contents

2 from the 3 editor’s 95 institute news 96 lists ceo note Busy, busy. Happiness.

5 brazil’s hard road 39 getting social policy done to affluence in a divided washington Say it ain’t so, Lula. Under the radar. by Robert Looney by Ron Haskins 14 free trade under fire 48 homeownership, Real problem, wrong fix. wealth creation and by Ed Dolan financial stability Debt bites. 26 seven tips for by Ed DeMarco interpreting macroeconomic data 60 universal wage insurance Secrets of the bean counters. and lifetime retraining by Jason Furman for a riskier job market. by Robert Litan 70 letter from bolivia Sensible socialists? 83 by Charles Castaldi book excerpt The Euro and the Battle of Ideas Marcus K. Brunnermeier, Harold James and Jean-Pierre Landau explain why the Euro mess isn’t going away. from the ceo

I am writing this in the midst of one of the most bitterly fought pres- idential elections in decades. But at the Milken Institute, even as we follow electoral politics with keen interest, the results of this year’s contest won’t change how we conduct our work. While we maintain a significant presence in Washington DC, we don’t fall into the pattern of many public policy organizations there whose fortunes revolve around who’s in and who’s out. Our practice since the Institute was founded in 1991 has been to tackle the nation’s problems in the most effective way we know – and that means working with those who want to accomplish important things, no matter their political affiliation. Some recent examples of the Institute’s results-oriented non-partisanship: • Our FasterCures center has unveiled “Rx for Innovation,” a program to inform the next administration’s views on the challenges facing the biomedical system. The center is reaching out to patient groups, researchers, companies, philanthropists and policymakers for their input, with the goal of crafting practical recommenda- tions for accelerating access to new and better treatments. • Housing finance is one area in urgent need of policy change, as revealed by the financial crisis. Experts at the Institute’s Center for Financial Markets are working with legislators and their staff on both sides of the aisle to develop guidance for housing finance reform that could be supported by both parties. • An equally urgent national need is expanded access to capital for business own- ers and entrepreneurs in minority communities. Our California Center and our Center for Financial Markets are partnering with the Small Business Administra- tion on a pilot program bringing together elected officials, business owners and lenders in two cities (Baltimore and Los Angeles) to chart how best to make credit and equity investment available to African-American and Latino small businesses. • This summer, the Institute partnered with the Bipartisan Policy Center to host forums at both political conventions. Among the issues addressed: medical innova- tion, economic competitiveness and tax policy. The Institute’s non-partisanship is part of our DNA. So, while we’ll be watching the inauguration ceremonies with interest come January 20, we will be ready to work with whoever’s in charge at 1600 Pennsylvania Avenue.

Michael Klowden, CEO

2 The Milken Institute Review editor’s note

So, here’s a problem: what is your humble editor to do if there simply isn’t room to fit everything worth reading between the covers of a 96-page quarterly issue? And here’s an answer: publish the extra content on our website, MilkenReview.org.

This issue includes an excerpt from The ment is linked to gains in income. Euro and the Battle for Ideas, a new book by “It is far too easy to slip off the economic Markus Brunnermeier, Harold James and ladder and never fully recover,” Litan notes. Jean-Pierre Landau that explains the dysfunc- “To manage the consequences of the sorts of tion of the Eurozone in terms of the diverging economic displacement that seem inevitable, economic cultures of the member-states. we need smarter government – not less of it.” Check that – this issue includes part of the ex- Robert Looney, an economist at the Naval cerpt. The rest can be found on our website, Postgraduate School in California, analyzes with a handy link that takes readers of the Brazil’s latest adventure in flying too close to magazine to the place they left off. the sun. “Brazil is a land of immense eco- Meanwhile, take a gander at what’s waiting nomic promise and immense disappoint- for you in this issue: ment,” he writes. “It is also becoming an icon Jason Furman, the chair of Pres. Obama’s of the reality that shortcuts to development, Council of Economic Advisers, offers a rare especially development subject to the middle- glimpse into the difficulties of analyzing mac- income trap, are deeply problematic.” roeconomic data and using it to predict Ron Haskins, the co-director of the Brook- growth, unemployment and inflation. “While ings Center on Children and Families, rebuts we no longer must cope with the information the conventional wisdom that partisan poli- void that policymakers faced in the 1930s, the tics has blocked all cooperation between mountain of data available creates its own Congress and the Obama White House, and problems,” he writes. “Chief among them is offers a menu for possible policy collabora- that we can sometimes ask too much of the tion on social issues after the election. “It data while doing too little to put it in context.” would be Pollyannaish to pretend that busi- Robert Litan of the Council on Foreign ness as usual has not been unusual in Wash- Relations offers two ideas for reducing job in- ington, or that the partisan divide hasn’t security in an era of rapid globalization. One taken a major toll on the quality of govern- is universal wage insurance that would re- ment,” he acknowledges. But he focuses on a place a portion of income lost when a dis- number of issues – with early childhood edu- placed worker takes a lower-paying job. The cation highest on the list – where common other: loans for job retraining in which repay- ground could still be found.

Fourth Quarter 2016 3 editor’s note “It’s pretty clear that we’ve been side- Charles Castaldi, a former NPR corre- tracked into policies that make the mortgage spondent, revisits Bolivia for an update on market bigger and more volatile,” he writes. how the country is coping with its deep eth- “It’s equally clear that we’ve strayed far from nic divisions – not to mention the rule of Evo the broader public interest – and that the Morales, the populist president who thumbs route back lies in building equity, not debt.” his nose at the former colonial powers. “The Ed Dolan, creator of an eponymous blog initial take in Washington was that Evo was on economic literacy, takes an unconvern- cut from the same cloth as Hugo Chávez in tional tack in asking what could be done to Venezuela and was sure to drive the economy help American workers displaced by interna- (further) into ruin,” Castaldi writes. “In fact, tional trade. Rather than (or in addition to) this government’s track record is the envy of helping them out with cash or retraining, he its neighbors.” focuses on removing impediments to going Ed DeMarco, the former acting director of where new jobs are plentiful. the Federal Housing Finance Agency, con- Among the most significant: occupational cedes that inertia and interest group politics licensing restrictions used to protect incum- make it very difficult to redirect Washington’s bents from competition, subsidies designed focus on home ownership. But he argues that to steer Americans toward owner-occupied the vast public resources committed to subsi- housing that is immensely costly to turn over, dizing private housing could be spent on and forced disclosure of criminal records that building equity rather than facilitating ever- make it very difficult to switch jobs. riskier borrowing. Happy perusing. —Peter Passell

You’ve probably figured it out Samuelson and Franco Modigliani) to transform- already: the caricature on the ing the department into the best in the nation. spine of the combined 2016 Yes, but what has he done? It’s impossible issues of the Review is Robert to overestimate the importance of his model of Solow, arguably the most influ- economic growth, which focused much of the ential living economist and cer- profession on the role of technological change tainly one of the nicest people you’ll in explaining how advanced economies prosper. ever meet. Certainly, the profession hasn’t; he’s won both A child of the Depression, he and a John Bates Clark Medal (awarded every two his sisters were the first in the fam- years to an economist under 40) and, of course, ily to attend college. But he picked a the Nobel Prize in 1987. good one (Harvard) and the rest is Less tangibly (but probably as important), history. Well, not quite. Solow made a he was a leading force in demanding mathe- detour between 1942 and 1945, fight- matical and statistical rigor from economists in ing the Wehrmacht in the hellish cam- training. Yet he never fell into the trap of treat- paign to capture Italy before return- ing economics as an elegant abstraction. Indeed, ing to Cambridge for a BA and PhD. he’s used his august position in the profession Then on to a job teaching economics at to promote smart, evidence-based policy analy-

MIT, where he was key (along with Paul sis throughout his career. smith david

4 The Milken Institute Review Brazil’s Hard Road to Affluence by robert looney

illustrations by flavio morais

Fourth Quarter 2016 5 For much of the past century, Brazil has been a classic economic under- achiever, the perpetual country of tomorrow. Then, early in the new mil- lennium, the country’s mold-breaking populist president Luiz Inácio Lula da Silva unveiled his version of “third way” development, dubbed the Brasilia Consensus, that mixed regulated markets and macroeconomic Fprudence with carefully targeted welfare programs. His ambitious ap- proach promised results sorely lacking not just in Brazil, but throughout Latin America: buoyant growth, increased equity, reduced poverty – and all of it without yet another round of accelerating inflation.

6 The Milken Institute Review Too good to be true? In a word: yes. But there’s still much to be learned from this lat- est ride on Brazil’s development roller coaster. In particular, that true institutional change comes slowly. And without change that more clearly limits the role of government and fo- cuses on getting economic incentives right, the economic pie won’t grow sufficiently to sustain a just and prosperous society. Looking back, it’s easy to see why longtime picked successor, Dilma Rousseff, the Brazil watchers allowed themselves to hope economy fell into deep recession. What had this time would be different. During his two- started out as a virtuous circle of broad-based term administration (2003-10), Lula scored growth under Lula rapidly turned into a vi- some stunning successes. GDP growth aver- cious circle of economic contraction, bal- aged 4.1 percent – tepid, perhaps, by East looning debt, soaring interest rates and a Asian metrics, but heavy duty by Latin Amer- sharply falling exchange rate under Rousseff. ican standards. Some eight million jobs were In 2013, mass protests swept Brazil for the created. More impressively, Lula managed the first time in decades. In May of this year, process of growth without exacerbating the Rousseff was suspended by the legislature: In country’s notoriously awful inequality. Quite August, she was removed from office. the contrary: the income of the poorest half With 20-20 hindsight, it’s easy to explain of households grew at nearly twice the rate of what happened. All it took was a poisonous the top 10 percent; all told, 17 million Brazil- mix of rapidly falling commodity prices ians climbed out of poverty. as the global economy stumbled (Brazil ex- Meanwhile, inflation was held to 6 to 7 per- ports a lot of oil, iron ore and soybeans) and cent, down from around 15 percent in the serious mismanagement of fiscal policy as 1980s and ’90s. Even in the midst of the 2008- government revenues shrank. The country’s 9 global financial crisis, Brazil continued to pervasive corruption became harder to ig- defy claims that inclusive growth was impos- nore as the economic pie shrank. But the sible in a Latin American context. speed and depth of the downturn left a lot of Indeed, by 2010, Brazil appeared to be observers wondering whether Brazil’s third on the cusp of becoming a major contender way wasn’t to blame. Which leads to a big on the emerging-market fast track. Brazilian- question: can Brazil’s no-family-left-behind style growth-with-a-heart was hailed as a growth model be salvaged – not just in Brazil, viable democratic alternative to the Chinese but throughout Latin America? authoritarian model or the privatize-or- perish free market approach forced on devel- lula and the brasilia consensus oping countries by international lenders. Be- As in many Latin American countries, Brazil’s lievers saw Brazil’s third way as a model for approach to economic development before other Latin American countries, and maybe Lula was largely driven by the conviction that eventually for sub-Saharan Africa. industrialization was Priority One. That re- Then, as suddenly as the good times ar- quired tariff and quota protection against rived, they vanished. Under Lula’s hand- cheaper, better-made imported manufactures.

