Reflections on Easterly

Full disclosure: I approached "The White Man's Burden" with skepticism about its basic premise that aid does not really work. I think this was largely because I had never actually read Easterly's writing, and had only heard other's descriptions of it. Those descriptions left me with the impression that Easterly believes foreign aid never works and that the West should therefore stop providing aid to the developing world. I began the book expecting to hear that argument, and expecting to disagree.

Easterly never made it. Instead, he advanced a nuanced, sensible argument that foreign aid as it is currently implemented -- in Big Plans from the top-down to solve Big Problems -- does not work; that only homegrown development based on the dynamism of individuals and free markets can end poverty; and that aid can work if it is focused on enacting piecemeal reforms that reduce the sufferings of the poor (368). That, it seemed to me, is a convincing argument. Many of Easterly's points were thought-provoking, but I found two of them particularly interesting.

Bureaucracy and Accountability 
The first was his insight that not all bureaucracies are ineffective, and that what separates the effective ones from the ineffective ones is accountability (pp. 165). Bureaucracy in rich countries works better than the bureaucracy of the aid agencies for the poor, Easterly explains, because the former are held accountable to voters or customers while the latter are not (pp. 166-167). Better public services go along with democracy; better private services go along with markets. But the poorest people in the world are "orphans": they have no money or political power to hold their foreign service providers accountable.

I found this point fascinating and largely agreed with it, but would extend Easterly's reasoning to poor people within free-market democratic societies. In the United States, poor people vote, volunteer, and donate to campaigns at much lower rates than middle-class or rich people. They also have less purchasing power. Could this be part of the reason why welfare and other poverty-reduction programs have been largely unsuccessful? Just like the poor single-mothers receiving foreign aid in Ghana, the poor single-mothers receiving welfare in inner-city L.A. lack political representation. They do not or cannot provide feedback to those who are trying to help them, and cannot hold politicians accountable for the results of the help they provide. In the last chapter (pp. 380-381), Easterly proposes a few ways to get feedback from the poor in developing countries. If we are serious about reducing poverty in  developed countries such as the U.S., we ought to do the same.

Inputs vs. Outputs
The second point that resonated with me was Easterly's criticism of the aid bureaucracy's focus on the inputs to international development -- total aid dollars spent -- rather than the output, i.e. results for developing countries and their people. He rightly criticizes politicians and international leaders for focusing on increasing the volume of foreign aid with a "strange fixation" on doubling it (182). Easterly suggests that aid agencies should stop using aid disbursements as a metric of success. "What matters is results," Easterly says, even though "the rich people who pay for the tickets are not the one who see the movie."

The focus on inputs frustrates me as much as it frustrates Easterly, especially because I notice it any many other areas of American political life. For example, consider the rhetoric of the Obama campaign on education. If you go to the White House's page on education right now, here are some of the headlines you will see on its rotator:

• 34 states. The White House has offered 34 states flexibility from No Child Left Behind to pursue reforms that will prepare all students for success in in college and career.
• 4.2 billion. The Obama administration invested $4.2 billion through Race to the Top to improve teaching and learning in America's schools.
• $10,000. The Obama administration established the American Opportunity Tax Credit to assist families with the costs of college, providing up to $10,000 for four years of college tuition.

The common theme in these "accomplishments'? No mention of results. Did the waiver to 34 states actually help improve education outcomes? Did the $4.2 billion in Race to the Top money lead schools to compete, thereby improving education outcomes? Did the extra money help more student attend college, and were those students able to find jobs after graduation? These are the important questions when assessing the President's record on education. And yet they are conspicuously absent from his self-assessment.  

To use Blinder parlance, Easterly's diagnosis and prescriptions for foreign aid are hard-headed and soft-hearted. He sounds angry sometimes. But "snapshots" and insights such as those above establish his soft-heart just as his economic analysis provides a harsh rebuke of the aid establishment's soft-head. One way to interpret Easterly's thesis is that only soft-hearted motivation for foreign aid coupled with hard-headed implementation offers hope for progress.

Unemployment and mandated employee benefits: a true trade-off?

Paul Krugman articulates the well-know argument of the trade-offs between requiring employee benefits and unemployment. While as a worker it seems intuitively preferable to compel firms through law to include important benefits such as a retirement plan and health insurance, this analysis makes a faulty assumption, that work will be available. This error stems from the fact that these lofty requirements make it extremely risky for businesses to sign-on new workers. If, to use France as an example, laws make it extremely difficult to fire new workers, firms may be hesitant to hire them at all. It seems safer to make less hires than risk swallowing the costs of an incompetent worker. Krugman explains this phenomenon, “For example, restrictive government policies that make it costly for firms to add employees can raise the NAIRU. Many economists blame such policies for “Eurosclerosis” – the persistent rise in European unemployment rates after 1970” (32). Thus, a worker’s preference for restrictive policies becomes more complex: if she actually gets a job, she will enjoy more benefits benefits, but the fewer jobs available increases the competitiveness of the application process and may prevent her from even finding a paying job.

