricultural output is expected to decrease by 21 percent by 2008. For countries like Morocco and Algeria; it could drop by roughly 40 percent (Cline, 2007). Moreover, the high salt content in much of the available water further complicates irrigation efforts, limiting the potential for additional development of irrigated agriculture in the region. Coping with the risk of food security will be beyond the capacity of many of the region’s countries and is expected to add new challenges to the social agenda. Deteriorating living conditions of the poor are estimated to revive earlier social tensions and conflicts. It will, therefore, be necessary to introduce an integrated strategy that increases the options for controlling the demand on water resources and for encouraging their efficient usage. H

Imed Drine is a Research Fellow at the World Institute for Development Economics Research of the United Nations University (UNU-WIDER), based in Helsinki, Finland. Endnotes 1. Arab League (2009), The Impacts of Rising in World Food Prices and its Effects on Living Standards of Arab Citizens (in Arabic). 2. United Nations Development Programme and Arab Fund for Economic and Social Development (2009), ‘Arab Human Development Report 2009: Challenges to Human Security in the Arab Countries’. New York: UNDP. 3. Warren, R., N. Nicholls, R. Levy, P. Price, J (2006), ‘Understanding the Regional Impacts of Climate Change: Research Report Prepared for the Stern Review on the Economics of Climate Change’, Tyndall Centre for Climate Change, Research Working Paper 90. 4. Cline, W. R. (2007). Global Warming and Agriculture: Impact Estimates by Country, Washington, DC: World Bank Publications.

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Amelia U. Santos-Paulino

Trade as a Growth Engine for Developing Countries The role of liberalization and specialization

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he creation of the General Agreement on Tariffs and Trade (GATT) in 1947 and the World Trade Organization (WTO) in 1995 are regarded as the foremost driving forces for free trade. Economic events during the 1980s and 1990s, such as the debt and financial crises, also prompted significant structural adjustments in developing countries. The policy changes included the reform of trade regimes by simplifying import procedures, the reduction or elimination of quotas, and the rationalization of the tariff structures. Liberalizing has fundamental consequences that affect the economic performance of countries and welfare within countries. Growing economic integration, part of the wider process known as globalization, has been the result of human innovation and technological progress. The process is reflected in higher trade and financial flows and has also affected the movement of people and knowledge across international borders. Additionally, rhere are cultural, political, and environmental dimensions of globalization beyond international trade in goods and services that merit attention and research. The relation between trade openness and economic growth has been extensively researched, and a smaller set of research on the

impact of liberalization on income inequality and the wage structure in developing countries has emerged.1 Yet the results from these studies are profuse. They also vary in the methodologies, the geographical, and the temporal span. However, we know less about other aspects of liberalization such as the balance of payments consequences of trade liberalization. In what follows, I discuss two lines of work that elucidate mechanisms relevant for trade and development: 1) the relationship between trade liberalization, the balance of payments and growth; and 2) the connections between trade specialization and growth. Trade liberalization and the balance of payments Trade liberalization is expected to promote economic growth by capturing the static and dynamic gains from trade through a more efficient allocation of resources, greater competition, an increase in the ow of knowledge and investment and, ultimately, a faster rate of capital accumulation and technical progress. Barriers to trade in general, and anti-export bias in particular, will reduce export growth below potential. Import controls are likely to reduce efficiency. Research on trade liberalization in devel-

oping countries and its impact on exports, imports, the balance of trade, and the current account of the balance of payments is critical for development and policy. That is, if trade liberalization leads to a faster growth of imports than exports, this can have serious implications for the balance of payments of countries that may constrain growth below the growth of productive potential. Trade liberalization may promote growth from the supply side but, if the balance of payments worsens, growth may be adversely affected from the demand side because the payments deficit resulting from liberalization are unsustainable and not easily rectiďŹ ed by relative price (real exchange rate) changes. That is, while trade liberalization may promote growth from the supply side through a more efficient allocation of resources, it may constrain growth from the demand side unless a balance between imports and exports can be maintained through currency depreciation or deficits can be financed through sustainable capital inflows. Empirical evidence for the case of developing countries that have undergone extensive trade liberalization since the mid1970s shows that export growth has risen following liberalization, but the effect on import growth has been larger, leading to a deterioration of the trade balance of at least 2 percent of GDP, on average.2 The impact on the balance of payments has been less, suggesting that while liberalization may have, in general, improved growth performance, countries have been forced to adjust in order to reduce the size of payments deficits to a sustainable level. The balance of payments crises experienced by a large number of developing countries, for instance in the 1980s and 1990s, has also exposed the extent to which growth rates have been constrained by their balance of payments positions and have come to depend on steadily rising export earnings and capital inflows. In this regard, more attention is needed to analyze not only how trade and exchange rate policies affect the balance of payments, but also how other reforms, such


HARVARD COLLEGE ECONOMICS REVIEW

Export Compostion

as financial liberalization, have influenced the overall balance. Trade specialization, openness and growth Exports—and international trade—are engines of growth and development. Therefore, an understanding of the determinants of exports and trade specialization is key to explaining growth and economic performance. Moreover, the specialization patterns and the increasing higher value added of exports have important effects on productivity and growth and thus have far reaching implications. For developing countries, exports are not only a major source of foreign exchange, but also a channel to new technologies and knowledge spillovers.3 Existing research shows that the array of goods that a country produces and exports is affected by knowledge spillovers and specialization, and that in turn affects economic growth.4 The empiri-

