Milken Institute Review Q4

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Fourth Quarter 2010


Sorceror’s apprentice or savior?

The Milken Institute Review • Fourth Quarter 2010 volume 12, number 4 the milken institute Michael L. Klowden, President and CEO Michael Milken, Chairman publisher Joel Kurtzman editor in chief Peter Passell art director Joannah Ralston, Insight Design

the milken institute review advisory board Robert J. Barro Jagdish Bhagwati George J. Borjas Daniel J. Dudek Georges de Menil Claudia D. Goldin Robert Hahn Robert E. Litan

managing editor Larry Yu

Van Doorn Ooms

Burton G. Malkiel Paul R. Portney Stephen Ross

The Milken Institute Review is published quarterly by the Milken Institute to encourage discussion of current issues of public policy relating to economic growth, job creation and capital formation. Topics and authors are selected to represent a diversity of views. The opinions expressed are solely those of the authors and do not necessarily represent the views of the Institute. Requests for additional copies should be sent directly to: The Milken Institute The Milken Institute Review 1250 Fourth Street, Second Floor Santa Monica, CA 90401-1353 310-570-4600 telephone 310-570-4627 fax Cover: JT Morrow

May 2– 4, 2011 • Los Angeles

Gary S. Becker

design assistance Linda Provost

ISSN 1523-4282 Copyright 2010 The Milken Institute Santa Monica, California


Insightful Inspiring Indispensable

Isabel Sawhill Richard Sandor Morton O. Schapiro

Today’s volatile markets and complex

John B. Shoven

challenges demand innovative thinking.

Robert Solow

That’s exactly what you’ll find at the 2011 Milken Institute Global Conference, where international leaders tackle the biggest challenges in energy, finance, philanthropy, health, government and education. With renowned speakers and an influential audience, Global Conference sells out every year. Tickets are in short supply, but the wisdom you’ll gain is unlimited.

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2 from the president 3 editor’s note

5 trends

North Korea’s end-game. by Robert Looney

14 charticle

The race-generation gap. by William H. Frey


book excerpt

Zombie Economics John Quiggin on dead ideas that hobble us.

90 institute view

Hollywood melodrama. by Kevin Klowden, Anusuya Chatterjee and Candice Flor Hynek

95 institute news 96 lists

16 resistance is fruitful

The case for bioengineered crops. by Matin Qaim

28 gold

A distraction or a warning? by Christopher Meissner

38 bursting the bubble Fixing what ails housing. by Lawrence J. White

48 overcoming myopia

After BP. by Howard C. Kunreuther and Erwann O. Michel-Kerjan

58 water woes


Markets can save us. by Gary D. Libecap

page 48

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from the president

This month, the Milken Institute hosts its 12th State of the State Conference, an annual event that focuses on the future of California. It’s no secret that the Golden State has lost some of its luster in recent years, thanks to an increasingly dysfunctional state government, a high cost of living, a struggling K-12 education system and other woes that have been amply aired in the media. Several years ago, that formidable list inspired us to establish the California Center within the Milken Institute. Its mission is to analyze the state’s economy and to make recommendations to policy leaders and the business community on ways to ensure that California is once again a model for the nation. With Sacramento locked in its annual summer ritual – the supercharged partisan budget battle that may not even be resolved by the time you read this – we felt it was time to look for some new solutions that would untie this Gordian knot. We have asked some of the state’s most respected leaders, from business executives to elected officials, to offer their best ideas for restoring California’s promise. With assets that are the envy of the world – everything from great research universities to technology clusters to the entertainment industry to abundant natural resources – surely we can find a way to break out of this malaise. We’ve collected the ideas that we solicited on a Web site: There you’ll find video of dozens of interviews in which experts outline ways to get the state back on track. We hope you will join the discussion – comments are welcome on the Web site. Why should we care about California? If it were a country, it would be the eighth-largest economy in the world. The ideas and trends (both good and bad) that take root here have a way of spreading. As California goes, so goes much of the United States – and perhaps the world. It’s going to take political will and no small measure of courage to restore the state to its former glory. But it can be done. Indeed, if America is to thrive, it had better be done.

Michael Klowden, President and CEO


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e d i t o r’s n o t e

JG ofPassadumkeag, Maine writes to ask whether we’ve ever considered moving

©dave & les jacobs/age fotostock

the Milken Institute from California to Lake Wobegon. Silly JG. Lake Wobegon is entirely a product of imagination. By contrast, California, where all the important news is about Lindsey Lohan and all the state’s budget woes will be cured by the next governor, is realitybased. Speaking of reality, check out this very real preview of the articles awaiting you in the pages to follow. Matin Qaim, an agricultural economist at the University of Göttingen in Germany, examines the benefits – and stunning potential – of genetically modified crops. GM crops “can increase productivity in agriculture, ensuring the availability of cheap food and other crop-based raw materials for a growing population with rapidly rising economic expectations, even as the non-renewable natural resource base dwindles,” he writes. And they “can reduce the negative environmental footprint of agriculture by reducing the demand for fossil fuels, toxic chemicals and water. “Indeed, the biggest challenge posed by genetic modification is how to create a regulatory framework that provides reasonable public oversight but resists the understandable impulse to curb progress linked to these technologies.” Chris Meissner, an economist at the University of California (Davis), revisits the gold standard in search of a way to reduce the global economy’s dependence on the green-

back. “The gold standard functioned reasonably well in a simpler time in which the handful of rich industrialized nations that ran the global economy was able to make common cause to bring the system through periods of stress,” he concludes. “Today’s policymakers won’t lock themselves into a similarly rigid system in an era in which the forces driving the global economy are changing rapidly. Replacing today’s messy

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and far from adequate system with a standard linked to gold (or some other commodity) is just not an option.” Larry White, an economist at NYU’s Stern School of Business (and a former mortgage regulator), dreams of the day Washington eliminates virtually all the subsidies – and, with them, much of the waste and volatility – from the market for housing. “Housing finance can’t be reformed overnight,” he concedes. “But the experience of the last few years (in which housing played a key role in triggering a terrible global recession), and the likely experience of the next few (in which the need for deficit reduction will be hard to ignore), could serve as the opening.” Bob Looney, an economist at the Naval Postgraduate School in California, ponders the future of North Korea at a time when its economy is imploding and its dynastic leadership is in flux. “Ironically, no one (with the likely exception of the great majority of North Koreans) is eager to see North Korea collapse,” he writes. “China doesn’t want a flood of refugees; many South Koreans fear the consequences of the economic dislocation. And nobody wants to face the increased prospect of military conflict during the transition, especially now that the North has nuclear weapons. This doesn’t mean that the economy (and the government) won’t collapse one day. But the push will probably have to come from within.”


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Howard Kunreuther and Erwann MichelKerjan of Penn’s Wharton School of Business analyze the sources of myopia that contributed to the BP oil spill and other catastrophes. “Human nature is ... human nature,” they acknowledge. “We cannot expect policymakers, investors, business executives and homeowners in the position to influence disaster mitigation to act rationally without a financial nudge and/or clearly enforced obligations. Nor is it enough to wring our hands and talk loudly after each fresh outrage. We need to give people tangible incentives to do the right things.” Gary Libecap, an economist at the University of California (Santa Barbara), examines the colossal failure of the market to allocate water efficiently in the increasingly arid American West. “In an economic culture that generally bows to the goddess of property rights,” he writes, “one might have expected that excess claims on existing water would have forced a clarification of rights, followed by the use of market pricing both to encourage conservation and to reallocate water to those who value it most. Indeed, just this sort of institutional evolution took place in the West with hard-rock minerals, oil and gas, timber and land. Yet that process is only beginning, and it is by no means certain that the market will come to the rescue.” And, of course, we couldn’t resist packing in more, more, more. The Institute’s Kevin Klowden, Anusuya Chatterjee and Candice Flor Hynek summarize their research on how to save Hollywood from encroachment by Vancouver (and New York City and North Carolina). Institute demographer Bill Frey offers some troubling numbers on the race/ generation gap. And in an excerpt from his new book, Zombie Economics, John Quiggin demolishes the myth of trickle-down growth. Happy perusing. — Peter Passell

jonathan twingley

e d i to r ’s n ot e

trends by robert looney

North Korea has been both a puzzle and an irritant to the international community for more than half a century. This highly secretive autocratic state possesses nuclear weapons, yet it depends on handouts to stave off mass famine. And just when it seems to be inching toward a more rational relationship with its neighbors, an incident like the March 2010 sinking of a South Korean navy ship, Cheonan, reminds the outside world about how little it knows about how North Korea

©jo yong-hak/reuters/corbis

makes policy decisions. This outlaw behavior has typically met with international outrage and high-minded demands that North Korea be held accountable. In the end, however, the United States and the major regional players – China, Japan, South Korea and Russia – conclude they have little to gain and much to lose from confrontation. Sanctions are watered down, and North Korea hints that it could be bribed to refrain from further bad behavior. This time around is probably no different. But the stakes seem especially high because the economy – and the regime that has managed it so badly – once again seem to be teetering. There has been much speculation not only about the succession, but also about the ability of North Korea’s ruling gang to survive. Since the demise in 1994 of Kim Il-Sung (Great Leader, who had led the country since 1948), observers have periodically predicted B ob Lo o n ey teaches economics at the Naval Postgraduate School in California.

Fourth Quarter 2010


the sudden collapse of the government in the face of rumors that Kim Jong-Il (Dear Leader, who succeeded his father) was in failing health. However, as the regime has survived economic crisis after crisis while maintaining one of the dozen largest conventional military establishments in the world, such predictions have become increasingly guarded. Optimists believe that concessions to North Korea (combined with pressure from China) can mute its rogue tendencies. Pessimists point to a long history of abominable behavior, from the bombing murder of most of the South Korean government’s cabinet in 1983, to its massive currency-counterfeiting and cigarette-smuggling operations, to its use of Japan as a missile-testing range. They insist that only relentless pressure through comprehensive economic sanctions will modify the country’s belligerency. Both camps, however, agree that progress in the economic and security arenas go hand in hand. Economic liberalization would improve economic performance and give the regime a bigger stake in the community of nations. By contrast, a retreat into ever-greater rigidity would put China, South Korea and Japan at greater risk of fallout – figurative and literal. A big question, then, in assessing North Korea’s impact on the region is how the economy will evolve in coming years.

organized crime Korea was a colony of Japan from 1905 until the end of World War II, and the North was briefly under the direct control of the Soviet Union thereafter. So the history of an independent North Korea really only begins in 1948. It is relatively well endowed with minerals, including coal and metal ores, though conspicuously lacking in oil and natural gas. By contrast, it has little arable land and highly 6

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variable weather – a glaring weakness because the leadership is committed to self-sufficiency in food. The work force is literate, and there seem to be no fundamental cultural barriers to making it far more productive. But as long as the economy is so poorly managed, the question is moot. Handicapped by infrastructure and industrial capital stock that are hopelessly out of date, GDP per capita is a miserable $1,900 annually in purchasing power terms – less than that of Sudan, Laos or Cam-




bodia, and only a tad more than Chad. The impact of adherence to a philosophy of extreme self-reliance, combined with flatfooted central planning, has been devastating. From 1995 to 1998, famine killed as many as one million people. Even in the best of times North Korea operates its obsolete manufacturing sector at only a small fraction of capacity for lack of fuel and spare parts. Meanwhile, the leadership’s obsession with top-down control denies the economy the benefits of relatively cheap modern technologies. Mobile

Fourth Quarter 2010


trends phones and Internet access are forbidden to all but the elite, and radio and television sets are manufactured to receive only government stations. Unauthorized travel within the country is banned. Large segments of the population live in extreme deprivation. Goods available to a vast majority of North Korea’s 23 million citizens are mainly agricultural products – the sector employs about 40 percent of the population. The bulk of the country’s very limited resources go to maintaining a supersized army, developing and producing nuclear weapons and missile delivery systems, and providing a decent standard of living for the political and military elite. Military control of so large a share of the nation’s resources – between 15 and 30 percent of GDP – stemmed from Kim Jong-Il’s early priorities. Instead of following China and other communist states toward market-based reforms after the death of the nation’s patriarch, Kim Jong-Il invested heavily in the care and feeding of the military as a means of stabilizing his power. This strategy, dubbed “military-first politics” by Dear Leader himself, offered the bonus of protecting the regime against foreign threats, both real and imaginary. Kim put forth an ingenious public rationale for this approach, turning the traditional “guns versus butter” trade-off on its head. He argued that defense would serve as the leading sector to spur development in other sectors – even in agriculture and light industry. This isn’t quite as dumb as its sounds: in the post-Mao period, China permitted its armed force to develop its own diversified industrial base, which arguably served as an intermediate step toward market-based decentralization by giving the officer corps a direct interest in industrial productivity. But there isn’t a shred of evidence that the approach has


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worked in North Korea. Another leg to Kim’s strategy for regime survival is what Charles Wolf of Rand calls the “court economy,” a patronage system of sorts that funnels consumer goods to the nation’s bureaucratic elite in return for support and a sense of legitimacy. Yet a third leg is the regime’s organized-crime strategy in economic dealings with the rest of the world, which Kim uses to pay for the first two. After defaulting on international debt in the 1970s, North Korea was frozen out of foreign capital markets and came to rely increasingly on illicit activities like drug trafficking, currency counterfeiting and insurance fraud to generate foreign exchange. Such crime-forprofit activities are reportedly orchestrated by a special office under the direction of the ruling Korean Workers Party. It is a surprisingly sophisticated operation, equal to the best of organized crime elsewhere. Indeed, there is considerable evidence that some of these activities involve complex transnational relations with various rogue-state and criminal networks. North Korea’s “rent seeking” also includes extortion: international payments for “protective services” – mainly promises to refrain from aggressive actions like the development of nuclear weapons and missile delivery systems. Payments often take the form of foreign aid in hard currency or commodity deliveries of fuel or food. Overall, the scale of this activity has been sufficient to provide a relatively comfortable life for North Korea’s elite in the midst of economic ruin. Unless things change drastically, the fortyfold GDP disparity between South and North Korea can be expected to widen because of the vicious circle in which the North has become entrapped. The circle begins with the country’s economy in which state-planned and managed operations are inherently inefficient, a military-first policy drains resources

The bulk of the country’s very limited resources go to maintaining a supersized army, developing and producing nuclear weapons and missile delivery systems, and providing a decent standard of living

north korea picture library/alamy

for the political and military elite. from potentially productive sectors and the elite must be kept in the style to which it has grown accustomed. The resulting scarcities, in turn, prevent the country from improving infrastructure and investing in modern equipment, which leads to further deterioration in industrial and agricultural productivity. Low agricultural productivity leads to malnutrition, which diminishes labor force productivity. And since the elite’s position has been secured by policies that inhibit growth, there is little incentive to change.

the future as revealed by the past Though the motives of North Korea’s leaders are open to interpretation, their past machinations do offer some insight into how the government will act in a period of economic

trauma and transition in leadership. Consider some scenarios. Muddling Through

In the base-case scenario, North Korea will pursue the same strategies that have kept its rulers on top for decades. Probably the key factor here is maintaining trade and investment flows from China and South Korea at levels adequate to satisfy the military and to generate survival rations for the masses. The Special Economic Zone (SEZ) at Kaesong (some 50 miles from the South Korean border), created in 2003 and operated by the Hyundai Group, looms large here. It is used by some 120 South Korean manufacturers, who employ around 40,000 North Koreans at an average wage of about one-third of that

Fourth Quarter 2010


trends paid for comparable work in the South. All told, South Korea has invested roughly $600 million in Kaesong’s infrastructure. Managers from the South run the factories, bringing in the necessary capital, equipment and technical expertise. South Korea even supplies the electricity – straight across the demilitarized zone.

Expansion of the SEZs would allow North Korea to bolster foreign exchange earnings without exposing the general populace to decadent Western influences. South Korea’s motives for maintaining the SEZ are more political than economic: low wages can go only so far in compensating for the inefficiency of running an island economy in the midst of a police state. But one would expect that North Korea would like to make the model sufficiently attractive to induce other companies (and other Asian countries) to outsource production to isolated zones. Whether this is practical is anyone’s guess. Foreign investors would have little control over their work forces and no credible guarantee that their property wouldn’t be confiscated. Muddling through would also require North Korea to play its hand deftly, using a mix of extortion and promises of détente to keep the cash flowing. This may not be so difficult, though, as long as China’s first priority is preventing a flood of refugees from North Korea and as long as South Korea considers the price of the status quo to be a bargain.

The SEZ is walled off from the rest of the city, with worker housing provided by the North Korean government. The government chooses the workers. And while the gross wage rate is about three times that of the average North Korean worker, it’s not known how much is diverted to government (and government officials’) accounts.


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Many observers doubt that the muddlethrough approach is sustainable in the long run. No matter how carefully the government tries to wall off the SEZs, news of conditions beyond North Korea’s borders are seeping through. And without some hope for a better life, North Koreans will increasingly question the regime’s legitimacy. Indeed, to judge by reports from refugees, this process has already begun. At some point, then, the government might well opt for economic liberalization as a

©view stock/age fotostock

Flirting with the Chinese Model

means of quieting discontent. It wouldn’t be the first time: North Korea initiated a number of such changes in its economic system in the late 1990s and early 2000s. It was widely hoped at the time that these changes were the start of a trial-and-error process akin to China’s reforms under Deng Xiaoping or Vietnam’s more recent economic liberalization initiatives. But in contrast to China and Vietnam, North Korea’s motives for reform smacked more of desperation than conviction that markets could legitimize the ruling elite. In the 1990s, change was spurred by the collapse of the planned economy during the famine, when the public food distribution system designed to ensure survival rations ceased to function. As desperate North Koreans sought ways to feed their families, black markets (supplied by food smuggled from China or grown in private plots) sprang up. In hindsight, the government’s decision to tolerate these markets seems purely tactical, unrelated to any larger vision of reform. Reforms initiated in 2002 looked a bit more promising. Planning was partly ceded to local governments and factories. Wages were raised and linked to performance; prices for commodities were allowed to fluctuate according to supply and demand. And it became legal for families to sell food and consumer goods in local markets. Note, too, that this was the time that the Kaesong special economic zone was established, and the exchange rate significantly devalued in what looked like an effort to position North Korea to compete in global markets. Eager to celebrate the opening of this bastion of autarky, analysts rushed to declare that the country had entered a new era. In the words of one, North Korea “crossed the Rubicon.” But in light of the timing, it’s more likely that the reforms were simply another tactical lurch. In other economies that have transi-

tioned from planning to markets, the state took the lead and tried to buttress the reforms by providing supporting institutions, like increased rule of law, property rights and regulatory reform. Marcus Noland of the Peterson Institute for International Economics and Stephan Haggard of the University of California at San Diego note that the North Korean case turned reform on its head, with change arising not out of a conscious topdown program, but as unintended (and in some respects, unwanted) byproducts of state failure. Comparisons have been made with the perestroika programs undertaken in desperation by Mikhail Gorbachev. With free markets and no real institutional framework, North Korean refugees have reported that the 2002 reforms benefit the elite who run and profit from them, while making ordinary citizens even more vulnerable to scarcities. While most North Koreans must now obtain a portion of their food from private markets, prices are typically 10 to 40 times higher than prices for state-rationed food (which is only sporadically available). And since just a tiny minority can afford to buy food on their official wages, the reforms effectively turned almost everyone into a scofflaw, hoarding, smuggling and demanding bribes on their own turf when they were able. In 2005, the regime reversed course, banning private trade in grain and seizing privately held stockpiles in rural areas. Women under 40, the main cohort of traders, were barred from participating in the markets. “Antisocialist conscience investigation teams” were deployed to shut down the remaining markets. And travel restrictions were strengthened, especially along the relatively porous Chinese border. The government also expelled a number of foreign aid agencies, including the World Food Program, whose job

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trends was to monitor the adequacy of food distribution in areas prone to shortages. A similar sort of haphazard reform and reversal was apparent in the currency “reform” initiated in November 2009. The government announced it would knock two zeros off its currency, the won, ostensibly to fight inflation. People had just one week to trade in their old money for new notes, with each family permitted to exchange a maximum of

The purpose of the currency reform was to destroy the budding private entrepreneurial class and to return ebbing power to those who live off the proceeds of government monopolies. 100,000 old won for 1,000 new won – less than $30. Here’s the kicker: any cash in excess of the limit became invalid unless it was placed in bank accounts to which the depositors were not guaranteed future access. The life savings of what passes for a middle class in North Korea, along with merchants’ working capital, were wiped out with the stroke of a pen. Thousands of people frantically tried to convert soon-to-be-worthless money into something of value. Prices of some goods rose hundredfold before traders shut down, realizing that their profits soon would be worthless, too. (Besides which, the reform would leave them without the money to restock.) If there was any method to this apparent madness, the purpose of the currency reform was to destroy the budding private entrepreneurial class and to return ebbing power to


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those who live off the proceeds of government monopolies. While, in theory, virtually every adult works for the state, North Koreans do all they can to escape from its clutches. Farmers tend their own gardens as weeds overtake collective farms, and urban workers duck state assignments to peddle everything from metal scavenged from mothballed factories to televisions smuggled from China. Ironically, to cushion the blow of the currency reform, workers were promised that their salaries would be restored – in effect, giving them a large pay raise since old nominal salaries were now paid in the revalued currency. All this implies that the Chinese model, however attractive it might appear to foreigners, does not mesh with the perceived interests of North Korea’s rulers. Perhaps they are too isolated from the realities of the global economy to see the necessity of enduring economic reforms. Perhaps they know that they lack the technical skills to manage decentralized markets. Or perhaps their control over the levers of power is too insecure to give them the leeway to experiment. But the country may once again be heading for a crisis in which business as usual simply won’t cut it. Indeed, just a few months ago, the government tacked back toward freer exchange, allowing local markets to stay open longer and to sell food without restriction in order to stave off the threat of mass starvation. Sudden Collapse

The fundamental economic collapse of a country with a huge conventional military, along with nuclear weapons and the means to deliver them, is without precedent. No one really knows, then, what would happen if already meager levels of production fell sharply, neighboring countries set conditions for helping that were unacceptable to North Korea’s leadership, and control over the popula-

tion was lost. But it is possible to make an educated guess. It is likely that large numbers of North Korean refugees would flee to the borders of China and South Korea, as they did in the 1990s famine. North Korea’s rulers might be reduced to making side deals in which their safety and wealth would be protected in return for assurance that the military would stay in the barracks. Ultimately, the process would lead to some form of union between North and South, as Southerners were moved to take on the burden of impoverished Northerners by a combination of family ties, nationalism, pressure from the West and economic self-interest in ending the chaos. There is general agreement that whatever the terms on which the North was absorbed, the cost would be enormous. In the latest forecast, a South Korean government think tank estimated that the price of reunification would amount to 2 percent of GDP for the next 60 years. Another government study estimated that renovating the North’s dilapidated infrastructure would cost at least $1 trillion. Foreign assessments are comparably daunting. In 2009, Credit Suisse estimated a cost of $1.5 trillion to raise North Korean incomes to 60 percent of those in the South. Peter Beck of Stanford believes that even this figure is far too low. He argues that raising income levels in the North to 80 percent of those in the South would become a political necessity and would cost $2 trillion to $5 trillion over 30 years. But as high as they are, such figures are probably manageable for a couple of reasons. First, because South Korea has prospered mightily over the last four decades: with a GDP of some $1.4 trillion in purchasing power terms and a future growth rate of perhaps 3 percent, South Korea could spend $40 billion on the North in 2011 without reduc-

ing its current living standard. And $40 billion would double North Korea’s income. Second, because the collapse of the North would allow the South to reduce its military outlays: while the South Korean defense budget is a secret, according to the World Bank it amounted to 2.6 percent of GDP in 2006. If that percentage remained constant, the budget was on the order of $30 billion in 2010. To put the issue in further perspective, consider western Germany, which has been subsidizing the former East Germany to the tune of $100 billion annually since 1991. While South Korea’s output is about half that of Germany, a comparable portion of the South Korean GDP would still amount to $50 billion this year. And, if the Korean economy grew at a modest 3 percent annually, the figure would rise to $90 billion in two decades.

through a glass, darkly Ironically, no one (with the likely exception of a great majority of North Koreans) is eager to see North Korea collapse. Too much is at stake. China doesn’t want a flood of refugees; many South Koreans fear the consequences of the economic dislocation. And nobody wants to face the increased prospect of military conflict during the transition, especially now that the North has nuclear weapons. So the best guess is that, in the end, the North Korean regime and state will be given every opportunity to muddle through, whether or not it is willing to negotiate away its nuclear option. This doesn’t mean that the economy (and the government) won’t collapse one day. Indeed, it is hard to imagine a state so incompetent and so lacking in popular support surviving indefinitely. But the push will probably have to come from within. Sadly, we may have gotten to the point where there are no longer optimists when it comes m to North Korea – only realists.