Europe, starting from the 70s and stretching to the present, provides an excellent framework from which to test this hypothesis. During this era, unemployment rates rose from their incredibly low 2% to as high as 12 %, eventually leaving off at around 7 % in 2008. Different countries with different political approaches to the stagnating economic environment, however, experienced very different unemployment rates. Consider the following figure analyzing Europe’s average unemployment rate (dotted line) compared with Austria, Denmark, the Netherlands, and Sweden’s unemployment rates (solid lines) from 1970 – 2008. The highly similar features of these four countries including size, homogeneity, and policy in the 70s make them ideal subjects for comparison.

As seen above, the Netherlands and Denmark experienced much greater success at lowering NAIRU quickly than either Austria or Sweden. These differences may reflect the different macroeconomic and labor policy approaches taken by the Netherlands and Denmark on one side and Austria and Sweden on the other. One argument developed by the BLS suggests that the Dutch and Danish governments more quickly shifted their policies, which had traditionally embodied strong welfare programs, to increase incentives for finding work and lower barriers to entry. In contrast, Austria and Sweden were more cautious with their political changes, which impeded them from pursuing free-market policies and absorbing more labor into the job market. Thus, Krugman’s analysis of the trade-off between mandated employee benefits and employment appears consistent with history, and it will be interesting to see how Europe responds to its current elevated unemployment levels.   

The Volcker Recession: The Good, the Bad and the Ugly

Krugman does his best to maintain a descriptive rather than normative tone in this book, though his dominant thesis is that the American people are largely content with lackluster economic performance, via their diminished expectations, so long as there is no crisis that shakes up their world. People can live with a little inflation, deficit-spending and/or unemployment so long as the costs in the short term seems relatively low. Given this argument, I want to explore if a crisis can ever be considered “worth it” under Krugman’s account if the economy is “better off” afterward. In particular, I will look at the in’s and out’s of the Volcker Recession of the early 1980’s, considered by many to be a boon rather than blight.

Carter appointed stern old Paul Volcker as chairman of the Fed in the late 70’s and he quickly took to attacking inflation by choking the economy with high interest rates. Both parties knew full well of the devastating effects this would have and agreed to the draconian contractionary monetary policy. By raising the Federal Funds rate as high as 20% in June 1981, Volcker squeezed inflation out of the US economy from 10.3% in 1981 to 3.2% in 1983, a remarkable drop that predictably caused a temporary recession and unemployment rates peaking at 10.8%. Once inflation was under control, Volcker took his foot of the brake and the economy boomed with the help of Reagan’s deficit spending. Though Volcker has been hailed as an economic hero by some, I think it’s important to take a closer look at his policies, perhaps through Krugman’s colored spectacles.

First of all let’s entertain the counterfactual. The impetus for this drastic manipulation of interest rates was that inflation was spiraling out of control. It seems, though, that this “spiraling” effect was an illusion due in large part to the massive oil shocks of the 70’s. Inflation spiked during the oil shock of 1973 but returned to around 5% in 1975, and spiked yet again in 1979, though this time drastic measures were taken. If Volcker had not acted, it is likely that inflation would have dropped via lower oil prices during the early to mid 80’s either way – an important point to consider. Another phenomenon in this era contributing to inflation was the wage-price feedback loop, often perpetuated by unions. However, during the late 70’s and early 80’s unionization was largely decreasing, and highly unionized industries such as manufacturing were facing competition from export-oriented Asian economies, would effectively reduced the feedback loop as well. This driver of inflation would have dropped significantly in the 80’s as well. The point is that drastically combating inflation in this era of unprecedented stagflation may have been more psychological than of necessity in hindsight.

Krugman makes the argument in this book that the real holy grails of economic well-being are productivity, income distribution and unemployment. He gives inflation a second-class and “neutral” status, a thorn in the side that can pose problems for the more “real” measures. Therefore, it would seem that he would prima facie oppose a recession that trade inflation for massive unemployment and loss of productivity, even if these ills were temporary in nature.

The argument can be made that most accounts of the Volcker recession view the US in a vacuum, and fail to consider its impacts more broadly. First of all, the residual effects of high interest rates were a leading factor in the Savings and Loans crisis that took place shortly after in the 1980’s. The high interest rates destroyed the ability of savings and loan associations to attract capital, and people fled to higher-earning commercial banks. Concurrently, the high interest rates hurt mortgages, which these S&L organizations used as underlying assets.

Often overlooked is the Volcker Recession’s effect on the rest of the world, which helped trigger and worsen the debt crisis in the Third World, in particular in Latin America. This is not unlike the recent global financial crisis, where US was the epicenter. Volcker visited the CMC Athenaeum, and asked by Bill Ascher if he considered the impact of his policies in this era on the international community he responded “Not at all”. While this may have been acceptable in the stagflated 80’s, it does not hold up to scrutiny today. Before we go trumpeting the success of aggressive monetary policy, we need to have a more serious look at these historical examples, and think seriously about the more long-term effects in the tradeoff between inflation and unemployment.

Krugman and the Twin Deficits

Though I generally thought that Krugman's simplifying perspective and historical support were quite interesting and somewhat compelling, I struggled to accept wholeheartedly his position on trade deficits.  Some of this is most likely my own lack of understanding (the economics of trade are very complicated, it appears), but I also thought that Krugman explained this phenomenon less well than the others.

Particularly striking to me was Krugman's favorable assessment of the idea that the budget deficit and the trade deficit are closely linked.  Though he does not completely endorse the conception of these "twin deficits," he does conclude that the United States could, if it really wanted to, erase the trade deficit, but this would require a balanced federal budget. I was curious to understand how this hypothesis might have held up under the infamous Clinton surplus (beginning shortly after the publication of the 2nd edition of this book).