Fourth Quarter 2016 7 brazil Although this approach worked (well, sort of worked) in the 1960s and ’70s, the chickens came home to roost in the 1980s. Low pro- ductivity and dysfunctional markets, com- pounded by macroeconomic policies that left the economy exceptionally vulnerable to run- away inflation, constrained development. Despite Brazil’s vast natural resources and rapidly growing labor force, GDP growth av- eraged only 3 percent in the 1980s and 1.9 percent in the 1990s. From 1960 to 2000, labor productivity growth averaged 1.7 per- cent, compared with 6.6 percent in South Korea and 7.8 percent in China. The coun- try’s teeming, violence-ridden favelas became symbols of the Brazilian elite’s indifference to extreme poverty. Income inequality was the highest in the Americas and gave a lot of failed African states a run for their greed. The year 2002 saw the election of Workers’ Party candidate Lula da Silva, a tough, leftist union leader who had fought the military governments of the 1980s. He surprised just about everybody by maintaining the prudent macro policies of his center-right predecessor, Fernando Henrique Cardoso, who had con- quered quadruple-digit inflation. And, as dis- cussed, Lula expanded programs targeted at relieving poverty with minimal impact on market efficiency. Specifically, Lula expanded the “condition- al cash transfer” social programs first intro- duced by the Cardoso administration. Low-income families received monthly cash stipends in return for commitments to send their children to school and to remain up to date on vaccinations. In 2006, roughly one in four Brazilian households were covered, vir- tually eliminating extreme poverty at modest

ROBERT LOONEY teaches economics at the Naval Postgraduate School in California.

8 The Milken Institute Review Fourth Quarter 2016 9 brazil wage increases and subsidized credit to small cost – an annual outlay of just 0.5 percent of businesses through the public banking sys- GDP. Instead of pursuing a classic outward- tem, accounted for the rest. oriented development policy, the export-led From a political perspective, the Consen- growth approach that has worked so well in sus worked (or at least endured) because Lula East Asia, Lula made lemonade from lemons. managed to redistribute income without di- He accepted Brazil’s relatively low savings rate rectly confronting Brazil’s business elite. In as a given, harnessing increased personal fact, he sought a convergence of interests spending to fuel the growth of jobs and wages. between labor and business though the ex- Lula’s Brasilia Consensus also deviated pansion of private consumption. Rates of in- radically from a conventional free-market ap- vestment were never high by emerging-market proach by intervening in key markets to give standards. But they were high enough to sus- domestic firms a leg up on foreign competi- tain a reasonable rate of growth. By the same tors. This was uncomfortably similar to Bra- token, government spending as a portion of zil’s failed import-substitution strategy of the GDP was high for an emerging-market econ- 1960s and ’70s; the government imposed high omy. But steady growth made it possible to tariffs on many imported goods to provide a keep budget deficits low and inflation in protected market for Brazilian firms and to check. encourage foreign manufacturers to set up production facilities in Brazil. To promote in- virtuous to vicious circles dustrialization, the government subsidized I know what you’re thinking: did Lula do it all credit through the state-run development by magic? Protectionism and promotion of bank. For foreign direct investors, state in- growth through the expansion of consump- volvement was somewhat heavier-handed – tion are widely viewed by mainstream econo- for example, imposing local-content rules mists as a problematic route to prosperity – at and local sourcing requirements on foreign best, a temporary fix for an economy that is firms in the mining and oil/gas sectors. operating below capacity and only needs the The four main elements of the third-way expansion of demand (any sort of demand) Brasilia Consensus proved roughly comple- to make everybody better off. mentary. Macroeconomic stability helped Actually, Lula benefited more from luck preserve the purchasing power of household than magic – the global commodity boom income, which was supplemented by the carried Brazil a long way. Lula’s successor country’s social programs. Increased family could not sustain prosperity based solely on income spurred domestic demand to drive the rising demand. What started out as a virtuous growth of jobs and wages. At the same time, circle of mutually complementary policies industrial policies favoring domestic produc- that expanded economic activity, reduced tion helped maintain employment and create poverty, blurred ideological divisions and incentives for foreign direct investment. made it possible to run a stable macro policy Interestingly, research suggests that Bra- without encountering bitter political resis- zil’s cash-transfer programs accounted for tance turned into a vicious circle of contrac- only one-fifth of the reduction in income in- tion and instability under Lula’s successor. equality. Economic growth and the associated After Rousseff took office in 2011, Brazil’s expansion in employment, plus minimum growth slowed sharply; then, in 2014, the

10 The Milken Institute Review What started out as a virtuous circle of mutually complementary policies that expanded economic activity, reduced poverty, blurred ideological divisions and made it possible to run a stable macro policy without encountering bitter political resistance turned into a vicious circle of contraction and instability under Luca’s successor. economy went into recession and shrank 3.9 ing over low productivity with credit subsi- percent. The IMF predicts further shrinkage dies. Incipient inflation was tamped down (more than 3 percent) this year. Unemploy- with price controls in key sectors. And with ment, which decreased from 11.7 percent to no growth to show for the effort in private 6.8 percent under Lula, drifted back up to 9.2 markets, her government resorted to infra- percent this year; squeezed between falling structure spending: government outlays as a tax revenues and rising welfare obligations, percentage of GDP under Rousseff have aver- the budget deficit has soared. aged 37 percent, compared with 33 percent The current slowdown is not unique to Bra- under Lula. Yet Brazil has little to show for the zil. As a major commodity exporter, Brazil, expenditure, in part because a lot of the like fellow emerging-market stars, Russia and money has been dissipated by corruption. South Africa, faces lower prices and volumes. The current macro statistics paint a grim However, many other commodity exporters picture. Export revenues are down sharply – were better prepared to weather the downturn. the current account deficit was 4.3 percent of In fact, when Chile experienced a major cur- GDP in 2015, leading to a 30 percent-plus rency depreciation in the wake of falling com- depreciation of Brazil’s currency, the real. In- modity prices, its government used the flation is approaching double digits and weakness to improve the country’s competi- wages aren’t keeping up, adding to popular tiveness in other areas. As a result, Chile has frustration. been able to maintain 2 percent-plus growth. Meanwhile, the budget deficit, which had But Rousseff’s version of Lula’s third way been in check for so long, climbed to 10.5 only dug Brazil into a deeper hole. Instead of percent in 2015. But deep into a recession, using the emergency to introduce measures Brazil is hardly in a position to cut social wel- that would increase market efficiency, she fare payments that are more important than doubled down on state intervention, paper- ever to the nation’s poor and near-poor.

Fourth Quarter 2016 11 brazil dation for the next stage of development. Rousseff disguised the deteriorating fiscal sit- Brazil is in the latter stages of what econo- uation during her 2014 re-election campaign; mists call a “middle-income trap” in which later, that fiscal sleight of hand was used as growth potential slows sharply after it runs the legal wedge to drive her from office. out of easy sources of gains like movement The country’s lack of progress in basic from low-productivity agriculture to high- governance and economic reforms is, of productivity manufacturing and services. course, only reinforcing the vicious cycle. To break out, it is critical to begin the tran- Brazil’s percentile ranking for government ef- sition from growth based on the accumula- fectiveness on the World Bank’s Worldwide tion of capital and labor and the exploitation Governance Indicators fell from an average of of natural resources to a knowledge-based economy in which innovation makes capital and labor more productive. Countries that Countries that don’t get better at don’t get better at governance – credible cor- governance — credible corruption ruption fighting, rule of law, regulation with a lighter touch – as they progress through fighting, rule of law, regulation with stages of development can’t expect to make a lighter touch — as they progress the leap to the prosperity possible in sophisti- cated, service-driven economies. through stages of development Brazil has also regressed on the Heritage- can’t expect to make the leap to the Wall Street Journal Index of Economic Free- dom. While there have been limited attempts prosperity possible in sophisticated, at market-oriented reforms, state controls re- service-driven economies. main especially burdensome in key areas ranging from electricity to financial services. Brazil currently ranks 122nd of 178 countries, 55 under the right-center regime of Cardoso well below decidedly un-free economies like to 53 under Lula to 50 under Rousseff. The Nicaragua, Saudi Arabia and Egypt. As the in- country’s percentile ranking on corruption dex’s subcomponents show, large drops under eroded from an average of 59 under Cardoso, Lula in Brazil’s business and fiscal freedom to 56 under Lula and 55 under Rousseff. The have been sustained under Rousseff. Mean- percentile ranking for regulatory quality also while, trade freedom, which increased under declined, from 64 during the Cardoso admin- Lula, leveled off under Rousseff. istration, to 56 under Lula and 54 under Other statistical ranking systems cast Bra- Rousseff. By comparison, Chile has consis- zil in the same weak light. When Lula left of- tently ranked in the 85th percentile for gov- fice, Brazil ranked 48th out of 144 countries ernment effectiveness and control of on the World Economic Forum’s Global corruption and above the 90th percentile for Competitiveness Index. In 2015-16, the coun- regulatory quality since the World Bank first try ranked 75th out of 140 countries. The introduced the governance indices in 1996. rankings are especially low in institutional Progress in governance is critical if Brazil quality (121), macroeconomic environment is not only to make the economy more resil- (117), health and primary education (103), ient to global shocks, but also to lay the foun- goods market efficiency (128), labor market

12 The Milken Institute Review efficiency (122) and innovation (84) – hardly nomic crisis, Brazilians tolerated corruption the profile of an economy eager for compari- because, as the popular saying goes, “Rouba, sons with Western Europe, North America or mas faz” – he robs, but he gets things done. the high-income economies of East Asia. With nothing much getting done in recent Indeed, looking back, the early success of years, tolerance is at an end. Brazil’s third way seems mostly the product That said, Lula’s efforts to attack poverty of a serendipitous mix of the global com- by means other than trickle-down were ad- modity boom, the demand-driven closing of mirable. And there is no good reason that a chronic gap between actual and potential more conventional (and more likely to suc- GDP, and the easy pickings to be had from ceed) approaches to development couldn’t be adopting straightforward income support for complemented with carefully targeted efforts the poor. When more was required to sustain to relieve the misery. Indeed, the conditional growth, Brazil came up short. cash transfer system pioneered in Brazil has been widely imitated – and has generally hard lessons proved effective – in Latin America. The appeal of third-way approaches to devel- Brazil is a land of immense economic opment is obvious. Pretty much every great promise and immense disappointment. It is development success has taken a high human also becoming an icon of the reality that toll. Lula promised development without shortcuts to development are deeply prob- tears, and he pulled it off – for a while. But he lematic. The big question is when (and never tackled the gnawing problem of cor- whether) Brazil will be able to lay the cultural ruption, and he relied on subsidies to paper and institutional foundation to build a over low productivity. Before the current eco- stable, prosperous society.