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charticle by william h. frey

Much has been made of the fact that fewer whites than nonwhites will soon be born each year in the United States. Minorities, in general (and Hispanics in particular), are younger and more inclined to have children. Meanwhile, older Americans are predominantly white and will remain that way for a long time. In the past, generations largely fought over values and lifestyles. This time around, the gap is also creating very visible divisions over

the use of public resources – think education, pensions and health care. And the differences have become especially sharp because the old

Large Metros — Greatest Cultural Generation Gaps oe

n ix, AZ: -41 85%

% ri

r ve

s i d e, C a : - 4 0



g o, C A : 34 % 71%


eg sv



The Milken Institute Review




a s, n v : 34 % 72%

, ca: 30 % 58%







g an

el e s, ca: 53%


ti n , tx: -29% 75%







s t o n, t x : - 3 1% 64%



s au

s, tx: - 34


o, f l : 31 an d % 76%

n, az: -4 0




l or




n sa





i lw

a u k ee , w i : - 2 9% 87%


left: ocean photography/veer; right: creatista/veer


have ever less in common with the young in terms of race, familial ties, national origins and language. All told, whites comprise 56 percent of American children and 80 percent of seniors, a gap of 24 percentage points. But the difference is far larger in the Sun Belt, which is a magnet to both white retirees and young Hispanics. Arizona, with a chasm of 40 percentage points, leads the states. And, not surprisingly, it has become ground zero on racially and economically charged immigration issues. Watch politicians in Nevada, California, Texas, New Mexico, Florida and Colorado try to have it both ways (or choose sides with a vengeance) on a host of issues like the funding of schools. Candidates for local elections face

similar decisions – especially in Phoenix, Riverside, Tucson, Dallas, Las Vegas and Houston. The irony is that the quality of life for retirees depends on the future productivity of younger, predominantly non-white Americans. Lower taxes, half-starved schools and less generous medical care for the young may work for seniors right now. But not far down the road, they will depend on a less healthy, less skilled, alienated workforce to cover the ballooning costs of Social Security, Medicare and Medicaid-funded nursing homes. Good luck with that. B i ll Fr ey is a senior fellow in demography at the Milken Institute and senior fellow in metropolitan policy at the Brookings Institution.

states — Greatest Cultural Generation Gaps

source: William H. Frey analysis of 2008 American Community Survey and U.S. Census projections.


i z o na : - 4 0 % 83%


va D A : - 3 4 % 77%


m e xi c o : - 3 1% ew n 60%

orgia: -25% 75%





r i da : - 2 9 % 78%


lo r

ado: -2 4% 84%



o r n ia: -3 3% 63%


are: -2 6% l aw 84%



t o ta l : - 2 6 80%



i n o is : - 2 5 % 80%



a s: - 3 1 %












% of population age 65+ that is white


% of population under age 18 that is white

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Resistance is Fruitful


Genetically modified crops hold vast economic promise. Will politics mow down progress? by matin qaim

Genetic modification of cultivated crops has widely been damned as the work of the proverbial sorcerer’s apprentice, a looming threat to public health and environmental stability. But in my view, the promise of genetic-modification technologies is vast and the perceived risks are overblown. The potential of genetically modified crops is manifold. They can increase productivity in agriculture, ensuring the availability of cheap food and other crop-based raw materials for a growing population with rapidly rising economic expectations, even as the non-renewable natural resource base dwindles. Genetically modified crops can reduce the negative environmental footprint of agriculture by reducing the demand for fossil fuels, toxic chemicals and water. What’s more, new seed technologies are likely to play an important role in alleviating poverty and income inequality by sustaining income growth in developing countries. And finally, genetic modification could transform staple sources of calories into far more balanced sources of nutrition needed to reduce childhood mortality and enhance the quality of life. Indeed, the biggest challenge posed by genetic modification is how to create a regulatory framework that provides reasonable public oversight but resists the understandable impulse to curb progress based on these technologies.


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tim bower (all)

Fourth Quarter 2010


ge n etic modi fication first things first A genetically modified plant is one in which bioengineering techniques have been used to insert one or more genes that code the plant for desirable traits. These genes may, of course, come from other plants, as well as from totally unrelated organisms. The basic technology was developed in the early 1980s, with the Global adoption of Genetically Modified Crops global gm crop area (million ha)

140 total

120 100

Industrialized countries

80 60 40

developing countries

20 0






source: International Service for the Acquisition of Agri-Biotech Applications

first genetically modified crops becoming commercially available in the mid-1990s. Since then, genetically modified crop adoption has increased rapidly. In 2009, genetically modified crops were grown on almost 10 percent of the world’s arable land. The crop traits sought through genetic engineering are not entirely novel: People have M ati n Qa im is a professor of agricultural economics and rural development at the University of Göttingen in Germany. Email:


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searched for centuries (with some success) for ways to adapt crops to soil and climate conditions and to pest challenges. However, since genetic-modification technology allows direct gene transfer across species boundaries, some traits that were previously difficult or impossible to obtain can now be bred with relative ease. Genetic-modification traits fall into three categories. First-generation genetically modified crops involve improvements in traditional agronomic traits like better resistance to disease. Second-generation genetically modified crops involve enhanced quality traits – say, adding a valued nutrient to a food crop – and third-generation crops are plants designed to produce special substances for pharmaceutical or industrial purposes. Whereas secondand third-generation technologies are still in the research pipeline, a few first-generation crops are already widely grown. Examples include insect-resistant corn and cotton, and herbicide-tolerant soybeans and sugar beets.

frankenfood? In spite of the potential of genetically modified crops, though, resistance to their development and use can be fierce. Reservations are particularly strong in Europe. But the consequences of European opposition have spilled over to other regions, thanks to a combination of trade regulation and active lobbying by public interest groups. Resistance is largely driven by the specter of environmental and health risks. But some people also argue that genetic-modification technology could disrupt traditional (and valuable) knowledge systems in developing countries – say, the way packaged baby formula displaced breastfeeding in Africa. Last but not least, critics argue that the increasing privatization of crop-improvement research, along with the broadening of intellectual property rights in

plants, will increase corporate market power in seeds at the expense of small farmers.

herbicide-tolerant crops Chemicals that kill weeds can often kill crops along with them. Genetically modified herbicide-tolerant crops coexist with specific broad-spectrum herbicides, like glyphosate or glufosinate, that are more effective, less toxic and usually cheaper than the more-selective herbicides needed to protect many unmodified plant species. The most successful of these in commercial terms today is an herbicide-tolerant soybean, which is now planted in more than half the total acreage devoted to genetically modified crops. Herbicide-tolerant soybeans are currently grown primarily in the United States and in Argentina, Brazil and other South American countries. Herbicide-tolerant corn, cotton and sugar beets are so far mostly confined to the United States, while herbicide-tolerant canola (the raw material for increasingly popular canola oil) is particularly important in Canada. The big benefit, from farmers’ perspective, is financial. In some, though not all, cases, herbicide-tolerant crops require less (as well as less-expensive) herbicide. Indeed, in Argentina, total herbicide use went up significantly after the adoption of herbicide-tolerant soybeans. This is largely due to the fact that, with these genetically modified seeds, using herbicide sprays as well can be a satisfactory substitute for tillage – an age-old way to control weeds. The portion of Argentine soybean farmers using direct seeding without prior tillage has doubled, to almost 90 percent, since the introduction of herbicide-tolerant technology.

At first glance, this suggests that herbicidetolerant soybeans have the potential to be more environmentally problematic than conventional soybean cultivation. But, in fact, no-till farming helps to reduce soil erosion and generates less greenhouse gas emissions because mechanical tillage burns a lot of fuel and sets free carbon dioxide and nitrous oxides bound in the soil.

Herbicide-tolerant technology has also expanded the use of no-till practices in the United States and Canada, with little loss in average yields. In a few cases, where weeds were difficult to control with selective herbicides, the adoption of herbicide-tolerant seed and the switch to broad-spectrum herbicides have actually resulted in better weed control and higher crop yields. Herbicide-tolerant technology can significantly reduce production costs by lowering

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ge n etic modi fication expenditures for herbicides, labor, machinery and fuel. However, since herbicide-tolerant crops were developed and commercialized by private companies, the price of the seeds includes royalty fees – and, of course, affects the financial incentives to switch to them. Research on the economic impact of herbicidetolerant soybeans in the United States shows

that the owners of the genetic-modification technology have captured most of the economic surplus – that is, the fee is often equal to (and sometimes higher than) the reduction in production costs at the farm level. The calculations for herbicide-tolerant cotton and canola cultivation in the United States generate similar results. So, apparently the main reason these farmers prefer herbicide-tolerant technology is that it saves management time and offers a more reliable way to control weeds.


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But in South America, farmers have a clearer motive for using herbicide-tolerant seeds. While these farmers’ methods are similar to those employed by farmers in the United States, their returns are larger because the royalties on seeds are lower – almost certainly because the seed companies can’t count on either the protection or enforcement of patents on herbicide-tolerant technology. Indeed, many soybean farmers in South America even use genetically modified seeds they reproduce from the seed companies’ versions. On average, Argentine farmers net an extra $25 per hectare (2.47 acres) by adopting herbicidetolerant technology. Genetically modified crops are apparently so profitable for growers that the seeds are now used for almost all soybean cultivation in the country. In Brazil and other South American countries, where the technology was commercialized more recently, adoption rates aren’t as high but are increasing rapidly. Who gets the benefits of increased productivity matters a lot, of course, to farmers, seed companies and soybean consumers. But it’s worth remembering that the division has no direct effect on the total size of the gain to society in terms of resource savings. The best estimates suggest that herbicide-tolerant soybeans are currently generating welfare gains of $5 billion annually, divided among farmers (in the form of higher profits), consumers (in the form of lower prices for soybean oil and meal), and herbicide-tolerant-technology owners (in the form of royalties). Comparable gains have also been generated by other commercialized herbicide-tolerant crops.

insect-resistant crops Bioengineering also makes it possible to create

insect-resistant genetically modified crops. The ones that have reached the stage of commercialization have employed genes from the soil bacterium Bacillus thuringiensis (Bt), which make the plants resistant to some pest species. The most widely used examples are Bt corn and Bt cotton. In 2009, Bt corn was grown on almost 40 million hectares (about 100 million acres) in some 15 countries. The biggest Bt corn areas are found in the United States, Argentina, South Africa, Canada and the Philippines. Bt cotton was grown on roughly 15 million hectares (37 million acres) in that same year – most of it in India, China and the United States. But farmers in other countries are beginning to adopt the technology, too. Where insect pests can be effectively controlled with chemicals, the main effect of switching to Bt crops is to reduce the need to apply insecticides. However, there are situations in which insect control with chemicals is just not practical. Insecticides may be far too expensive to use, or too toxic to farm workers, or unavailable because of supply constraints or import restrictions. In those cases, Bt technology represents the sole means for reducing crop damage and raising yields. Both insecticide-reducing and yield-increasing effects of Bt crops can be observed in the table to the right. With conventional cotton, large quantities of chemical insecticides are normally used to control the bollworm. Bt cotton generally eliminates this pest without resorting to chemicals. Accordingly, Bt cotton adoption has led to reductions in insecticide use of 30 to 80 percent, along with substantial increases in yields, especially in developing countries. In Argentina, for instance, conventional cotton farmers tend to use chemical insecticides at less-than-optimal levels, so the pests are not effectively controlled. In India and China,

chemical use is much higher. But the insecticides are not always very effective, due to low quality, resistance among the local pest populations and, sometimes, incorrect timing of spraying. Similar effects have been observed with Bt corn. Bt seeds are more expensive than conventional ones. But the economic advantages associated with insecticide savings and higher effective yields more than offset the royalties in all the countries studied. As with herbiFarm-Level Effects of Bt Crops insecticide increase in increase in country reduction effective yield farm profit (%) (%) (US$/ha)

Argentina Australia China India Mexico South Africa United States Argentina Philippines South Africa Spain United States

47% 48 65 41 77 33 36 0 5 10 63 8

Bt cotton 33% 0 24 37 9 22 10 Bt corn 9 34 11 6 5

$23 66 470 135 295 91 58 20 53 42 70 12

source: the author

cide-tolerant crops, the farmers’ gains from using Bt crops varies from country to country, in large part because seed companies capture less of the surplus in economies where intellectual property is less protected. The total gains accruing to farmers, consumers and technology owners through the use of Bt seeds amounts to several billion dollars annually – in the same range as the gains from herbicide-tolerant crops. The indirect benefits are substantial, too. Less use of insecticides generates benefits to human health and reduces environmental stresses associated with farming. Furthermore, crop damage from insects leads to the proliferation of toxic funguses. So Bt crops are generally less

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ge n etic modi fication contaminated with mycotoxins than their conventional counterparts – a big advantage with corn, which ends up in animal feed as well as in myriad food products manufactured with corn syrup and corn oil.

next-generation applications A number of other Bt crops have been com-

mercialized recently or are likely to be marketed soon. Bt rice and Bt eggplant have already been field-tested extensively in China and India, with the expected insecticidereducing and yield-increasing impact. Genetically modified crops engineered to resist harmful funguses, viruses, nematodes and bacteria can be expected fairly soon. The impact on yields will likely be more pronounced in the tropics and subtropics, where pest pressure is often higher and farmers face


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more severe financial constraints in controlling pest damage. By the same token, the effects of genetically modified crops engineered to cope with other kinds of environmental adversity will vary greatly with regional conditions. A genetically modified crop built to tolerate drought, for example, will have a far greater impact on yields in semiarid regions – especially in the impoverished semiarid tropics where irrigation is not available. Likewise, engineered tolerance to heat, salinity, floods and other stresses will probably matter most to farmers in poorer countries. Climate change seems to be associated with more frequent weather extremes, so genetically modified crops could make a big difference in reducing the risks of crop failures and food crises as greenhouse gases accumulate in the atmosphere. Researchers are also working on nutritionally enhanced genetically modified crops, like oilseeds with fats that are less likely to lead to cardiovascular disease and staple foods with enhanced mineral and vitamin content, in poor countries. Enhancing nutritional content is called biofortification. For example, a bio-fortified crop called Golden Rice, which contains significant amounts of provitamin A, could become commercially available in some Asian countries in 2012. Golden Rice could prove to be a major health advance because vitamin A deficiency is widespread in poor households, reducing resistance to infectious diseases while increasing child mortality and blindness. Recent research suggests that Golden Rice could reduce the health burden of vitamin A deficiency by up to 60 percent – and at a far lower cost than getting vitamin A supplements to the people

in need. Significant health benefits can also be expected from other bio-fortified crops. Among the candidates are staple foods rich in iron, zinc, folate and essential amino acids. Finally, a number of third-generation genetically modified crops are in the pipeline. These involve molecular farming, where the crop is used to produce pharmaceuticals like monoclonal antibodies and vaccines, or industrial products like enzymes and biodegradable plastics. While concepts have already been proven for a number of such technologies, product development and regulatory issues are inherently more complex than for first and second-generation genetically modified crops. We need to be sure that the substances produced in the plants do not enter the regular food chain. Therefore, it is both likely and desirable that third-generation genetically modified plants that are not used directly or indirectly as food will need to pass regulatory hurdles. It’s also likely that they will only be licensed for use under contained conditions. What is clear at this point, though, is that the potential is enormous – and that the genetically modified crops commercially available so far represent only the first steps in a long technological march that could revolutionize the use of agriculture.

genetically modified crops and poverty reduction Seventy-five percent of all poor people in the world are small farmers or rural laborers in developing countries. Therefore, genetically modified crops might have important implications for poverty and income distribution. If only rich farmers benefit, inequality will increase. Yet, if resource-poor farmers could

obtain genetically modified seeds suitable for their situations, the poverty and equity effects might well be positive – and large. The way the technology evolves matters here, of course. But so, too, does what social scientists like to call the institutional setting. For instance, the strength of patents will have a major impact on the way the windfall from genetically modified crops is divided. So, too,

will the degree of competition in the seed markets (at both the wholesale and retail levels), the availability of credit to buy genetically modified seeds, and the availability of information about which seeds work best under what conditions. Herbicide-tolerant crops have so far not been widely adopted by small farmers. They often weed manually, so herbicide-tolerant crops are less advantageous unless labor becomes more expensive. Not so with Bt crops,

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ge n etic modi fication where brute-force labor is simply not a substitute for chemicals or engineered insect resistance. In India, China and South Africa, Bt cotton is often grown by farmers with less than two hectares (five acres) of land. And in South Africa, many smallholders grow Bt white corn as their staple food. Research shows that the advantages of Bt technology are of a similar magnitude for small farmers as for industrial farming – and Household income effects of Bt cotton in India $600 500


bio-safety and food-safety regulation

Bt cotton

Conventional cotton

400 300 200 100 0

All households

Extremely poor

Moderately poor


source: Qaim et al. 2009

sometimes even greater. One recent study investigated the broad impact of Bt cotton in India, including the effect on landless laborers and local sectors linked to agriculture. Each hectare of Bt cotton adds $250 more income than the marginal hectare of conventional cotton – an increase of 83 percent. For the total Bt cotton area in India, this translates into an annual income gain of over $2 billion for rural households. All income classes benefit, including households below the poverty line. In fact, a remarkable 60 percent of the gains accrue to the poor. These re-


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sults stand in stark contrast to claims by antibiotech activists that Bt cotton is ruining peasant households in India and driving farmers to suicide. The positive social effects from India cannot be extrapolated to other genetically modified crops and other countries, as the impact depends on the conditions in a particular setting. But the example underscores the reality that genetic-modification technology has the potential to contribute to both poverty reduction and to the growth of a rural middle class in developing countries, if the institutional setting gives a fair break to small farmers.