I pasted graphs below, but interestingly enough I did not see the correlation that Krugman among others predicted.  Though there was a surplus from 1998 to 2001, over the same time period the trade deficit continued to grow both as a % of GDP and as absolute dollars - we do not see the reduction in the trade deficit that was supposed to mirror the budgetary surplus.  Furthermore, the deepening of the deficit in 2009, though obviously a symptom of the financial crisis, tracks actually with a reduction in the trade deficit.  This makes sense given the contraction of the US economy (decreased demand), but fails to support Krugman's hypothesis.


US Surpluses/Deficits (Inflation Adjusted): http://www.davemanuel.com/charts2/surpluses_and_deficits_1940-2011.html (not the most official source, but a pretty graph which matched all the others I found too)

US Trade Deficit as a % of GDP: http://static.seekingalpha.com/uploads/2009/3/6/saupload_trade_def_to_gdp.jpg

US Trade Balance in $:
http://seekingalpha.com/article/272498-can-the-u-s-become-a-net-exporter-again

Re-Re-Re-Re Insurance: Lloyd’s Plays With Grey Swans

Re-Re-Re-Re Insurance: Lloyd’s Plays With Grey Swans

            Krugman’s account of Lloyd’s insurance company in his Losing It chapter jumped out at me for a number of reasons. First, it seemed an interesting lesson in regards to the recent financial crisis. We saw a similar problem, and with insurance companies no less! AIG would agree to insure home loans, assuming some supposedly estimable and extremely unlikely event would occur (a large number of defaults, in this case driven by a housing bubble bursting). This allowed banks and other institutions to sell of risk for what they perceived as a cheap price, and thus were encouraged to seek more risky transactions due the moral hazard associated with gaining fees and bonuses from large deal flow and not being faced with downside risk due to insurance. When AIG looked like it would be unable to make good on this insurance, there was a dramatic system shock.

            This is, in many ways, similar to Lloyd’s. Lloyd’s, losing market share in a growing competitive field decided to make risky bets as well. They again, those funding the insurance, the Names, may not have been as aware of the risk they were taking on. This information asymmetry was present in both scenario’s allowing one party, in this case Lloyd’s,  to take advantage of its reputation for ethical behavior (as some have argued that modern banks did in the opaque derivative market) to take on excessive risk in search of quick returns. In both scenarios, we see exposure to large downside risk being realized with dramatic results.

            There are of course a number differences and the analogy does break down. Lloyd’s may not have had quite as large a global impact as the US banking crisis, but it certainly had a larger effect on individual names, given the fact that it was not set up as a limited liability structure, and Names were thus liable to lose all of their possessions.

            The second thing that jumped out at me, apart from the parallels to the modern crisis, was the structure of the insurance itself. Lloyd found itself in a dangerous area, namely it was insuring very rare events, with enormous impacts. These rare, impactful events were written about extensively by N. Taleb in The Black Swan. He, along with some behavior economists and psychologists like Khaneman, have noted that people generally have trouble estimating these very rare, but very impactful events both from a mathematical and a psychological standpoint. The general idea behind Taleb’s argument is that those quantitatively analyzing risk (like those pricing insurance for Lloyd’s) have trouble estimating how “fat” the tails of the probability curve are (how common the extreme events are) (i.e. the kurtosis). Using Taleb’s definitions of these events, Lloyd’s was dealing in grey swans, large impact (remember they are insuring other insurers against risk above a certain amount—they are essentially only dealing in rare, large events!) events that were conceivable although extremely rare (although perhaps not as rare as the insurers believed). It seems likely that in addition to having issues of moral hazard and myopia in investment decisions, Lloyd’s was perhaps exposing itself to risk that is difficult to accurately estimate, namely these large tail events. Modern finance has recently recognized some of the shortcomings with attempting to fit normal distributions, or even historical distributions to future data sets, and are using stress tests and other metrics to attempt to solve these “tail event” grey swans associated with the Lloyd fiascos and the recent financial crisis.

            

Krugman - Is China the new Japan?

Reading Krugman, it was interesting (if perhaps only because of my historical ignorance) to see how much he emphasized Japan as the major perceived economic threat at the time. Now, of course, if one goes by what was said in the presidential debates on Monday, China is the major economic “threat” to the US, in addition to perhaps Brazil, India, Russia, and other better off, large developing countries. Just noticing this difference was interesting because it suggests that perhaps global “competitors” can change fairly quickly (over the course of a few years to a decade).

I also can’t help but wonder if there might be other aspects of China’s economic performance that might make the situation now different than the situation with Japan earlier. For one, it seems that China, unlike Japan, has many protectionist policies (rather than the de facto cultural protectionism Krugman describes), such as pegging its currency, discriminatory industrial policies that favor domestic firms, discriminatory health and safety rules on imports, and so on [1]. China also has failed to effectively enforce intellectual property rights [1].