Fourth Quarter 2016 13 Free Trade

Under Fire by ed dolan illustrations by dan page

14 The Milken Institute Review Free trade has taken some major hits this election season. In the Republican primaries, Donald Trump’s forthright protectionism helped him defeat the few rivals who stuck by the traditional Republican free trade line. Those who retreated to the intentionally ill-defined middle ground of “free but fair” did no better. On the Democratic side,

Fourth Quarter 2016 15 free trade under fire Chinese abuses and crack down on currency Bernie Sanders’ attacks on Nafta and the manipulation that hurts American workers. pending Trans-Pacific Partnership raised his Mainstream economists have supported popularity with rank-and-file voters, helped free trade since David Ricardo outlined the to propel him from fringe candidate to a real theory of comparative advantage in the early contender for the nomination and effectively 19th century. However, dissent has increas- killed the TPP’s prospects for ratification in ingly begun to appear. Robert Reich, a profes- the current Congress. sor at the University of California, Berkeley, Trade promises to be even more central in who was secretary of labor in the Bill Clinton the general election campaign. Taking a leaf administration, wrote last year: from protectionists who preached economic I used to believe in trade agreements. That was isolation during the Great Depression, Trump before the wages of most Americans stagnated is doubling down on his promises to reverse and a relative few at the top captured just about all the economic gains. globalization. Speaking in June in western Pennsylvania, he said: Paul Krugman, the Nobel Prize-winning Our politicians have aggressively pursued a economist, who, as a New York Times colum- policy of globalization – moving our jobs, our nist, is arguably the most influential left-center wealth and our factories to Mexico and over- economist in the country, acknowledges the seas. … Globalization has made the financial many benefits of trade. But he notes: elite who donate to politicians very wealthy. But it has left millions of our workers with [N]ot all free-trade advocates are paragons nothing but poverty and heartache. … It of intellectual honesty. In fact, the elite case doesn’t have to be this way. We can turn it all for ever-freer trade, the one that the public around – and we can turn it around fast. hears, is largely a scam. … What you hear, all too often, are claims that trade is an engine of Under pressure from right and left, Hillary job creation, that trade agreements will have Clinton has rapidly backed away from sup- big payoffs in terms of economic growth and port for trade agreements that she formerly that they are good for everyone. … Yet what praised as first lady and secretary of state. In- the models of international trade used by real terestingly, the “issues” section of her official experts say is that, in general, agreements that lead to more trade neither create nor destroy campaign website, which covers nearly every jobs; that they usually make countries more other topic, does not include a specific head- efficient and richer, but that the numbers ing on globalization or trade. The “manufac- aren’t huge; and that they can easily produce turing” section, however, provides the losers as well as winners. following goal statement, which is hardly a So who’s right here, the protectionists or ringing endorsement of free trade: the free traders? Free traders are mostly right Level the global playing field for American to say that trade promotes economic growth workers and manufacturers by aggressively and efficiency, but wrong to think that effi- combating trade violations. Establish and ciency is everything. Anti-traders are right to empower a new chief trade prosecutor report- say that economists should pay more atten- ing directly to the president, triple the number of trade enforcement officers, stand up to tion to the reality that trade produces losers as well as winners, but wrong to think that protectionism is the cure for what ails. Both ED DOLAN is the creator of Ed Dolan’s Econ Blog and is sides need to be open to ideas for managing the author of the textbook Introduction to Economics, now in its sixth edition. trade policy to minimize the social costs.

16 The Milken Institute Review Deficits are also a reflection of the fact that, more often than not, foreign- ers seek to store their wealth in dollar-denominated U.S. securities, both government and private, because they are seen as the safest in the world. trade fallacies more is invested in the U.S. economy than Opponents of free trade have achieved con- American households and companies are will- siderable political success, but not because ing to set aside in savings, the difference must they make a good case. Many of the argu- be reflected, dollar for dollar, in the trade def- ments published on blogs or heard in stump icit as foreigners make up the difference. speeches reveal a regrettable ignorance of Actually, pretty much all the reasons for re- basic economics. Some examples: jecting the equivalence of trade deficits with Trade deficits imply that we are losers col- economic mismanagement are unintuitive. lectively. One of the oldest arguments against Deficits are also a reflection of the fact that, free trade is the claim that countries running more often than not, foreigners seek to store trade deficits are like spendthrifts eating the their wealth in dollar-denominated U.S. secu- seed corn. In the case of the United States, rities, both government and private, because there are a host of reasons that deficits don’t they are seen as the safest in the world. And imply economic weakness. Start with the they are partly due to the status of the dollar most fundamental, though least intuitive. If as the world’s reserve currency; as a matter of

Fourth Quarter 2016 17 free trade under fire other high-wage countries is fair because it is convenience and safety, governments and a contest among equals, while trade with global businesses typically hold their cash re- poor countries is unfair because American serves in dollars, creating a chronic net de- companies can compete only if they engage mand for dollars that must be offset by U.S. in a race to the bottom on wages, benefits and current account deficits. Protectionist mea- working conditions. sures would do little to change any of this, ex- But that view reflects misunderstanding of cept, perhaps, to undermine the reputation of the factors that determine a country’s average America as a country willing to compete ag- wages and their producers’ international gressively in global markets and worthy of competitiveness. The high wages of U.S. ongoing investment by foreigners. workers reflect the effects on labor productiv- Americans are victims of currency manipu- ity of a host of factors, including the efficien- lation. Another favorite tactic of protection- cy of capital markets, the quality of technical ists is to emphasize currency manipulation education and a judicial system that enforces – that is, foreign government intervention in contracts. currency markets to drive down the exchange Those institutions help American workers value of their own currencies – as a source of to remain competitive despite high wages – or trade imbalances. Both Trump and Clinton rather, they make high wages competitive be- have indulged in this argument, pointing to cause they enhance productivity. But it’s China as the prime offender. worth remembering that they do not affect all In fact, the Chinese have manipulated the sectors equally. They make a comparatively value of the renminbi in the past, with the large difference in sectors like pharmaceuti- goal of making Chinese exports more com- cals, financial services and large-scale agricul- petitive. But the charge is years out of date. ture, allowing them to thrive as exporters. But Since 2014, China’s foreign currency reserves they matter less in manufacturing – especially have been falling, reflecting the central bank’s manufacturing that demands a lot of less- efforts to strengthen – not weaken – the ex- skilled labor. So, thanks to the flip side of change rate. The strong currency policy part- comparative advantage, the United States im- ly reflects the government’s pride in the ports most of its clothing, furniture, consum- renminbi’s recent inclusion in the basket of er electronics and the like. currencies the IMF uses to calculate the rela- Measures to make the United States self- tive value of its own proto-currency, called sufficient in low- and middle-tech manufac- special drawing rights. It also reflects Beijing’s turing would mean shifting labor and capital current concern that a declining currency from sectors where the country’s hard-won could touch off a wave of capital flight from advantages make them more productive to China that would undermine growth. sectors where they are less productive. Yes, Trading with poor countries always puts that might create jobs – but only if it also de- Americans at a disadvantage. During the pri- pressed wages. mary campaign, Trump and Sanders both di- rected special opprobrium at trade with poor the real case against trade countries, where workers earn a tiny fraction If the protectionists’ arguments are wrong on of what their American counterparts take their face, why are they winning the political home. The implication is that trade with debate? Because there is a real downside to

18 The Milken Institute Review trade, one that free traders have long known from trade were large, while the losses were about but often glossed over. smaller, transitory and spread widely among That downside lies in the fact that the ben- the same people who benefit from cheaper efits of trade in terms of higher wages, higher tires. The tire example is not hypothetical. A profits and lower prices are hardly shared study from the Peterson Institute for Interna- equally. Suppose that I decide to switch from tional Economics in Washington estimated American-made tires for my car to Chinese- that the gains to consumers from Chinese tire made tires. There are lots of winners here: I imports in the form of lower prices amount- pay less, the importer makes a profit and the ed to more than $800,000 for each job lost in Chinese tire worker who makes the tires the domestic tire industry. Moreover, when earns more. consumers spent the money they saved on However, the American plant that used to other goods and services, they would create make my tires is now out of business. Joe the new jobs for the former tire workers. The tire worker has lost his job. So has the guy at study dismissed policies devised to protect the food truck where Joe bought his lunch, the U.S. market from cheap tires as a highly maybe the teachers at the schools whose bud- inefficient way of preventing displacement or get depended on taxes paid by the factory, offsetting the consequences. and so on. But what if the adjustment to trade shocks Economists have traditionally excused is not smooth? What if Joe, after losing his job these losses by arguing that the overall gains at age 55, never finds steady work again?

Fourth Quarter 2016 19 What if he has to get by on odd jobs, food several pessimistic conclusions: stamps and Social Security? Or must uproot • The costs of trade shocks, including lower his family to move 1,000 miles to Texas to wages and loss of jobs, persist for years. take a job at $12 an hour rather than the $30 • They are concentrated on workers in he earned making tires? What if the consum- specific local labor markets. Labor mobility is ers who saved on tires never spent a cent of not sufficient to ensure widespread sharing the savings in Joe’s old hometown? of losses by workers across all regions and in- If such displacement is permanent, or at dustries of the economy. least long-lasting, the net gains from trade in • When an increase in the overall trade def- tires must be smaller, and the losses more icit accompanies a trade shock (as was the concentrated on the directly affected industry case for the China shock), workers displaced and region, rather than spread widely via by import competition do not quickly find labor and product markets. comparable jobs in more competitive indus- Recent research seems to suggest that tries. Those who do find work often end up in worst-case outcomes for Joe and other dis- service jobs that are a poor fit for their skills. placed workers are more common than has • The enduring local effects of trade shocks generally been acknowledged. In an influen- include increases in unemployment claims, tial new paper, “The China Shock: Learning disability benefits, food stamps and other from Labor Market Adjustment to Large forms of government assistance. Changes in Trade,” the economists David • Trade shocks disproportionately affect Autor, David Dorn and Gordon Hanson reach lower-wage workers.