instance electronics, as can be noted in Figures 1 and 2. Consequently, they have experienced higher productivity growth than other economies. The composition of exports and higher sophistication of developing countries’ trade also has significant impacts on factors endowments and the countries’ technological capabilities. The emerging pattern of specialization challenges the traditional assumption that knowledge creation is exclusively the domain of advanced economies. Recent evidence suggests that developing economies rely on skills and knowledge creation to grow and develop. Also, foreign investment in general, and multinational enterprises’ investment in high technology and knowledge creating activities such as research and development (R&D) is concentrated in a few 
 emerging countries, notably Brazil, China, Hong Kong, India, Mexico, Singapore, and South Africa. China, India, and Brazil are currently considered three of the top ten destinations for foreign R&D expansion. This phenomenon is mostly due to the countries’ endowment of low-cost and well-trained scientists and engineers and is supplemented by fast growing domestic markets and increasing FDI in manufacturing.5 What is the way forward? Developing countries have made considerable efforts in restructuring their economies and opening up to world trade. Yet there are further challenges to be tackled. The full impact of economic liberalization cannot be assessed without considering the 
 adjustment implications for specific factors cal evidence further implies that a country’s or groups. Crucial issues related to globalizapattern of specialization and exports could tion include the changes in wages and profits; be as important as openness to international international labor and capital mobility and trade. Leading developing countries such as related changes in global markets and power Brazil, China, and India, have managed to structures; the nature of technical progress increase their presence in more progressive resulting from more openness to trade; and or technologically advanced industries, for the connotations for human capital. H Amelia U. Santos-Paulino is a Research Fellow at the World Institute for Development Economics Research of the United Nations University (UNU-WIDER), based in Helsinki, Finland. Endnotes 1. Goldberg, P. and N. Pavnick (2007), ‘Distributional effects of globalization in developing countries’, Journal of Economic Literature 45 (1), pp. 39-82. 2. Santos-Paulino, A. U., and A. P. Thirlwall (2004), ‘The impact of trade liberalisation on exports, imports and the balance of payments of developing countries’, Economic Journal, 114 (493), F50-F72. 3. Santos-Paulino, A.U. (2010), ‘Export Productivity and Specialization’, World Economy, forthcoming. 4. Hausmann, R., Hwang, J., and Rodrik, D. (2007), ‘What you export matters’, Journal of Economic Growth, Vol. 12, pp. 1-25; and Feenstra, R.C. and S.-J. Wei, Eds (2010), China's Growing Role in World Trade, University of Chicago Press. 5. Santos-Paulino, A. U., M. Squicciarini, and P. Fan (2008), ‘R&D (re)location: A bird's eye (re)view’, WIDER Research Paper (100).

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Kathryn Graddy

A Fishy Market

Price discrimination prevents the development of competitive markets

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conomists have been interested in fish markets for over a hundred years. British economist Alfred Marshall, in his Principles of Economics, which was first published in 1890, used a fish market as one of his primary examples. On the surface, a fish market appears to be perfectly competitive. There are many sellers and buyers, the same type and quality of fish is approximately a homogeneous good, and it would appear that there are no great costs to a fish dealer in entering or exiting a market. Furthermore, search costs are low as dealers at a market are generally located next to each other. Yet, economists have shown that fish markets often do not fit the model of perfect competition. Below, we take a close look at the history and functioning of the Fulton fish market in order to understand why the model of perfect competition does not fit. History The Fulton market was historically located in lower Manhattan—near the Brooklyn Bridge, just a few blocks from Wall Street. The market first opened on that site in 1807 on land donated to New York City, and at first was a general market for both fish and other goods. In 1822 the fish merchants occupied a new Fulton Market building, located on South Street between Fulton and Beekman Streets.

Prior to 1850, housekeepers from Brooklyn and nearby areas would purchase fish directly from the market. However, since that time, wholesale customers were the primary buyers. The market gradually gained importance, and in 1924, the market sold 384 million pounds of fish, about 25 percent of all seafood sold in the United States. However, the relative importance of the Fulton market has declined in recent years because of competing geographic markets such as Philadelphia and the New Jersey docks, and also because of the increasing use of national or regional suppliers. In 2005, less than 5 percent of U.S. seafood sales flowed through the Fulton market. Without a doubt, overnight shippers have increased the market for seafood brokers. This option is available to merchants in the New York area, but many merchants prefer to choose their fresh fish themselves, given the quality and variety that is available at the Fulton market. The Fulton market was located primarily in two open air structures, the “Tin Building” and the “New Building,” in which various dealers rented stalls from the Port Authority of New York with closed offices at the back of the stalls. The New Building was opened in 1939 by Mayor La Guardia after pilings of the old market building gave way in 1936 and the entire building slid into the river.

Not only was the marketplace old and established, but also many of the wholesalers at the Fulton market were well-established firms. For example, the grandfather of an owner of Blue Ribbon Seafood started his business in the very early part of the twentieth century. The traders also had established histories and family ties to the business. In November of 2005, the market moved from the South Street Seaport in lower Manhattan to a large facility built for the market at Hunts Point in the South Bronx. Most of the wholesalers and traders have moved to the New Fulton Fish Market in the Bronx. How the Market Worked at Fulton Street Fish began arriving at the market around midnight. Historically, fish was received at the port of New York City by boat, but subsequently, all fish was brought in by truck or air from other areas. The market was open from three to nine in the morning on Monday and Thursday and from four to nine on Tuesday, Wednesday, and Friday. Teams of loaders transported the fish from the trucks to the stalls by hand trucks and small motorized pallet trucks. Once the buyers chose their fish, the loaders reloaded the fish onto the customers’ trucks. The market had three main sets of players: the buyers who purchase on be-


HARVARD COLLEGE ECONOMICS REVIEW

half of retail fish stores and markets, the wholesalers or dealers at the market, and the suppliers who caught the fish in the first place. A common sight at the market was buyers of tuna for sushi going around and sampling different tuna. The buyers would take a sample, look at the color, rub the sample between their fingers to determine the oiliness and taste it. Buyers who were interested in different varieties of high-quality fish for their restaurant or retail shop were not inclined to leave the purchasing decision to an agent. Conversely, some buyers were happy with fish of a lower quality (primarily fish that were not quite so fresh), if the quality were at least acceptable and they could get the boxes at a cheap price. To determine acceptable quality and negotiate a good price, these owners or their agents would inspect the fish and negotiate the price themselves. In the early 1990s there were 35 wholesalers actively operating in the market. However, not all dealers carried all types of fish—in the early 1990s, for example, there were only 6 major dealers in Whiting. The supply arrangements for the different types of fish differed. Whiting was supplied by fishermen’s cooperatives, packing houses, and smaller fishing boats in New Jersey, Long Island, and Connecticut each day before the market opened. However, the price that a dealer paid a supplier for a particular day’s supply of Whiting was determined at the end of the day by the prices the dealer received for

the Whiting on that particular day. Each supplier serviced multiple dealers. A supplier would refuse to deliver fish to a dealer from whom he continually received a poor price relative to other dealers. In this way, dealers competed with each other for fish supplied in the future by the amount they paid the suppliers for fish on a particular day. One dealer stated that he kept five-fifteen cents on each pound of Whiting sold (although this margin could not be independently verified). Due to custom and the practicalities of loading and unloading fish, the quantity of Whiting received for a particular day was received in its entirety before the market opened. The quantity that each of the dealers received was readily observable by all dealers. If one dealer did not receive what he perceived to be enough Whiting, another dealer would sell him Whiting before the market opened. The price was set not at the time of sale, but toward the end of the trading day. A dealer often had a good idea of the quantity that would be available before the market’s close on the previous day. Quantity supplied was primarily determined by weather conditions. Wind and waves are the greatest determinant of the quantity of fish likely to be caught. Other determinants of supply in the Fulton market were prices in other places such as Philadelphia and the New Jersey docks, and the price received for Whiting relative to the prices received for other fish on days in the recent past. If the price of Whiting was relatively low, fishermen would seek other