Of course, as Blinder and others have pointed out, even if there are barriers to free trade, we are often still better off trading freely ourselves, but as Krugman asserts “free trade becomes very difficult to sustain politically if there is a widespread and growing perception that one of the main players is following different rules” (Krugman, 133). This describes almost perfectly the sort of public attitudes towards China that Romney and Obama were attempting to address and navigate around on Monday night. Though Krugman notes that for Japan, because the closed nature of its markets arises from decentralized cultural forces, threatening protectionism won’t work, he seems to have little concern about the issue. The Japanese advantage, he says, hurts our economy only marginally, and suggests that the “Japan problem” might “simply fade away” on its own (Krugman 152).

I am not sure if we could as easily apply this answer to China, however. Certainly, many are concerned by the fact that China’s GDP (purchasing power parity) is rapidly catching up to the US’s ($11.4 trillion versus $15.3 trillion)[2]. I do not doubt that if China surpasses our GDP that will have some economic impact on US-China trade, though (again as Krugman predicts) it might be minimal. However, it seems to me that China’s political position is far more formidable. With a centralized government, China would reasonably be more effective in enforcing anti-market and anti-free trade regulations than we are, and thus once more threats of protectionism from our slow-acting democracy would prove impotent. Yet there also seems to be another significant difference between China and Japan, being that China is a very strong military power with nuclear weapons. As such, China has considerably more leeway than Japan in using their political power to, say, collect on loans or snub the international community.

It seems to me that this combination of political power and economic power is what most concerns and frightens the American public. But I really wonder how much it matters that China is second (third if you count the EU as a whole) in GDP, or that this economic power is combined with a very centralized, powerful state with significant military (and nuclear) power. Krugman’s discussion of how exports and imports take up a relatively small fraction of the US economy (and thus our productivity is the most important determinant of economic growth) seems to suggest that there are limits to how much China can impact our economy, even if they take a very extreme path (which, given the current state of international affairs seems fairly unlikely). Though obviously more information and data is needed, it seems that (if Krugman’s analysis is right) China would be far more of a political threat than an economic one.

[1] Morrison, W. M. (2011). China-U.S. trade issues. Washington, DC: Congressional Research Service. http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=1867&context=key_workplace

[2] https://www.cia.gov/library/publications/the-world-factbook/rankorder/2001rank.html?countryName=United%20States&countryCode=us&regionCode=noa&rank=2#us

Krugman, Income Distribution, and Gini Coefficients, oh my!

In chapter 2 of The Age of Diminished Expectations, Paul Krugman discusses income distribution in the United States. “The surge in inequality in the United States after 1973,” he states, “completely reversed the movement toward equality…By the 1990s, America was probably about as unequal a society as it had been in the Great Gatsby era of the 1920s” (23). He concludes that no one knows exactly why there has been a dramatic widening of income inequality in the U.S., and although income distribution affects individual American’s standard of living, it is not a major policy issue. Although Krugman is very correct in his statement that no one knows exactly why there has been a dramatic widening of unequal income distribution in the U.S., by comparing the U.S.’s demographics, population size, nature of the economy, and Gini coefficient to other countries that share similar qualities, we can see that there may be a positive correlation between these specific qualities and the growth of unequal income distribution.

            The below graph is from the CIA World Factbook in 2009. It color-codes each country based on their Gini coefficient. The U.S. ha a Gini coefficient in the range of .45 to .49. India has a Gini coefficient between .35 and .39. China has a coefficient between .45 and .49. These countries have populations of 311,591,917 people, 1,241,491,960 people, and 1,344,130,000 people respectively. All of these three countries have a wide range of ethnicities, languages, and religions within their borders; China has over 8 languages spoken in its different regions, and 15 different ethnicities, while India has 2 major ethnic groups, over 14 languages spoken, and three major religions practiced. The U.S., being known for its ‘melting pot’ culture, has over 5 ethnicities, four different languages spoken, and over 7 different religions practiced within its borders.

Now lets compare the inequality in the above countries’ income distribution to those of Norway, Sweden, and Finland. Norway population of 4,952,000, Sweden has a population of 9,103,788, and Finland has a population of 5,262,930. All of these countries have a Gini coefficient that is either in the .25 - .29 bracket, or below .25. Not only are these countries small in population and in geography, but they are also relatively homogenous. 96% of those who live in Norway are Norwegian; 3.6% are from other European countries, and 2% are from elsewhere. It has one official language, and a majority of its people (85.7%) practice with the Church of Norway. Sweden and Finland are similar to Norway in the sense that they have one official language, and a majority of their populations (over 85%) are Lutheran. When comparing these smaller, homogenous countries with the large, heterogeneous U.S., India, and China, we see that these smaller, homogenous countries have a more equal income distribution.

The distinction between income distribution in large, heterogeneous societies and homogenous smaller ones evokes Barro’s argument in favor of the optimal size of a nation and the attraction of secession. When there is either a shock (the Arab Oil Embargo in 1973 as hinted at by Krugman, or the American Civil War as pointed out by Barro) or a change (modernization/becoming more open to international trade) to the system, heterogeneous countries with a free market and large population have a harder time managing the divergence of their income distributions. After making this comparison between countries, we have to ask whether growing income distribution is and inevitable consequence of a large, free-market, heterogeneous society that undergoes modernization.