20 The Milken Institute Review The paper has touched off a lively discus- most affected individuals and regions while sion among economists. Some say they were ensuring that those who benefit from trade aware of the magnitude of the downside, but share the costs of adjustment. [See the article didn’t dwell on it because the net benefits by Robert Litan on page 60 of this issue.] Those were still substantial. Others critiqued the pa- are the intended goals of the federal Trade per’s assumptions, methods and data sources, Adjustment Assistance program. as good fellow professionals should. The But the TAA has a poor reputation. Some question I find most interesting, though, is critics think the program is too narrow and how policy should change, if the pessimistic inadequately funded; they urge expansion of conclusions that Autor and his colleagues TAA. Others point to studies that show the made about slow adjustment to trade shocks training offered has sometimes been poorly are valid. designed and ineffective. Whatever the reason, TAA clearly has not prevented the persistent speeding adjustment adverse effects seen in the Autor study. If slow adjustment to shocks undermines the We need to recognize that the effectiveness gains from trade and amplifies the pain, we of TAA is undermined by numerous policies ought to be asking what can be done to speed that retard adjustment and increase the pain. adjustment. The traditional answer has been What’s more, the problem seems to be getting to offer a mix of temporary income support, worse. Economists and policymakers need to retraining and help with job search and relo- more directly confront policies that throw cation to minimize the consequences for the sand in the wheels of labor market adjust- ment. A checklist: Work disincentives in the social safety net. Autor et al. show that when a trade shock hits a region, total government benefits increase by a bit less than $60 for each $1,000 increase in trade; of this, TAA itself accounts for less than $4. Each of these social programs – un- employment insurance, food stamps, Social Security disability, etc. – helps cushion the pain of trade-related job loss, but together they cre- ate disincentives to finding new employment. Those disincentives arise from the way that benefits fall as family earnings rise. Indeed, a recent report from the Congressional Budget Office estimates that the combined effects of benefit reductions on food stamps, the earned-income tax credit, cost-sharing subsi- dies for health care and other programs can take back 60 percent or more of the income earned by low-income households. Effective marginal tax rates are especially high for secondary earners in two-earner

Fourth Quarter 2016 21 free trade under fire

households. If we take child care, transporta- successful in easing the pain of displacement, tion and other work-related expenses into ac- they slow the speed of adjustment. count, it may not pay at all for a second The way to resolve this situation would be household member to take a job. That situa- through a broad-based reform of safety net tion could easily fit a family in which one programs, not through a constant tug of war spouse lost a factory job because of import over eligibility. A good first step would be to competition while the other retained a job as, consolidate and cash out the numerous, over- say, a retail clerk. lapping programs now available to displaced This poses a dilemma. As research from workers, moving in the direction of a broad- the Center on Budget and Policy Priorities ened earned-income tax credit or negative in- shows, conservative initiatives to restrict eli- come tax. As I argued in an earlier article in gibility for safety net benefits have lowered the Review, a universal basic income might the average effective marginal tax rates for be an even better way to meet the basic needs low-income households. However, tighter eli- of displaced workers while maintaining work gibility limits increase the pain felt by dis- incentives. placed workers and thus could be expected to Portability of health care. Another reform strengthen the political backlash against trade. that would speed adjustment is to move to- Progressives push back against measures to ward a system of universal health insurance narrow eligibility. But to the extent they are that fully decoupled coverage from employ-

22 The Milken Institute Review ment, income or place of residence. The Af- younger families are increasingly passing up fordable Care Act has improved matters in the tax advantages of home ownership in one important respect, making it possible for favor of renting, in many cases because of the people with pre-existing conditions to pur- flexibility that renting affords. They expect to chase individual health insurance when they move repeatedly from job to job and city to lose coverage from their employers. However, city in a labor market that, by all forecasts, the law left intact the central role of employ- will remain volatile across their working lives. er-provided insurance. As a result, displaced Tax policies that treat renters and homeown- workers face, often for the first time, the task ers equally, like those of Canada, Australia, of choosing an insurance company and an in- Germany, Japan and other high-income surance plan on a state or federal exchange. countries, would ease labor mobility for Furthermore, the cost and availability of cov- trade-displaced workers. erage vary widely from state to state, making The scourge of occupational licensing. In a it more problematic for displaced workers to recent book, the University of Minnesota move in search of work. economist Morris Kleiner found that occupa- Note, too, that ACA subsidies for individ- tional licensing has increasingly spread be- ual policies that low-income families buy on yond high-skill professions like law and the insurance exchanges are themselves sub- medicine to relatively low-skill occupations ject to a substantial benefit reduction as like florists and hair braiders. Nearly one in household income rises, which increases the three jobs now requires some kind of govern- effective marginal tax rates faced by people ment license, up from one in 10 in the 1970s. who already receive benefits from other safety Kleiner compares occupational licensing to net programs. Premium support under the the medieval guild system, in that the goal is fo- ACA extends further up the income scale than cused on protecting incumbent practitioners most other safety net programs; subsidies do from competition rather than on protecting not entirely phase out until a household consumers from the risks of tastelessly ar- reaches 400 percent of the poverty level. That ranged flowers or clumsily braided hair. makes them relevant to workers even in rela- The fact that licensing requirements vary tively high-paid jobs and two-earner families, widely from state to state is a particular prob- categories into which many workers dis- lem for displaced workers. Suppose, for ex- placed by trade would fall. ample, that the family of a trade-displaced The ownership bias in housing. Housing factory worker is now dependent on the in- can be another important barrier to mobility come of a spouse who is a licensed interior for trade-displaced workers. As Autor’s re- designer, manicurist or pest control worker. search shows, trade shocks do not hit individ- Moving to a new state in search of a new fac- ual workers at random; rather, they slam tory job would mean loss of that second in- entire regions. Housing prices can fall cata- come during an extended, and often costly, strophically in areas affected by plant closings, process of requalification. a factor that makes it hard for displaced Three kinds of reform could reduce the ad- workers to move to localities with higher verse impact of occupational licensing on labor housing costs in search of new jobs. mobility. One would be to lift licensing re- The bias of U.S. housing policy toward quirements altogether for occupations where ownership exacerbates this problem. Already, the risk of harm to customers is minimal –

Fourth Quarter 2016 23 free trade under fire ployers of criminal records on preliminary flower buyers beware. A second would be to job applications. The campaign encourages make licensing requirements more uniform employers to evaluate criminal records on a and transferable from state to state. A third case-by-case basis after an applicant passes would replace licensing with simpler certifi- initial screening. cation systems that are less prone to abuse by incumbent practitioners. why protectionism is not the Criminal records and background checks. answer According to the Brennan Center for Justice, It’s a fact we ignore at our collective peril: the some 70 million Americans have criminal re- changes brought by globalization have been cords. That is as many as have college degrees, painful to millions. However, a reversion to and far more than have served in the military. protectionism would be a terrible, self-defeat- Criminal records represent a significant bar- ing response. Withdrawing from trade agree- rier to labor mobility, and not just for the 20 ments and imposing high tariffs on imports million who have felony convictions. Misde- would not restore the imagined glories of meanors like possession of small amounts of American manufacturing or make the coun- marijuana, arrests for infractions like disor- try great again. derly conduct that do not result in charges One reason is that a sharp swing toward and even prosecutions that result in not- protectionism would itself be an enormous guilty verdicts are sufficient to make prospec- shock to labor markets. Tens of millions of tive employers think twice. The number of American workers are employed in export in- people with criminal records, like the number dustries that would face loss of business or of people who are incarcerated, has grown outright retaliation from trading partners if steadily in recent years. Furthermore, online the United States raised tariffs or withdrew databases make it more likely that prospec- from agreements. More millions are em- tive employers will learn of even minor en- ployed by companies that are inextricably tied counters with the criminal justice system. to global supply chains or import finished Many people with criminal records do goods for resale. Still others work in logistics eventually manage to find some sort of work. or financial service operations that would be However, it does not help that many licensed disrupted by a sharp reduction in imports. occupations are off limits to people with Even if protectionist measures did open up criminal records. What’s more, if a job offer new jobs in domestic industries, workers dis- materializes in a distant city, a criminal record placed by foreign retaliation or supply-chain can make it harder to obtain a mortgage or problems would face the same barriers in rent an apartment. moving to jobs that trade-displaced workers Obviously, one policy change that would have faced in the past. The research by Autor ease this burden on labor mobility would and others suggests that it would take years be to reduce incarceration rates. However, for the consequences of such a shock to work that would not help people who already have its way through the economy and that some records. Another approach is that of the na- industries and regions would remain perma- tional “Ban the Box” campaign. Its aim is to nently depressed. reduce discrimination by removing the re- A second reason protectionism is not the quirement that people notify prospective em- answer is that trade is only one factor behind

24 The Milken Institute Review the transformation of American manufactur- assembles iPhones, are laying off workers and ing. Automation and technological change replacing them with robots as wages rise. In have had an even greater impact. That is evi- short, the days when high-school-educated dent from the fact that the number of U.S. workers could find factory jobs at wages suf- manufacturing jobs has been falling since the ficient to sustain a middle-class living stan- late 1970s, long before Nafta and the rise of dard are not going to return – not in the China. United States or anywhere else. But even if high tariffs forced manufactur- It isn’t beyond the ingenuity of good- ing operations back to the United States, there willed people to create policies (at reasonable is no reason to believe that manufacturing cost) that allow globalization to run its course jobs would return to previous levels. As the without leaving successive waves of workers Harvard economist Dani Rodrik has meticu- jobless or transforming them into itinerant lously documented, loss of manufacturing laborers. But it isn’t going to happen until jobs is a worldwide phenomenon that has af- policymakers and politicians recognize that fected Europe, Latin America, Africa and the the damage done by globalization is very real early industrializers of Asia. Manufacturing – and that the alternative to confronting the jobs appear to have peaked, even in China. damage is to risk the rise of the dema- Big operators like Foxconn Technology, which gogues and opportunists.

Fourth Quarter 2016 25 tk

26 The Milken Institute Review Extracting the Signal From the Noise

Tips for Interpreting Macroeconomic Data

by jason furman illustrations by raul arrias

n the early stages of the great depression, policymakers in Washington were faced with a profoundI gap in their understanding of the state of the U.S. economy: no one actually knew how many Americans were out of work. Aside from some attempts in the decennial census, before the 1930s no government agency had regularly mea- sured the number of individuals seeking work in the United States. tk

Fourth Quarter 2016 27 interpreting data ways that in theory provide different routes to This inability to measure basic economic the same destination: Gross Domestic Prod- conditions may seem shocking to observers uct and Gross Domestic Income. In the sec- of the U.S. economy today. The federal statis- ond quarter of 2015, the economy grew a tical agencies – the Bureau of Economic Anal- disappointing 0.6 percent, according to one, ysis, the Bureau of Labor Statistics (BLS) and and a solid 2.6 percent according to the other. the Census Bureau – and a variety of other In this case the difference between these two public and private entities now provide a numbers was simply statistical noise, a re- wealth of economic data on an annual, quar- minder that these statistics are an imprecise terly, monthly and sometimes even weekly way to measure the economy’s temperature at or daily basis. a quarterly frequency. Yet, while we no longer must cope with the These are not just academic issues. How void that policymakers faced in the 1930s, the individuals and institutions (and in some mountain of data available creates its own cases, computer algorithms) interpret and problems. Perhaps chief among them is that react to economic data influences economic we can sometimes ask too much of the data policy as well as private consumption and in- while doing too little to put it in context. The vestment decisions. conflicting demands for timely reporting of In the midst of the economic crisis, for ex- data and their accuracy and completeness ample, economic growth for the fourth quar- make it necessary to be cautious in interpret- ter of 2008 was initially estimated at –3.8 ing the numbers. percent and job losses in November 2008 For example, the BLS originally reported were originally estimated at 598,000. These that the economy added 38,000 jobs last May, data points affected perceptions in Washing- which could have led an observer to believe ton of what constituted an appropriate fiscal the economy was slowing markedly since job policy response. However, the estimates growth had averaged over 200,000 a month in would later be revised down to much grim- both 2014 and 2015. But then in June, accord- mer numbers (–8.2 percent growth and ing to the Bureau’s initial estimate, the econ- 791,000 jobs lost), which, had they been omy added 287,000 jobs – a boom. known earlier, might well have led to a pro- The truth is that, at a monthly frequency, it posal for more stimulus. is difficult to accurately measure the vitals of Here, I offer seven lessons to help guide the economy, and placing much weight on those trying to make sense of the wealth of monthly data when they are first released can economic data available today, many of them lead one seriously astray in assessing what’s drawing on analytical work by the Council of happening. Economic Advisers. I also provide some ap- It is not just that numbers bounce around plications of these lessons that have proved from month to month; seemingly compara- most valuable in understanding the economy. ble measures can offer divergent readings But all of this has a simple bottom line: when even for the same period. The United States assessing the overall health of the economy, measures economic output in two different never read too much into a single data snap- shot. Rely, instead, on data series over sub- stantial periods and in the context of what JASON FURMAN is the chairman of President Obama’s Council of Economic Advisers. other data suggest is happening.