types of fish. Anyone can purchase fish at the Fulton fish market, but small quantities were not sold. For Whiting, the minimum quantity that was sold is one box, approximately 60 pounds (except as favors to regular customers). Most of the customers were repeat buyers, but buyer-seller relationships varied. Some buyers regularly purchased from one seller, and other buyers purchased from various sellers. Most buyers followed distinct purchasing patterns. Monday, Thursday, and Friday were big days, but Tuesday and Wednesday were relatively quiet. Whiting stayed sufficiently fresh to sell for at most four days after it was received. However, it was usually sold either the day that it was received or the day after. About half of the time, the total quantity received exceeded total sales. As would be expected, there was a small amount of oversupply as some inventory loss is inevitable in the selling process, especially given the perishable nature of fish. Over 111 days in late 1991 and early 1992, the total quantity received exceeded the total quantity sold by 11,237 pounds, which amounts to about 1.6 percent of total sales. The bulk of this difference consisted of fish that is not sufficiently fresh to sell and is literally thrown out. Most buyers purchased their fish on credit, with charges payable the following week. It did not appear that there was a premium for credit purchases. Interest rate effects were minimal and defaults were generally rare, as buyers were generally repeat customers. Many of the market details are similar at the New Fulton Fish Market in the Bronx. However, some details have changed. For example, the loading and unloading of fish is done very differently, primarily because of better access to the dealer’s stalls. Pricing The Fulton Fish Market had no posted prices, and each dealer was free to charge a different price to each customer. If a customer wished to buy a particular quantity of fish, he would ask a seller for the price. The seller would quote a price and the customer would usually either buy the fish or walk away. Prices were generally quoted in five-cent increments, which can seem quite large, considering the average price was about 85 cents per pound.

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While sometimes the customer would respond with a price that is five cents lower and back and forth bargaining would take place, (.65- .70 -.65 -.70 – and so on), overt bargaining generally only occurred with only a very few large customers. Sellers were discreet when naming a price. A particular price was for a particular customer. Prices at the market varied tremendously. For example, the average price in a Whiting transaction on Friday, May 1, 1992, was $.33/lb., and the average price on Friday, May 8, was $1.75/lb., an increase of almost six-fold. There was often a large decline in price after 7:00 a.m, but the pattern before 7:00 a.m. was not easily predictable. Daily supply shocks, primarily caused by weather, were largely responsible for the high volatility in dayto-day prices. Fish of the same variety at the same point in time can also differ tremendously in price because of differences in quality. Most fish merchants wish to choose the fish themselves, matching the quality of Whiting to the eventual use. Price Discrimination During the early 1990s, about 60 percent of the purchasers at the market were Asian, and sellers quoted lower prices to Asian customers for the same box of fish. The price difference would usually be about five cents, though it could go to as large as 10 cents. Regressions that carefully control for other variables, including time of sale and quality, indicated that whites pay on average 6.3 cents per pound more on each transaction for the same type and quality of fish than do Asian buyers. While quality controls could naturally be imperfect, these regressions were consistent with the observation that the sellers would quote a different price to Asian customers than to white customers for the same box of fish. Why and how could this price difference occur? On the demand side, there was strong anecdotal evidence that Asian buyers were more elastic than white buyers. Asians buyers would resell their Whiting to retail shops which wanted the whole fish, to fry shops which would make fish sandwiches, and to other establishments that would make the fish into fish balls. Most of these establishments were located in very poor neighborhoods. Resellers had little scope to raise the price of Whiting for their ultimate customers. Consequently, they would bargain very hard at the market. Further-

more, some of the Asian buyers purchased their fish at the Fulton market and then resold it in Chinatown. Chinatown has a reputation for being the cheapest place to buy seafood in New York City. Store owners claimed they must keep their prices low due to fierce competition and the fact that their customers cannot pay more. Asian buyers appeared to be more organized than white buyers. The Korean buyers had an active retailers’ organization. Shortly before my time at the market, the association organized a boycott of one of the dealers because he was allegedly shortchanging the pounds of fish included in a box. The dealers at Fulton Street may have recognized that this organized group had more options. In contrast, many white buyers (though not all) had more scope to pass on prices to customers. For example, for the local fish dealer in Princeton, New Jersey, Whiting was a very small part of his purchase; he would spend no time shopping around for price on Whiting. If prices were especially high at the market, he could explain to his customers that fish were expensive at Fulton Street and his customers would often be willing to absorb costs by paying higher prices. Why did the Asian buyers not arbitrage the market, buying low and then reselling to other customers? In all likelihood, it is

very unlikely that either white buyers or Asian buyers actually knew this was happening. Prices were quoted discretely for particular customers. White buyers rarely socialized with Asian buyers and hence communication between the two groups was limited. Imperfect Competition These conditions establish why price discrimination might have been profitable on the demand side. The presence of price discrimination itself establishes that the market was not perfectly competitive. However, why weren’t any extraordinary profits competed away? The structure of the Fulton market for sales of Whiting, at least in the early 1990s, appeared conducive to tacit collusion, rather than perfect competition. Only a small number of dealers at the market (six at the time) carried Whiting. Many of the dealers at the market had been operating for many, many years. Dealers would trade with each other before the market opened. The dealers would price fish on a daily and sometimes hourly basis and would receive feedback from the buyers on other dealers’ prices. Dealers in such a situation could easily become very good at tacit communication. Finally, the presence of organized crime in the market may also have discouraged entry. H

Kathryn Graddy is an Associate Professor of Economics at Brandeis University.


HARVARD COLLEGE ECONOMICS REVIEW

Ray C. Fair

How Well Can Economists Forecast?

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omeone observing weather forecasting and economic forecasting over the past several decades would likely conclude that the former has become more accurate while the latter has not. The boom in the U.S. economy that began in the mid 1990s and lasted until the end of the century was not well forecasted. Nor was the recession that followed, nor was the housing boom that followed the recession, nor was the severe recession that began in June. Macroeconomists build models to explain and forecast the macro economy, just as weather scientists build models to explain and forecast the weather. Why have economists lost out to weather scientists? I leave it to others to explain weather forecasting. My concern in this essay is to explain limits to economic forecasting. Macro-econometric models have equations explaining variables such as consumption, investment, and inflation. An important influence on both consumption and investment is the level of stock prices and hous-

ing prices. In a stock market boom like the one we had in the late 1990s, household equity wealth increases and the cost of raising funds decreases, and this has a positive effect on both consumption and investment. Similarly, in a housing price boom like the one in the 2003—2006 period, household housing wealth increased, which has a positive effect on consumption. Estimated consumption and investment equations show that these effects can be large. Much of the economic boom in the last half of the 1990s can be explained by the stock market boom, and much of the contraction that followed in 2000—2001 can be explained by the stock market fall. Also, much of the 2003—2006 expansion and later contraction can be explained by the large increase and the decrease in housing prices. Turning to inflation, estimated equations show that cost shocks have important effects on inflation. Two main sources of cost shocks are oil prices and exchange rates. Much of the inflation in the 1970s