Sachs Wants More, Easterly Wants Less, But the Answer is Neither

The Easterly reading was an interesting read and in many places, I agreed with his arguments. I found it interesting that a large portion of the book was argued directly against Jeffrey Sachs who believes that more aid is beneficial to the poorest developing countries. I do agree that solutions need to be tailored to the local context, which allows the Searchers to be more practical and make impact, albeit on a smaller scale. However, one can imagine the following scenario. For instance, a Searcher builds a brand new school catering to the needs and cultural context of the region in order to address the lack of formal education. However, the efficacy results are subpar because students are not able to concentrate in class if they are malnourished and have no energy to learn. Therefore, a Searcher in another town focuses on reducing the number of malnourished children with vitamin injections, food programs, etc. Instead, these kids become healthier but they don't go to school and instead help their parents tend the fields for economic survival. In another village, daughters are incentivized to go to school and get an education like their male counterparts because of another Western initiative to close gender income gaps, however, the patriarchal culture leaves women out of jobs and no opportunities to start business even with an education.

The point is, Easterly talks about the importance of the local context; however, there is the concern that small-scale reforms are too small scale and don't address the complexity of the issues at hand. If you focus on one at a time in the trial and error format Easterly discusses, that is almost just as inefficient as trying to solve everything in one go.

My last piece of beef with him is that he writes a 400 page book on how the West has thrown so much money at these countries with very little results, which is a depressing thought. Not only that, but he leaves very little room at the end for solutions to fixing this problem. Yes, he mentions from the very beginning that readers who are looking for his grant plans of fixing Africa are missing the point of the book altogether - that there is no such grand plan. However, he is also making sweeping generalizations that no plan is the best plan. Based on a situation like the one above, it seems like some type of coordination of efforts would make all the initiatives more effective.

Sachs wants more aid while Easterly wants less. However, the answer is never black and white because that would just be too easy...Instead there needs to be a combination of aid along with other interventions. While these two economists provide valuable discourse for development economics, there is a third person who examines the issue from a slightly different lens: Paul Collier, author of the Bottom Billion. Collier argues that aid is important, but there are other structural issues that need to be dealt with along with the small scale interventions: conflict trap, natural resource trap, landlocked with bad neighbors, and bad governance in a small country. He mentions the curse of civil wars in particular and how the poorer countries have a higher likelihood of engaging in civil war, which then reduces GDP per capita even more. Collier's research shows that once a country slides into the worst levels of poverty, it tends to remain in that category for roughly 50 years, "costing the affected country and its neighbors an estimated $100 billion in lost income. The price of experiencing civil war is higher still.  Collier and Hoeffler estimate that the average conflict-torn developing country loses at least 105 percent of its pre-war GDP simply by virtue of experiencing conflict, and can cause neighboring countries to lose 43 percent of their pre-war GDP.  Assuming the average GDP of low-income countries is $19.7 billion, Collier’s conservative estimate is that the average civil war today costs developing countries about $54 billion." (http://www.brookings.edu/views/papers/rice/poverty_civilwar.pdf) Although I do not fully understand the data, the following Harvard economic paper talks about the impact of civil war on GDP as well. Essentially, there is more to what Easterly argues in his book, and it is not about simply providing less aid .

 

So Sen-sible

I found Easterly's critique of foreign aid to be very persuasive. Almost too persuasive. When he argues that aid programs should be tailored to their targeted societies, should sidestep dealings with corrupt governments, and should heed feedback mechanisms from the local populations, it is difficult to disagree with him.

But surely our aid programs, even if prone to the occasional error, already set out with Easterly's intentions in mind? In other words, don't aid programs already try to incorporate Easterly's suggestions?

Easterly almost agrees. He notes that "the working-level people in aid agencies or nongovernmental organizations (NGOs) are more likely to be Searchers than Planners." (18) This relationship makes sense: the upper-class American is the Planner, wants to combat poverty, donates to the Red Cross worker in the developing world, who determines the best use of that donation.

I repeat: is this not what is already happening?

Easterly says no. He qualifies his praise for the working-level people by observing how "Big Plans foist on these workers...taking money, time, and energy away from the doable actions that workers discover in their searching." (18)

To be honest, I do not really know what Easterly means by this. Is his point that aid programs are so large and bureaucratic that they waste aid dollars? Possibly. Easterly certainly criticizes the bureaucracies in his Tanzanian pothole anecdote. (174-175)

Source: PolitiFact

Data on several NGOs, however, reveal reasonable efficiency levels. As the chart above shows, 92 cents of each Red Cross donation dollar reaches its targeted aid program. The same goes for 83 cents of every UNICEF dollar. While clearly imperfect, the operational efficiency of NGOs likely is not the explanation for the ineffectiveness of foreign aid.

Is his point, then, that the leaders of NGOs, the World Bank, and the IMF are incompetent? Not really.

Easterly concedes that "the IMF and the World Bank do succeed in attracting professionals who are dedicated to the mission of poverty reduction...and employees with strong norms of professional conduct do perform better." (177)

Amartya Sen (remember him?) authored a compelling critique of Easterly that captured many of my reactions. Sen wrote that if delivered in a less-extreme fashion, Easterly's lessons "could have yielded an illuminating critical perspective on how and why things often do go wrong in the efforts to help the world's poor." Yet Sen could not accept "Easterly's overblown conclusions...[because even Easterly] acknowledges the successes of many international aid efforts." (Sen, 172)

Ignore poverty reduction for a moment. International aid performs critical humanitarian functions. A recent study by the Social Science Research Network found that foreign aid played a substantial role in reducing infant mortality rates in Kenya. The Chief Economist of the IMF, whom Easterly cites as a denier of the growth effects of foreign aid, admits aid can be useful to save lives.