28 The Milken Institute Review FIGURE 1: LABOR PRODUCTIVITY GROWTH, NON-FARM BUSINESS SECTOR

12%

10 Quarterly growth 8

6

4

2

0 PERCENT CHANGE, ANNUAL RATE CHANGE, PERCENT -2

-4 Trailing ten-year moving average

-6 1960 1970 1980 1990 2000 2010

source: Bureau of Labor Statistics, Productivity and Costs; CEA calculations

vast and rapidly changing economy like that 1 of the United States. More data over longer periods make it eas- ier to disentangle underlying trends from transitory noise. While there are a variety of so- phisticated statistical techniques to smooth economic data, a simple moving average that look to weights past as well as current numbers equally longer-term offers a reasonable way to assess trends. trends Take labor productivity, a measure of how much output is produced by an average hour nderlying economic reality, as of labor. Measured productivity growth is ex- well as our attempts to measure it, ex­ tremely noisy – that is, full of spurious volatil- U hibits substantial volatility. Hence, as impor- ity – at a quarterly frequency, and we largely tant as it can be to gauge turning points in look to it to answer longer-run questions prices, employment, output and the like on a about the economy. Moreover, there is some frequent basis, it is also important not to lean evidence that the best predictor of productiv- heavily on any single data point – or even on ity growth is a long-term average of past pro- a combination of data points – because our ductivity growth. All of this suggests that, at a measures are nowhere close to perfect. This is minimum, productivity growth should be as- not the fault of the statistical agencies, but sessed with something like a trailing 10-year simply due to the inherent complexity of a moving average as shown in Figure 1.

Fourth Quarter 2016 29 FIGURE 2: PRIVATE-SECTOR PAYROLL EMPLOYMENT, 2008-2016

400

200

0

-200 Trailing twelve-month moving average

-400 THOUSANDS

-600

Monthly growth -800

-1,000 2008 2009 2010 2011 2012 2013 2014 2015 2016

source: Bureau of Labor Statistics, Current Employment Statistics, CEA calculations

FIGURE 3: WEEKLY UNEMPLOYMENT INSURANCE CLAIMS, 2012-2016

450 Weekly initial jobless claims 425

400 Four-week moving average 375

350

325

THOUSANDS 300

275

250

0% 1/2012 1/2013 1/2014 1/2015 1/2016

source: Department of Labor

Payroll job growth is less volatile than pro- month – a much more accurate picture of the ductivity growth and thus can be examined economy than the excessive optimism sug- in the context of a shorter window like the gested in the many months when job growth 12-month trailing moving average shown in came in above that average or the excessive Figure 2. From 2012 to the end of 2015, the pessimism of news reports in the many 12-month moving average of private-sector months when job growth fell well short of job growth held steady at about 200,000 per that average.

30 The Milken Institute Review Averaging over time is essential with higher- ing to get a clear picture how many Ameri- frequency data, like initial claims for unem- cans are involuntarily out of work. Last May, ployment insurance. Initial claims are for example, initial claims spiked for exactly compiled weekly from administrative data one week entirely because an unusual law in from state offices, so they are not subject to New York permits many public school em- the same measurement error as data derived ployees to claim benefits for their time off from sample surveys, such as estimates of job during spring break. Using a four-week mov- growth. But the series bounces around from ing average helps avoid some of the zigzags, week to week, with dramatic movements in as shown in Figure 3, giving a more stable both directions that can mislead anyone try- picture of recent trends.

2 fueled concerns the economy was headed into a double-dip recession. But the latest revised estimate for job growth in that month is a far- less-concerning 107,000. Some of the clearest instances of revisions changing the economic narrative come from the Bureau of Economic Analysis’ corrections to quarterly GDP data. When the advance es- timate for GDP growth in a given quarter is mind the published, the bureau does not yet have all of revisions the timely data on international trade, busi- ness inventories and spending on services; t’s standard practice for the statistics thus, the agency must use projections based agencies to issue revised estimates of eco- on statistical modeling to pencil in more than nomicI data that incorporate new information half of the data. Even nearly three months as it becomes available – a fact that is easy to after the quarter ends, it still has to use trends miss, given that these revisions can occur or indirect indicators to estimate compo- months or even years after the initial report- nents that comprise about one-third of GDP. ing. For example, with each month’s release of employment data, the Bureau of Labor TABLE 1: EXAMPLES OF SUCCESSIVE REVISIONS Statistics also revises the prior two months’ TO REAL GDP GROWTH (PERCENT CHANGE, estimates of job growth. These revisions are SEASONALLY ADJUSTED ANNUAL RATE) often large and economically meaningful, es- 2001:Q4 2015:Q1 pecially around economic turning points. Es- First Estimate...... 0.2...... 0.2 timates of monthly job growth are then Second Estimate ...... 1.4...... -0.7 revised once a year for the next five years. For Third Estimate...... 1.7...... -0.2 example, in September 2011, the Bureau of Estimate as of 8/16...... 1.1...... 2.0 Labor Statistics reported that job growth in source: Bureau of Economic Analysis, National Income and August had been zero, a striking number that Product Accounts

Fourth Quarter 2016 31 FIGURE 4: REAL GDP GROWTH, 2013–2016 subsequent annual revisions brought it back down to 1.1 percent. In the first quarter of 2015, 5% on the other hand, the advance estimate of 0.2 4 percent was revised downward to a decrease of 0.7 percent; the most recent estimate for the 3 period was a robust increase of 2.0 percent. (Putting this in context today, 0.1 percent 2 of U.S. GDP – that is, one-thousandth of the

1 GDP – equals about $18 billion.) These data clearly demonstrate the trade- 0 off between timeliness and more complete

PERCENT CHANGE, ANNUAL RATE CHANGE, PERCENT and accurate information. It is always impor- -1 tant to be mindful that data can be subject to

-2 considerable revision. At the same time, poli- Q1 Q3 Q1 Q3 Q1 Q3 Q1 cymakers can’t afford to ignore the latest 2013 2013 2014 2014 2015 2015 2016 numbers in trying to gain an understanding source: Bureau of Labor Statistics, National Income and Product Accounts of the state of the economy – for example, to assess whether we are at a turning point in The Bureau of Economic Analysis makes the business cycle and should adjust macro- additional revisions to several years’ worth of economic policy accordingly. data each July. Together, these revisions can In this case, it is often useful to combine have a dramatic effect on measured economic data from multiple sources to gain a more ac- growth, as shown in Table 1. In the fourth quar- curate picture of current conditions. The re- ter of 2001, the bureau’s advance estimate of maining five tips offer examples of how to do real GDP growth (calculated as an annual rate) this, with the caveat that even these methods was a tepid 0.2 percent. By the third estimate, can only minimize, not eliminate, the inher- this had been revised upward to 1.7 percent; ent difficulties in measuring the economy.

eported gdp growth rates vary 3 substantially from quarter to quarter. R Some volatility is due to true economic fluc- tuations and some to measurement problems, but it is difficult to figure out whether a star- tling data point is due to reality or our mea- surement of reality. For example, it is possible that the economy contracted dramatically in the first quarter of 2014 and then grew rapid- ly in the next (as Figure 4 shows). But pat- combining measures terns like this seem much more likely to that are conceptually identical reflect noise in the data. With economic output, the Bureau of

32 The Milken Institute Review Economic Analysis publishes an alternative to FIGURE 5: GDP AND GDI GROWTH, 2013–2016 GDP called gross domestic income (GDI), 5% which aggregates income flows including wages, salaries and business profits. Concep- 4 tually, these two measures of output – GDP and GDI – should be equal in a given quarter 3 because the sum of expenditures in the econ- 2 omy should equal the sum of income in the economy. In reality, GDP and GDI nearly al- 1 ways differ, because each measure relies on different data sources and methods of statisti- ANNUAL RATE PERCENT 0 cal estimation. -1 GDO (GDP–GDI Average) It turns out that an equal-weighted aver- GDI growth GDP growth age of the two indicators is close to the opti- -2 mal way to combine them, since the average Q1 Q3 Q1 Q3 Q1 Q3 Q1 2013 2013 2014 2014 2015 2015 2016 of GDP and GDI more closely tracks the most up-to-date estimates of GDP growth and is a source: Bureau of Labor Statistics, National Income and Product Accounts better predictor of future economic growth than either GDP or GDI alone. The Bureau of than either GDP or GDI. GDO growth shows Economic Analysis now publishes this aver- a similar pattern as GDP growth in the first age, a concept that the Council of Economic half of 2014, albeit a less dramatic one than Advisers refers to as “gross domestic output” the noisier GDP data alone. And over the last or GDO, as part of its quarterly data on out- four quarters GDO growth has been relatively put. As shown in Figure 5, GDO provides a steady, avoiding the zigzags that measured much more stable reading of the economy GDP growth has undergone.

ombining multiple indicators can 4 be valuable even when they measure C somewhat different concepts. One example of how combining different measures of a similar concept can be useful concerns wages. Statistical agencies publish a dozen-plus mea- sures of wages and labor compensation for the U.S. economy. There are conceptual dif- ferences among them, so even if they were measured perfectly they would still track dif- ferently. But much of the difference among them is almost surely the result of challenges combining measures that are in statistical measurement (such as sampling conceptually similar error) that are uncorrelated across the differ- ent measures. As a result, by combining these

Fourth Quarter 2016 33 FIGURE 6: MEASURES OF WAGE GROWTH, 1985-2016

9% Compensation per hour, 8 non-farm business sector

7 Employment Cost Index, Weighted average 6 Wages and Salaries 5

4

3

2 Median

FOUR-QUARTER PERCENT CHANGE PERCENT FOUR-QUARTER Average hourly weekly 1 earnings (production earnings and non-supervisory) 0

-1 1985 1990 1995 2000 2005 2010 2015

note: Weights for average derived from principal component analysis. source: Bureau of Labor Statistics; CEA calculations

measures, we can lessen the influence of mea- surement error and can build a better picture of the underlying trend. 5 Figure 6 shows four such measures – com- pensation per hour, average hourly earnings, the employment cost index for wages and sala- ries and median usual weekly earnings – as well as a weighted average of the four. (The weights are generated through principal com- ponent analysis, a statistical technique that ex- tracts common information that may be contained in each series.) Despite the volatility combining measures in each measure, the weighted average isolates of different concepts: the consistent story they tell: wage growth in employment vs. output the United States remains below its historical average, but has picked up substantially over the past year. At times, however, growth in this ven when combining various mea- weighted average has differed by 1.5 percent- sures of the same concept to improve an age points or more from the common headline estimate,E different aspects of the economy estimate of growth – average hourly earnings sometimes provide contradictory signals. In for private production and non-supervisory this case, it is important not only to estimate workers – which receives roughly one-quarter the truth in any one measure but to under- weight in the overall index. stand the full context of the data available.