can be explained by the huge increase in oil prices. Exchange rate changes also effect import prices, which affect costs. For example, a depreciation of a country's currency is inflationary. So both oil price increases and exchange rate depreciations are bad for inflation. Now to the forecasting problem. Stock prices, housing prices, oil prices, and exchange rates are all determined in asset markets. What we know about asset prices is that changes in these prices are essentially unforecastable. The best prediction of what an asset price will be tomorrow is roughly what the price is today. If assetprice changes cannot be forecast and if asset prices have important effects on consumption, investment, and inflation, then consumption, investment, and inflation are not capable of being forecast well when asset-price changes are large. It may be that conditional on knowing asset prices, equations explaining consumption, investment, and inflation in macro models are accurate. They may explain the past behavior of the economy well. But then again, forecasting is another matter if asset prices are not known. My work suggests that of the eight U.S. recessions since 1954, five are driven by unforecastable events and so could not be forecast well. The high inflation in the 1970's was also not forecasted because it was driven by oil price changes . It should be obvious to even the casual observer that the recession that began in 2008 was driven in large part by the collapse of housing prices, which could not have been predicted. This is not to suggest that macroeconomic models are useless. As noted above, conditional on knowing asset prices they can be accurate. This means that policy experiments can yield useful information. Say that a policy maker wanted to know what the macroeconomic effects would be of a stimulus bill to go into effect in 2011. This requires two forecasts . The first would be with no stimulus measures included, and the second would include the stimulus measures. The difference between the two forecast values for each variable and each quarter is the model's estimate of the effect of the stimulus measures on the variable. Each of the two forecasts would be based

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on the same assumptions about asset prices. These assumptions could be way off if, say, there turned out to be a stock market boom that was not predicted, but both forecasts would have made the same error. The difference in the forecast values would not be affected—the errors cancel out. Models are better at answering policy makers questions about how different the economy would be if a particular policy were executed than at answering questions about what the state of the economy will actually be in future periods. The current government budgetary situation in the United States provides an interesting example of asset-market issues. Most forecasts of the U.S. economy have the federal debt as a percentage of GDP rising to over 70 percent by 2020 (from about 35 percent in 2007). I have such a forecast with my macro model, assuming no major tax increases or spending decreases in the future. There is nothing in my model that predicts bad consequences from a rising government debt. The private and foreign sectors simply increase their holdings

of U.S. government debt. This is what has been happening and continues to happen. One would think, however, that the likelihood of negative asset-market reactions to the rising debt would increase as the debt gets larger and larger as a percent of GDP. Possible asset-market reactions are a large fall in U.S. stock prices, a large depreciation of the dollar, and a large increase in interest rates on U.S. government securities due to a perceived increase in the riskiness of the securities. None of these possible assetmarket reactions can be predicted ahead of time. All that one can say is that they may become more likely as the debt rises. It may be that the fear of asset-market reactions leads Congress and the Obama Administration to raise tax rates or lower spending before some reaction actually happens. Or it may be that it takes an actual reaction to trigger such policy changes. I have examined using my macro model the

consequences of a major tax increase or spending decrease. Large tax increases or spending cuts solve the debt problem, but at a cost of lowering output. This may be the price the U.S. government has to pay for getting its budget in control. This result is again where a macro model can prove useful—the consequences of policy changes can be predicted with more accuracy than the actual state of the economy in the future. To end on a note of interest to current Harvard undergraduates, it seems likely during your peak earning years that you will pay higher taxes than are currently being paid by those in their peak earning years. You will in effect pay for the large current government deficits. This may be triggered by fear of asset-market reactions or by actual reactions, but it will probably be triggered in the next ten years. But I can't forecast when! H

Ray Fair is the John M. Musser Professor of Economics at Yale University.

HARVARD C O LLEGE Economics Review would like to thank

The Harvard Institute of Politics The Harvard Undergraduate Council for their generous support of this issue.


Kwon-Yong Jin

The Search for Panacea

The Federal Reserve's TALF and the perils of uncoordinated policy

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tudents of macroeconomics traditionally learn the three basic tools of monetary policy: the Federal Funds Rate, the discount rate, and the reserve requirement. Of the three, the latter two have fallen out of public attention; the last time the Fed instituted a major change to the reserve requirement was 1992 (when it decreased it from 12 percent to 10 percent), and the shifts in the discount rate have been largely dictated by those of the Federal Funds Rate. As such, in recent history the main tool of monetary policy has been the Federal Funds Rate. The Federal Open Market Committee would decide a target Fed Funds Rate to be achieved through a combination of sale and purchase of short-term treasury bonds. During this era, the Fed’s main dilemma was not how to expand or shrink money supply but when and whether to implement these policy decisions. However, the question facing the Fed changed completely when the financial crisis hit in 2008. It was quite clear that the economy was in dire need of an expansionary monetary policy. The problem was not whether to expand money supply but how. With the Fed Funds Rate already at zero bound by early 2009, the Fed could no longer rely on its traditional tools to stimulate the economy.

Thus, the Federal Reserve began a foray into an uncharted territory, establishing lending facilities and other policies so innovative that some even questioned the Fed’s authority to implement them. The Fed rescued financial institutions from the liquidity crisis through the Term Auction Facility, suppressed long term interest rates through the purchase of long-term treasuries, and stimulated the commercial paper market through the Commercial Paper Funding Facility. Fortunately, these programs for the most part succeeded in averting a second Great Depression in the aftermath of Lehman Brothers' failure, helping inject liquidity into the frozen financial market. While the degree to which the Fed’s liquidity facilities contributed to the recovery in the financial market since September 2008 is up to debate, there is little doubt that the Fed contributed to the restoration of financial activity. Yet, the Fed’s partial success in averting a second Great Depression did not mean that it rescued the economy from a recession. The crisis that originated in the housing sector spread to the financial market, decimating consumer lending and damaging the real economy. In order to stimulate lending and support the real economy the Federal Reserve moved from facilities designed to boost liquidity to those that pro-

vided incentives for financial institutions to give out loans to consumers and businesses. Thus came the Term Asset-Backed Securities Loan Facility, otherwise known as TALF. Announced in late 2008, TALF provided loans to investors in exchange for eligible AAA-rated asset-backed securities (ABS)—including those backed by auto loans, student loans, and credit card loans—as collaterals. By providing non-recourse loans in exchange for ABS as collaterals, TALF would stimulate the issuance of ABS, thereby increasing the supply of credit available to households and businesses. With the impending downturn of the commercial real estate market, commercial mortgage-backed securities, both new and legacy, were added to the list of eligible collaterals in mid-2009, expanding the scope of the program. The reason the Federal Reserve chose to focus on the ABS market was simple; it is the bridge between financial markets and the real economy. When a financial institution gives out loans to households and businesses, it packages those loans and securitizes them into an asset-backed security. By pooling illiquid loans into a liquid, tradable security, the financial institution originating this ABS is in effect connecting secondary investors—those who purchase