Governments have an important role in ensuring that novel foods are safe for human consumption and that novel agricultural inputs do not damage the environment or impair agricultural productivity in the long term. Most countries, with the notable exception of the United States, consider any food that incorporates genetically modified crops to be a novel food, no matter how far up the production chain one goes. Hence, new laws and institutions to regulate potential bio-safety and food-safety issues have been established, requiring that genetically modified products be approved before they may be grown, imported or consumed. Since approval processes vary from country to country, regulation has become a major barrier to the spread of genetically modified crops and technologies around the world. For example, the EU has not yet approved some of the genetically modified corn technologies that are used in the United States and Argentina, which obstructs trade not only in the technologies but also trade in corn and corn products. In the EU, the regulatory barriers seem to be a political reaction to popular sentiment. In

other parts of the world, however, the failure to approve genetically modified crops is often due to the reality that countries (and farmers) lack the expertise to set and enforce rational standards. Smaller developing countries have the most problematic records in this area. In countries where there is a bio-safety system in place, most of the regulatory effort is put into preventing the commercialization of products that might harm people or the environment. Regulators typically err on the side of caution, requiring arduous testing over long periods. Such caution comes at a high price: it typically costs about $10 million to obtain regulatory approval of a new Bt or herbicide-tolerant corn technology in a single country. Commercializing the same technology in other countries requires seed vendors to jump through the same hoops yet again. And, beyond these direct regulatory costs, there are indirect costs in terms of delayed approvals and the risk that blanket moratoriums on new approvals of any sort will stop the process in midflight. The biggest impact is on minor crops and small countries, where markets are not large enough to justify the initial cost. Note, moreover, that regulatory barriers have a disproportionate impact on small firms that can’t afford to play the game. As a result, the genetically modified seed industry is highly concentrated – a reality that reduces the pace of innovation and makes it less likely that competition will force down royalty rates. If such lengthy and complex procedures were really necessary to ensure reasonable levels of safety, the outlays (and reduction in competition) involved would be justified. But

since there is no evidence that the use of firstand second-generation genetic engineering entails exceptional risks, it makes no sense to subject genetically modified crops to a much higher degree of scrutiny than conventionally bred crops. The regulatory complexity follows from the lobbying success of nongovernmental organizations opposed to the use of biotechnology in agriculture.

labeling and coexistence Many countries have labeling systems for consumer foods. Mandatory labeling is often used to warn consumers of specific health risks (for example: cigarettes cause cancer), whereas voluntary labeling is more common to differentiate products with desirable characteristics for marketing purposes (like organic, low-salt or high-protein). Both approaches can provide the same information. But in light of the fact that only genetically modified products

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ge n etic modi fication considered safe by regulators are approved for market release in the first place, mandatory labeling is deeply problematic. Nonetheless, the EU requires labeling that may add significantly to costs – and certainly reinforces the notion that genetically modified products are inherently unsafe. Defenders of the EU’s choice of mandatory labeling say consumers have a right to know, a stance that in this context seems an invitation to use labeling systems as a backdoor form of resistance to products that have already passed regulatory scrutiny. Note, moreover, that labeling forces producers to segregate genetically modified ingredients from non-genetically modified ones, which can be quite costly – especially if the products are sold in several countries with varying labeling rules. Labeling and segregation are also related to what can be called the issue of coexistence. The EU has established rules to ensure the coexistence of genetically modified crops with conventional crops as well as those labeled organic. To manage this, regulators must create detailed standards – everything from minimum distance requirements for cultivation to liability and insurance measures. The resulting degree of complexity and uncertainty created by coexistence rules represent clear disincentives for EU farmers to plant genetically modified crops.

the patent perplex In the United States and most other developed countries, living organisms (and parts thereof) have been patentable since the 1980s. This has spurred a tremendous amount of private research. More than 75 percent of all patents related to genetically modified crops are held by the private sector, most of them by a handful of multinational corporations. Note the fundamental economic tension 26

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with genetic-modification patent protection (and intellectual property protection in general). While strong protection creates robust incentives for private investment in R&D, it leads to higher prices for the products that are created. More to the point, it inevitably creates a gap between prices charged and the marginal cost of production. So the degree of intellectual property protection in a country affects the rate of genetically modified crop adoption, as well as the division of benefits between property owners on the one hand and farmers and consumers on the other. When royalties on genetically modified seed prices are high, poor farmers in particular may not adopt them. It follows that the optimal level of patent protection and enforcement (from the perspective of society as a whole) will be lower in developing countries. The proliferation of patents on genes and technologies has also led to access and freedom-to-operate problems within the biotechnology industry itself. Since the development of a single genetically modified crop may require the use of dozens of patented enabling technologies, licenses have to be negotiated with multiple parties – a process that can generate high transaction costs. And since large corporations are better able to operate in this high-transaction-cost environment, the freedom-to-operate problem may contribute to further industry concentration. Public-sector research organizations are particularly at a disadvantage because they typically have little to offer in trade for licenses from private companies. Even the largest individual public-sector patent holders, like the University of California and the U.S. Department of Agriculture, own less than 2 percent of total agricultural biotechnology patents; by comparison, Monsanto and DuPont each control more than 10 percent of biotech patents.

All told, though, public organizations hold 24 percent of these patents, and in some areas they could develop genetically modified crops without having to rely on patents from the private sector. Special clearinghouse mechan­ isms to reduce transaction costs might facilitate public-sector joint ventures. One example is the Public Intellectual Property Resource for Agriculture, which brings together intellectual property from over 40 universities and public agencies and helps to make their technologies available to innovators around the world. Such public-sector steps are important, as some R&D challenges in genetic modification are unlikely to be addressed by private companies because of the limited size of potential commercial markets – for example, technologies especially designed for poor farmers and consumers in developing countries. By the same token, more public-private partnerships should be sought in order to harness the comparative strengths of both. Universities are typically better suited to basic research, whereas private companies have advantages in applied R&D.

the way forward With constraints on climate, energy and water increasingly impinging on the world’s capacity to expand agricultural output by conventional means, genetic-modification technologies are likely to become ever more important in maintaining high living standards in the industrialized world and allowing billions of others to enjoy the fruits of economic development. No less significant, third-generation genetic-modification technologies have the potential to harness plant life in tasks ranging

from synthesizing antibiotics to cleaning up oil spills. But ironically, just as genetic-modification technologies are beginning to deliver on their promise, opposition to these technologies is growing – especially in Europe. There are, of course, risks to virtually every technological change built on the manipulation of life forms. But every path to the future bears risk.

And the response to the risks generated by genetic-modification technologies has largely been unconstructive, slowing innovation, increasing industrial concentration and creating biases against changes that would benefit the poor. This is not to say that zero regulation would be desirable. But it would be sad, indeed, if critical technologies that could help to overcome the daunting challenges faced by the planet were sacrificed on the altar of fear m and ignorance.

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gol Its recent glitter might be the portent of a nightmare


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ld By Christopher Meissner

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Cambridge University dons are widely respected (excessively, on occasion) for their sagacity. In 2005, when I was one of them, a student’s

mother cold-called me: “Dr. Meissner, is this the time to buy gold?”

C h r i s M e i s s n e r, an economist at the University of California (Davis), specializes in the history of the international economy.


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to facilitate exchange in a global economy that has apparently entered a period of considerable instability.

been there, done that Gold is quite scarce. In fact, if all the gold ever mined were spread over a football field, the pile would be only about five feet high. That’s why relatively small increases in demand can lead to big increases in the price. So, where has this price-destabilizing demand been coming from? Gold does have significant commercial uses. It’s valued for its electrical conductivity, for its role as a catalyst in myriad chemical reactions and, of course, for its color, malleability and resistance to discoloration when used for decoration and display. But these sources of demand have not changed much in recent years; nor are they expected to. That leaves less tangible sources of demand to explain the jump in price. First, from those worried about the potential fall in value of other assets in a period of inflation, depreciation of the dollar, or widespread failure of financial institutions. Gold, in short, has always been viewed as insurance against hard times. Second, from those who don’t share the doom and gloom outlook, but do want to ride the wave of a rising asset class – Keynes’ aforementioned speculators. Is the first group (the worrywarts) right? Unlike the bank reserves and paper money that the Federal Reserve can create in almost unlimited quantities, the supply of gold

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Now, followers of the dismal science are generally not inclined to speculate on the timing of financial investments. Indeed, most economists assume that nobody has much to say that’s worth hearing on this subject. Accordingly, I told her that her guess was as good as mine. The rest, as they say way too often, is history. The price of gold hit a 30-year high in 2010. A $100,000 bet on gold in 2005 would be worth, as I write this piece, about $300,000. If only I’d ignored all this “efficient market” nonsense. It’s clear that the spectacular jump in the price of gold in the last few years is the market’s way of telling us something. Less clear is what. Not a few people feel that gold is an excellent way of insuring against imminent financial turmoil and dollar depreciation. But there are other interpretations. John Maynard Keynes argued that asset and commodity prices are often driven by nothing more than guesses about other people’s guesses about other people’s guesses, etc. Investors may simply be loading up on gold because they have made the calculation that others will continue to buy gold – at least for a while longer. But, as an economist, I like to think I still have some interesting things to say about the mystical metal – in particular, about its role, past and future, as a way to store wealth and


changes relatively slowly and thus would be expected to gain value in relative terms in periods of inflation. And this points to a broader question that people have been asking for centuries: Wouldn’t a gold “standard” that tightly limited the capacity of governments and private banks to create money be a way to make sure that financial assets remained a safe store of value? Indeed, wouldn’t a gold standard have limited the expansion of credit that led to the speculative boom and bust in the housing market over the past decade? If banks had been obliged to exchange gold (or currency backed by gold) on demand for bank deposits, wouldn’t they have been a lot more careful about the quality of the collateral that they accepted on loans? Last but not least, if a gold standard had been in place and if banks hadn’t been able to rely on the Federal Reserve to bail them out in a crisis by creating more money, wouldn’t they have acted more prudently in the first place?

And what about the international role of the dollar? Booming demand for dollardenominated financial assets from China (and a handful of other countries with massive savings-investment imbalances) led to the easy credit regime of the last decade. With lending constrained in the United States, wouldn’t those global imbalances have been smaller, or at least have been channeled into less volatile assets? The short answer to all these questions is that the potential gains from a commodity money regime would almost certainly have been outweighed by the damage, if and when the system broke under pressure. The Great Depression, perhaps the greatest financial and economic crisis ever, took place in spite of the gold standard – and the damage was made much worse by the constraints imposed by the standard. We can’t write off the Great Depression as a special case. Banking crises were just as common in the 19th century, when much of the world was operating

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g o l d ’s l at e st g l i t t e r on a gold standard. Nor, for that matter, did the gold standard succeed in stabilizing prices over long periods.

failure of the collective memory Government central banks, which largely determine the volume of liquid financial assets used as money, are the rocks on which the modern market system is built. The more economic actors who trust central bank money as a medium of exchange, a store of value and a unit of account, the more efficient the mon-

into other currencies at a fixed rate. In effect, the global economy had tied itself to a currency union. This reduced the one major source of uncertainty associated with international trade and investment: the risk that obligations would be paid in the depreciated currency of another country. Trade and cross-border capital flows surged. And a virtuous circle emerged: Exchange rate stability allowed globalization to flourish, which encouraged laggards to join the gold standard. The pace of growth accelerated along with trade.

A commodity money standard can deliver on its promise of stability only if participating countries are willing and able to stick by the standard in periods of economic and financial stress. etary system. To this end, the primary task of an independent central bank, at least since the 19th century, has been to maintain the relative value of the currency (i.e., to avoid inflation and deflation) by making sure that neither too much (nor too little) money is created. To this end, major economies all established commodity-based systems using gold or silver (or both) as “backing” for the local currency – a voluntary straightjacket of sorts. In the United States, the official parity for the dollar from 1873 to 1914 was $20.67 per troy ounce (about 1.1 avoirdupois ounces on the grocer’s scale) of gold. Private banks had strong incentives to extend credit judiciously under this regime because their depositors could always ask for their money back in gold (or government currency formally backed by gold). By 1878, most leading economies outside Asia had adopted a gold standard. Their currencies were convertible into gold, and hence


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The conventional view is that the system worked automatically and smoothly to stabilize price levels and to correct global financial imbalances – that is, large current account surpluses and their counterpart deficits – by forcing price adjustments in countries prone to inflation or deflation. (This, of course, is in contrast to today’s apparently unsustainable imbalances, which persist in an atmosphere of political tension and mutual recrimination.) But a closer look suggests that the gold standard was not all that stable. From 1873 to 1896, industrialized countries were forced to cope with an almost continuous deflation. In the United States, prices declined on average by 1 percent annually for almost a quarter century, as growth in the quantity of commodity money (gold) failed to keep pace with growth in economic activity and forced adjustment through falling prices. At the same time, Asian countries that

had adopted silver as commodity money faced inflation as the relative value of silver versus gold declined by half. Then, gold discoveries in South Africa and Alaska in the 1890s, along with technical advances that made it practical to produce gold from lower-grade ores, led to a rise in the supply of gold – and to inflation in gold standard countries. In the United States, prices rose at an average rate of 2 percent annually from 1896 until 1914. The commodity monetary standard had effectively made prices hostage to the vicissitudes of the supply of the underlying commodity backing the money supply. Unanticipated deflation or inflation can generate political tensions because it redistributes wealth and income. In the 1870s and 1880s, farmers in the American Midwest, who perceived themselves as victims of deflation (though the actual sources of their malaise seem to be more complex), formed a “soft money” coalition. They decried the gold standard as unfair to debtors who had to repay mortgages with ever more valuable dollars that were ever more difficult to earn by selling crops whose prices were falling. (In the words of the Democratic presidential candidate William Jennings Bryan: “You shall not crucify mankind [i.e., U.S. farmers and laborers] upon a cross of gold.” Republicans, who had ties to both banks that held the debt and to East Coast industrialists who believed they benefited from deflation, defended the system. Consider, too, another fundamental drawback of a commodity money standard: it can deliver on its promise of stability only if participating countries are willing and able to stick by the standard in periods of economic and financial stress. Europe’s industrialized

core did stay on the gold standard (and, accordingly, their exchange rates remained stable) for the duration of the Belle Époque. However, many countries on the periphery – Argentina, Brazil, Greece, Italy, Portugal – periodically fell off the wagon.

The United States remained true to the gold standard from 1879 to 1933. However, on numerous occasions banking panics led to local “suspensions of convertibility” in which depositors would receive private IOUs in lieu of gold-backed currency. And from 1891 to 1896, the United States Treasury came dangerously close to running out of gold reserves, as holders of dollars exchanged them for

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metal because they feared that Bryan would be elected president and devalue the currency. Uncertainty about the will and ability to deliver on gold-standard promises – and occasional panics that followed – ended in the United States only with the introduction of government deposit insurance, regulation that made the retail banking business boring but profitable, and the creation of a true central bank (the Federal Reserve) to serve as a lender of last resort to illiquid (but solvent) banks. The Bank of England, the watchdog and regulator of the 19th-century global financial system based in London, maintained the con-

vertibility of the pound into gold from 1821 until the start of World War I in 1914. But the gold standard did not make countries that played by the rules immune to the consequences of the behavior of countries that did not. In the Baring Crisis of 1890-91, a global financial meltdown reminiscent of the 2008 crisis, the eminent Baring Brothers bank in London was caught holding vast amounts of Argentine government debt. When Argentina defaulted and Baring Brothers found itself in a liquidity and solvency crunch, the Bank of England saved Barings by organizing several loans from abroad. Why, then, did the gold standard endure as long as it did? For one thing, economic elites favored commodity money systems because they made it difficult for officials to act on

political incentives to make credit cheaper or to devalue the currency as a means of supporting export interests. Contrary to the conventional view that the gold standard was a straitjacket, it acted more like a structure designed to survive an earthquake by flexing with the strain. The gold standard managed to accommodate great stresses because governments temporarily suspended adherence in times of war or severe economic crisis. Britain and the United

sort during wave after wave of banking panic. Similarly, France waited (at great cost) until 1936 to devalue the franc and expand the money supply. One reason that the gold standard collapsed in the 1930s was, of course, the severity of the crisis. But the lesson of history had been pretty clear for quite a while by then: dropping convertibility allowed economies to recover more quickly. What, then, determined the timing of its abandonment?

In the broadest sense, the virtues and drawbacks of the gold standard illustrate the tradeoff between a system that permits discretionary monetary policy and one that is rigid and rule-based. States both managed to restore the credibility of their commitments by restoring gold convertibility after the Napoleonic wars and the American Civil War, respectively. By the same token, the system managed some flexibility within its rigid shell through international cooperation. When national gold reserves fell below critical levels, it was not unknown for central banks to lend reserves to one another. For example, the Bank of Russia and the Bank of France came to the rescue of the Bank of England in 1890 during the Baring crisis. But the gold standard truly broke under the strain of deflation, bank illiquidity and export collapse in the Great Depression of the 1930s. Indeed, many economic historians blame the stubborn adherence to the gold standard for the severity of the Depression. In the United States, maintenance of gold convertibility at a fixed parity (which ended only in 1933 under Roosevelt) limited the Federal Reserve’s capacity to act as lender of last re-

Democracy played a role. The newly enfranchised mass electorates of the early 20th century had learned that cyclical unemployment could be cured by growth in the money supply not possible under a gold standard. Another reason was the erosion of cooperation among the major economic players in the harsh peace that followed World War I. During the 1930s, central banks proved reluctant to come to one another’s rescue. And “beggar they neighbor” policies, in which currency devaluation was used to make one country’s exports more competitive at the expense of others, was no longer deemed an unpardonable breach of diplomatic etiquette. In the broadest sense, then, the virtues and drawbacks of the gold standard illustrate the tradeoff between a system that permits discretionary monetary policy and one that is rigid and rule-based. When viewed from this perspective, there is a pretty strong case for opting for flexibility.

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g o l d ’s l at e st g l i t t e r And so our global financial system has adapted. What we have learned from two centuries of economic history is that discretionary monetary policy (one not tied to the quantity of a yellow metal held in government vaults) can go a long way toward stabilizing economic growth and employment. To do so, however, nations must summon discipline in other ways – through regulating the banking system and by operating an accountable and transparent central bank that has the capacity to act as a lender of last resort.

Over the last decade, the excess savings in Asia and the Persian Gulf that poured into dollar assets financed enormous increases in government- and consumer-debt in the United States. Since no nation can expect foreigners to subsidize its consumption indefinitely, many analysts worry that market sentiments will shift abruptly at some point and that the dollar will collapse as businesses, funds and foreign governments attempt to trade dollars for other liquid assets – foreign currencies and commodities. Even in the best of scenarios, the international demand for

Discretionary monetary policy — one not tied to the quantity of a yellow metal held in government vaults — can go a long way toward stabilizing economic growth and employment. the dollar as the world’s reserve currency The purpose of the gold standard was to stabilize prices and to force automatic adjustments in price levels when international financial flows associated with trade and investment were not balanced. But gold also served as a medium of exchange and a store of value. And with the demise of the gold standard, the national currencies of economic powers with a commitment to stable prices effectively filled the vacuum. The dollar has come to serve as the globe’s primary reserve currency. And, in spite of the fact that the recent financial crisis was driven by turbulence in the United States, demand for U.S. government debt as a store of value actually increased more sharply than its amazing increase in supply during the crisis. But it would be foolish to assume that the dollar will remain the global reserve currency.


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dollars is likely to dry up, forcing the U.S. Treasury to finance huge budget deficits in other ways. In either situation, the United States would face the prospect of both high inflation and falling output. The rest of the world, which depends far too much on U.S. economic activity to sustain growth, might well follow America into deep recession. Rapid depreciation of the dollar would spell the end of the greenback as the global financial anchor – and leave a very big part missing from the machinery of international finance. Nations with international balance of payments surpluses accumulate reserves that must be held in liquid form. By the same token, international banks and businesses need stable liquid assets as working capital. This demand for safe liquid assets is large and growing, both because the world economy is growing and because savings imbalances among economies are large and show no sign

of shrinking. Indeed, the scarcity of suitable assets to fill this role probably explains why the dollar is still treated as a reserve currency in spite of the glaring weaknesses of the American fiscal and financial systems. So where is there left to go? The obvious place is to other currencies. In theory, the euro ought to be a candidate. The market for high-quality euro-denominated securities is huge, as are the outstanding liabilities of Euro-­ zone central banks. But the Greek fiscal crisis, which underscored the fundamental problems facing Europe’s monetary union, suggests that private and official investors aren’t about to create an unofficial euro standard. Japan has plenty of outstanding debt to use as a liquid store of value and a record of stable (even falling) prices. But, because of slow growth and a rapidly aging population, Japan’s long-term economic prospects are problematic. And in any event, other Asian central banks running big surpluses are reluctant for political reasons to depend heavily on Japanese currency as a store of value. Why not create a new international currency to serve an increasingly integrated global economy? The International Monetary Fund already produces such an asset: Special Drawing Rights, which were introduced in 1969 in response to the perception that the world needed another reserve asset to supplement gold and U.S. Treasury liabilities. The exchange value of SDRs is determined by a formula that weights the value of dollars, euros, yen and British pounds. Central banks now hold some $320 billion worth of SDRs, which can be traded at any time for conventional reserve currencies at the daily posted value. But an SDR-based system would face major governance issues. First, someone would have to decide how many SDRs to create, and when. In a dollar-based system, the

decision is effectively left to the Federal Reserve and the U.S. Congress – hardly a delegation of authority that pleases other countries. But the dollar solution at least avoids the problems of collective decision-making. Then, there’s the question of who gets the gravy. Under the current system, SDRs are allocated among member states in proportion to their IMF quotas – their commitments to participate in IMF loan programs. But when SDRs were first dreamed up, the BelgianAmerican economist Robert Triffin suggested that newly created SDRs should be allocated to poor countries as a form of collective foreign aid. And with tens of billions or even hundreds of billions of SDRs being added to the system annually, the issue would surely arise once again.