Even if one accepts only the premise that aid does good in the humanitarian realm - rejecting the idea that aid fights poverty - he or she still stands with Sen.

And I stand with Sen. Ample evidence, at the very least for humanitarian efforts, demonstrates the benefit and necessity of foreign aid. Yet I still find in The White Man's Burden welcome insights into ways of heightening the impact of foreign aid programs.

--

In all seriousness, I highly recommend reading the Sen critique. I struggled all day to write this blog post because Easterly seems so right and so wrong at the same time - I'd imagine many of you feel this way too. Find the critique here.

Sources:
Politifact
OECD
WHO
IMF
World Bank
Social Sciences Research Network
New York Times
JSTOR

Raghuram Rajan and Arvind Subramanian

Aid, Dis-aggregation, and Infant Mortality

Easterly primarily argues that aid has failed to promote growth. His evidence seems relatively convincing. However, GDP growth is not the primary goal of most aid projects. Aid is typically designed to improve education, health, infrastructure, or improve governance, all with the goal of alleviating poverty. While poverty is very clearly linked to GDP and GDP growth, this may be through the long term. Furthermore, GDP could grow in some parts of the country, leaving others impoverished. Easterly is jumping to the end goal but doesn't look methodologically at where in the chain the failure is occurring. He suggests doing this through more micro-level assessments of what works. However, I think that more could be done at the macro-level to see whether aid is failing and why as well.  In order to assess why aid fails, I think Easterly could have constructed a model linking aid to GDP growth and test each link in this chain.  The model should be (un-academically and non-mathematically expressed because it would be a series of equations with other factors included) something like this:

(created by me, ideas partially taken from Fidley and Hawkins (2009))

It would be useful to look at which of these types of aid is failing to create outputs in the "quality of life" section and then which of these outputs is not strongly linked to poverty reduction and growth outcomes, thereby accounting for the lack of evidence that aid works. If the research showed that aid is a significant contributor to improved health, reduced conflict, improved education, improved investment, and democracy, all measured separately, then aid could be taken as a useful tool to alleviating poverty. The question would then be, why are improved health, education, governance, etc. unsuccessful in improving growth rates or what is wrong with the literature.

Since this would be a massive undertaking, I decided to look at a portion of this: whether health aid reduces infant mortality. In contrast to the effects of general aid on growth, health aid seems to also have a controversial  impact on reducing infant mortality. Mishra and Newhouse (2009) uses data from 118 countries between 1973 and 2004 in a dynamic panel with fixed effects to show that doubling health aid is associated with a two percent drop in the infant mortality rate, implying that for the average country, an increase in per capita health aid of $1.60 per year is associated with 1.5 less deaths per thousand births. In contrast, Boone (1995) finds no impact. Thus, from a cursory look at the research, it seems that health aid is a part of the problem. If health aid is not consistently found to improve health outputs, it could not reduce poverty or increase growth outcomes.

Regardless, before believing Easterly's conclusion that aid is generally ineffective and aid agencies must be held accountable and more careful measurement of each intervention is needed, I would want to make sure that the careful measurements are being done efficiently. More accountability to aid agencies means more accountability for those who they fund. This would direct the accountability upwards to the donors as opposed to the poor people in the local communities they serve. Thus, more accountability for aid agencies could mean less accountability to local people. Overly extensive date reporting standards also result in inefficient aid - for example, the requirements for reporting for EU aid take about 50 percent of the total time and thereby expenses of the project. Furthermore, requirements for types of projects that are proven to be effective could reduce innovation at the local NGO level, who are more likely to be seeking solutions to local problems than planning grand schemes from above.

Federal Debt and Interest Costs

In Krugman's chapter on the budget deficit (Chp. 7) I noticed something that seemed odd: in Figure 17 (pg.96) Krugman notes that net interest on the federal debt makes up 14 percent of the federal budget. That seemed rather large to me -- I would have guessed around 5 or 6 percent -- so I looked into historical data for U.S. net interest as a percentage of federal outlays.

Turns out Krugman was right, but my intuition was not far off. Net interest as a percentage of federal outlays has fluctuated over time, reaching a peak in 1947 (just after the second world war) at 14.4 percent, but then dropping to 7.7 percent and staying there till 1977. From 1977-1999, it rose and remained at or above 14 percent. This is period in which Krugman writes.

From 2000-2003, however, interest payments on the debt as a percentage of federal outlays dramatically declined: by 2003, it reached less than 7 percent. It rose again slightly between 2003 and 2007, but still stayed well below 10 percent.

Net Interest as a Percentage of Total Federal Outlays (1941-2011)
Source: Office of Management and Budget (OMB)

2008 is when things get really interesting (enlarge graph above). The net interest as percentage of federal outlays drops from over 8 percent in 2008 to 5 percent in 2009. From 2009-2011, this number rose slightly but stayed below 8 percent.

This data seems puzzling at first glance. U.S. debt to GDP ratio is substantially higher today (70 percent) than it was even at the peak of the 1990s (50 percent). If debt-GDP is a decent measure of how financially "leveraged" the government is, we would expect interest payments on that debt to be higher with higher debt-GDP ratios. Instead, we find exactly the opposite: interest payments as a percentage of the federal budget today are half as much as they were during the 1990s.