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the ABS—with borrowers, stimulating investment and consumption. This market exploded in the years preceding the financial crisis, but since 2008 the market for ABS had virtually disappeared due to concerns over default risk. In order to restore activity in the assetbacked securities market and stimulate the economy by increasing the availability of credit, TALF came to the forefront of the Fed’s unprecedented expansionary monetary policy. It formed the backbone of Treasury Secretary Geithner’s PublicPrivate Investment Program, designed to remove toxic ABS from the balance sheets of financial institutions. The Federal Reserve had high hopes for the program, increasing its initial loan limit of $200 billion to $1 trillion in expectation of overwhelming demand for TALF loans. In reality, TALF was not a blockbuster. When it ceased making new loans in late March 2010, it had given out approximately $50 billion of loans, one-twentieth of the loan-limit. Activity in the market for ABS has not picked up significantly, as issuance of new asset-backed securities in 2009 increased only slightly from 2008 and remained much below its pre-crisis level. Total issuance of new ABS in first quarter 2010 amounted to only $34 billion, onefifth of first quarter 2007 level of $178 billion. Worse, the commercial mortgagebacked securities (CMBS) market remains nonexistent, as no CMBS issuance took place during the first ten months of 2009. Given these numbers, it is tempting to characterize TALF as a complete failure. It did not fully accomplish its original mission of stimulating the ABS market and the real economy. As such, many have come up with explanations for the supposed failure of TALF. Some have claimed that the stigma associated with government funding, whether it be from TARP (Troubled Asset Relief Program) or TALF, discouraged firms from seeking TALF loans. Others argue that the bureaucratic red tape and stringent requirements—eligible ABS must be AAA-rated—contributed to TALF’s seeming demise. Yet, to characterize TALF as a complete failure would be to ignore the circumstances under which TALF operated. Lowering the standards for eligible collaterals and abbreviating the review process would have certainly boosted the ABS market further. However, as much as these actions would have decreased the potential

obstacles a TALF borrower would have faced, they would also have increased the risk to the Federal Reserve’s balance sheet. Even in this dire time, the Fed was not in the business of owning risky private assets. Should its balance sheet have taken a hit, the effects on the financial system and the economy as a whole would have been immense. There are also legal barriers to holding risky assets on the Fed’s balance sheet. While a no-holds-barred approach to stimulating the ABS market may have seemed attractive, the risks associated negated the potential benefits of a more active ABS market. Also, to put the effects of TALF in proper perspective, we must understand that there are always two sides in a market: supply and demand. TALF is aimed at increasing the supply, not demand, of credit. Even if it encourages banks to give out loans to households and businesses, slumping demand for credit could handicap the market. Despite signs of an economic recovery, consumer sentiment and business outlook have both been subpar. As of March 2010, the University of Michigan index of consumer confidence was hovering around 70, much below its precrisis level of 80 to 90, and with such low consumer and business confidence, house-

holds and businesses tend to be hesitant to take out loans. Slumping demand for credit, therefore, likely contributed somewhat to the ABS market’s stagnation, creating a difficult condition for TALF. Of course, there is no doubt that TALF did not live up to its expectations. A year after its inception, the economy is still in a recession, and the ABS market is all but frozen. But TALF’s supposed failure does have an important lesson for the monetary and fiscal authorities in the face of this long recession. No policy in itself can be a panacea to a recession. In the aftermath of the debacle in the financial market, the fiscal and monetary authorities devised numerous plans to help the economy from an impending recession. Yet, however effective a policy measure may be, it by itself cannot rescue the economy. Every policy has its limitations—either due to the authority’s mandate or practical considerations. TALF was a well-designed policy measure, but the Federal Reserve’s legal limitations and its one-sided effect on the market hampered its performance. Thus, coordination and variety remain the key principles of economic policy. We cannot expect to recover from this recession by addressing only a part of the economy or using only one tool. H

Kwon-Yong Jin is a freshman economics concentrator at Harvard College.


maria carla chicuen

Breaking the U.S. Embargo The British Leyland in Havana (1963-1964)

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he arrival of the German ship Heinrich Heine, carrying the first 16 British Leyland buses of the four hundred fifty subscribed to Cuba, in the port of Havana the morning of July 15, 1964, meant success to both Leyland and Fidel Castro’s government.1 As the large British automobile manufacturer had secured a multimillion-dollar deal and dealt a blow to other European bidders, the Cuban government had covered a critical gap in its transportation system and provoked another violation of the U.S. embargo. For the British government, this transaction did not seem so evidently desirable. The high level of uncertainty and opposition that permeated negotiations to secure government backing of the sale demonstrated that Britain’s pendulum swung between defending private eco-

nomic interests and protecting its “special relationship” with the United States. Surprisingly, the Kennedy administration might have actually supported the Leyland sale despite the Johnson administration’s later condemnation of the transaction. The Leyland tale is thus not a story of British interest in cordial bilateral relations with Cuba, nor is it evidence that general U.K.-U.S. relations at the time allowed for Britain’s engagement in trade with Cuba with no foreseen negative consequences for the “special relationship.” Moreover, the Leyland case is not an accurate example of the British private sector’s general attitudes toward Cuban markets at the time, nor does it portray Castro’s particular commitment to strong bilateral diplomacy with Britain. Ultimately, the

Leyland case is an example of the normal behavior of a multinational firm seeking profitable business and of Cuba’s simultaneous efforts to fulfill domestic interests in order to advance the goals of the Revolution. These two parallel moves were blessed by their timing. In the second half of 1963, a British government desperate to save a struggling economy in the light of upcoming elections and the Americans’ controversial sale of wheat to the Soviet Union tipped the balance in favor of the deal. In July 1963, Leyland asked British E.C.G.D. for cover on a contract with Cuba involving the purchase of buses and credit for new purchases in the following five years.2 Though Leyland’s proposal came after hearing of Cuba’s needs for transportation, Cuba had independent inter-