34 The Milken Institute Review In the first quarter of 2014, GDO increased nominator (hours worked) and undoubtedly 0.4 percent, while non-farm employment overstates the true volatility of productivity. rose by 1.5 percent. (Both figures are annual- This suggests that, when output and em- ized rates.) In theory, both of these could be ployment are sending diverging signals, the correct – businesses may have stepped up truth is likely somewhere in between – again, their hiring while workers became less pro- implying that combining different measures ductive, thus decreasing total output. As a may be superior to viewing each in isolation. matter of accounting, these two concepts are In this case, it is reasonable to put substantial- reconciled in the productivity statistics, which ly more weight on early estimates of employ- show that productivity fell by 3.7 percent at ment growth than on early estimates of out- an annual rate in the first quarter of 2014. put growth, in part because GDP growth is Measured labor productivity growth is, in fact, typically subject to larger revisions. Even after extremely volatile, as shown in Figure 1 earlier. a more accurate measure of output like GDO That reflects a combination of measurement arrives, one should still place more weight on error in both the numerator (output) and de- employment growth than output growth.

6 sometimes volatile from month to month, as shown in data is so Figure 7, with many instances of sudden spikes noisy it in gains (1.27 million jobs added in July 2016) is best and losses (293,000 jobs lost in April 2016). ignored The establishment survey, on the other hand, can also be somewhat volatile, but does not show nearly the same dramatic month-to- month swings. he bureau of labor statistics pub- This difference in volatility is due to the lishes two measures of job growth every fact that the establishment survey includes month:T the “establishment” or “payroll” sur- about 440,000 worksites covering about one- vey, which asks employers how many people third of U.S. employees. In contrast, the they have on their payrolls, and the household household survey is based on only 60,000 survey, which asks if individuals are employed households. But the establishment survey is or unemployed. Like the different measures of imperfect and suffers from both statistical wages, these represent different ways of mea- noise and systematic errors, especially in re- suring very similar concepts. As a result, dif- cording employment gains at new firms that ferences between them are more likely to have just come into existence and employ- reflect noise than reality – so, in theory, com- ment losses at old firms that have closed. bining them could provide a superior measure But combining the two does not always of job growth than relying on either one alone. lead to more accurate estimates. Although in In understanding whether or how to com- theory both should contain some informa- bine them it is important to note that the tion, in practice the household survey is so household survey in particular is extremely volatile that it contains practically none. The

Fourth Quarter 2016 35 FIGURE 7: MONTHLY EMPLOYMENT GROWTH, JANUARY 2015-JULY 2016

1,200

Establishment survey 1,000 Household survey (payroll concept)

800

600

400

200 THOUSANDS OF JOBS THOUSANDS

0

-200

-400 1/2015 4/2015 7/2015 10/2015 1/2016 4/2016 7/2016

note: Data as of August 9, 2016. source: Bureau of Labor Statistics

optimal weights to combine information from household survey contains virtually no new the payroll and household survey is some- incremental information about job growth – thing like 95 to 100 percent of the weight on and it might as well be ignored. Job growth the former and 0 to 5 percent of the weight should thus be estimated by the number in on the latter. So, for all practical purposes, the the payroll survey.

s assessed by gdo growth, the 7 economy was relatively weak in the first Aquarter of 2014. A more important question at the time was how much of the weakness was transitory (for example, the result of bad weather) and how much was likely to carry forward. Answering this question involves forecasting future economic performance, something that should only be done with great trepidation and humility, given the predicting the large uncertainties inherent in the economy future by filtering noise and the limitations of our understanding of how it works.

36 The Milken Institute Review FIGURE 8: CONTRIBUTIONS TO GDP GROWTH

3.5 Change in private inventories 3.0 Personal consumption

2.5

2.0

1.5

1.0

0.5

0 PERCENTAGE POINTS, ANNUAL RATE POINTS, PERCENTAGE

-.05

-1.0

-1.5

-2.0 Q1 2013 Q3 2103 Q1 2014 Q3 2014 Q1 2015 Q3 2015 Q1 2016 note: Data as of August 9, 2016. source: Bureau of Economic Analysis, National Income and Product Accounts

That said, one option is to build an intri- A historical review of the different compo- cate model of the economy using statistical nents of GDP, for example, can give us a bet- techniques. Another approach is to use judg- ter sense of which components are transitory ment – for example, looking at the weather and which tend to be persistent indicators of and attempting to assess the impact it could economic growth. Within GDP, inventory in- have had on different components of GDP. A vestment bounces around without a clear third approach is simply to extrapolate from longer-term trend, as shown in Figure 8, with recent performance, a method that, while performance in any given quarter not telling simplistic, can still generate reasonable fore- us much about the likely performance in the casts. The question, however, is from which next quarter. Figure 8 also shows personal measurements of recent performance we consumption, which tells a different story. should extrapolate. Personal consumption is about half as vola- As discussed above, economic data are tile as inventory investment and tends to be noisy in part because of statistical quirks, but much more persistent. the economy itself is also subject to transitory One way to make use of this observation is fluctuations. When we try to measure eco- to focus not on the growth rate of GDP as a nomic output writ large, we must be mindful whole but on the growth rate of personal con- that broad aggregates like GDP encompass sumption and fixed investment – a combina- many different components, some of which tion called private domestic final purchases contain useful information about the future (PDFP). Analysis by the Council of Economic and some of which do not. Advisers has found those two components of

Fourth Quarter 2016 37 FIGURE 9: QUARTERLY GDP AND PDFP GROWTH, 2013-2016

7%

Gross Domestic Product (GDP) 6 Private Domestic Final Purchases (PDFP)

5

4

3

2

PERCENT, ANNUAL RATE PERCENT, 1

0

-1

-2 Q1 2013 Q3 2103 Q1 2014 Q3 2014 Q1 2015 Q3 2015 Q1 2016

source: Bureau of Economic Analysis, National Income and Product Accounts

GDP to be the most stable, which means that ter predictor of future economic perfor- they are the best predictors of GDP over the mance than current-quarter GDP. next quarter or the next year. (GDO is a more accurate measure of what economic perfor- last thoughts mance actually was in the current quarter, It’s pretty clear that the most reliable long- complete with true transitory shocks like term economic analysis comes from looking weather.) across many samples, time periods, measure- As shown in Figure 9, GDP growth in the ments and concepts and avoiding putting too first quarter of 2014 was negative, in part be- much emphasis on any single piece of infor- cause of bad weather. PDFP growth also mation. This is difficult when even a casual slowed in the same quarter because of the observer faces a deluge of economic data. rough winter, but to a lesser extent than GDP It’s important not to overstate the preci- growth did. In the second quarter of 2014, sion we can derive even from a careful read- there was a large rebound in GDP growth, but ing of these inherently imperfect measures, a smaller bounce-back in PDFP because it is given the level of uncertainty and volatility in a more stable measure of the underlying the economy. But by taking a holistic view of trend in the economy. In general, PDFP is a economic data and considering each new re- more stable, less volatile measure because it port in the context of other data as they be- contains more of the signal of underlying come available, it is possible to get a much trends in the economy, while GDP picks up deeper, and more accurate, understand- more of the noise. As a result, PDFP is a bet- ing of what’s really happening.

38 The Milken Institute Review illustrations by elvis swift

Fourth Quarter 2016 39 getting policy done tisan education-reform bill was enacted by Who says nothing gets done in the nation’s Congress and signed by President Obama in capital? While it is true that many major is- December 2015. Among the provisions: more sues, including such basic functions of gov- flexibility on what tests and standards schools ernment as passing a budget and taming the may use to measure the progress of their stu- federal debt, go without resolution or even dents, what accountability goals to adopt, and serious discussion, a number of important changes in the preconditions for state take- domestic social issues have been addressed in over of failing schools. legislation in recent years or appear likely to be addressed soon – and usually on a biparti- welfare reform san basis. Here, I review initiatives in various Education is not the only social issue moving stages of their Congressional journey and in Congress. This year marks the 20th anni- speculate about what might reach the social- versary of the sweeping 1996 welfare-reform legislation agenda in a still-divided govern- law that replaced the landmark New Deal ment after the election. program, Aid to Families with Dependent Children, with the Temporary Assistance for education Needy Families program. The differences be- After enactment of the No Child Left Behind tween the two are substantial. For example, law in 2002 at the behest of the Bush II ad- whereas the older program guaranteed bene- ministration, the federal role in education be- fits to destitute families with children, under came even more controversial than usual. the newer one recipients are required to work Many Republicans found themselves with or prepare for work in order to get benefits. buyer’s remorse because the legislation was Similarly, whereas under Aid to Families with seen as empowering the federal government Dependent Children, states mostly just sent to impose burdens on states and to violate the out benefit checks, Temporary Assistance for longstanding principle of state and local con- Needy Families requires each state to have a trol of education – the opposite of the direc- welfare-to-work program in which at least tion conservatives preferred in trying to limit half of its caseload is enrolled. the reach of Washington. But Democrats Despite the fact that President Bill Clinton came to dislike the law as well, in large part favored the reform and half the Democrats in because it imposed achievement goals on Congress voted for it, many liberals outside states that proved impossible to meet and be- Congress predicted disaster as a result of what cause of what many – including parents – saw they saw as the harsh provisions of the wel- as an excessive focus on testing. fare-reform law. In particular, they worried Rising popular condemnation of gridlock that the tough eligibility requirements would put pressure on both political parties, pro- lead to much higher poverty rates. In fact, ducing a window for action on an issue on during its initial years (the late 1990s), the which Republicans and Democrats shared new law was associated with an unprece- some common ground. Thus, a major bipar- dented increase in work rates by poor moth- ers and a major drop in poverty among chil- dren in families headed by single mothers. RON HASKINS holds the Cabot Family Chair in Economic In those early years, around 70 percent of Studies at the Brookings Institution, where he co-directs the Center on Children and Families. the mothers who left welfare found work.

40 The Milken Institute Review After enactment of the No Child Left Behind law in 2002 at the behest of the Bush II administration, the federal role in education became even more controversial than usual.