Gold has long been the foul-weather asset of choice. And in an era of high financial volatility and no clear path to a stable future, it’s not surprising that the price of gold is pushing record highs. Nor is it surprising that people who don’t look very closely may choose to view the era of the gold standard as a model for fixing the global financial system. But nostalgia should not be confused with analysis. The gold standard functioned reasonably well in a simpler time in which the handful of rich industrialized nations that ran the global economy were able to make common cause to bring the system through periods of stress – stress, incidentally, that rarely translated into large changes in income or long periods of high unemployment. Today’s policymakers won’t (and shouldn’t) lock themselves into a similarly rigid system in an era in which the forces driving the global economy are changing rapidly. Replacing today’s messy and far from adequate system with a standard linked to gold (or some other commodity) is just not an option. m

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It’s time for real change in housing finance

e h t g n i t s r Bu


The financial crisis of 2007-09 was, of course, triggered by the puncture of a great housing bubble that had been inflated by mortgage lenders and their agents. And while the full story of this debacle (like every story involving trillions of dollars in capital) is complicated, its outline is pretty straightforward. When home prices began to slip after peaking in mid-2006, a trickle and then a flood of borrowers defaulted on their mortgage payments. This generated losses for lenders and, in turn, the owners of securities that had been backed by those mortgages. A few very large investment banks and commercial banks figured prominently among the ranks of those owners. And their thin capital proved inadequate to absorb the losses, bringing the global financial system to the brink of a true collapse that was prevented only by massive government intervention. The Dodd-Frank Act of 2010, signed by President Obama in July, addresses some of


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Bubb le

jonathan twingley (all)

by lawrence j. white

the weaknesses made plain by the crisis – notably by requiring lenders to keep more capital on hand and giving regulators some tools to contain the systemic risk created by lenders’ behavior. But the law offered only half-measures with regard to the way housing is financed. In particular, it didn’t settle the fate of Fannie Mae and Freddie Mac, the quasi-governmental sources of mortgage finance that have been left holding

Fourth Quarter 2010


the lion’s share of losses from the housing collapse. Nor did the new law touch the direct and indirect subsidies for homebuyers that helped fuel the speculative boom and have long diverted capital from more productive uses. Washington may be loath to revisit housing finance any time soon. But it still makes sense to think through what ought to be done before the next crisis. And even without a crisis to force the issue, housing-finance policy will surely resurface in any serious debate over federal deficit reduction. After all, federal mortgage subsidies


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cost hundreds of billions of dollars annually, much of which is frittered away in building oversized dwellings that savings-strapped America can ill-afford.

gilding the lily Housing-finance policy is a creature of interest-group politics, designed to feed huge construction and finance sectors as well as to please voters by making homeownership cheaper. Consider this embarrassment of riches: The deductibility of mortgage interest and property taxes from taxable income… The exclusion of the ongoing “services” – the equivalent of rent – provided by owner-occupied

housing from taxable income… The exclusion of much or all of the capital gain from selling a personal residence… Reduced costs for mortgages that are routinely insured by the government and government-supported companies for less than the cost… Tax credits for first-time home purchases (which come and go)… Rent subsidies for low-income households… Subsidies for the construction of rental housing… Direct government provision of low-income housing… Myriad indirect subsidies to mortgage lenders… Last year, the nonpartisan Congressional Budget Office estimated that these measures

cost Uncle Sam a whopping $290 billion – some $2,800 per American household. That figure, of course, doesn’t count the cost of regulation that is largely devoted to protecting housing interests from the pain of competition – like many local building codes, states’ effort to protect both full-service real estate brokers and title insurers, and restrictions on imports of building materials, notably lumber. Housing policy is driven by a variety of motives. On the high-minded end, there’s the encouragement of homeownership on the grounds that owners are better citizens than renters and, thanks to the accumulation of home equity, less likely to become burdens on

the state or on their families. Another virtuous goal: redistribution of income (in the form of housing) to needy families in a country that is otherwise reluctant to redistribute income to the poor. But the rock on which the policy is built is the sustenance of a vast commercial ecosystem – the care and feeding of everyone from specialized craft workers to homebuilders to earth-moving-equipment manufacturers to appliance makers.

swamped by technology Before the 1980s, residential mortgages were largely originated, financed, serviced and held

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housing finance to maturity by local deposit-taking institutions – usually savings-and-loan associations and occasionally commercial banks or credit unions. This “vertical integration” of housing finance made economic sense in an era of high-cost data processing and telecommunications. Local lenders were best positioned to judge the creditworthiness of borrowers and to provide funds for and service loans. But the information technology revolution made it practical (and often remarkably profitable) to look to broader markets for mortgage finance and to specialize in component services like mortgage origination and mortgage servicing. The crowning glory of this transformed market: securitization. In 1970, the federally owned Ginnie Mae (the Government National Mortgage Association) first created residential mortgage-backed securities – RMBS, for short. The federally chartered Freddie Mac (the Federal Home Loan Mortgage Corporation) was just a year behind, while the federally chartered Fannie Mae (the Federal National Mortgage Association) entered the great game in 1981. Securitization grew modestly in the 1980s, and then took off in the 1990s as the privatized Fannie and Freddie saw gold in the business. [For a more extensive discussion of Fannie and Freddie, see White’s article in the Second Quarter 2008 issue of the Review.] With securitization, home loans could be originated by specialized mortgage bankers, which immediately sold the mortgages to packager-securitizers, who bundled loans into pools with predictable risk characteristics. The routine servicing of individual mortgages – collecting checks, dunning late payers, L awr e n c e J. Wh ite is a professor of economics at NYU’s Stern School of Business and a former regulator of the savings-and-loan industry.


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managing defaults – could be done by yet another specialized party. And since investors no longer needed local knowledge to assess these mortgage-backed securities, institutions ranging from insurance companies in San Francisco to banks in China could participate. Meanwhile, cheap, fast information technology minimized the cost of the dauntingly complex process of creating and evaluating both the risks and the likely pace of amortization of RMBS. One more invention was needed, though, to push securitization into hyperdrive: securities insurance. Conservative investors needed to be assured that they would receive their interest and principal repayments in a timely fashion. This guarantee was provided by Ginnie Mae (which had the explicit backing of the federal government and which securitized mortgages that were themselves individually insured by the Federal Housing Authority and the Veterans Administration) and by Fannie and Freddie (which, despite being publicly traded companies, had special and very reassuring ties to the federal government). In turn, these securitizers (along with the Federal Housing Administration and Veterans Administration) inherited the task of policing the accuracy of the credit-quality claims made by the mortgage originators. Starting in the late 1990s “private label” securitization by both commercial banks and by investment banks began a rapid ascent. These issuers faced the same problem of how to convince distant, passive investors that they would get their money back. The banks solved this problem with combinations of overcollateralization (backing the mortgages with more than 100 percent of their value in property), reserve funds, and – most important – by slicing the securities into “tranches” with distinct risk characteristics. This last technique arrayed the cash flows from the un-

derlying mortgages in payment priority, so that the most senior tranches would be the last to incur losses from any defaults in the pool, while the most junior tranches would be the first to absorb any losses. (Intermediate tranches would absorb losses only after tranches junior to them had been wiped out by earlier losses.) With the government not in the picture, investors in the private-label RMBS made use of credit-rating agencies to help assess risk. Indeed, prudentially regulated institutional investors like banks, insurance companies, pension funds, broker-dealers and moneymarket mutual funds were largely restricted to tranches with “investment-grade” ratings. Securitization generated large, very real benefits. It allowed borrowers to draw capital from a vast market, increasing competition and lowering mortgage costs. It permitted greater specialization of functions (and thus efficiency) in creating, financing and servicing mortgages. And it managed mortgage risk more effectively through a combination of diversification and tranche creation. On the other hand, the complicated, vertically deintegrated chain of services in securitization opened the door to cheating – economists prefer the more neutral term “moral hazard” – in which the agents at one or more stages had incentives ­to fudge on the creditworthiness of the mortgages and make some extra loot in the transaction. Moreover, with private-label securitizations, the question of whether a servicer should make concessions to a defaulting borrower – a common practice in simpler loan transactions – wasn’t really addressed until it was too late.

pathological optimism and see-no-evil regulation Financial bubbles are nothing new. What made this last housing bubble different is that

the combination of government subsidies, securitization and regulation magnified its size and spread the consequences far wider. After a few years of housing-price increases, too many people came to believe that housing prices could only increase. And this, in effect, made credit quality irrelevant: lenders would always be protected against losses in default by the rising value of the collateral.

After a few years of housing price increases, too many people came to believe that housing prices could only increase. And this, in effect, made credit quality irrelevant. By the same token, if mortgage defaults would never be a problem, neither would defaults on mortgage-backed securities. So, in this world of ever-rising house prices, the vertical partners in the securitization process did not need to be vigilant. These middlemen might fudge credit quality or suck in borrowers with back-loaded repayment terms that would eventually become unaffordable. But with all that collateral being created by rising house prices, default was nobody’s problem. Just why a few years of rising housing prices convinces otherwise rational people that prices will never go down is a puzzle more likely to be solved by psychologists than by economists. Of course, housing prices did peak in mid-2006 and then began to fall, stripping away home-equity collateral that was supposed to protect owners of private

Fourth Quarter 2010


housing finance l­abel RMBS. The consequences were exacerbated by the fact that large investment banks and commercial banks, along with their holding companies, owned great quantities of RMBS. Their thin (though not illegally thin) capital buffers were inadequate to absorb the losses, and the term “too big to fail” became part of the American vernacular. Fannie Mae and Freddie Mac were not immune. Although they had previously maintained high underwriting standards on the mortgages that they bought and securitized, their standards slipped toward the middle of the decade as their executives sought a bigger piece of the profit from the housing boom. By mid-2008, losses had wiped out their capital, and both became wards of the federal government in September 2008. Excess leverage wasn’t just a problem for the lenders. In the go-go years of the housing boom, homeowners were encouraged to minimize down payments and to refinance as soon as possible with the goal of pocketing the cash from the inevitable gain in value. Thus, while one of the reasons for encouraging homeownership was to give households a way to build wealth by amortizing mortgages, the system encouraged them to minimize the equity in their homes. Why wait to renovate the bathroom or to take a cruise? Just cash in the “free money” buried in your house! Note, too, that, the system created incentives to buy (or rent) too much housing. In part, of course, that followed from the relaxation of credit standards and the rise of backloaded mortgage-payment plans that arose during the inflation of the bubble. But it was also the consequence of all those housing subsidies discussed above. Research in the 1980s concluded that long before the housing boom, people were buying or renting 30 percent more housing than would have been the


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case absent the financial incentives. So what’s the big deal? It’s that the resources spent on all that housing had to come from somewhere – in particular, from industrial capital, education and social infrastructure. All told, the capital diverted to excessive housing could have increased GDP by an estimated 10 percent. These findings don’t necessarily contradict claims that we have spent too little on lowincome housing, where distorting housing markets with subsidies-in-kind (like rent vouchers) has been seen as one of the few politically palatable ways to redistribute income to the poor. But a disproportionate share of the subsidies has gone to affluent households – people who were likely to buy anyway and who were in a position to get the most mileage from the tax-deductibility of mortgage interest and property taxes. That largely explains why homeownership rose just five percentage points (from 64 percent to 69 percent) between 1975 and the peak in 2005, while the square footage of new houses grew by about a whopping 50 percent across the same period. It also helps to explain why new dwellings in Germany, France, Belgium and Sweden – countries with living standards and homeownership rates close to those of the United States – are roughly half the size. Ironies pile on ironies. While subsidies and preferences reduce the cost of housing, restrictive zoning, excessively stringent building codes, import restrictions on building materials, and state protection of title insurers and full-service fixed-fee real estate brokers have served to keep housing prices high – especially along the East and West Coasts. Though fraud perpetrated on borrowers was not the major cause of the debacle, there clearly were such instances – especially among low-income, elderly and less-educated households. Further, anyone who has bought a

house and gone through a closing knows what a nightmare that process can be: stacks of documents that the buyer has not a clue about to be signed, multiple checks to be written, impenetrable statements on costs and obligations to be deciphered.

fixing the mess As this is being written, in the late summer of 2010, housing and mortgage markets have not fully recovered from the trauma of the bubble. Housing prices have not yet stabilized; mortgage lenders and residential mortgage-backed securities investors have not adopted a comfortable stance toward the trade-off between risk and return in housing. Consequently, radical moves – like changing the structure of Fannie and Freddie, or eliminating the mortgage interest deduction – are not only politically unrealistic, but would also be unwise in the short run. Nevertheless, it’s time – long past time – to think hard about the rationale for government intervention in housing markets: Homeownership is not for everyone. A house is a large, illiquid asset that often serves as an impediment to job mobility. Homeownership is not an automatic route to building wealth. Indeed, it can be a heavy burden for people with highly variable incomes and expenses. Modest encouragement of homeownership is probably justifiable in economic and social terms. But subsidies should be modest and –

equally important – limited to cash incentives for first-time homebuyers with modest incomes. And government aid should be accompanied by counseling with respect to the responsibilities and burdens of homeownership. Subsidies of any sort to higher-income households serve no social purpose and divert resources from more-productive investments. Using cheap loans to increase homeowner-

ship is bad policy. Borrowing means leverage; subsidized borrowing means excessive leverage. Leveraging is the antithesis of building equity and makes defaults more likely in the event of house-price declines. By contrast, lowering the cost of housing by making the inputs cheaper may make sense.

That can be done by making land cheaper (by reducing or eliminating unwarranted zoning), by making materials cheaper (by allowing competition from imports), by making construction cheaper (by not using restrictive building codes as a way to protect favored contractors and workers) and by making sales transactions cheaper (by not protecting fullservice real estate brokers, title insurers and other providers of closing services). Using government supported agencies like Fannie and Freddie to mediate housing markets is a mistake. They haven’t made much

difference in homeownership rates. But they have distorted mortgage markets, indirectly subsidizing credit and leaving taxpayers holding the bag. Direct government intervention, with the FHA and VA insuring mortgages, and Ginnie Mae packaging them as securities, constitutes a problematic subsidy, even though it has not

generated comparable financial losses. Historically, this route was restricted to lowerpriced homes (the maximum FHA/VA insured loan was in the vicinity of 65 percent of the maximum Fannie/Freddie loan), so moderate-income buyers were the primary beneficiaries. But when the FHA/VA mortgage limit was raised above $700,000 in 2008, the rationale for such insurance evaporated. Deductions (as opposed to credits) are an inherently inferior means of providing subsidies,

because the benefits are higher for higherincome taxpayers and only go to those who itemize deductions on their tax returns.

Fourth Quarter 2010


housing finance Subsidies for housing do create jobs, but so does pretty much any other form of government spending. It’s especially hard to justify

permanent housing-subsidy programs when the nation faces large and growing budget deficits. In light of all this, here’s how I would reform housing policy: 1. Phase out tax preferences. The deductibility of mortgage interest and local property taxes and the exclusion of capital gains on home sales will reduce government revenue by about $160 billion next year. In five years, the cost will be pushing $235 billion annually. It would be unfair (and politically impossible) to eliminate the deduction for existing home mortgages. But a 10-year phaseout, in which the interest deduction on new mortgages would become progressively less valuable, might be palatable. Better yet would be a reform that transformed these deductions into refundable tax credits, so the benefits would not go disproportionately to the affluent. 2. Truly privatize Fannie and Freddie. Once mortgage markets stabilize, securitization can and should become a matter for private markets – and securities regulators who compel transparency. If the brand names, systems and personnel of Fannie and Freddie still have value, they should be able to survive as wholly private entities; if not, then the market will pull the plug. In any event, alas, the accumulated losses of the two companies ($145 billion, and counting) must simply be absorbed by the federal government. Even if true privatization proves to be a political nonstarter, the scope of their mission could be scaled back. One straightforward way: gradually (say, over 10 years) reduce the size of the maximum mortgage that they can purchase and securitize, perhaps to $200,000 or maybe to the median house price.


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3. Private mortgage insurers could pick up the slack. Although private insurers were

damaged by the debacle, they appear to be healing, and others will likely arise. The need for Ginnie Mae would also disappear. 4. Focus remaining subsidies. My preference here would be to strip down the subsidies to a flat $10,000 check for moderate-income firsttime homebuyers. The goal should be to encourage purchases by households that can afford and benefit from homeownership, but are short on the down payment. 5. Encourage competition. The elimination of protection against lumber imports from Canada would make a material difference in construction costs. The larger and more pervasive restraints on competition – everything from interest-group-driven building codes to laws protecting incumbent brokers and title insurers – are creatures of state and local governments. This makes them tough nuts to crack. But one could imagine a combination of mandates and financial incentives from Washington that would induce reforms. 6. Keep the door open to innovative finance.

The goal, as with securitization, is to reduce the cost of capital. Take the case of “covered bonds,” which are bank-issued debt instruments that use pools of mortgages as collateral and are widely used in Europe. The bond investor’s first claim is on the issuing bank. But if the bank becomes insolvent, the investor has a direct claim on the collateral. This collateralized form of borrowing is already used in the United States, in the form of banks’ very-short-term repurchase arrangements (“repos”) with securities dealers and banks’ short- and medium-term advances from the Federal Home Loan Bank System. But it has never been tried for long-term bank debt. The Federal Deposit Insurance Corporation has discouraged such secured borrowing, because it gives lenders priority over it

when banks fail. There is, however, a way to reconcile the FDIC’s legitimate interests with those of the issuers: let the secured lender (or the borrowing bank) pay a fee to the FDIC to compensate it for the loss of seniority. 7. Revive prepayment fees. The option to prepay a fixed-rate mortgage – especially the option to refinance when interest rates decrease from the levels at which the mortgage was originally extended – is valuable to borrowers and costly to lenders. If lenders are not permitted to charge explicitly for the exercise of the option, they can (and surely do) add the expected option cost into the interest rates that they charge on mortgages generally. As a result, borrowers who do not refinance pay part of the costs of those who do. Better, then, to have an explicit fee for the exercise of the option. Note, moreover, that explicit pricing of the prepayment option would make investments in residential mortgage-backed securities more attractive to life insurance companies and pension funds, which need long-term assets to offset their long-term liabilities. 8. Make originators more responsible for mortgage decisions. Most buyers are clearly at

a disadvantage in obtaining a mortgage. The transaction is infrequent and unfamiliar; the sums are large; the options can be many. Stockbrokers have an obligation not to bamboozle their customers by selling them investments that are inappropriate for them – say, by selling pork-belly options to retirees with modest incomes. Mortgage originators should have a parallel obligation to steer borrowers away from, say, back-loaded payment structures that they won’t be able to afford. 9. Make closings consumer-friendly. Because there are likely to be multiple – and un-

familiar – services provided at a closing, with multiple fees, homebuyers are in a poor position to shop around. Far better to encourage one-stop shopping through “aggregators,” who would work like general contractors, competitively bidding to provide all closing services. Aggregators, in turn, would have incentives to pressure subcontractors to deliver specialized closing services at competitive prices. By the same token, buyers deserve something better than an incomprehensible heap of paper outlining the mortgage terms. It is quite possible to devise a one-page statement in reasonably sized print that lays out the basics of the mortgage and the closing costs. Indeed, this should be “job one” for the new Bureau of Consumer Financial Protection that has been established by the DoddFrank Act.


Housing finance can’t be reformed overnight. But the experience of the last few years (in which housing played a key role in triggering a terrible global recession), and the likely experience of the next few (in which the need for deficit reduction will be hard to ignore), could serve as the opening. Eight decades of housing preferences heaped on preferences must be gradually stripped away, with substantial savings for the federal budget. Regulators must focus on creating a competitive private mortgage market – one in which lenders are less likely to destabilize the whole financial system and consumers are protected from abuse. In that world, Americans would likely buy less housing. But grass would not grow in the streets of America as a consequence. Indeed, successful reform could free hundreds of billions of dollars of capital annually for more productive uses – which might even include m more parks in which to grow grass.

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Learning From the BP Oil Spill and Other Catastrophes


by howard c. kunreuther and erwann o. michel-kerjan

The 2010 oil spill on the Gulf Coast is just the latest disaster that highlights a general problem: Decision makers often regard catastrophic events as below their threshold of concern until they occur. This seems to be true for all decision makers – business professionals, homeowners and public officials in charge of minimizing disaster damage. Read the questions below, and ask yourself if you would really, truly answer them differently: Q: Could my company be responsible for a mishap that would have major enduring social, economic and environmental impact? A: It’s not going to happen to us! Q: Would I have the financial resources to rebuild my house after a hurricane? A: The government would bail me out. Q: Could a cyberattack paralyze our infrastructure for several days? A: Science fiction!

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Worldwide Evolution of

Catastrophe Insured Losses, 1970–2009

$100 9/11/2001 loss (liability and life) 9/11/2001 loss (property and bi)



natural catastrophes man-made catastrophes











source: Kunreuther and Michel-Kerjan, At War With the Weather (MIT Press, 2009)

H owa r d Ku n r euth er is Cecilia Yen Koo professor of decision sciences and public policy at the Wharton School of the University of Pennsylvania and co-director of the Wharton Risk Management and Decision Processes Center. E rwa n n M ich e l-Ker jan teaches at Wharton and is managing director of the Wharton Risk Center. They are coauthors of At War With the Weather: Managing Large-Scale Risks in a New Era of Catastrophes (MIT Press).