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ests in purchasing buses from Britain. In the early 1960s, Cuba’s demand for public transportation increased especially for the rural areas as the government developed projects, such as the literacy campaign, which required the flow of people between the cities and the countryside. The recent American trade embargo had also hindered Cuba’s imports of parts for the island’s fleet of General Motors buses. From the Cuban point of view, it was not irrational to think that Britain specifically would answer the call for trade. In the last few years, the trade balance with Britain had actually increased steadily in Cuba’s favor with the volume of Cuban exports to Britain exceeding Cuba’s British imports. Overall British trade with Cuba had begun to increase in 1962, though British purchases of Cuban exports in general had seen a steady increase starting in 1960. When the British Exports Credit Guarantee Department received Leyland’s request for cover, it had to weigh both economic and political considerations. On the economic side, the British government’s concerns included domestic industrial interests as well as Cuba’s creditworthiness and current foreign exchange position. On the political side, Britain had to test the sentiments of the national constituents and anticipate the reactions not only of the United States, but also of Latin America and N.A.T.O. allies. While

some of these considerations favored making the sale, others did not, splitting the committee in charge of negotiations so that each actor pulled toward its own side, leaving the final decision in hands of the cabinet.3 The economic concerns floated in committee discussions were certainly worth considering. Since the beginning of 1962, E.C.G.D. business with Cuba had been conducted on an ‘Irrevocable Letter of Credit’ basis, which meant that the Cubans paid for goods at the time of shipment; E.C.G.D. cover for the present proposal therefore would have meant a departure from this principle.4 The E.C.G.D. was also apprehensive about the fact that almost half of the 1.6 million pounds from Leyland’s 1959 contract with the Cubans was still outstanding, though payments had been made regularly under this contract, usually with a delay of three to four months. Another concern emerged from Cuba’s lack of foreign currency, a situation that was likely to deteriorate after the recent freezing of Cuban assets by the United States. If Britain’s only considerations had been economic, it is likely that it would not have taken the E.C.G.D. and the government in general so much deliberation to reach a conclusion. The Foreign Office expected opposition from Latin America, most of which had by then already broken

relations with Cuba. The deal would also surely raise suspicions among N.A.T.O. allies, since the E.C.G.D. cover would have been the first of its kind to be extended from a N.A.T.O. member country to Cuba since the end of 1961. Most importantly, there was an overarching fear and absolute certainty that the deal would annoy the Americans. This issue, above all, led the E.C.G.D. to arrive at the following first verdict: “On balance, we are inclined to advise against cover being granted in this case. But since the issue is important enough to be referred to Ministers we should welcome the views of the Committee.”5 The opposition of the Foreign Office might be explained by the stance of Foreign Secretary Sir Alec Douglas Home. Although a desire for better commercial relations with Cuba did not particularly influence British decision-making, the foreign secretary seemed to be especially indifferent toward Cuba. According to Home, “very few took much notice” of Castro’s intentions.6 His autobiography reveals that between 1961 and 1964, Home’s foreign policy concerns focused on Vietnam and on Russia’ activities in Berlin. He accepted that Britain was a medium-sized power, and that playing the role of a big power was not conducive to achieving domestic and international policy agendas.7 According to Home, the political risks of the deal could even damage Britain’s economic interests.8 Given the Foreign Office’s opposition, the actions of the British embassy in Havana in favor of E.C.G.D. credit acquire greater significance. According to the Embassy, a refusal “might jeopardize repayments and prospects of increased export business.”9 In a telegram to the Board of Trade, the Embassy reported that K. J. Maddox, the Leyland representative in Cuba, had returned to Havana to “hold the fort because his company fears that there is a risk that they might lose the order to West European competition.”10 Leyland itself levied decisive pressure on the government. The chairman of Leyland went as far as sending a letter to the chancellor requesting that he persuade the E.C.G.D. to grant cover urgently. Just a few days before the final decision was reached, Maddox sent a cable to Britain in which he revealed talks conducted between Transimport and the president of Ikarus Hungarian bus manufacturers after a Hungarian commercial


HARVARD COLLEGE ECONOMICS REVIEW

delegation arrived in Cuba on September 12. On September 19, the British embassy in Havana warned the Foreign Office that, in the light of foreign competition, a decision must be made urgently in order to win the contract.11 Evidence suggests that the combined pressure exerted by Leyland and the British Embassy in Havana led the cabinet to make a time-sensitive decision. On the same September 19, Douglas Home, Board of Trade President Reginald Maudling and Board of Trade Minister Alan Green met one last time before transferring the matter to the ministers. The main political objection was still the concern that the Americans would react poorly to the deal. Nonetheless, Maudling and Green recommended the extension of credit to Leyland, whereas the Foreign Office held firm to its position.12 On the other side of the Atlantic, that same day, Kennedy communicated to the Export Control Review Board that he approved its recommendations for an expansion of trade with the Soviet Union, but added that “in giving this approval I should like to have it understood that I am strongly in favor of pressing forward more energetically than this report and its recommendations imply, in our trade with the Soviet and Eastern bloc.”13 At the cabinet’s last meeting on September 24, the president of the Board of Trade accepted that the U.S. government would likely oppose this transaction for political reasons, but he saw no economic reason to treat Cuba less favorably in terms of credit guarantee than various other countries. Its balance of payments was no worse than other countries that engaged in trade with Britain, and her annual earnings of convertible currency, estimated at about 65 million pounds, “were substantial in relation both to the installments that would be due under the contract now in question and to her trading debts on which repayments were being made. Moreover, there was keen foreign competition for the present order.”14 Douglas Home, speaking on behalf of the Foreign Office, dismissed the severity of competition and maintained that U.S. assistance to Britain should not be jeopardized “at a time when we were particularly dependent upon their support and assistance for the protection of our interests in Indonesia.”15 However, Home did not completely reject covering the sale, settling for the contract at is-

sue to be financed on cash terms. After accepting that E.C.G.D. cover would be based on commercial criteria and would not be regarded as equivalent to a government subsidy, the cabinet agreed that the Export Credit Guarantee Department might provide cover to Messrs. Leylands Ltd.16 Surprisingly, the British government delegation’s visit to Washington just a few days after the final cabinet meeting revealed that U.S. concerns about AngloCuban trade focused on British shipping to Cuba—not so much on the goods being shipped. By 1963, about one-sixth of all ships calling at Cuban ports were British, the great majority of which were engaged not in Anglo-Cuban trade, but in the carriage of goods between Cuba and the Soviet bloc under charter arrangements. Existing legislation did not grant the British government control over the operation of these ships, and the government was “opposed in principle to assuming such powers in peacetime.”17 When the president asked Home if the British government could do anything about the situation, Home did not give any promises; solving the matter would require legislation. It

was only in passing that he mentioned the U.K. negotiations with Cuba for the sale of some buses.18 President Kennedy finally took notice of the Leyland deal just four days after his meeting with Douglas Home. On October 8, Ambassador Ormsby Gore reported that the president had called him and asked that the British government make an announcement about the sale of American wheat to Russia in the next day or two. Kennedy feared that his opponents would say that the British had only gone ahead with the sale of buses to Cuba after the Americans had set an example by their wheat sales to Russia. Though the negotiations between Leyland and the Cuban government had not yet concluded, the British promised Kennedy that they would let the news leak in London that the British government had raised no objection to the sale and that it was a normal commercial transaction. Since “all that was necessary from the president’s point of view was that it should be clear that the British Government’s decision had been taken before his own decision to sell wheat to Russia,”19 one can assume that Kennedy was not personally opposed