The explanation for this counterintuitive result lies in interest rates. As we discussed in class, in recent years U.S. T-bills have looked increasingly appealing as the rest of the world does worse economically than the United States. The amount of debt interest a government must pay depends on two factors: the amount of outstanding debt and the interest rate on government bonds. While the amount of outstanding debt is much higher than it was during the late-1980s and 1990s, interest rates on government bonds are much lower (enlarge graph below). In the late 1980s, the U.S treasury bond interest rate was 13 percent; by 2011, it had steadily declined to 2 percent. That's an 11 percent drop from peak-to-present day.

U.S. Treasury Bond Interest Rates (Historical)
Source: Dept. of Treasury

The above comparison between 1980s/90s interest payments and present-day illustrates the importance of the interest rates the federal government is charged to finance its debt. Even if the economy's debt burden increases dramatically, as it has since the 1990s, federal interest payments on the debt can still decline if interest rates also decrease dramatically. This is significant because lower interest payments mean that the federal government can use the money "saved" to finance its other obligations -- e.g. entitlements, defense, education, etc.

This analysis also highlights the importance of keeping interest rates low: if net interest rises to levels at the time of Krugman's writing, the United States will face a more severe struggle to meet its spending and debt obligations.  Interest payments have contributed to deficits and helped fuel a rising debt burden in the past. Rising debt, in turn, raise interest costs and cause the federal government to increase debt held by the public to finance these costs. This has been is the so-called "vicious cycle" of ever-increasing interest payments and debt burdens. 

If Congress needed another incentive to reach a grand bargain to solve America's long-term debt problem, the prospect of rising net interest payments provides a strong one. 

The Appropriate Bubble? A look into the boundaries of emissions trading

            In regards to economic policy, Blinder makes a persuasive argument that market-based approaches to pollution-reduction are more effective in reducing costs and emissions politicians or the rigid mandates of environmental agencies.  Blinder explains, “The main reason why direct controls cost society so much more than pollution fees, you will recall, is that there are disparities from firm to firm in pollution abatement” (152). Specifically, certain firms will find it much more costly to reduce emissions than other firms, and free-market approaches, unlike straight-jacket mandates, can use this discrepancy to help lessen the economic burdens on firms while still producing the same outcome. For example, if firm Pear-Picking can lower emissions at a meager marginal cost of $5, whereas the Shoe-Scrubbing firm must spend $500 dollars to make an equal reduction, an emissions market would efficiently allocate the pollution reduction to the Pear-Pickers. Thus, by taking advantage of different firms’ varying marginal cost of emissions reduction, a minimal burden on the market can be achieved.

While I agree thus far with Blinder’s logic, I would like to point out an important complexity that Blinder calls the “bubble concept.” Blinder explains that the more firms (and potentially types of pollutants) that are incorporated into the emissions trading circle, the more efficient the market will become. If more firms are able to trade their emissions permits, the firm with the lowest marginal cost for emissions reduction will be compensated by the other firms to do so, resulting in a healthier environment at a limited cost to the economy. Similarly, if x amount of carbon emissions are found to have the same detrimental effect on the environment as y amount of methane gas, firms may individually, and through trading, collectively, weigh the potential burden to reducing each pollutant and make the most efficient plan in acquiring the desired decrease in pollutant production. However, how wide exactly should we open this market? To minimize reduction-costs, the answer would be, completely open. If one firm can reduce admissions at a lower cost, then by all means they should do it.  However, another consideration exists in tension with the principal of maximizing effiency. If I live in California, I may not particularly care that an environmental policy will reduce CO2 emissions in New York, or in South Africa. Consider the following example illustrated by the relative costs of carbon emissions price in Sweden and Germany. While this graph illustrates the relative carbon taxes, not the actual marginal cost of reduction, for my purposes this is not important. As illustrated by the relative slopes, Germany can reduce its emissions at a much lower cost than Sweden. In this Figure, Req = required emissions reductions. In this example, Germany has an opportunity to profit if it reduces more emissions than required and sells these permits to Sweden, who are incentivized to buy them because internal costs of reduction are higher. Thus, Sweden makes cuts costs by buying emission permits from Germany and Germany profits. Everyone wins! J

The potential problem here though is that Sweden citizens would be living in an environment where more pollution exists. It may be true that some forms  of emissions affect citizens of the world equally (Green House Gases may), but other pollutants affect local regions more severely. Smog in LA is a testament to this truth. LA citizens may rightfully be unhappy, then, if the trading “bubble” of emissions permits are expanded to include state, country, or even international markets. The fact that pollutant externalities effect local pollutions more severely pulls against the economic motive to have entirely free markets and should be closely considered and weighed against cost considerations when making policy decisions. 