True, most ended up in low-wage jobs. But gressional Research Service concluded that other federal programs that had been de- the work-support programs reduced the pov- signed to subsidize low-wage work of families erty rate among all female-headed families by with children and thereby make work more about half, and even held poverty among attractive made most of these families better these families almost steady during the Great off financially than they had been before wel- Recession. Thus, despite the recessions, low- fare reform. Between 1995, the year before income mothers still work more today than welfare reform, and the back-to-back reces- they did before welfare reform and the pov- sions of the early 2000s, the poverty rate erty rates for them and their children are, as a among never-married mothers and their chil- result, still lower. dren (an extremely poor demographic group) But all is not well with the Temporary As- fell from 52 percent to 39 percent, the lowest sistance for Needy Families program. After that had ever been measured for this group. two decades, the reforms seem to have run out A recent study by the nonpartisan Con- of steam, and, as the law permits, states are

Fourth Quarter 2016 41 using money from the program for purposes Congress is now considering ways to repair other than providing cash welfare and encour- Temporary Assistance for Needy Families. aging work. Meanwhile, an increasing number This is a good year to do so because the pro- of mothers and their children, who before gram needs to be reauthorized this year. (In 1996 would almost certainly have received Aid writing legislation, Congress often requires it to Families with Dependent Children cash, are to be reauthorized every several years, in not receiving benefits under the newer pro- order to force itself to assess the impacts of gram because of its restrictive provisions and the legislation and to give relevant commit- the way states are administering it. tees an opportunity to hold hearings and As a result, the number of female-headed draft amendments.) families in deep poverty (with income at or Surprisingly, Republicans and Democrats below one-half the poverty level, or about on the House Ways and Means Committee $10,000 for a mother and two children) in- reached bipartisan agreement on a reform bill creased, even as the overall poverty rate was last year that included more education and falling. These mothers need help in the form other provisions that may have induced states of cash welfare or in preparing for and find- to pre-emptively improve their work programs. ing jobs, and many states are not doing a But many conservative Republicans strongly good job of providing either. objected to the bipartisan bill because they be-

42 The Milken Institute Review lieved it weakened the work requirement and modest, is increasingly influential in federal was too narrowly focused. The Republican and state policymaking. The Temporary As- Study Committee, an influential House group sistance for Needy Families clearinghouse that speaks for the right wing of the Republican would provide detailed information about Party, held out for a much broader bill that state and local welfare-to-work programs that included reforms of other welfare programs have been shown to succeed, that have been and that tightened – not weakened – the work tried but have not been well evaluated and requirement in those other welfare programs that have been tried and shown to fail. such as food stamps and housing. Whether this provision will lead to change The bipartisan bill written by the Ways remains to be determined. A problem pre- and Means Committee was thereby doomed. venting states from trying innovative pro- And Republicans on Ways and Means decided grams is that many have already committed to take the path of least resistance and drop their Temporary Assistance for Needy Fami- nearly all the reforms in order to ensure that lies dollars to other functions, such as child reauthorization for Temporary Assistance for protection and abstinence-based sex educa- Needy Families would pass this year. Failing tion, which they were allowed to do under the to reauthorize the law would mean that the 1996 reforms. The money is thus filling gaps federal government could not give states the in other parts of the states’ budgets; trying to $16.7 billion in annual grants authorized by get it back to ensure benefits for eligible fam- the 1996 law, an outcome that would be ex- ilies will set off a conflict between the state ceptionally embarrassing to Republicans and agency that controls the money and the potentially disastrous to some of the poorest state’s Temporary Assistance for Needy Fami- people in the nation. lies program. Place your bets on the agencies The reauthorization bill that has now been that currently control the funds. approved by the House by voice vote (with The second provision, on social-impact fi- the reluctant acceptance of Democrats) and nancing (also called “pay for success”), is de- awaits Senate action has only two provisions signed to promote a clever way to finance besides the language that reauthorizes spend- government social programs. The idea, devel- ing. The first sets aside $100 million for states oped over the past decade, is to use money to conduct research on their programs – a supplied by private entrepreneurs (including welcome change in that it reflects a new em- foundations) to conduct intervention pro- phasis on rigorous evaluation of social pro- grams that would save government spending. grams. (I return to this topic below.) The pro- If the government saving is actually realized, grams to be evaluated are ones that aim to as determined by a high-quality evaluation, help welfare recipients prepare for, find and the investor is paid back with interest. The ap- keep jobs. proach involves two of the fundamental tools In addition, the research provision would of the current emphasis on evidence-based create a clearinghouse at the Department of policy. Investors use their own money to sup- Health and Human Services that would make port programs they have reason to believe are the results of the state evaluations available to going to succeed and thereby save govern- other states and to the public. These clearing- ment money, which harmonizes with the goal houses are a fundamental part of the evi- of getting government to spend its funds on dence-based movement that, although still programs that produce results. In addition,

Fourth Quarter 2016 43 getting policy done any given moment). Most child protective ser- rigorous evaluation is a central part of the ap- vices offices also offer prevention services, proach because paying for success requires a which are much preferred because they often reliable way of measuring outcomes. allow children to stay with their parents and These provisions on developing and testing avoid the collateral damage of foster care. programs that work to help poor parents and Washington spends about $7.6 billion on children, plus the reauthorization of the $16.7 these programs. But this money is used inef- billion in Temporary Assistance for Needy ficiently. Because of the way the 1980 law that Families spending, allowed the bill to sail established the major federal programs was through the fractious House. There appears to drafted, most federal dollars can only be spent be some opposition in the Senate to the way once children have been removed from their the House bill finances the pay-for-success homes and families – in spite of the fact that provision. But there is a good chance that, be- researchers and administrators have come to fore Congress adjourns in the fall, House and the view that many more abused and ne- Senate negotiators will work out a final bill glected children should be kept at home while that closely resembles the House’s bipartisan their parents participate in treatment. On nu- bill. Then it will be up to states to serve their merous occasions over the last quarter cen- function as the laboratories of democracy and tury, Congress has considered amending the cure what ails the Temporary Assistance for law to permit more of the federal dollars to be Needy Families program. spent on prevention and treatment. But the legislation has never passed. child-protection reform Now the Obama administration and Con- Few people dispute that the focus of the pro- gressional leaders are very close to agreement gram, helping poor single mothers support on changes that would give states more money their families, should be a priority. But an- for prevention and treatment. The legislation other critical issue is coping with child abuse passed the House by voice vote. Interestingly, and neglect, preventing it where possible and the House worked with the Obama admin­ minimizing the consequences where it isn’t. istration to develop the legislation and to Each year, around 700,000 children are re- convince Democrats to support it. Now the ported by states to be victims of abuse or ne- House and the administration are working glect. More than 1,500 children die each year together to convince the Senate to put the bill from abuse or neglect, about 80 percent of on the president’s desk. As in the case of the them at the hands of their parents. education bill and reauthorization of Tempo- To deal with this problem, every state has rary Assistance for Needy Families, this shows an elaborate program supported by federal, that bipartisan action is still possible – in this state and sometimes local dollars and usually case, on legislation that many previous Con- called child protective services. That pro- gresses were unable to pass. gram’s offices investigate reports of maltreat- ment and then offer a range of services and evidence-based policy treatments to the adults and children who are The most basic goal of the rapidly expanding involved in confirmed cases. Children are evidence-based-policy movement is to focus often removed from their parents’ homes government funds on social programs that (about 400,000 children are in foster care at work, if possible by taking money from pro-

44 The Milken Institute Review grams that don’t. Although this goal seems so So policymakers and the public have no way obvious that many people assume that gov- of knowing whether the programs work. The ernment has always operated this way, noth- heartwarming anecdote is often king of poli- ing could be further from the truth. Most de- cymaking in legislative bodies. cisions in Washington and in state capitals are But this is changing. The movement for based on shifting mixtures of ideology, the evidence-based policy draws energy from the personal views of elected officials and impor- fact that it is difficult for elected officials to tant constituents, the interests of contractors, deny that they should want good evidence of the availability of funds to pay for the pro- whether a program is producing the intended grams and so forth. Evidence of whether a impact – and that the evidence should be program works has often been a minor con- used to shift spending from ineffective pro- sideration, especially when the federal govern- grams to effective ones. And it’s about time: ment distributes billions of dollars to states most social programs – including widely her- through programs with broad goals, such as alded programs such as Head Start and Drug “to improve education,” “improve health” or Abuse Resistance Education (DARE) – don’t “reduce child abuse and neglect.” Such goals consistently produce good results. are so general that evaluation is meaningless, One measure of the efficacy of evidence- and in many cases nobody even bothers to try. based policy is the share of federal and state

Fourth Quarter 2016 45 getting policy done In an even more striking example of the social spending that goes to programs with rise of evidence-based policy, Paul Ryan, the strong evidence of success. But the evidence- Speaker of the House, a Republican, and Sen- based movement has a quiver full of addi- ator Patty Murray, a Democrat, sponsored tional arrows. One of the most popular is the legislation creating a bipartisan commission pay-for-success approach, mentioned above. charged with helping government and pri- Although still in the experimental stage, with vate researchers gain access to administrative more than 30 projects now going on across the data while ensuring that privacy is protected. country, pay for success is closely tied to rigor- Although increasing the use of this source of ous evaluation of programs. Without it, entre- data may seem like a bureaucratic detail, preneurs won’t have accurate guides to where there is now widespread agreement that data success is possible – and administrators won’t sets maintained by the Social Security Ad- know whom to reward and by how much. ministration, the Internal Revenue Service and other federal agencies are gold mines of evidence about vital national issues. Espe- Broader use of evidence-based policy cially important here is that access to the data could lead to almost immediate im- can greatly reduce the cost of research and produce much more reliable results because provement in government programs of the huge sample sizes involved. that transcend the many previous I’m convinced that the potential for evi- dence-based policy is enormous. Broader use, efforts to improve their efficiency supported by a bipartisan coalition, could and effectiveness. lead to almost immediate improvement in government programs that transcend the many previous efforts to improve their effi- The evidence-based movement is not ciency and effectiveness. something dreamed up by policy wonks that’s being foisted on the federal government from prospects for the new the outside. Rather, for nearly a decade now, administration both Congress and the executive branch have The beginning of a new administration is been buying into ever-expanding uses of evi- usually a time of intense legislative activity. dence of program success or failure. In 2009, New presidents, knowing that a short honey- in a move to both expand evidence-based pol- moon period is likely, are anxious to enact as icy and test its effectiveness, Congress (with much of their agenda as possible. Donald the approval of the White House) passed sev- Trump has announced few, if any, social poli- eral pieces of legislation that established pro- cies that he would implement if he were grams requiring those applying for cash to elected, unless trade protectionism, mass de- show they were using model programs with portation and the exclusion of immigrant evidence of success, to employ high-quality groups are seen as solving social problems. By evaluation procedures to test their ongoing contrast, Hillary Clinton has proposed a host effectiveness and to make the results of their of initiatives. Her campaign website lists 32 evaluations public. Bills further expanding areas of domestic policy in which she favors evidence-based policy are in the works. specific legislative changes. If elected, she is