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to the Leyland deal and that the U.S. government did not present any objections to the British government while negotiations were carried.20 Although primary documents drafted at committee and cabinet meetings on the Leyland issue only make reference to political and economic considerations directly related to Britain’s foreign policy toward Cuba and the United States, it is worth considering a number of domestic factors that certainly created favorable conditions for the Leyland sale, even if they did not directly influenced the British government’s decision to allow it. It was a historical tradition, for example, that the British government preferred dealing with governments. Because state agencies generally had good credit and E.C.G.D. cover was given on the basis of risk, Cuba had a significant starting advantage.21 Furthermore, it was Britain’s policy to maintain relations with Communist countries, save for strategic concerns, on a commercial basis. Since Cuba’s balance of payments prospects were no worse than those of some other countries to whom Britain was extending credit at the time, and the Cubans had conscientiously been

paying off previous debts to suppliers in Britain, Cuba was not to be dismissed as a potential trading partner based on its creditworthiness.22 The increase in sugar prices meant that Cuba could afford to pay Leyland; as such, the Leyland sale also represented a potential opportunity for Britain to restore its trade balance. From the perspective of the national economy, there were also important reasons to maintain a high level of commercial vehicle exports. Competition in the European auto industry was reaching new heights. The British, along with the Germans and Italians, were now devising ambitious investment plans in the motor industry in order to compete with the French, who were industry leaders. Furthermore, Britain’s recent entrance into a stage of commercial liberalization after the Kennedy Round of General Agreement on Tariffs and Trade (G.A.T.T.) negotiations begun in 1963 made the country even more susceptible to restrictions in trade. For the first time in British history, there was “official” economic advice, which viewed international competition as crucial to fostering domestic efficiency.23

The British government’s receptiveness to Leyland’s request becomes more rational when one appreciates the level of influence that business exerted upon the government, especially upon the incumbent Conservatives. From 1961 to 1963, the government had sought consultation from individual business leaders regarding entrance into the European Economic Community (E.E.C.). These leaders eventually formed one of the most important sectors of the British political community promoting the cause, producing pamphlets, publishing articles in their journals, and organizing conferences.24 It is not surprising, then, that the Conservative Party was financed largely by business. Many of the members of the House of Lords, including the chairmen of Leyland and Shell, were important business figures. The explosion of provocative headlines that made the covers of all major newspapers in the United States, Cuba, and Western Europe when the Leyland sale was announced to the public justified the careful deliberations of the British government. Headlines such as “Quest for Profit Thwarts Policy: Sale of Goods to Communists Shows Dangerous Lack of Allied Unity”25 and “British Aid to Castro”26 fueled negative public opinion. Such frenzy led to a wave of obsessive rationalization from the British government that contrasted with the high level of uncertainty that had characterized committee negotiations but that was seen as necessary to placate the interrogations of the media, the U.S. government, and the world at large. On one side, the government communicated that controls on Cuba should seek to limit its military capability, not its industrial growth. In the meantime, the Foreign Office would explain the decision to grant cover “in the light of current information about Cuba’s convertible currency earnings.”27 Another common argument developed out of buses’ exclusion from the Coordinating Committee for Multilateral Export Controls (CoCom) list—a list of export controls of goods to Soviet bloc countries. Because buses did not constitute strategic goods, Cuba should be treated no differently from the European Soviet bloc in trade matters.28 This was an ex post rationalization. After all, for a while it had seemed that the government would reject the Leyland request. Even though Kennedy had expressed no objections to the Leyland sale, the


HARVARD COLLEGE ECONOMICS REVIEW

Johnson administration’s response to hysteria in Washington took the form of strong diplomatic pressure on Britain to rescind the deal. As Kennedy had feared, the British government’s stance was bolstered by the U.S.-U.S.S.R. wheat deal, which strengthened “[the British] hand for resisting American pressure.”29 The U.S. government had not only agreed to sell wheat to the Soviet Union, but it had also provided that the wheat be carried to the Soviet Union in American ships, a provision “inconsistent with the State Department’s attempts to persuade us that British ships should withdraw from the Cuban trade in order to put greater strain on Soviet shipping resources.”30 Kennedy had called the deal “a hopeful sign that a more peaceful world is both possible and beneficial to all” and, indeed, the Agriculture Department would announce it as “the biggest sale of American wheat in American history.” 31 On August 2, 1964, when Leyland buses went into service, crowds in Havana lined the streets and applauded as Sir Leyland passed by, perhaps sensing that the event marked the beginning of a stronger Anglo-Cuban commercial relationship. Despite U.S. threats, Transimport signed a contract with Leyland on January 6, 1964 to supply 400 urban buses for $11.2 million and spare parts for more than $1 million. Both the Cuban government and Leyland had successfully persuaded the British government that the deal would be beneficial for the national economy, and the Americans’ apparent indifference toward the sale after Douglas Home briefly informed Kennedy had surely brought relief to the British. Other private British firms such as English Electric were motivated by Leyland’s enterprise, and their interest in Cuba served to enhance Cuba’s own commitment to increasing trade with Western Europe. The commercial breakthrough, however, would not be complete, as some British shipping companies actually refused to carry the Leyland buses to the island. Ironically, private business interests in Britain would prove more accommodating to U.S. policy than the British government itself in the matter of trade with Cuba. At a speech delivered on May Day at the Revolution Plaza, Fidel Castro said that Cuba promoted a policy of long-term agreements. According to Castro, Britain’s defense of freedom in trade was a

question of principle: Of course Britain is in a pre-electoral period, and it is in British politicians’ interest to defend all of these problems related to free trade, because the people that elect British policymakers are precisely the British, and Britain is concerned with British interests.

Why would they care about the anger of Mr. Johnson and Mr. Rusk?32 A group of Leyland workers had attended May Day. Two of them made headlines when they said to the press that they would not be satisfied until “our country does something like Cuba.”33 H

Maria Carla Chicuen is a senior history concentrator in Mather House.