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sequences of such myopic behavior grow. Not addressing them will simply make the impact of future events more devastating.

a new era of catastrophes Large-scale disasters are low-probability events – but the probability is not as low as it once was. Indeed, such disasters have come with startling frequency in the last decade: Terrorist attacks in New York and Washington (September 2001) killed thousands and forced wrenching changes in security efforts around the world… The Northeast blackout (August 2003) demonstrated how human error and short-term competitive pressure could deprive more than 50 million people of electricity in the United States and Canada... The great Indian Ocean tsunami (December 2004) killed some 300,000 people… Hurricane Katrina (August 2005) devastated New Orleans and overwhelmed emergency services capacities… An earthquake in Sichuan province in China (May 2008) killed

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Accordingly, oil companies underinvest in measures to decrease the likelihood of a major spill as well as in ways to limit the damage if one does occur. Many property owners decide to buy flood insurance only after their houses are under water – and then cancel them a few years later if they haven’t experienced further damage. Public officials won’t burn political capital by imposing costly, but economically justifiable, regulations on bank exposure to financial risk in advance of a crisis because they don’t see how it would help them get re-elected. Yet as the economy becomes larger, more complex and arguably more vulnerable to a wide variety of catastrophes, the potential con-

Bt cotton

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Conventional cotton

nearly 70,000, just a few weeks after a major cyclone killed more than 100,000 in Myanmar... A massive earthquake in Haiti (January 2010) killed 230,000, and a few weeks later another one in Chile caused multi-billion dollar property damage... The collapse of the mortgage bubble (mid-2008) triggered the longest and deepest global economic downturn since the Great Depression… And, of course, the recent BP oil spill (April 2010) cost the U.S. economy billions and damaged the ecology of the Gulf of Mexico in ways not yet fully known. The severity of these events suggests that the world is changing and that we have entered a new era of catastrophes. Of the 25 most costly insured catastrophes in the world since 1970, 17 occurred since 2001. From 1970 to the mid-1980s, annual insured losses from natural disasters (including forest fires) were in the $3 billion to $4 billion range. In fact, before Hurricane Hugo in 1989, the insurance industry had never suffered a single loss over

$1 billion. But these losses radically increased in the 1990s and that trend has continued. The principal reason is that more people are residing in hazard-prone areas and, as a result, more property is at risk. Take Florida. The population was 2.8 million in 1950; today, it is close to 19 million. So a Category 3 hurricane that would have had limited economic impact 60 years ago is likely to do multibillion dollar damage today. By one estimate, the damage from Hurricane Andrew, which occurred in 1992, would be more than twice as great if it occurred in 2010. Today, there are nearly $10 trillion of insured assets on the coast running from Texas to Maine (private and public insurance), all of it at risk from major hurricanes.

behavioral bias What explains our unwillingness to look ahead and act? Findings from lab experiments and field studies by psychologists and behavioral economists reveal a variety of biases that

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overcoming myopia cause decision makers to ignore both the likelihood and the potential consequences of large-scale disasters. Misperceptions of the risk. We often underestimate the likelihood and consequences of extreme events, either by failing to imagine the scenarios in which they might occur or by simply assuming that “it will not happen to me.” Ambiguity of experts. Estimates of the likelihood and consequences of low probability events often differ, given the limited historical data and considerable scientific uncertainty. Decision makers often choose to use the estimates from experts that provide justifications for their preferred actions. Short horizons for valuing protective measures. Businesses (and households) look only

a few years ahead (if not just months) in deciding whether to spend money on lossreducing measures like strengthening structures to reduce hurricane damage. As a result, risk-reducing measures that could be justified financially when comparing costs and expected returns over the long run are often rejected. Disregarding interdependencies. The value of some investments for disaster protection depends on the willingness of others to undertake parallel actions. For example, bank regulation or anti-terrorism measures are far less effective if other nations aren’t on board. Thus, individual countries or companies are reluctant to be first movers, lest they waste political and financial capital. Failure to learn from past disasters. There is a tendency to discount past unpleasant experiences. Emotions are high when we experience a catastrophic event, or even view it on television or the Internet. But those emotions fade, making it difficult to recapture these concerns about the event as time passes. Mimetic blindness. Decision makers often imitate the behavior of others without ana-


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lyzing whether the action is appropriate for them. By doing what other firms do in their industry (or imitating the behavior of friends and neighbors), decision makers can avoid the psychological stress of thinking independently. There is also a tendency to favor the status quo – to not change current practice. In addition to behavioral biases, there are economically rational reasons that firms and individuals in hazard-prone areas don’t undertake risk-avoidance measures. Consider MonkeySee, a hypothetical firm in an industry in which its competitors do not invest in

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loss prevention. MonkeySee might understand that investment can be justified when considering how it reduces the risks and consequences of a future disaster. However, in the near term, the firm may be at a competitive disadvantage because it must bear the higher costs of risk avoidance. Or consider the equally hypothetical Safelee family, which is deciding whether to invest in disaster prevention – say, in a nonflammable roof for the house. If they plan to move in a few years and doubt that potential buyers would appropriately value such a roof,

they may find that the short-term benefits are less than the cost of the improvement.

theory made real Many recent catastrophes can be tied in part to behavioral biases. The BP Oil Spill

BP’s behavior in recent years is puzzling. On the one hand, the giant oil company has invested heavily in green technologies, a seemingly long-term view of the company’s future prospects. BP Solar has become one of the

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world’s largest developers and manufacturers of solar power equipment. And since 2005, the company has invested in wind power as well. On the other hand, BP’s behavior in its core business suggests that the company is myopic with respect to risk, and adapts poorly to past mistakes. A 2005 explosion at BP’s Texas City plant killed 15 people and injured more than 170 others in one of America’s worst industrial accidents in a generation. The government subsequently identified


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more than 300 safety violations, and BP agreed to pay $21 million in fines. There have been other BP accidents since the Texas City explosion. A BP oil platform in the deepwater Gulf of Mexico almost sank in Hurricane Dennis in 2005, and the company was responsible for a significant oil spill in Alaska in 2006. BP exhibits several of the decision biases we discussed above, including maintaining the status quo and mimetic blindness. Appar-

was caused by a failure of a simple engine part – the now-infamous O-rings. Diane Vaughan of Boston University concluded that this tragedy was due to an organizational culture in which production costs took priority over safety. NASA had flown previous shuttles despite recurring O-ring damage. And agency officials were intent on flying the shuttle to maintain financing for the space program and viewed the likelihood of such a disaster as below their threshold of concern. Strikingly, NASA behaved similarly with the Columbia shuttle in February 2003. Despite warning signs and reports that foam debris could cause deadly damage to the aging Columbia, the agency decided to launch – a decision apparently driven by NASA’s focus on making sure that shuttles were launched on time after a history of repeated delays. Eighty-two seconds into the flight, foam debris damaged the shuttle’s thermal protection system, causing the craft to break up upon reentry. Flight operations were delayed for two years after the catastrophe. Terrorism Insurance Markets Before and After 9/11

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ently no one else in the industry had an adequate plan for a deepwater failure. It is likely that BP could not imagine the scale of the disaster that occurred last April in the Gulf Coast or the impact it could have on so many others – and in the end, on its own reputation. Challenger and Columbia Shuttle Accidents

The destruction of the space shuttle Challenger shortly after takeoff on Jan. 28, 1986,

Even risk analysis experts demonstrate behavioral biases. Before 9/11, insurers operating in the United States viewed potential losses from terrorism as so improbable that the risk was neither explicitly mentioned nor priced in any standard policy. Moreover, terrorism was not excluded from so-called “all risk” insurance with the exception of some marine cargo, aviation and political risk policies. The first World Trade Center attack in 1993 (which cost insurers more than $700 million) and the Oklahoma City bombing in 1995 were thus not seen as foreboding enough for insurers to revise their view of the terrorist risk. The actuarial models that insurers used to set premiums included no explicit estimate

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overcoming myopia of the expected cost of terrorism. Most tellingly, there was no change in the way risk was evaluated in the wake of these incidents. Insurers and reinsurers paid $35 billion for the 9/11 attacks – at that time the most costly event in the history of insurance. After that, most of them swung to the other extreme, refusing to offer coverage against terrorism at any price, even though the likelihood of another successful attack on U.S. soil was presumably lower, given the renewed security efforts by governments and private companies. Non-enforcement of Building Codes

Our Wharton colleague Robert Meyer has studied the devastation of Pass Christian, Miss., by Hurricane Katrina in 2005. The storm wiped out all structures on the coast. But apparently no lessons were learned: an apartment complex was rebuilt in 2007 – on the same vulnerable site. Ironically, this was not the first time that apartments had been rebuilt in this area after a disaster. Hurricane Camille destroyed the coastal buildings in Pass Christian in 1969. Although building codes had been in place since 1957, they were not enforced. And they were not enforced again after Camille. Indeed, the obligation to obtain a building permit was initially waived. As a result, homes and businesses built after Camille were wiped out by Katrina. Failure of Individuals to Purchase Flood Insurance

Since 1968, flood insurance has been provided at relatively inexpensive rates in hazard-prone areas by the federal government through the National Flood Insurance Program (NFIP). Still, many people who live in flood-prone areas don’t buy coverage. Many behavioral biases apply here: residents misper-


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ceive the degree of risk, or simply don’t believe a flood could happen to them. Others have short-term horizons. Accordingly, if they have not collected on their insurance policies after a few years, they cancel them. Based on an analysis of the 10-year data set of the entire portfolio of the NFIP, we found that, on average, people let their flood insurance policies lapse after just three or four years. Interestingly, this average tenure hasn’t changed since Hurricane Katrina, when flood insurance claims exceeded $16 billion – a record for this program, which covers more than five million households. While many more people bought flood insurance immediately after the disaster, attention faded a year or two later. The evidence of such imprudent behavior is illuminating. For instance, The New York Times reported that six out of 10 residents in Orleans Parish had no flood insurance when Katrina hit. Or consider the flood in August 1998 that damaged property in northern Vermont. FEMA found that 45 percent of those who resided in designated flood hazard areas had evaded their obligation to maintain insurance coverage.

what to do As these examples show, we excessively discount future returns by focusing on shortterm rewards. That is, we don’t invest in costly mitigation measures because the upfront expenses exceed the short-run benefits. Those concerned with managing extreme events thus need to recognize the importance of providing incentives to offset this myopia. To that end, regulations designed to reduce the likelihood of catastrophic events and to ensure preparedness for recovery need to be tightly enforced. It is important that financial incentives be structured so decision makers’ interests mesh with those of society.

Many people who live in flood-prone areas don’t buy coverage. Residents misperceive the degree of risk, or simply don’t believe a flood could happen to them. For example, executive pay needs to be linked to the long-term performance of a firm, rather than being based on what happened during the past 12 months. It would also make sense to figure out ways to create more immediate rewards for investments in disaster prevention – say, by reducing insurance premiums for homeowners who meet minimum standards. By extending the time horizon and creating appropriate economic incentive systems, we may be able to nudge individuals into taking steps to reduce their own risk exposure while reducing the costs to society in the process. As a concrete example, consider the case of flood risk. One idea we have proposed would be to move from the traditional one-year flood insurance contract and adopt multiyear contracts attached to the property, not to the owner. This would give houses in floodprone areas a fixed, inflation-corrected annual premium for a designated period (for example, 5 or 10 years). In addition, if long-term loans for flood mitigation were offered by banks, households with multiyear flood insurance policies would be encouraged to invest in loss reduction measures. If the measures were cost-effective, the discounts in annual insurance premiums would be greater than the annual cost of the loans. So homeowners would see an immediate advantage in investing in such lossreduction measures. Should the owner sell the property before the end of the policy period, both the insurance and the loan would automatically be transferred to the new owner. Under such a program, millions of house-

holds that are uninsured today would be financially protected, banks would have more secure assets, and the general taxpayer would assume a lower cost of disaster relief after future floods and water-related damage from hurricanes. A win-win-win for all!


Human nature is… human nature. We cannot expect policymakers, investors, business executives, homeowners and others in positions to influence disaster mitigation to act rationally without a financial nudge and/ or clearly enforced obligations. Nor is it enough to wring our hands and talk loudly after each fresh outrage. We need to give people tangible incentives to do the right things. Happily, these seem to be ideas whose time has come. Two examples from our own experience: The World Economic Forum has begun an initiative on global risks in partnership with the Wharton Risk Center and private industry. The project evaluates expert views on the severity and interdependencies of 20 risks over the next 10 years and suggests strategies to manage them using privatepublic partnerships. Similarly, the Organization for Economic Cooperation and Development established an International Network on the Financial Management of Catastrophes in 2006 (again, in partnership with the Wharton Risk Center). The goal is to develop strategies for financing recovery after major man-made and natural disasters that will also encourage investments in risk-reducing measures. Fortune, reminded Sophocles, cannot aid m those who do nothing.

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Water Woes

Using Markets to Quench the Thirst of the American West by gary d. libecap


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It goes without saying that modern civilization turns on the

availability of clean, fresh water at reasonable cost. So it is not surprising that in the semi-arid American West, complex institutions evolved to determine who got access. And while

these rights were often vaguely defined, until the 1990s there was enough water available through government infrastructure that had been bought and paid for decades earlier to satisfy burgeoning demand. Those halcyon days are over. Rapid popula-

tion growth and expanded economic activity have pushed existing capacity to the limit. Mean-

while, the region’s notorious drought cycles, which many believe will be exacerbated by climate change, have made supply more problematic. Now add to that picture two other concerns

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– evidence that more water is needed to protect the environment and a scarcity of capital for expanded storage and transport capacity – and it has become clear to almost all the stakeholders that muddling through has become a very high-risk option. In an economic culture that generally bows to the goddess of property rights, one might have expected that excess claims on existing water would have forced a clarification of rights to that water, followed by the use of market pricing both to encourage conservation and to reallocate water to those who value it most. Indeed, just this sort of institutional evolution took place in the West with hard-rock minerals, oil and gas, timber and land. And there is every reason to believe that markets would narrow price differences between uses and among localities, freeing water for higher-value uses. Yet that process is only beginning, and it is by no means certain that the market

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wate r woes will come to the rescue. Here, I explore why water is such a tough case and what might be done to speed the process.

the water-rights maze For a whole host of reasons – everything from the fact that it is both a private and public good, to the reality that it can be consumed by multiple parties simultaneously – water fits uneasily in textbook models of market allocation. Indeed, the interconnected, overlapping nature of water demands and uses explains in part why various stakeholders have resisted letting markets work their magic. I ask your forbearance in sitting still for a brief (as possible) enumeration of the arcana that stand between business-as-usual and rational allocation that would effectively solve the region’s water problems for decades to come. Appropriative Surface-Water Rights

In Western states, rights to flowing water (i.e., surface water) are largely based on the priorappropriation doctrine, which allows rightsholders to withdraw specific amounts from a natural water course to use where they choose to – in some cases, places far from the source. The prior-appropriation doctrine emerged in the 19th century in response to the opening of rich opportunities in mining and agriculture far from rivers and streams, and the need to support the people arriving to exploit those opportunities. The appropriative system opened the door to using infrastructure – everything from ditches to massive dams to aqueducts – to create great wealth. By law, earlier claimants to appropriative Ga ry L i b e cap teaches in the economics department at the Bren School of Environmental Science and Management at the University of California (Santa Barbara) and is on the Property Rights Task Force at the Hoover Institution.


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rights have priority over later ones. Rights are retained in perpetuity unless claimants fail to put the water to “beneficial” use. And in what amounts to a use-it-or-lose-it mandate, rights revert to the state and can be claimed by others after a specified period of nonuse. Appropriative rights can be traded and, during droughts, senior rightsholders can (and often do) lease water to junior parties. Because lower-priority claims carry greater risk that water won’t be available when it is needed most, they are, of course, of less value. Appropriative rights are measured in terms of quantities diverted from the source. And in many Western watersheds, water has been overallocated because diversions have not been carefully measured and because rights were granted in times of unusually large stream flows. Overallocation can be addressed through mediation or court action. But, not surprisingly, the process can be contentious. Typically, much of the water used by a senior rightsholder seeps back to the stream or percolates down to an aquifer, creating access for junior rightsholders. Thus, market transfers that change the point of diversion, the timing of diversion or the way the water is used – and thereby threaten access for other rightsholders – are regulated to minimize the effects on third parties. Riparian Surface-Water Rights

In the Eastern states, by contrast, water rights are attached to the land through which the water naturally runs, and cannot be separated from it. “Riparian” landowners have rights to this water for reasonable use, including fishing and navigation, and can utilize it as long as doing so does not harm riparian claimants downstream. In cases of drought, all parties share in the reduced flow. Only a handful of the wettest states in the West recognize riparian rights. But when

prior-appropriation and riparian systems do function in the same place, there can be questions of the priority of claims if diversion under the appropriative system reduces access for riparian owners.


Groundwater Rights

Groundwater rights vary across the West and are generally not as well defined as surface rights are. They are also assigned via prior appropriation, granting landowners access to “reasonable use.” With multiple landowners sitting on top of the same pool, many groundwater basins are subject to competitive withdrawal and classic tragedy-of-the-commons conditions in which users bear only a fraction of the full cost of their pumping decisions in

terms of land subsidence, saltwater intrusion, quality degradation and higher lifting costs – and thereby have inadequate incentive to conserve. Some states (notably Arizona) that depend heavily on groundwater have enacted legislation to define groundwater rights more clearly and to manage its sources better. Others, notably California, are far behind. Indeed, even though about 30 percent of California’s water comes from wells, of the 431 groundwater basins in the state, only 22 have had their water rights clearly defined. Rights definition is a costly process, and it should be no surprise that most of the places where the legal and technical issues have been thrashed out are in the arid southern part of

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the state. But as groundwater becomes more important throughout the West, it is likely that linkages between surface and groundwater will be defined more precisely. Beneficial Use, Diversion Requirements, Preferential Uses

Appropriative rights are legally conditioned on placing the water into beneficial use without undue waste. Most Western states define beneficial uses fairly clearly as agriculture, industry, municipal supply, power generation and navigation. But the definition is flexible. For example, leaving water in streams for habitat preservation has recently been accepted as a beneficial use – though the rules vary from state to state. Typically, one can see a symbiosis at work here: private owners shift water rights into instream rights that are nonappropriative in order to protect their own rights from loss due to nonuse. Historically, the requirement to use or lose water motivated farmers to irrigate low-value water-intensive crops, like alfalfa for cattle


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feed. Indeed, the failure to dump water on growing plants of one sort or another could be interpreted as evidence of a lack of beneficial use, opening it to claims by others. No Injury Rules

If a senior rightsholder sells water or increases consumption, the amount available for subsequent users may drop. The prospect of such third-party impairments has led Western states to create procedures that must be followed before water use can be altered or rights transferred. Although these procedures vary, they typically allow changes in use or transfers only if there is no harm to other rightsholders – i.e., those states effectively created a no-injury rule. Before water can be sold or leased, the owner must get permission from the relevant state agency, with the burden of proof of no injury usually resting on the applicant. Objections from users down the line may be resolved by adjustments in the amount of water, timing or allowable uses in the exchange – or

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with cash. But the resolution of other thirdparty complaints may not be so straightforward. If, for example, substantial amounts of land are taken out of agriculture when water is diverted, all the stakeholders in local farm economies may be affected. And here, figuring out who owes what to whom is no easy matter. Moreover, the uncertainty created by such claims undermines the potential for using markets to allocate water to its highestvalued use. One way to finesse these claims is to shift the burden of proof of harm to those who protest water transfers. But that does not address fairness concerns in rural communities where equity issues loom large in local politics. Nor does it offer a way to win over other stakeholders – everybody from farm-equipment dealers to tax collectors – whose interests are indirectly linked to agricultural output. Luckily, though, only modest amounts of water (the proverbial low-hanging fruit) need be traded to generate major gains in efficiency. Regulation overseeing trading varies. Cali-

fornia has an especially tortuous system, with the state’s Water Resources Control Board and Department of Water Resources, as well as the Federal Bureau of Reclamation, getting in on the act. The control board has legal authority to veto transfers that would “unreasonably affect the overall economy of the area from which the water is being transferred.” Further, 22 of California’s 58 counties have asserted rights to restrict the extraction and export of groundwater. These county ordinances also can limit surface-water transactions if they appear to diminish groundwater resources. Indeed, there is little doubt that the whole point of the ordinances is to preserve the status quo, to prevent reallocation to urban or environmental uses. Ironically, California (unlike many other states) already has an elaborate physical infrastructure in place for transferring water from wetter places (in the north) to drier, more populous areas. However, the north-south flow goes through the Sacramento-San Joaquin Delta, home to the endangered delta

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Public Resource, Public Interest, Public Trust

Some people argue that water is too important to be left to markets – that it should be owned and allocated by public agencies. But the record of government involvement is problematic at best. In the case of ocean fisheries, for example, public ownership and management has generally led to overuse, while privatization through the creation of tradable catch permits has resulted in both lower fishing costs and significant rebounds of stocks.