Inflation, Unemployment and Happiness

When exploring further the relationship between inflation, unemployment, and growth, I found something that caught my eye: the relationship between inflation, unemployment, and happiness. This interested me because GDP is used to measure "wellbeing" as a basic proxy when many would argue that what really matters is happiness. Thus, it might make more sense to measure the correlates of happiness. In Di Tella et. al.'s 2000 paper, "Preferences over Inflation and Unemployment: Evidence from Surveys of Happiness" they find that from an OLS regression of reported life satisfaction in Europe from 1975 to 1991, happiness and unemployment and inflation are both correlated with lower levels of life-satisfaction. Even when controlling for the personal characteristics of the respondents, country fixed-effects, year effects, country-specific time trends, and a lagged dependent variable, both inflation and unemployment were significant.  A percentage point increase in unemployment is associated with a -2.8 through -2.0 change in reported life satisfaction. A percentage increase in inflation is also associated with decreases in happiness, specifically a one percentage point increase leads to a between -1.4 and -1.2 decrease in life satisfaction. Life satisfaction is on a scale of 1-4, so these changes are huge. The study suggests that Europeans would trade off a 1 percentage point increase in the unemployment rate for a 1.7 percentage-point increase in the inflation rate.

This points to a discrepancy between the economic and psychological effects of inflation. While life satisfaction may drop significantly during periods of higher inflation, economic growth is less effected. From Barro and Easterly's 1995 Working Paper, they found that when crisis of high-inflation (over 40 percent) are excluded, inflation is not significantly correlated with changes in economic growth.

Thus, one of the main problems with inflation may be psychological. Older people may be nostalgic for nickel and dime stores and 25 cent gallons of gas, regardless of what their incomes were actually.

Galbraith and Blinder...

Just as an aside, I wanted to discuss an interesting parallel I saw between Blinder’s and Galbraith’s economic and political observations about American society. Blinder discusses politician’s use of ‘superficially appealing slogans’ based on faulty reasoning and blind ideology. He compares politics to merchandising, in the since that you have to gimmick to sell the product. In a political market place in which explaining policies needs to happen in less than 40 seconds, good economics rarely sells. This mentality of summing up complex realities with false big ideas is likewise found in Galbraith’s description of the ‘production driven’ mentality of the U.S. economy. Merchandising is used to manipulate the consumer into believing that he or she needs the next most luxurious item (iPhone 5, anyone?). These two ideas shed light on a broader phenomenon happening in the development of the U.S. economy. The fact that the consumer is the individual unit that drives the market leads to manipulations of the consumer, which results in market inefficiencies. Blinder’s description of ‘t-shirt ideas’ suggests that politics have become politician-driven just as Galbraith’s economy is production-driven. In the pursuit of self-interest, the political and economic sphere have been transformed so they are not driven by the demand of the consumer/voter, but rather by the product/policy produced by the seller/politician. During tutorial, Erin and I discussed the idea that implementing inefficient economic policies might just be indicative of democracy because politicians have to ultimately represent the beliefs and desires of their constituents, even if these politicians know that a more nuanced economic policy would be more efficient. Politicians are thus forced to create a simplistic and ideological representation of a complex economic reality in order to sell it to their voters. The nature of this economic and political system suggests that Blinder’s recommendation of increased economic education among the public would be ineffective.

TIPs: Further Explanation

When I was reading Blinder’s chapter on ‘Striking a Balance between Unemployment and Inflation,’ I was fascinated by his description of tax-based incomes policy, and how it could possibly be a better way to combat inflation than wage-price controls enforced by the state. I decided to dedicate my blog post to exploring the argument behind TIPs more than Blinder did.

In a nutshell, tax-based income policies are policies that control the rate of increases in wages and the associated increase in prices through tax penalties and incentives (sticks and carrots). Specifically, a TIP is an incentive to the employer or employees at a firm to reduce the firm’s own wage increase.  Laurence Seidman composed a paper released by Brookings Institution that explained the concept of TIPs by comparing them to levying a tax on an externality like pollution. In order to see the externality that necessitates TIPs, we have to assume that the nature of the labor market lead a firm to raise its wage rate increase relative to that of the last period at an unemployment rate in which the marginal unemployed worker prefers work to leisure. Externalities result from the firm’s action of increasing wages in two different ways depending on the economy’s reaction. First, if monetary and fiscal policy maintain this unemployment rate, accelerating inflation is generated, harming the public. Second, if monetary and fiscal policy allow for a higher unemployment rate so as to reduce inflation, there is lost output and optimal unemployment, both of which have a value that exceeds the value of the aforementioned ‘leisure’ to the marginal unemployed worker. By prescribing a tax to internalize this externality, each firm must weigh the social cost of raising the rate of unemployment when it increase its wage rate. In his paper, Seidman concludes that a permanent TIP would permanently reduce the unemployment rate while keeping inflation constant.  Although few economists advocate for tax incentives because they assume individuals act in their own self-interest, Seidman believes that the most effective TIP would not be solely a penalty or a reward, but rather a combination of the two.

Another Brookings Institution paper written by Larry Dildine and Emil Sunley further explores the idea of implementing a combination of penalty and reward TIPs. First, if tax penalties were imposed on employers of employees to restrain price or wage increases, small and/or unincorporated businesses would be excluded from the program because of their generally rudimentary accounting. This exclusion would greatly reduce administrative problems without having a serious impact on the effectiveness of the whole program. However, if a tax incentive were levied, there would be mounting pressure to allow all business taxpayers and their employees to participate and take advantage of these rewards (assuming all are driven by self-interest). In order to fix these administrative problems, Dildine and Sunely suggest a ‘stick’ approach to implementing TIPS, which would impose penalties on firms that increase wages above a certain threshold while also giving a tax reduction for workers if wages have not exceeded this threshold.