Endnotes 1. “Llegan hoy los primeros Leyland." Revolución, July 1964: 1. 2. Her Majesty’s Treasury Export Guarantee Committee, Note by Export Credits Guarantee Department, 9 December 1963, TNA: PRO AK1154/38. 3. The Treasury, the E.C.G.D., the Foreign Office, the Board of Trade, and the Bank of England constituted the Committee, though the opinions of the British embassies in Washington and Havana also influenced negotiations. 4. E.C.G.D. Cover for the Sale of Leyland Buses to Cuba, From the Treasury to the Export Guarantee Committee, 13 August 1963, TNA: PRO FO371/168197. 5. E.C.G.D. Cover for the Sale of Leyland Buses to Cuba, from the Treasury to Export Guarantee Committee, 13 August 1963, TNA: PRO FO371/168197. 6. Alec Douglas Home, The Way the Wind Blows: An Autobiography by Lord Home (London: William Collins Sons and Co Ltd Glasgow, 1976), 147. The author’s absolute omission of both the Cuban Missile Crisis and the Leyland controversy is puzzling given his active participation in the resolution of both events, first as foreign secretary and later also as Prime Minister. 7. Ibid., 168-84. 8. From Douglas-Home to du Cann, 16 September 1963, TNA: PRO FO371/168195 AK1152/14. In contrast with Douglas Home, Labor Party candidate Harold Wilson was a top class economist who was very close to leading business figures and who believed in a direct role of government in support of business.Moreover, he was in favor of deals with the Soviet Union (Paul Hare, e-mail message to author, February 26, 2010). 9. Inward Telegram from Embassy in Havana to Board of Trade, 30 August 1963, TNA: PRO AK 1154/19. 10. Ibid. 11. Watson to Foreign Office, 20 September 1963, TNA: PRO FO371/168195 AK1152/15, 271. 12. Internal Minute “Leyland Buses for Cuba” by Slater, 19 September 1963, TNA: PRO FO371/168198 AK1154/32, 269. 13. U.S. Department of State, Foreign Relations of the United States, 1961-1963, Vol, IX, Foreign Economic Policy (Washington, DC: GPO, 1995), 740. 14. Conclusions of a Meeting of the Cabinet held at Admiralty House, 24 September 1963, TNA: PRO CAB128/37 C.C. (63) 57th Conclusions. 15. Ibid. 16. Ibid. 17. Foreign Office to certain Her Majesty’s Representatives, 13 December 1963, TNA: PRO AK1152/46. 18. Ibid. 19. Ibid. 20. I have not found enough evidence to argue that President Kennedy was explicitly in favor of the bus deal, or that the bus deal inspired him to approve the wheat deal.However, I have also not found enough evidence to argue that President Kennedy opposed the bus deal. 21. Paul Hare, Interview with the author, Boston University, 18 September 2009.See Table 1, which shows that the price of sugar increased in the early 1960s, especially in 1963, reducing fear of Cuban non-payment. 22. Ibid. 23. Ibid., 45. 24. Neil Rollings, British Business in the Formative Years of European Integration, 1945-1973 (New York: Cambridge University Press, 2007), 139. 25. David Lawrence, “Quest for Profit Thwarts Policy: Sale of Goods to Communists Shows Dangerous Lack of Allied Unity,” Star, January 15, 1964. 26. “British Aid to Castro,” Chicago Daily News, February 17, 1964. 27. From Foreign Office to Washington, 7 October 1963, TNA: PRO Telegram No. 9917. 28. Kenneth Aaron Rodman, Sanctions Beyond Borders: Multinational Corporations and U.S. Economic Statecraft (Lanham: Rowman and Littlefield Publishers, Inc., 2001), 51. 29. British Shipping to Cuba, 14 November 1963, TNA: PRO AK1121/162. 30. Ibid. 31. "The Great Trade Muddle," Saturday Evening Post, March 14, 1964, 82, http://search.ebscohost.com. 32. “Discurso pronunciado por el comandante Fidel Castro, primer ministro del gobierno revolucionario y primer secretario. El primero de mayo, en conmemoración del dia internacional del trabajo,” Noticias de Hoy, May 2, 1964, 4. 33. Quoted in letter from I. J. M. Sutherland, British Embassy, Washington D.C. to J. M. Brown, Esq., American Department, Foreign Office, 7 May 1964, TNA: PRO AK1153/136.

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book review

Too Big to Fail

N

ew York Federal Reserve chair Timothy Geithner, not having been accustomed to waiting in line for a taxi for years, sheepishly asks his assistant to cover his cab fare en route to testifying before the Senate Banking Committee on the deal that saved Bear Stearns. Lehman Brothers CEO Dick Fuld struggles with jet lag as he hurries back to the office to manage the wild rumors floating about his firm’s financial position. Federal Reserve chairman Hank Paulson retches violently behind the safety of his office’s closed doors after a day of exhausting negotiations with the legislative branch on the $700 billion bailout bill. And nine of the most powerful men in finance consent to travel to Washington at a moment’s notice, unaware beforehand that they are about to be strongarmed into accepting government capital to encourage stability in the financial system for the national good, a move upending long-time rules of engagement between the public and private spheres. These episodes—these seemingly trivial flashes of vivid description and masterful storytelling—shine through the 624 pages of “Too Big To Fail,” a blow by blow account of the failure of storied investment bank Lehman Brothers. Andrew Ross Sorkin, chief mergers and acquisitions reporter and financial columnist for The New York Times, draws upon skills and sources developed over more than a decade of financial journalism experience to reconstruct Lehman’s final days. Tracing the conversations of each of the major players in the days of crisis, when the fear was all too real that each Monday morning would see another bank go under, Sorkin reveals not only the reasoning behind some of the momentous decisions made during this time,

but also a myriad of paths not taken. The end of this saga sees the emergence of a new financial paradigm, though the book makes it too clear that the course of events could have easily gone a different way. Sorkin glosses over the causes of the financial meltdown, making little effort to hypothesize as to how Lehman reached the point of no return or why the entire financial system came to a standstill so rapidly. This is not a book for readers who want answers to these profound questions. If anything, Sorkin emphasizes the human element of the crisis to the detriment of rigorous economic theory. With such a fascinating cast of characters, though, “Too Big To Fail” makes up for what it lacks in economic substance with sheer dramatic tension. Above all else, Sorkin excels at conveying the enormity of the task at hand—the race to save the banks—and the passion with which the various actors tackle it. But the most compelling picture that Sorkin paints is one of human weakness, a culpability bred in a world where everyone at some point has no idea what is going on. (To digress, several CEOs and top government officials express this sort of confusion at various points, which casts doubt on their abilities to lead their respective institutions). There are no heroes but also precious few villains in this version of the story—just a group of men and women who more or less tried their best, lost control of the rapidly deteriorating situation, and wondered, befuddled, how it came to be that good intentions just weren’t good enough. —Athena Jiang is a junior economics concentrator in Pforzheimer House.


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HCER Spring 2010