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A less extreme means of second-guessing private allocation is to require that water be used in the “public interest.� But that notion is vague. And the broader the interpretation, the more difficult it is to use market incentives to encourage conservation or to channel the resource to higher-valued uses. It is true that some societal values are not reflected in market prices freely determined by private contract. But these values can be incorporated by allowing markets to price water and then acquiring the water needed for public purposes with government funds or charitable contributions. This approach has been used in purchases and leases of water for instream flows by organizations that

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smelt and other species protected by federal law. And the courts have not looked kindly on trades through the delta.

include the Oregon Water Trust, the Montana Water Trust and Trout Unlimited. Such transactions make the real value of water more transparent, creating incentives for more efficient use. Consider, too, the related doctrine of “public trust,” which is a common law principle giving the public a claim on certain lands and waters, like tidewaters, navigable rivers and other natural resources with high amenity or public-goods values. It was applied in a farreaching ruling by the California Supreme Court in 1983 involving Los Angeles’ claims to the water in streams leading to Mono Lake. And it may be applied retroactively to roll back existing appropriative rights that are deemed inconsistent with the public trust. There need be no compensation under the public-trust doctrine. Accordingly, compromise is difficult. In the Mono Lake case, the litigants battled for 20 years before Los Angeles was forced to relinquish its rights to bring water down the Los Angeles Aqueduct. A negotiated purchase of the rights, perhaps under the threat of condemnation, would likely have been timelier and much less costly.

the decision makers As noted above, numerous third parties can play key decision-making roles, adding perplexing complexity to this stew of interest groups. State Regulators and Water-Supply Organizations

Some 1,100 water-supply organizations, ranging from irrigation districts to municipal water districts to private water companies, may have leverage over trading decisions, and their incentives to facilitate market transfers vary widely. For example, the governing boards of irrigation districts may effectively be controlled by farmers who could make a

lot of money selling water, or the boards may be elected by the whole community, which has nothing to gain and much to lose from sales that take land out of farming. The experiences of the Palo Verde and Imperial Irrigation Districts in California illustrate the differences. The Palo Verde district’s board is elected by property owners. It reached agreement quickly and smoothly in 2004 to let between 7 and 29 percent of its members’ land lie fallow on a rotating basis in return for cash from the Metropolitan Water District, the huge agency that delivers most of the water to Southern California. By contrast, the board of the Imperial Irrigation District, which has a claim to about two-thirds of all the Colorado River water diverted to California, is elected by all registered voters. Beginning in the 1990s, there were efforts to transfer some of that water to San Diego and other cities. A tentative agreement was reached in 2002, but it collapsed when local officials protested the likely losses in jobs and taxes. The deal was only resurrected after the U.S. Department of the Interior (which administers Colorado River water) intervened – and only after more money was included for community compensation. The Bureau of Reclamation

The Federal Bureau of Reclamation is the largest wholesaler of water in the country, capturing water in some 600 dams and reservoirs, and selling it to 140,000 farms covering millions of acres in 17 states – often at far below market value. And its policies with regard to transfer, official and unofficial, have varied greatly with time and place. One consequence: it reduces farmers’ incentives to resell water because they fear they may lose access to federal largesse. This maze of institutional barriers suggests that selling water is hardly like selling

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Water Transfer Prices by Sector, 1987-2008

plying there is much opportunity to increase the value of water through trading. Because sales (as opposed to Agriculture- Agriculture- Agriculture- Agriculture to-urban to-agriculture to-urban to-agriculture leases leases sales sales leases) create a perpetual (and thereMedian Price $74 $19 $295 $144 fore more valuable) claim on water Average Price $190 $56 $437 $246 flows, sales prices are naturally higher. Number of Trades 204 207 1,140 215 Prices also differ sharply by state, with averages for one-year leases source: author’s calculations ranging from $8 per acre-foot in other real property. And the resulting ineffiIdaho to $87 in Arizona and averages for sales ciency is reflected in the low level of transacranging from $113 acre-foot in Idaho to tions and seemingly permanent price differ$6,592 (!!!) in Colorado. These price gaps unentials between localities and among uses. derscore the inefficient segmentation of water markets. Water Price Differentials, 1987-2008 In theory, one could get a clear sense of the potential gains from unimpaired water tradFew Western states keep systematic records of ing from these price differences. Unfortuwater transactions. My own analysis is based on 4,220 transactions from a 22-year period nately, water markets are too thin to make this easy. But one example is illustrative. from 1987 through 2008, as compiled at the Bren School at the University of California, Groundwater for farming cotton near MaSanta Barbara from reports in the trade jourrana, Ariz., costs approximately $27 per acrefoot. The same water supplied to Tucson, nal Water Strategist. which is about 25 miles away, will cost urban The table above shows average and median customers $479 to $3,267 per acre-foot. prices per acre-foot (the amount of water it WestWater Research, a water broker, offers takes to cover one acre a foot deep, or approximately 325,000 gallons) for the 12 Western more illustrations. Nevada’s Truckee River states. The prices for sales and multiyear Basin has been one of the most active markets leases are given as the value per acre-foot of in the Western United States, thanks largely to urban growth in the Reno-Sparks area. Bethe committed flow of water. Where multitween 2002 and 2008, there were 1,025 water year contracts are involved, the quantities are discounted in a process analogous to detersales to urban users, with a median price of $17,685 per acre-foot, as compared to only 13 mining the present value of a bond. Because sales to agricultural users, with a median most water has been consumed in agriculture (at prices set by historical cost) but most new price of $1,500. By contrast, the market built around the demand is for urban and environmental uses, the trades reported are mostly for transfers Colorado-Big Thompson project in northern out of agriculture. Colorado yielded much narrower differences. The findings confirm the obvious: agricul- And no wonder. Within this large waterture-to-urban prices are far above those for supply project, each user has an identically agriculture-to-agriculture trades. A bit of the defined claim to water units that are tradable, and there are no return-flow considerations difference may be associated with the higher costs of moving water to cities, but not much: that could lead to third-party impairments. the market for water is grossly inefficient, im- Water trades occur smoothly and frequently. (2008 dollars per acre-foot)


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For example, in October 2008, an agricultureto-agriculture trade took place at $9,152 an acre-foot, just $53 less than an agriculture-tourban trade that same month. Unfortunately, the Colorado-Big Thompson market is a very unusual one. But it provides a template for what might be possible elsewhere. Welfare Gains from Greater Trading

Differences in water values across sectors indicate that moving water from agriculture to urban and industrial uses can yield enormous returns. As I have noted, the calculation of the benefit is complicated. Nevertheless, we can use price data for different types of trades and United States Geological Survey estimates of the amount of water applied in irrigation to perform a simple exercise that illustrates the potential for trading. Transferring a relatively small amount of Western water – 3 percent of water currently used for surface irrigation – from agriculture to urban use would generate $98 million per year in net benefits. Patterns of Water Trading, 1987-2008

All Western states allow for transfers of water under terms ranging from short (one-year) leases to long (35-year) ones. Some are simple transfers between agricultural users in the same locality. Some involve transfers among uses from a common source, while others involve long-distance exchanges. As the figure at right shows, volumes in agricultural-to-urban and agricultural-to-environmental transfers are increasing, while ag-to-ag trades suggest no discernable trend. But the pattern varies greatly by state. Colorado dominates in terms of total market transactions, reflecting the institutional advantages of the Northern Colorado Conservancy District and the Colorado-Big Thompson Project, where the costs of trading are low

number of transfers in 12 western states 350 300 total

250 200 150 ag-to-Urban



50 0






source: author’s calculations

and most involve sales of relatively small amounts of water. Other active-market states are California, Texas, Arizona and Nevada. California’s institutional and regulatory environments explain the focus on short-term leases. In Arizona and Nevada – both rapidly urbanizing, dry states – sales are common, But – not surprisingly – Montana and Wyoming, the least urban of the 12 Western states, have the fewest water sales. There are also important differences in the parties involved in the transactions. In Colorado, Nevada and Washington, agricultureto-urban trades account for most of the water, reflecting rapid urbanization. In California, single-year leases within agriculture dominate, with a few large multiyear leases from ag-tourban use in Southern California. Most transfers are within states, limiting the potential gains associated with transfer to higher-value uses. Even so, the numbers are fairly impressive, offering a hint of the opportunities for addressing growing problems of regional scarcity.

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wate r woes Farmers are often eager to engage in water trades; the financial benefits can be quite a lure. For example, consider a sale of 1,200 acre-feet of groundwater in California from agriculture-to-urban use. At a sale price of $275 an acre-foot, plus a processing fee of $20,000, the total revenue to the farmer was $350,000. In spite of pumping costs of $50 to $75 per acre-foot, consulting fees of $25,000 to gather needed hydrological information for regulatory review and $70,000 in legal fees for the regulatory process, the net income was still $165,000. A bonanza, compared to, say, the economics of growing alfalfa to feed animals. The big question, then, is how to remove unreasonable hurdles from the process.

the way forward To create reasonably efficient markets with low transactions costs, a variety of changes are needed: Surface-water rights must be better defined and quantified, and recorded in state registries. Groundwater rights must be simi-

larly defined, with withdrawals monitored by local water masters. Meanwhile, the links between ground- and surface water need to be recognized in defining rights. Private water rights need to be endorsed as a basis for use and exchange by state legislatures. And the ownership of water within

supply organizations like irrigation districts needs to be clarified, with decision-making assigned to owners – not boards controlled by ancillary groups. Private water banks need to be encouraged.

These would involve virtual deposits of excess water, whereby owners could offer specific amounts for sale or lease at specified prices. These banks would standardize terms of transfer, like other commodity exchanges do. Such banks have been used in the past, but


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the prices have been heavily regulated and the administrative fees imposed have exceeded real costs. The no-injury harm rule for assessing water trades should be defined precisely and the

range of objectors limited to those with a direct stake in the process. “The public interest” should be defined clearly and narrowly to reduce uncertainty. Similarly, area-of-origin restrictions on trading should be limited to actual hydrological effects of trading – and not used to mitigate pecuniary effects of transfers. The public-trust doctrine should be invoked only as a last resort. Instead, water should be

purchased for environmental use by state agencies or nonprofit groups, and the possibility of condemnation of water for public uses employed as a lever in bargaining. This threat would work much the way it works in land condemnation to overcome the holdout problem in public infrastructure investments. Retail urban water pricing needs to be reformed to promote efficiency. Some cities, in-

cluding Sacramento, do not meter water use at all; others charge flat unit prices that don’t reflect the high cost of adding new supplies. Consider two Arizona desert cities. Tucson’s water rates rise steeply with consumption, and in 2007, annual use per capita was 140,800 gallons. By contrast, Phoenix has flat rates, and consumption was 75 percent greater.


The West’s water policy is a minefield in which policymakers and politicians are inclined to step gingerly – or not at all. But with urban and environmental demand for water growing at a prodigious rate and supply growth constrained by a host of factors, the path of least resistance is no longer an option. The region’s fabled quality of life turns on easy access to water, and only well-functioning markets can offer the prospect of delivering m that water at reasonable cost.

b o o k e x c e r p t

Zombie Economics

How Dead Ideas Still Walk Among Us

i l l u st r at i o n s b y edward kinsella


John Quiggin, an economist at the University of Queensland and a prolific blogger, is

not as well-known as he should be outside

Australia. But we suspect this is about to change. Quiggin’s book, Zombie Economics: How Dead Ideas Still Walk Among Us, to be published this fall, is a devastating critique of the conventional economic wisdom that brought us to the precipice in the financial crisis and stands in the way of the fundamental reforms needed to revivify market capitalism. ¶ The chapter excerpted here explores what’s often called the “trickledown” hypothesis – the notion that we all have a common interest in the success of the wealthiest among us and, accordingly, that inequality in incomes and wealth should not be a concern. Quiggin, a social democrat in the mold of a Paul Krugman or a Joe Stiglitz, offers a scathing analysis, arguing … well, let’s let him speak for himself.

— Peter Passell

*Published by Princeton University Press. All rights reserved.

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The money was all appropriated for the top in the hopes that it would trickle down to the needy. Mr. Hoover didn’t know that money trickled up. Give it to the people at the bottom and the people at the top will have it before night, anyhow. But it will at least have passed through the poor fellow’s hands. – Will Rogers As long as there have been rich and poor people, or powerful and powerless people, there have been advocates to explain that it’s better for everyone if things stay that way. The hymn “All Things Bright and Beautiful,” one of the favorites of my youth is, for the most part, a paean to the beauties of creation. Sadly, the real message comes in the verse, “The rich man in his castle, the poor man at his gate, God made them high and lowly, and ordered their estate.” Many of the greatest economists, including Adam Smith, John Stuart Mill and John Maynard Keynes have supported income redistribution through progressive taxation, and the great majority of economists do so today. Nevertheless, there has always been a plentiful supply of economists and others willing to argue that it is better to let the rich get richer, and wait for the benefits to trickle down. This idea seemed dead in the years after 1945, when a massive reduction in inequality went hand in hand with full employment and prosperity. The outcome, unique in history, was a society that was overwhelmingly middle class in terms of living standards. The Marxist critique of capitalism, still issued regularly by Soviet propagandists, came to seem quaint and old-fashioned. But as inequality returned in the 1980s, so did its intellectual defenders. Advocates of lower taxes on the rich argued that, sooner or later, everyone would be better off if their policies were adopted. For a while their promises seemed on the verge of fulfillment, as


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most people seemed to share in the prosperity of the 1990s. The failure of this promise in the 2000s has been accompanied by the death of most of the theoretical ideas that supported it. But trickle-down economics lingers on in zombie form. Like most labels, “trickle-down” is a pejorative term, used mainly by critics. The trickle-down idea has been summed up more positively in the aphorism “a rising tide lifts all boats” attributed to John F. Kennedy, and a favorite of Clinton advisers Gene Sperling and Robert Rubin. One important version of trickle-down economics is the “supply-side” school of economics, which came to prominence in the 1980s. The extreme claims made by some supply-siders threw this school into disrepute. However, more restrained versions, referred to by terms such as “dynamic efficiency” and “new tax responsiveness,” were widely accepted during the years of the Great Moderation of the 1990s – years of stable prices and solid economic growth. This didn’t happen in a vacuum. The renewed popularity of trickle-down economics coincided with a resurgence of the political right, and with financial globalization, which constrained the ability of governments to redistribute income from capital to labor. It was also, no doubt, influenced by the fact that most economists were among the beneficiaries of this process. That was true, in part, because most economists are in the top 20 percent of the income distribution, which


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received most of the growth in income over this period. More important, perhaps, the huge growth in the financial sector, and in the incomes of those who worked there, had a flow-on effect to related professions. For economists, at least, trickle-down really worked.

birth: from supply-side economics to dynamic scoring Regardless of nomenclature, the near-universal prosperity of the postwar boom seemed to constitute a refutation of trickle-down economics every bit as decisive as the refutation of pre-Keynesian economics by mass unemployment in the 1930s. Throughout the developed world, the growing prosperity of the years after 1945 was accompanied by reductions in income inequality and a softening of the differences between classes. The experience of the United States was particularly striking. Emerging as the unchallenged economic leader of the world after 1945, U.S. firms were in a position to pay manual workers at rates that propelled them into the middle class. And the middle class itself grew and prospered to an extent that seemed to portend the end of class conflict – and even the end of class itself. The American middle class enjoyed living standards that, in many respects, outstripped the best that had been enjoyed by the rich in any other time and place. All of this was achieved under policies that are, in retrospect, hard to believe were ever politically possible. Income taxes, then still a novelty, were steeply progressive. Top marginal rates often exceeded 90 percent. Inheritances were also heavily taxed, while ordinary people benefited from a variety of new welfare measures, such as Social Security in the United States, which provided protection against the risks of old age, unemployment and disability. Economic historians Claudia


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Goldin (Harvard) and Robert A. Margo (Boston University) called the resulting period of high equality the Great Compression. The Great Compression ended almost as suddenly as it began. From the early 1980s onward, the gains in equality were reversed. This occurred partly as result of the changes in the distribution of market incomes: profits grew at the expense of wages, and the distribution of wages became more unequal. But changes in market income were reinforced by public policy. The steeply progressive income tax rates of the postwar era were replaced by a flatter tax system. Maximum rates were cut to 40 percent or less. Initially, and to some extent even today, these measures were presented as providing tax relief to the “middle class.” This is an elastic term, but one that is typically taken to include families with incomes ranging from the median to the 90th percentile of the income distribution, or sometimes even higher. Increasingly, however, tax reductions were focused on those in the top 10 percent of the income distribution – people who could not be called middle class, even on the broadest use of the term. The pattern set by the United States in the 1980s was followed, to a greater or lesser degree, by other English-speaking countries as they embarked on the path of market liberalism. The most striking increases in inequality were in Britain under the Thatcher government, where the widely used measure of inequality called the Gini coefficient rose from 0.25, a value comparable to that of Scandinavian social democracies, to 0.33, which is among the highest (that is, most unequal) values for developed countries. New Zealand started a few years later, but chose even more radical reforms, cutting the top marginal rate of income tax from 66 percent in 1986 to 33 percent by 1990. Not surprisingly, this pushed New Zealand’s Gini coeffi-

cient from an initial value of 0.26 to 0.33 by the mid-1990s. Canada and Australia both followed a similar path, as did Ireland in the 1990s. Most countries in the European Union resisted the trend to increased inequality through the 1980s and 1990s, but recent evidence suggests that inequality may be rising there, also. The increase in inequality did not go unnoticed. By the 1980s, economists including Katharine Bradbury (Federal Reserve Boston), Gary Burtless (Brookings) and Paul Krugman (Princeton) were pointing with alarm to the

ductions in taxation. A variety of ideas of this kind were put forward under the banner of “supply-side” economics. The term dates back to the 1970s, when it was popularized by Jude Wanniski, then an associate editor of The Wall Street Journal and later an economic adviser to Ronald Reagan. Wanniski, a colorful figure, did not let his lack of academic credentials deter him from taking on big names in the economics profession, including not only Keynes and his followers, but also Milton Friedman.

In the years after 1945, the American middle class enjoyed living standards that, in many respects, outstripped the best that had been enjoyed by the rich in any other time and place. disappearance of the middle-class America in which they had grown up. This concern has since increased, as the growth of inequality has become ever more visible. On the other hand, many other commentators regarded the growing inequality of the market-liberal years with complacency or positive approval, typically focusing on its supposed consequences, such as economic dynamism. The growth of inequality attracted attention only briefly, when it was blamed on politically controversial policies favored by market liberals such as free trade and expanded immigration. A flurry of studies demonstrated that these factors were unlikely to be important. It was concluded, by default, that technological change must be the driving force. Supply Side

As inequality increased, so did the demand for theoretical rationalizations of policies benefitting the wealthy – and in particular for re-

The central idea followed directly from the negative conclusions of the then-in-vogue New Classical economics regarding the possibility of successful demand management. If, as the New Classical school believed, such demand-side policies were bound to be ineffectual or counterproductive, the only way to improve economic outcomes was to focus on the supply side – that is, to increase the productive capacity of the economy. Although many policies, such as improved education, might be advocated as ways to improve productivity, Wanniski focused on the kinds favored by market liberals, including reduced regulation and lower income taxes. Wanniski started the process with his “Two Santa Claus” theory of politics. This was the idea that, in a contest between one political party (the Democrats) favoring higher public expenditure, and another (the Republicans) favoring lower spending, the high-spending party would always win. So, the correct political strategy for conservatives was to campaign

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for tax cuts, without worrying too much about budget deficits. Any problems with budget deficits would be resolved by the higher growth unleashed by improved incentives and reduced regulation. This idea was the starting point for a famous lunch meeting between Wanniski, Donald Rumsfeld, Dick Cheney and University of Southern California economist Arthur Laffer. These four, relatively obscure figures at the time, were to play a central (and disastrous) role in the economic and political events of the next 30 years. Everyone knows the story of how Laffer drew a graph on a napkin, illustrating the point that tax rates of 100 percent would result in a cessation of economic activity and therefore yield zero revenue. Since a tax rate of zero will also yield zero revenue, there must exist some rate of taxation that yields a maximum level of revenue. Increases in tax beyond that point will harm economic activity so much that they reduce revenue. Wanniski christened this graph the “Laffer Curve.” But as Laffer himself was happy to concede, there was nothing original about it; it can be traced back to the 14th century Arabic writer Ibn Khaldun. Laffer credited his own version to the nemesis of supply-side economics, John Maynard Keynes. And while few economists had made much of the point, that was mainly because it seemed too obvious to bother spelling out. What was novel in Laffer’s presentation was what might be called the “Laffer Hypothesis” – namely, that the United States in the early 1980s was on the descending part of the curve, where higher tax rates produced less revenue. Unfortunately, as the old saying has it, Laffer’s analysis contained a mixture of correctness and originality. The Laffer Curve was correct but unoriginal. The Laffer Hypothesis was original but incorrect.

More sophisticated market liberals could also see that the Laffer Hypothesis represented something of an “own goal” for their side. (In soccer, an own goal is one accidentally kicked by a player on the defending side, and counts as a goal for the other side.) If the debate over tax policy turned on whether tax cuts produced higher revenue, and were therefore self-financing, the advocates of lower taxes were bound to lose – at least in policy circles where empirical evidence was taken seriously. Embarrassingly for their more sophisticated allies, supply-siders made, and continue to make, obviously silly arguments. Fairly typical is the claim that, despite cutting taxes, Ronald Reagan doubled U.S. government revenue, a claim derived from the work of right-wing think tanks such as The Heritage Foundation. Leaving aside the fact that revenues did not, in fact, double under Reagan, such claims ignore the reality that tax revenues, and the cost of providing any given level of government services, rise automatically with inflation, population growth and increases in real wages. Even with cuts in tax rates, revenues are bound to rise over time as the nominal value of national income increases. For the Laffer Hypothesis to be supported, tax cuts would have to increase revenue more rapidly than would be expected as a result of normal income growth. In fact, as Richard Kogan of the Center on Budget and Policy Priorities has shown, income tax receipts grew noticeably more slowly than usual after the large cuts in individual and corporate income tax rates in 1981. To the extent that there was an economic response to the Reagan tax cuts (and to those of George W. Bush 20 years later), it seems largely to have been a Keynesian demand-side response, to be expected when governments provide households with additional net income in the context of a depressed economy.

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In fact, some supply-siders, happy to push any argument for tax cuts, ended up embracing the most simplistic forms of Keynesianism, much to the disgust of more consistent market liberals. The Dynamic Trickle-Down Hypothesis

Mainstream market liberals were generally disdainful of the “voodoo economics” of the Laffer Hypothesis. They nonetheless accepted the central postulate of trickle-down economics, that policies favorable to the wealthy will in the long run produce benefits for everyone, compared to the alternative of progressive taxes and redistributive social welfare policies. Rather than rely on the simplistic and easily refuted Laffer Hypothesis, market liberals claimed that the trickle-down effect would work through so-called dynamic effects of free-market reforms. The appeal of this argument depended in large measure on conflating the ordinary language meaning of “dynamic” with the technical economic meaning. In technical terms, “dynamic” effects are those realized over time – in this case, as the capital stock in an economy changes. But in political discussion, it is easy to slide from this technical use into rhetoric about dynamism (and its opposite, sclerosis) that relies on the ordinary language meaning. This analysis formed the basis of a number of “dynamic scoring” exercises aimed at estimating the effects of the Bush tax cuts of 2001. Supporters of the Laffer Hypothesis hoped that these exercises would show tax cuts paying for themselves in the long run. Dynamic scoring analyses found some positive effects on capital accumulation, but they were too small in terms of their effect on incomes and tax revenues to offset the initial costs of the tax cuts. The most optimistic study, undertaken by Greg Mankiw, former chairman of President George W. Bush’s


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Council of Economic Advisers, and Matthew Weinzierl (Harvard University), found that dynamic effects would offset about 17 percent of the initial cost of a cut in taxes on labor income and about 50 percent of the cost of a cut in taxes on capital income. However, as subsequent analysis showed, these results depended critically on technical assumptions about how the tax cut was initially financed. Mankiw and Weinzierl assumed that tax cuts were associated with expenditure cuts sufficient to maintain budget balance, and that the expenditure that was cut was a pure transfer rather than investment in something productive. Eric Leeper (Indiana University) and ShuChun Susan Yang (IMF) examined the case when, as actually happened, the cuts were initially financed by higher debt. In this case, it turns out that dynamic effects can actually increase the initial cost of a tax cut. A further difficulty was that, since the increased income was the result of additional savings (and therefore, less consumption), it could not be regarded as a pure economic benefit. The relevant measure of economic benefit, netting out costs from benefits, is the change in the present value of current and future consumption, which is much smaller than the final change in income. Even for large tax cuts, the net dynamic benefit is rarely more than 1 percent of national income. The same point may be made in terms of the effects on the government budget. Even if tax cuts eventually generated enough extra revenue to match the annual cost of the cuts (and, of course, they never do!) the budget would still be in long-term deficit because of the need to service the debt built up in the transition. The implications for the trickle-down hypothesis are even worse. Under standard assumptions about the way the economy works, all the benefits of additional investment go to

Defenders of the trickle-down hypothesis frequently employ what blogger John Holbo calls “the two-step of terrific triviality,” which is to “say something that is ambiguous between something so strong it is absurd and so weak that it would be absurd even to mention it.” those whose savings finance that investment. That is, cutting taxes for the rich may lead them to save and invest more, thereby making themselves still richer. But there is no reason to expect any benefit for the rest of the community except to the extent that the cost of the original tax cut is partially defrayed. Finally, and most importantly, the neoclassical model used to derive estimates of dynamic benefits implicitly assumes that the extra investment generated by more favorable tax treatment is allocated efficiently so as to produce higher rates of long-term economic growth. Until the financial crisis, the experience of countries that cut taxes on capital income appeared to validate this assumption. Iceland, Ireland and the Baltic states, among others, experienced rapid economic growth as a result of high domestic investment and strong capital inflows. But the economic crisis proved that this apparent success was built on sand. Much of the extra investment went into real estate, or into speculative ventures that collapsed when the bubble burst. Another version of the argument was put forward by economists associated with the Republican Party, notably Martin Feldstein (chairman of the Council of Economic Advisers and chief economic advisor to Ronald Reagan) and Lawrence Lindsey (director of the National Economic Council under George W. Bush). Feldstein and Lindsey presented arguments referred to as the “new tax respon-

siveness” theory, suggesting that tax cuts for the very rich would lead them to reduce their efforts at tax avoidance and thereby raise additional revenue. Subsequent work found that the results of Feldstein and Lindsey were overstated, and led to the common-sense conclusion that the best way to minimize tax avoidance was to tighten up on tax loopholes and tax havens.

life: excuses for inequality Defenders of the trickle-down hypothesis frequently employ what blogger John Holbo calls “the two-step of terrific triviality,” which is to “say something that is ambiguous between something so strong it is absurd and so weak that it would be absurd even to mention it. When attacked, hop from foot to foot as necessary, keeping a serious expression on your face.” The self-evident and weak version of the trickle-down theory starts with the observation that we all benefit, in all kinds of ways, from living in an advanced industrial society with access to modern medical care, consumer goods, the Internet and so on. Stretched widely enough, the term “capitalism” includes all advanced industrial societies, from Scandinavian social democracies to the Hong Kong version of laissez-faire. So, in this sense, the benefits of capitalism have trickled down to everyone. The strong version of the claim is obtained by shifting the meaning of capitalism to

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mean the free-market version of capitalism favored by market liberals. And relatively few of the benefits mentioned above can be traced directly to this form of capitalism. Many advances in medical care have come from publicly funded research and from innovations developed in the public health sector. The contributions of for-profit pharmaceutical companies, though important, have been modest by comparison. Similarly, the Internet was developed by the publicly funded

Income, Inequality and Taxation

The most obvious implication of the trickledown hypothesis is that inequality in market incomes is not only harmless but positively desirable, producing benefits for everyone in the long run. The general idea is that, the greater the rewards given to owners of capital and highly skilled managers, the more productive they will be. This will lead both to the provision of goods and services at lower cost and to higher demand for the services of less-skilled

It is easy to suggest that tax and other policies should apply neutrally to all sectors of the economy, but harder to define how this should actually work. university sector. Even now, the most exciting developments are nonprofit innovations like Wikipedia. The crucial question is not whether technological progress and economic development yield benefits to everyone. Clearly they do, at least in material terms. What matters is whether market-liberal policies generate more progress than more egalitarian alternatives – so much more that everyone is better off in the end. It is this strong claim that was made repeatedly during the era of market triumphalism in the 1990s and was repeated, though with somewhat less conviction, through the 2000s. The growth in U.S. inequality during the Great Moderation was undeniable (though that didn’t stop some commentators and think tanks trying to deny it). Optimistic assessments of economic performance during the period appeared to support the claim that rising inequality must be good for, or at least consistent with, economic growth that would ultimately benefit everybody. Now, in the wake of the global financial crisis, this claim can be seen to be unambiguously false.


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workers who will therefore earn higher wages. In the abstract language of welfare economics, the central implication of the trickledown hypothesis is that policy should be aimed at promoting efficiency rather than equity since in the long run, equity will take care of itself. Put in terms of a more homely metaphor, we should focus on making the pie bigger, rather than sharing it out more equally. In reality, things are not that simple. It is easy to suggest that tax and other policies should apply neutrally to all sectors of the economy, but harder to define how this should actually work. It might seem that a “flat” tax system in which all forms of income are taxed at a low,uniform rate would satisfy the efficiency criterion. But advocates of trickle-down argue that income from capital should not be taxed at all. Going further, market liberals have claimed that, since everyone benefits from many of the services provided by government, the most efficient and equitable form of taxation is a poll [head] tax. A poll tax was, in fact, introduced by the Thatcher government in Britain to finance local government services, but was

abandoned in the face of massive protests. Once we turn from theoretical policy debate to the details of design, implementation and enforcement, the well-off invariably do better than theory would suggest and the poor do worse. This was true, to some extent, during the postwar Great Compression. Although the tax system appeared steeply progressive, the deductions, loopholes and tax minimization schemes meant that it was, at best, only moderately progressive. Under the systems in force since the 1980s, which are only marginally progressive in their design, the actual outcome has been that many high income earners pay a smaller proportion of their income in tax than the population as a whole. The absence of substantial progressivity in the tax system is obscured by the focus, in the United States and elsewhere, on the fact that high income earners pay the bulk of income tax. A good deal of the material appearing on this topic in The Wall Street Journal and elsewhere gives the impression that income tax is the only tax in the system. In reality, income tax is not even the sole tax imposed on income. Most countries, including the United States, levy payroll taxes on labor income. Unlike the progressive income tax, which falls most heavily on high income earners, payroll taxes are regressive. In most taxation systems, capital gains are accorded concessional treatment or not taxed at all. Unsurprisingly, a large share of capital income is taken in the form of capital gains, moving the tax system closer to the trickledown ideal where all taxes fall on wage-earners. That’s not all. Taxes on income and wealth only account for about half of government revenue in most tax systems. Consumption taxes make up about half of all government revenue, and these taxes are regressive. That is, those with low incomes typically pay a higher proportion of their incomes in consumption taxes

than do those with high incomes. There are a number of reasons for this. Low-income earners generally don’t save very much, so the ratio of consumption to income is higher for these groups. Taxes on items such as tobacco, alcohol and gambling are levied at very high rates, and these items tend to make up a larger share of the expenditure of the poor (though absolute expenditure is higher only for tobacco). Finally, there is tax avoidance and minimization. A vast industry of lawyers and accountants exists solely to ensure that no one with sufficient means should pay any more tax than the minimum they are obliged to pay under the most creative possible interpretation of the law. History shows that, no matter how favorably the well-off are treated, there will always be arguments to suggest that they should receive even better treatment. Trickle-down theory offers no limit to the extent to which the burdens of taxation and economic risk can or should be shifted from the rich to the poor. In the end, according to the trickledown story, that which is given to the rich will always come back to the rest of us, while that which is given to the poor is gone forever. The Role of the Financial Sector

The financial sector is the crucial test case for trickle-down theory. During the era of market liberalism, incomes in the financial sector rose more rapidly than in any other part of the economy and played a major role in bidding up the incomes of senior managers as well as those of professionals in related fields such as law and accounting. According to the trickle-down theory, the growth in income accruing to the financial sector benefitted the U.S. population as a whole in three main ways. • The facilitation of takeovers, mergers and private buyouts offered the opportunity to increase the efficiency with which capital was

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used, and the productivity of the economy as a whole. • Expanded provision of credit to households allowed higher standards of living to be enjoyed, as households could ride out fluctuations in income, bring forward the benefits of future income growth and draw on the capital gains associated with rising prices for stocks, real estate and other assets. • Thanks to the classic trickle-down effect in which the wealth of the financial sector generates demands for luxury goods and services of all kinds, workers in general, or at least those in cities with high concentrations of financial sector activity, such as London and New York, earned higher incomes. The years from the early 1990s to 2007 gave some support to all of these claims. Measured U.S. productivity grew strongly in the 1990s, and moderately in the years after 2000. Household consumption also grew strongly, and inequality in consumption was much less than inequality in income or wealth. And, although income growth was weak for most households, rates of unemployment were low by post-1970 standards. Very little of this is likely to survive the financial crisis. At its peak, the financial sector (finance, insurance and real estate) accounted for around 18 percent of GDP and a much larger share of GDP growth in the last two decades. With professional and business services included, the total share of financial sector output in GDP was greater than 30 percent. The finance and business services sector is now contracting, and it is clear that a significant part of the output measured in the bubble years was illusory. Many investments and financial transactions made during this period have already proved disastrous, and many more seem likely to do so in coming years. In the process,


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the apparent gains generated through the expansion of the financial sector will be lost. Equality of Outcome and Equality of Opportunity

The trickle-down hypothesis is closely related to the distinction between equality of outcomes, like life expectancy, and equality of opportunity. This distinction has long been a staple of debates between market liberals and social democrats. Many market liberals argue that as long as society equalizes opportunity, for example by providing good schools for all, it’s not a problem if outcomes are highly unequal. Even though some people may do badly, it’s claimed their children will benefit from growing up in a dynamic society where everyone has a chance at the glittering prizes. Writing in The Wall Street Journal, Wisconsin Republican Paul Ryan attacked President Obama’s first budget saying, “In a nutshell, the president’s budget seemingly seeks to replace the American political idea of equalizing opportunity with the European notion of equalizing results.” A year earlier, following his victory in the Republican primary in South Carolina, John McCain said, “We can overcome any challenge as long as we keep our courage, and stand by our defense of free markets, low taxes and small government that have made America the greatest land of opportunity in the world.” As these quotations suggest, the trickledown hypothesis relies on the claim that equality of opportunity and equality of outcome are not only distinct concepts but stand in active opposition to each other. By removing disincentives to work, such as high tax rates and elaborate social welfare systems, it is claimed, an economic system that tolerates highly unequal outcomes will also provide those at the bottom with the incentives and


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opportunities to haul themselves up into the middle class and beyond. The idea that the United States is a “land of opportunity” and “the most socially mobile society the world has ever known” (as conservative blogger Scott Norvell put it in a piece calling for patriotic consumer spending in the wake of 9/11) is central to the American national self-image. The belief that this high social mobility derives from free markets is widely shared. Empirical studies of social mobility do not support such beliefs. But most economists are not engaged in studies of social mobility, and many of them share these popular assumptions. This is true not only of self-satisfied American economists promoting the merits of the status quo and calling for more of the same, but also of European critics of the welfare state who accept the characterization of their own societies as rigid and sclerotic by comparison with the dynamic and flexible United States.

death: the rich get richer and the poor go nowhere Although the trickle-down hypothesis never had much in the way of supporting evidence, empirical testing was difficult. In particular, its proponents never specified the period over which the benefits of growth were supposed to percolate through to the poor. But the global financial crisis marks the end of the era of finance-driven market liberalism. And to the extent that any assessment of the distributional effects of market liberal policies will ever be possible, it is possible now. The data on income distribution for the United States show that households in the bottom half of the income distribution gained nothing from the decades of market liberalism. Apologists for market liberalism have offered various arguments to suggest that the


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raw data leave the wrong impression, but none stand up to scrutiny. All the evidence supports the common-sense conclusion that policies designed to benefit the rich at the expense of the poor have done precisely that. The United States Since 1970

The GDP of the United States grew solidly during the decades of market liberalism since the 1970s, if not as rapidly as during the Keynesian postwar boom. More relevant to the trickle-down hypothesis, the incomes and wealth of the richest Americans grew spectacularly. Real incomes in the top 5 percent of the income distribution doubled and those of the top 0.1 percent quadrupled. By contrast, the gains to households in the middle have been much more modest. Real median household income rose from $45,000 to just over $50,000 between 1973 (the last year of the long postwar expansion) and 2008. Real incomes for the lower half of the distribution have stagnated. The same picture emerges if we look at wages. Median real earnings for full-time year-round male workers have not grown since 1974. For males with high school education or less, real wages have actually declined. The average annual earnings of 25- to 29-yearold high school graduates, expressed in 2005 dollars, fell from $30,900 in 1970 to $25,900 in 2000, and have stagnated since. One result can be seen by looking at the proportion of households living below the poverty line. The poverty rate declined steadily during the postwar Keynesian era. But it has remained essentially static since 1970, falling in booms but rising again in recessions. The United States has an official poverty line fixed in terms of absolute consumption levels and based on an assessment of a poverty-line food budget undertaken in 1963. The proportion of Americans below this fixed

poverty line fell from 25 percent in the late 1950s to 11 percent in 1974. Since then it has fluctuated, reaching 13.2 percent in 2008, a level that is certain to rise further as a result of the recession. And since the poverty line has remained unchanged, the real incomes accruing to the poorest 10 percent of Americans have fallen over the last 30 years. These outcomes are reflected in measures

non of the era of market liberalism. During the decades of full employment, homelessness was confined to a tiny population of transients – mostly older males with mental health and substance abuse problems. By contrast, in 2007, 1.6 million people spent time in homeless shelters and about 40 percent of the homeless population were families with children.

The experience of the United States in the era of market liberalism was as thorough a refutation of the trickledown hypothesis as can reasonably be imagined. of the numbers of Americans who lack access to the basics of life: food, shelter and adequate medical care. In 2008, the U.S. Department of Agriculture classified 49.1 million Americans as “food insecure,” meaning that they lacked access to enough food to meet basic needs at all times. Some 17 million more lived in households with “very low food security,” meaning that one or more people in the household were hungry over the course of the year because of the inability to afford enough food. This number had doubled since 2000 and has almost certainly increased further as a result of the recession. The number of people without health insurance rose steadily over the period of market liberalism, both in absolute terms and as a proportion of the population, reaching 46 million, or 15 percent of the population. Among the insured, an increasing proportion was reliant on government programs. The traditional model of employment-based private health insurance, which was developed as part of the New Deal eroded to the point of collapse. More on Inequality

Homelessness is almost entirely a phenome-

The experience of the United States in the era of market liberalism was as thorough a refutation of the trickle-down hypothesis as can reasonably be imagined. The well-off have become better off, and the rich have become super-rich. Despite impressive technological progress, those in the middle struggled to stay in place, and those at the bottom became worse off in crucial respects. There have been plenty of attempts to deny the evidence presented above, or to argue that things are not as bad as they seem. Some can be dismissed out of hand. Among the most popular and the silliest is the observation that even the poor now have more access to consumer goods than they had in the past. For example, Michael Cox (Federal Reserve Dallas) and Richard Alm (The Dallas Morning News) observe in their book Myths of Rich and Poor that, in spite of the rise in inequality, “a poor household in the 1990s was more likely than an average household in the 1970s to have a washing machine, clothes dryer, dishwasher, refrigerator, stove, color television, personal computer or telephone.” The common feature of all these items is that their price has fallen dramatically relative

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to the general price level. This means that, even if incomes were exactly the same as in 1970, we would expect to see a big increase in consumption of these items. Unfortunately, if these items have become relatively cheaper, others must have become relatively dearer – and therefore less accessible. It’s not hard to find examples of expenditure items that have become more expensive.

decreased. The average household contained 1.86 equivalent adults in 1974 and 1.68 equivalent adults in 2007. Income per equivalent adult rose at an annual rate of 0.7 percent over this period. Note, too, that women have done a little better than men. The median earnings for women who were full-time workers rose by about 0.9 percent per year over this period. By no coin-

The myth of trickle-down was sustained, in large part, by the availability of easy credit. Now that the days of easy credit are gone, presumably for a long time to come, reality has reasserted itself. Unsurprisingly, access to health care for poor households has become worse, as has the gap in health outcomes between the rich and the poor. College education provides another important example. The cost has risen dramatically, particularly for the elite institutions that provide the pathway to the best jobs. In this case, it is the middle class who have suffered the biggest losses. Only the brightest children from poor backgrounds ever made it into elite colleges, and for this group, financial aid has remained accessible. The middle class, on the other hand, have been faced with a combination of higher fees and reduced aid. As a result, between 1985 and 2000, the proportion of high-income (top 25 percent) students among freshmen at elite institutions rose steadily, from 46 to 55 percent. The proportion of middle-income students (between the 25th and 75th percentiles) fell from 41 to 33 percent. Some adjustments should be made to measures of household income that make the picture look a little better than suggested by the statistics cited above. Household size has


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cidence, the main factors sustaining growth in incomes for American households outside the top 20 percent has been an increase in the labor force participation of women. Finally, until the 1990s the consumer price index took inadequate account of changes in product quality, so the decline in real wages was somewhat overstated. The Boskin Commission, appointed by the U.S. Senate in 1995, introduced a number of changes that lowered the estimated annual rate of inflation by about one percentage point. So, while the stagnation of median incomes in the 1970s and 1980s might be overstated, that of the 1990s and 2000s is not. The myth of trickle-down was sustained, in large part, by the availability of easy credit. Now that the days of easy credit are gone, presumably for a long time to come, reality has reasserted itself. With sufficiently optimistic assumptions about social mobility (that low-income households were in that state only temporarily) and asset appreciation (that the stagnation of median incomes would be offset by capital gains on houses and other investments) increases in

debt used to sustain consumption could be made to appear manageable. Once asset prices stopped rising, they were shown to be unsustainable. The contradiction has been resolved for individual households by a massive increase in bankruptcy and other forms of financial breakdown. In normal times, the renewed surge in bankruptcy would have been a major issue. In the recent crisis, however, the upward trend has been overshadowed by foreclosures on home mortgages. During the boom, when overstretched householders could normally sell at a profit and repay their debts, foreclosures were rare. From 2007 onward, however, they increased dramatically. Banks foreclosed 2.3 million houses in 2008 and 2.8 million in 2009. In hard-hit areas of California, more than 5 percent of houses went into foreclosure in a single year. Econometric Studies

The relationship between inequality and economic growth has been the subject of a vast number of econometric studies, which have, as so often with econometric studies, yielded conflicting results. Early studies focused on the relationship between initial levels of inequality and subsequent levels of economic growth. These studies consistently found a negative relationship between initial levels of inequality and subsequent growth. On the other hand, increases in inequality appeared to be favorable to growth. This apparent contradiction may be explained by the observation that the initial impact of an increase in inequality should be favorable to economic growth, but that the long-run effects are mainly harmful. In the era of market liberalism, growth in inequality was closely associated with financial deregulation and the growth of the financial sector. The short-term effects of financial deregula-

tion have almost everywhere been favorable. The negative consequences take years or even decades to manifest themselves. So, it is unsurprising to observe a positive correlation between changes in inequality and changes in economic growth rates in the short and medium term. It is only relatively recently that studies of this kind have explicitly examined the trickledown hypothesis. Perhaps the most directly relevant work is that of Dan Andrews and Christopher Jencks of the Kennedy School of Government at Harvard and Andrew Leigh of the Australian National University. Andrews, Jencks and Leigh found no systematic relationship between top income shares and economic growth in a panel of 12 developed nations observed for between 22 and 85 years in the period 1905 to 2000. After 1960, there is a small, but statistically significant relationship between changes in inequality and the rate of economic growth. However, the benefits to lower income groups flow through so slowly that they may never catch up the ground they initially lose. Social Mobility

The United States is characterized by highly unequal economic outcomes compared to other developed countries. The fact that these outcomes have grown more unequal during the era of market liberalism is undeniable. That hasn’t stopped people denying it, though, especially when they are paid to do so. But at least such denials must be presented, in contrarian fashion, as showing that “everything you know about income inequality is wrong.� By contrast, the belief that this inequality is offset by high levels of social mobility is widely held in and outside the United States. In the late 19th century, the United States was indeed a land of opportunity compared to the hierarchical societies of Europe, and many

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believe that this is still the case. But the evidence is clear: among the developed countries, the United States has the lowest social mobility on nearly all measures, and the European social democracies the highest. Ron Haskins and Isabel Sawhill of the Brookings Institution analyzed social mobility by looking at the life chances of men whose fathers were in the bottom fifth of the income distribution. In a world of equal opportunity, we might expect that 20 percent of them would end up in the same group as their fathers. In fact, Haskins and Sawhill found that 42 percent of American men with fathers in the bottom fifth remain there, compared to 25 percent in Denmark, 26 percent in Sweden, 28 percent in Finland and Norway, and 30 percent in the United Kingdom. As the welloff have drawn away from the rest of the community in terms of income share, they have pulled the ladder up behind them, ensuring that their children have better life chances than those born to poorer parents. The evidence suggests that the alleged tension between equality of outcomes and equality of opportunity, a central theme in marketliberal rhetoric, is inconsistent with empirical reality. More equal opportunities make for more equal outcomes, and vice versa. It’s not hard to see why this should be so. The highly unequal outcomes of marketliberal policies are often supposed to be offset by an education system available to all, and by laws that prevent discrimination and encourage merit-based employment. That might work for a generation, but in the second generation the rich parents will be looking to buy a head start for their less-able children – for example, by sending them to private schools where they will be coached in examination skills and equipped with an old school tie. One generation more, and the wealthy will be fighting to stop their tax dollars from


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being wasted on public education from which they no longer benefit. Those who remain in the public system will lobby to get their own children into good public schools and ensure that these schools attract and retain the best teachers, benefit from fund-raising activity, and so on. As a result, both the importance of ability as a determinant of educational attainment and the importance of educational attainment as a source of social mobility have declined over time. The inequalities are even more evident in higher education. Thanks to scholarship programs, a handful of able students from poor backgrounds make it into Ivy League colleges like Harvard and Yale every year. But their numbers are far outweighed by students from the top quarter of the income distribution whose families have the financial resources to afford hefty fees and the cultural capital to navigate the complex admissions process. Those with old money, but less than stellar intellectual resources, have their own highly effective affirmative action program: the (formal or informal) legacy admission system by which the children of alumni gain preferential admission. In 1998, William G. Bowen, a former president of Princeton, and Derek Bok, a former president of Harvard, estimated that “the overall admission rate for legacies was almost twice that for all other candidates.” While education is critical, high levels of inequality naturally perpetuate themselves through other, more subtle channels, like health status. While the problem is worse in the United States than elsewhere because of highly unequal access to health care, high levels of inequality produce unequal health outcomes even in countries with universal public systems. There are other factors at work. A widely dispersed income distribution means that a much bigger change in income is needed to move the same distance in the income distri-

bution – say from the bottom quintile to the middle, or from the middle to the top. So, unequal outcomes represent a direct obstacle to social mobility. The evidence that, under market liberalism, social mobility is low and declining should not surprise anyone. On the other hand, it is disappointing that the myth of equal opportunity continues to be believed so many decades after it has ceased to have a basis in fact. The Unhealthiness of Hierarchies

Some of the most compelling evidence against the trickle-down hypothesis has come from studies of social outcomes such as health status, crime and social cohesion. It is commonly thought that, while it is better to be at the top of the hierarchy than at the bottom, there are some offsetting disadvantages – particularly in relation to health. While the poor suffer from lack of access to good medical care, the rich are supposed to suffer from diseases of affluence like heart disease, compounded by the stresses of life at the top. But epidemiologist Michael Marmot’s book The Status Syndrome documents that people at the top of status hierarchies live longer and have better health than those at the bottom. Marmot’s work began with a study of British civil servants, which is an interesting population for two reasons. First, it excludes extremes of wealth and poverty. The civil service is not a road to riches, but even the lowestranking civil servants are not poor. Second, the public service provides a clear-cut status hierarchy with very fine gradations. Marmot found that senior public servants at the top of the status hierarchy were healthier than those at the bottom. More surprisingly, he found that, throughout the hierarchy, relatively small differences in pay and status

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were associated with significant differences in life expectancy and other measures of health. The finding has been replicated across all sorts of status hierarchies. As you move from the slums of southeast Washington, DC, to the leafy suburbs of Montgomery County, Maryland, life expectancy rises a year for every mile traveled. Among actors, Academy Award winners live, on average, four years longer than their Oscarless co-stars. Along the way, Marmot demolishes the myth of executive stress. Despite their busy lives, Type A personalities and so on, senior managers are considerably less likely to die of heart attacks than the workers they order around. Marmot, along with others who have studied the problem, concludes that the crucial benefit of high-status positions is autonomy – that is, the amount of control people have over their own lives. There is a complex web of relationships between health status and autonomy, both self-perceived and measured by objective job characteristics. Low levels of autonomy are associated not only with poorer access to health care, but with more of all the risk factors that contribute to poor health, from homicide to poor diet. In The Spirit Level, epidemiologists Richard Wilkinson and Kate Pickett build on Marmot’s work and other statistical evidence to produce a comprehensive case for the proposition that inequalities in income and status have far-reaching and damaging effects on a wide range of measures of social well-being – effects that are felt even by those who are relatively high in the income distributions. First, in all countries, there is a strong relationship between social outcomes and social rank, much greater than can be explained by income differences alone. Second, greater inequality within a country is associated with a steeper social gradient.


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The United States is the obvious outlier in almost all studies of this kind. It is the wealthiest country in the world and the most unequal of the rich countries. The United States is disappointing on a wide range of measures of social well-being, from life expectancy to serious crime, and even on average height. [Height is a valuable proxy for childhood nutrition.] These poor performances cannot be explained by the continuing black-white divide or by poor outcomes for immigrants. All but the very richest groups of Americans do worse on most measures of social well-being than people with a comparable position in the income distribution in more equal countries. These bad outcomes occur even though the average income of the non-Americans in these groups is much lower than that of the corresponding Americans.

after the zombies: economics, inequality and equity The longer-run implications of the current economic crisis have yet to be fully comprehended. Even when economic activity recovers, consumer credit will be more restricted than in past decades. As a result, there will be no escape from the implications of decades of stagnant wages for workers at the median and below. The traditional avenues of upward social mobility, both through higher education and through promotion within large organizations, are being closed off. With good jobs increasingly depending on an education at a good university, the chances of climbing the ladder diminish all the time. There does not yet exist a political movement ready and willing, let alone able, to mobilize popular support for a program of income redistribution. Rather, revulsion against the willingness of politicians to bail out the banking system has been reflected most clearly in the confused and angry demagogu-

ery of the Tea Party movement, which has been manipulated to serve the very interests that have generated the feelings of injustice that drive it. But measures to protect individuals and families against the risks and inequities of market liberalism are gaining more acceptance. The prescription drug benefit introduced under the George W. Bush administration provides one example. Another positive development has been the continued extension of unemployment benefits in response to the depth and duration of the current recession. The most critical test for developments in the United States will be the success or failure of health care reform legislation. At the time of writing, its fate remains unclear. However, other reforms of this kind, controversial at the time, have come to be generally accepted. Rather than consider questions of political strategy, however, I will focus on the way in which the failure of the trickle-down hypothesis should change the questions economists ask, and the way in which they should seek to answer them.


The failure of the trickle-down hypothesis provides economists with plenty of challenging research tasks. A crucial problem is to understand why and how inequality increased so much under market liberalism, and why it increased so much more in the Englishspeaking countries. The idea that growing inequality was a natural market response to unspecified changes in the structure of the economy no longer appears tenable. The huge increases in remuneration in the financial sector (and for senior managers more generally) has not produced a more efficient and productive economy, with benefits for all. In fact, the crisis has undermined the view that incomes accruing to different groups in

the community are an accurate reflection of their marginal contribution. The policies and institutional changes that took place under market liberalism have almost all pushed in the direction of greater inequality. Corporations have been deregulated while the full power of the state has been turned against unions. Tax schedules have been flattened. The main income sources of the wealthy, including capital gains, inheritance and dividends have been given progressively more favorable treatment. Corporations have competed with each other to pay ever larger amounts to their CEOs. And, at the very top, there is, indeed, a trickle-down effect. Stratospheric CEO salaries encourage huge increases for other top executives and substantial increases in payment for senior professionals, even as wages stagnate or fall for ordinary workers. It remains unclear, though, which feature of market liberalism contributed most substantially to the growth of inequality, and how those policies interacted with other social developments. The importance of the links between inequalities in income, health, education and political power is evident from the work of Marmot and others. But the links between economic variables like income inequality and personal and social outcomes realized over generations are inherently complex. It seems clear enough that inequality is bad for us, but much harder to say how and why. All this is merely a preliminary to the big question: how can the growth in inequality be reversed and the more egalitarian society of the Great Compression be restored? Some steps, such as restoring progressivity to the tax system, seem obvious. But even the obvious steps must confront the political realities of a system in which political power has m shifted overwhelmingly to the wealthy.

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institute view b y k e v i n k l o w d e n , a n u s u ya c h a t t e r j e e and candice flor hynek

From programming shot in studios in Burbank to cutting-edge special effects and animation conjured up by digital artists in the San Francisco Bay area, film and television production is a significant part of the California economy – as well as a bedrock element of the state’s identity and image. But past dominance is no guarantee of future prosperity. Make no mistake: motion picture and television production in California remains strong. Hollywood is still the clear leader in terms of economic output and innovation, and California’s entertainment-industry employment levels far exceed those of the rest of North America. In 2008, 160 movies and 320 television programs were filmed in the state. The two employment categories that make up the entertainment industry (motion picture and video recording – which also encompasses post-production – and independent artists, writers and performers) together generated $25 billion in output and sustained 167,000 jobs. California’s robust infrastructure and critical mass of talent, supported by a variety of strong allied industries, have contributed to maintaining its supremacy. But the state’s mantle is slipping. The high costs of living and doing business have prompted producers to look elsewhere. Producers are finding it more cost-effective to K ev i n K lowd e n is a managing economist at the Milken Institute, where he serves as director of the Institute’s California Center. A n usuya C h atter j ee and Can dic e F lo r Hyn ek are senior research analysts in the Institute’s regional economics group.


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film in other locations, despite the fact that most of the industry talent lives in California. Smaller films made for limited release are rarely filmed in California, and even largebudget films have achieved significant savings by going out of state – or out of the country. Forty-one other states and the District of Columbia are currently vying for a piece of the $57 billion United States film-production industry by offering tax incentives. New York, North Carolina, Louisiana and New Mexico have all made significant inroads in attracting this commerce, and Georgia is coming on strong. Although other locations, including Michigan, have been aggressive in providing tax breaks and other incentives to film locally, the four states mentioned above have now built a true critical mass of production and post-production activity that can sustain ongoing work, rather than just landing one-shot projects. New York, in particular, has the built-in appeal of being a hub of the entertainment industry and a major cultural capital, with a strong concentration of television, radio and theater talent. Competition, moreover, does not come just from inside the United States. Many other

©asp/kl/age fotostock

countries have long had successful local film industries. But thanks to Hollywood’s vast marketing reach and superior filmmaking technology, most film-based revenue has historically been captured by the United States. However, the size of the pie that’s up for grabs has prompted several countries to intensify their effort to lure American productions to augment their indigenous film industries. Countries vying for a piece of the American-based industry include Canada, Australia, New Zealand, Britain, Germany and India. A

combination of financial incentives and the existence of the quality infrastructure that had already been established for their own national movie and television industries have made them increasingly successful in landing American productions. Canada, where film production is a leading industry, is the most striking example. Film contributed nearly $8 billion (U.S.) to Canada’s economy in 2008. Vancouver, Montreal and Toronto are now considered top locations for filming, approaching the caliber

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institute view of Los Angeles and New York. Although Canada had been home to the occasional film and television production in the 1970s and 1980s, the industry really took off in the late 1990s. Canada’s concerted push also coincided with a period of favorable exchange rates against the American dollar, which made Canada a relatively cheap place to do business in general. But the key to Canada’s ongoing success has been a potent combination of financial incentives, lower labor costs, skilled English-speaking workers and short flying time to the United States.

Employment in California’s movie and video industry (encompassing production, post-production and independent artists) reached its peak in 1997. The state’s share of North American employment in the industry has since declined from 40 percent (1997) to 37.4 percent (2008). Our research concludes that if California had managed to retain the 40 percent share it once enjoyed, some 10,600 jobs, paying an average wage of about $92,000, would have been preserved. California has acknowledged the drain, and in July 2009, introduced a tax credit for projects filmed in state with budgets of $75

An onerous permit process, increased restrictions and city-imposed moratoriums on location filming driven by residents’ complaints, along with a lack of highly functional industrial space, are further eroding California’s appeal to filmmakers. After 2002, Canada found itself faced with increased competition from a number of localities in the United States that adopted their own financial incentives and launched aggressive marketing campaigns. Its provinces responded both by introducing a second layer of incentives on top of those offered by the federal government, and by bolstering their local infrastructure. Vancouver’s capabilities are now so sophisticated that the city has become the main center for television filming in North America outside of Los Angeles and New York. As noted, California still leads the nation in production, turning out 160 films in 2008. It’s worth considering, though, that the number of movies either wholly or partially filmed in California has fallen sharply: 272 were made in the state in 2000.


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million or less. The credit is designed to offset lower costs (and government subsidies) offered elsewhere. While this is a positive first step, it makes little sense to exclude big-budget films (which have the most impact on jobs and incomes) from the incentive program. This became apparent recently as filming got under way for the latest installment of the Transformers film franchise: While Los Angeles captured much of the production, it lost six weeks of shooting to Michigan and Illinois, with producers citing the subsidies offered there. Due to its $200 million budget, this film did not qualify for tax credits in California. An onerous permit process, increased restrictions and city-imposed moratoriums on location filming driven by residents’ complaints, along with a lack of highly functional

industrial space, are further eroding California’s appeal to filmmakers. Faced with rising costs, increased competition, lower profits, and, in the case of some publicly traded companies, increased pressure from shareholders, executives of studios in the United States have had to find innovative ways to cut costs. A growing number of states and foreign countries are courting these producers with competitive tax breaks, even establishing offices in Los Angeles to market themselves. The places most successful in attracting filmmakers offer incentives with less restrictive qualification criteria. And they have been able to adopt innovative policies to ensure the availability of high-quality infrastructure and labor, cut the red tape in getting permits, provide adequate security and address local concerns about noise, traffic and other issues. Data from FilmL.A., a nonprofit organization that coordinates permits for on-location shooting, shows a strong increase in production days in Los Angeles for the first two quarters of 2010, which the group largely attributes to the new state incentives. While this is an early positive sign, the battle isn’t won yet. We conclude that to expand film and television production, California will also need to take the following steps: Track film production data more effectively

to determine how many days of production are spent within the state versus other locations, along with the utilization rates of studio soundstages and similar facilities. Create a balanced two-tier film incentive program, with one set of benefits to engage

big-budget studio films that are not covered under the current incentive program and another to attract smaller independent productions, including those intended for cable TV. Expand the current tax credit for television production to encompass network and pre-

mium cable shows.

Make the tax incentive programs permanent, signaling a long-term commitment to

retaining the industry. Consider a new digital media tax credit to

attract and retain developers of digital animation, visual effects and video games. Encourage long-term investments in infrastructure by implementing tax credits for

building or upgrading studio and post-production space. Improve the ability of local film commissions to coordinate with local authorities in

expediting the film-permit process. Create proactive marketing and outreach strategies to communicate new incentives and

programs. Establish cooperative relationships with civic and industry leaders beyond the state’s

borders to attract foreign-funded productions. One route to implementing several of these recommendations would be to provide the California Film Commission (which is part of the state’s Business, Transportation & Housing Agency) with more staff and marketing resources. The commission could then take on the task of comprehensive data collection, establishing the capacity to monitor the health and development of a crucial industry, and to gauge the effectiveness of public policy. Industry data is currently inconsistent and often incomplete – a problem that needs to be corrected, given the importance of film to the state’s economy. In addition to measures carried out at the state level, some promising initial steps have recently been taken by the City of Los Angeles. It does not have its own tax-credit program, but the City Council did recently pass filmfriendly initiatives to “keep Hollywood home.” The program extended the free use of cityowned buildings, added more access for film producers to city-owned parking spaces, delegated the Department of Water and Power

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institute view to install energy nodes around the city to accommodate filming equipment and reduce energy-related costs to filmmakers, and mandated the creation of a film coordinator within the Recreation and Parks Department. But Los Angeles could go further by giving the film industry an all-purpose ombudsman in city government. With one person installed in City Hall to serve as a liaison to FilmL.A., the city would be better able to cut through the bureaucracy to obtain filming permits from various city and county agencies.


Given the state’s gaping budget deficit, there is no denying that California can barely afford to provide tax breaks. But in this case,

it can’t afford not to. The state can’t squander opportunities to retain and add significant numbers of high-paying jobs. And the longterm payoff to be realized in shoring up a major industry far outweighs the short-term cost in revenues. That said, the state should not attempt to match incentives from other locations that provide large upfront cash advances and unsustainably large film credits. However, by providing somewhat more generous and more effectively targeted credits that lower the cost of production to a reasonably competitive level, California will position itself to win over producers based on its strengths in human capital and facilities, as well as its repm utation for excellence.

And the guy on the spine is... who now teaches at MIT’s Sloan School of Business. Formerly the low-profile (but very competent) chief economist at the IMF, Johnson morphed from Clark Kent to the Superman of center-left economics – a public intellectual in the same league as Paul Krugman – when he returned to academia in 2008. He is probably most famous for his 2009 article in The Atlantic Monthly. There, he explained how wellconnected investment bankers had taken control of U.S. economic policy in a “quiet coup” that culminated in the Great Recession. Today, it’s hard to surf the Web without bumping into his wellreasoned arguments in defense of tougher regulation of the financial services industry, and in opposition to deficit hawks willing to risk the economic recovery in order to put Washington’s fiscal house in order. For a proper dose of Johnsonomics, check out his blog, BaselineScenario .com (written with James Kwak), his contributions to the Economix blog at The New York Times, or his book, Thirteen Bankers: The Wall Street Takeover and the Next Financial Meltdown (also with Kwak).


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david smith

Simon Johnson, a macroeconomist

institute news

california dreamin’ California may be down, victim to its failure to confront its daunting economic and social problems. But we think the Golden State is far from out of the running as the place where dreams can be realized. The Milken Institute’s California Center is building a library of ideas from leaders across the state on how to get California back in the game. Videos, along with an interactive idea slate can be found at The contents will be a focus of our annual State of the State Conference, held October 19 at the Beverly Hilton in Los Angeles. For more on the conference (including how to attend if you are reading this before 10/19), visit

the show must go on Everybody wants to be a star these days. California now competes with 41 states and a gaggle of other countries for a piece of the action in the $57-billion U.S. film production industry. And the battle has been bloody: The Milken Institute’s report, “Film Flight: Lost Production and Its Economic Impact on California,” found that California has lost 10,600 entertainment industry jobs, $2.4 billion in wages and $4.2 billion in total economic output since 1997. Additional changes to the state’s financial incentives, plus a healthy dose of cooperation from local governments, could make a big difference. Download the full report at no cost from, or read a synopsis on page 90 of this issue.

something completely different For the bad news on the U.S. econry ecove n to R ecessio eturn to Growth omy, just keep R m R Fro erica’s ng Am Analyzi turning that dial. 10 For his part, Ross July 20 DeVol, executive director of economic research at the Institute, takes issue with conventional wisdom. In “From Recession to Recovery: Analyzing Am­erica’s Return to Growth” (download free at, he sees a light at the end of the tunnel, citing positive upticks in business equipment and software, low interest rates and growing exports. Or read the highlights, published in The Wall Street Journal (online.wsj .com/article/SB1000142405274870399510457 5389041193020822.html).

Ross C

partnering for cures FasterCures, the DC-based medical solutions center of the Milken Institute, is convening the second annual Partnering for Cures meeting December 13-15 in New York City. Join research leaders, policymakers and advocates from a host of public and private organizations in their quest for ways to expedite medical R&D. For more about the program and the opportunity to register, go to

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Budget Buster Medicare is rightly considered the monster most likely to chew through the federal budget in coming decades. But Social Security will soon be in need of beaucoup bucks, too. If Congress does nothing, the difference between the system’s revenues and its outlays will top $1 trillion annually around 2050. But, unlike Medicare, the Social Security deficit could be tamed (for a long while, anyway) with increases in revenues or cuts in benefits totaling a relatively modest 1.6 percent of predicted GDP over the next 75 years. Consider some options: Option

APPROXIMATE % of Gap Closed

Eliminate the $106,000 cap on taxable wages (starting in 2012). . . . . . . . . . . . . . . . . . . . . . . . . . . . 100%

Cut initial benefits to offset the cost of rising life expectancy (starting in 2017). . . . . . . . . . 33% Raise age for full retirement benefits from 67 to 70 (starting in 2022). . . . . . . . . . . . . . . . . . . . . . . 50%

Index full retirement age to longevity (starting in 2012). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33% Reduce cost-of-living benefit adjustments by V percentage point (starting in 2012) . . . . 50% source: Congressional Budget Office (2010)



Increase payroll tax by one percentage point (starting in 2012) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50%

The Milken Institute Review • Fourth Quarter 2010 volume 12, number 4 the milken institute Michael L. Klowden, President and CEO Michael Milken, Chairman publisher Joel Kurtzman editor in chief Peter Passell art director Joannah Ralston, Insight Design

the milken institute review advisory board Robert J. Barro Jagdish Bhagwati George J. Borjas Daniel J. Dudek Georges de Menil Claudia D. Goldin Robert Hahn Robert E. Litan

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Burton G. Malkiel Paul R. Portney Stephen Ross

The Milken Institute Review is published quarterly by the Milken Institute to encourage discussion of current issues of public policy relating to economic growth, job creation and capital formation. Topics and authors are selected to represent a diversity of views. The opinions expressed are solely those of the authors and do not necessarily represent the views of the Institute. Requests for additional copies should be sent directly to: The Milken Institute The Milken Institute Review 1250 Fourth Street, Second Floor Santa Monica, CA 90401-1353 310-570-4600 telephone 310-570-4627 fax Cover: JT Morrow

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Robert Solow

That’s exactly what you’ll find at the 2011 Milken Institute Global Conference, where international leaders tackle the biggest challenges in energy, finance, philanthropy, health, government and education. With renowned speakers and an influential audience, Global Conference sells out every year. Tickets are in short supply, but the wisdom you’ll gain is unlimited.

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matin qaim

On genetically engineered crops. Progress can be scary.

robert looney

On North Korea’s economy. Truth really is stranger than fiction.

larry white

On housing markets. First, we kill the subsidies.

chris meissner

On reviving the gold standard. It never worked very well, anyway.

howard kunreuther and erwann michel-kerjan

The Milken Institute Review • Fourth Quarter 2010 • volume 12, number 4

In this issue

Fourth Quarter 2010


Sorceror’s apprentice or savior?

On making economic sense of disasters. The rising cost of myopia.

gary libecap

On water shortages in the American West. Getting serious about free markets.

kevin klowden, anusuya chatterjee and candice flor hynek On the flight from Hollywood. Money trumps location.