46 The Milken Institute Review likely to focus on a handful of them that stand on the fact that many Republicans see the at least some chance in a polarized Congress. value of preschool and accept federal involve- My guess is that early-childhood educa- ment in preschool funding, she will need to tion would be near the top of the list. And work closely with Republicans on Capitol Hill here, there is a real opportunity to find com- to develop her proposals, which will have the mon ground with a majority in Congress. effect of greatly reducing the scope of what Clinton is proposing a robust early-child- she is now proposing. hood agenda with three core goals: expand Given the years of hostility between Hillary Early Head Start for children under age 3, en- Clinton and Republicans, it seems obvious sure that all 4-year-olds have access to high- that no matter what the issue, Republicans quality preschools and provide scholarships will be wary and some will be hostile at the for preschools to low-income families. Liber- onset of a Clinton administration. And some als and most conservatives agree that the fed- will never change their reflexive rejection of eral government has a role to play in equaliz- all things Clinton. The new president and her ing economic and educational opportunity. aides will thus need to display great patience And they agree that children from poor fami- and thick skin in the initial days of the ad- lies fall behind during the preschool years, ministration to get anything done – except, thus providing a solid rationale for beefing up perhaps, in the unlikely event that a Clinton federal involvement in preschool programs. landslide ushers in Democratic majorities in Starting with Lyndon Johnson, every pres- both the House and Senate. ident has expanded the federal commitment to early childhood development, either by on reflection creating new programs, expanding old ones It would be Pollyannaish to pretend that or both. As a result, the federal and state gov- business as usual has not been unusual in ernments now spend nearly $34 billion annu- Washington for more than a decade, or that ally on these programs. But there are some the partisan divide hasn’t taken a major toll children, including poor ones, who do not re- on the quality of government. Even so, on ceive any federal support during the pre- some important social issues – especially school years and many more who get federal those that can safely remain below the radar support but have access only to substandard – Congress has been engaging in normal de- programs. Research has repeatedly shown bate and discussion, generally following rou- that only high-quality programs boost child tine Congressional procedures and some- development in a way that is likely to improve times passing important legislation. We don’t children’s school performance and achieve- know whether or how a Trump administra- ment in the long term. tion would develop working ties with a di- Clinton has called for doubling expendi- vided Congress, at least in part because we tures on Early Head Start and in campaign don’t know what Trump would want to do speeches has said she would also increase beyond his signature initiatives on immigra- Head Start spending. Although Clinton does tion and trade. But the prospects for a con- not specify how much she wants to spend on structive relationship – albeit, one at arm’s the latter or how it would be financed, her length – between a Clinton White House and proposals would undoubtedly cost many bil- the Republican Congressional leadership lions per year. If Clinton wants to capitalize seem at least possible.

Fourth Quarter 2016 47 tk

48 The Milken Institute Review Homeownership, Wealth Creation and Financial Stability

by ed demarco

The dream of homeownership remains alive and well in the United States. Despite the disastrous consequences of the Great Recession for millions of homeowners, polls suggest that Amer- icans still want their names on deeds. We have a long history of public poli- cies that promote homeownership and few politicians are inclined to challenge them. This doesn’t mean, however, that Tthose policies achieve their intended outcome. Examining the policies today, especially in light of the recent financial crisis and the wreckage it left in its wake, raises important questions as to whether they encourage families to take on more risk in buying a home than in generations past. Indeed, while Washington struggles to put back together the secondary- mortgage market that led to the federal takeover of the big secondary-market lenders, we should also use this interlude to rethink our approach to promoting homeownership. tk

Fourth Quarter 2016 49 homeownership did the same, often by reducing consumption u.s. housing policy is a until they brought their debts down to more debt policy manageable levels. By the same token, many At the federal level, the cornerstones of policy families have deferred buying homes while designed to promote homeownership are: undertaking this balance-sheet repair. • The tax subsidy implicit in the mortgage Thus it seems that banks and households interest deduction. have gotten the message. It is time to get pub- • The mortgage-guarantee programs oper- lic policy to adjust as well. ated by the Federal Housing Administration and the Veterans Administration and several wealth building and smaller such programs. risk management • The subsidization of the mortgage mar- With rental housing, the monthly payment ket through explicit and implicit guarantees goes to the landlord and that’s that. But in for the giant market makers – Ginnie Mae, paying a mortgage, as the principal balance is Fannie Mae and Freddie Mac. gradually paid down, the ownership stake in- The common denominator of these poli- creases. That has motivated millions of fami- cies is that all three use subsidies to encour- lies to buy houses as a means of creating age taking on debt to finance a home rather personal wealth. And it has motivated policy- than subsidizing the process of building equi- makers to make this possible – especially for ty in a home. Granted, even wealthy house- low- and moderate-income families that holds typically borrow to buy a house. But would otherwise have a hard time saving. people don’t aspire to own the mortgage, they This sounds great, and actually works out aspire to own the house. some of the time. But very few homebuyers Ownership in the broader spirit of the live in their houses long enough to amass American dream means having equity in a much equity before moving on. Moreover, home. So why doesn’t public policy focus the risks of taking on debt collateralized by more on helping families build equity rather housing are often given short shrift, while the than on taking on debt, especially in light of benefits are exaggerated. the damage wrought by millions of foreclo- In view of some seven million foreclosures sures during the Great Recession? and forced sales in the past decade, we have Leverage, using borrowed money to fi- been warned. Poor health or unemployment nance an asset purchase, enhances returns if can drive homeowners into foreclosures in things go well and increases losses if they which they lose some or all of their equity. don’t. High leverage – extreme reliance on Meanwhile, house values can fall for reasons borrowed money relative to equity capital – beyond the owners’ control, vaporizing equi- led to both record bank failures and record ty in the process. foreclosures in the wake of the financial crisis. The costs created by forced sales typically Banks subsequently responded by increasing go well beyond the immediate loss to the sell- their capital relative to their debt. Families er. Foreclosure ruins personal credit, often for rob wilkinson/alamy rob

years. Health effects can be substantial as well, © ED DEMARCO, a senior fellow in residence at the Milken particularly in poorer neighborhoods. Ant- Institute’s Center for Financial Markets, was the acting won Jones and Gregory Squires of George director of the Federal Housing Finance Agency and the

post-crisis conservator for Fannie Mae and Freddie Mac. Washington University and Cynthia Ronzio previous page:

50 The Milken Institute Review In view of some seven million foreclosures and forced sales in the past decade, we have been warned.

of Health Policy Initiatives document these has this effect, both due to the costs involved stress-related impacts in an article in the in each sale and purchase and because it does Journal of Urban Affairs. They note moreover not give the owner time to amass equity. that the adverse health consequences may ex- Finally, even if the homebuyer stays in the tend beyond the family facing foreclosure, house long term, makes timely mortgage pay- into the surrounding neighborhood. Speak- ments and does not refinance, the economic ing of spillover effects, the foreclosure or returns to ownership usually fall well short short sale of one house will likely reduce the of those from other investments. Owning a value of other houses in the neighborhood. home is an expensive proposition; every Other routine behavior undermines the house requires a lot of maintenance. More- wealth building capacity of homeownership. over, unbeknownst to most Americans, aver- For one, withdrawing equity through cash- age price appreciation is just slightly greater out refinancing, or even just extending the than the rate of inflation. Compared to long- borrowing term by refinancing for a longer term investments in financial assets such as period than is left on the mortgage, lengthens stocks and bonds, the real return on residen- the period needed to pay down the mortgage tial real estate in most areas has fallen well

justin sullivan/getty images justin sullivan/getty principal. Frequent change of residence also short.

Fourth Quarter 2016 51 Families do, of course, derive substantial payment and the higher the homeowner’s benefits from being masters of their own do- marginal tax rate, the greater the value of this mains. Just don’t look for those returns on deduction. The mortgage interest deduction the bottom line. For most people, the returns thus lowers the cost of financing a home, cre- from owning a home derive primarily from ating incentives to purchase more-expensive the gratification and independence that own- homes – as well as homes purchased with ership brings. more debt financing – than would otherwise be the case. Moreover, the benefit accrues rethinking housing-debt policy mainly to higher-income homeowners. Most As noted above, federal policies to promote middle-income families utilize the standard homeownership largely consist of making it deduction even if they have a mortgage, so easier for buyers to leverage their purchases. this tax benefit’s perceived value may have Let’s reconsider each of the cornerstones. a larger effect on homeownership rates than The mortgage interest deduction lowers a its actual value. But it surely increases lever- homeowner’s personal income tax by allow- age among homeowners and subsidizes more ing mortgage interest payments to be a de- consumption of housing relative to other zuma press, inc./alamy zuma press,

ductible expense. The larger the interest goods or savings. ©

52 The Milken Institute Review The FHA, the VA and other mortgage- and implicit government benefits is needed guarantee agencies also promote homeown- to make homeownership more affordable, ership by affecting the availability and cost of those benefits have the cumulative effect of mortgage debt. By insuring creditors against driving up house prices, thereby offsetting loss in the event of borrowers’ defaults, they some or all of their presumed benefit – espe- use the federal government’s pristine credit to cially to first-time buyers. The combined ef- lower borrowing costs. They also promote fects also create costs borne by the broader homeownership by offering mortgages with economy. The more we borrow to finance little or no money down. While they have dif- homeownership, the less is available to fi- ferent underwriting standards, the effect is to nance productive investment or other con- make the cost of mortgage credit lower and sumption. In economic terms, there is an its availability greater than it would otherwise opportunity cost from the foregone activities be, and to encourage purchases with minimal that may have otherwise been financed. down payments. Finally, over the past several decades, the he more we borrow to finance secondary-mortgage market has become criti- T cal in maintaining the flow of credit into hous- homeownership, the less is ing. Replacing traditional lenders, such as available to finance productive savings and loans – which financed mortgages with their depositors’ money – the secondary investment or other consumption. market gives banks, thrifts and mortgage bankers the option of originating and then In sum, these housing policies result in in- selling mortgages to investors. Mortgages are creased leverage and extended repayment pooled and packaged into mortgage-backed terms while driving up house prices. The in- securities and sold to institutional money creased leverage adds risks to household bal- managers around the globe. Most of these ance sheets, which leads to more foreclosures securitizations are carried out through a gov- with their attendant costs than would other- ernment corporation (Ginnie Mae, which wise result. securitizes FHA and VA mortgages) and two government-sponsored enterprises (Fannie the equity alternative Mae and Freddie Mac, which have been oper- Can we reorient public policy so it continues ating in taxpayer-backed government conser- to foster homeownership, especially for lower- vatorships since 2008). The liquidity of and middle-income households, while reduc- mortgage securitization is enhanced by the ing these associated risks and increasing the taxpayer-backing of the securities, which ulti- likelihood that ownership helps families build mately leads back to lower borrowing costs. wealth? Taxpayer-backed securitization contribut- Let me stipulate here that I am accepting ed to the dominant role of 30-year fixed rate the view that promoting homeownership, mortgages in U.S. housing finance. Without particularly for lower-income families, re- taxpayer support, shorter-term mortgages and mains a desired goal of public policy. That adjustable rate mortgages that are less risky for stipulation would be worth re-examining. lenders would likely be more common. But here, I’m limiting my analysis to asking While many argue this package of explicit how it would be possible to give such families

Fourth Quarter 2016 53 homeownership As a recent Urban Institute study points out, a chance to build wealth in housing over their though, this is likely due to the VA’s use of a working lives while reducing the risks associ- more conservative income-based underwrit- ated with high leverage. ing test and the limit on the maximum size of How might a focus on equity work? Con- its guarantee. sider the key building blocks of the current There is a way out – indeed, multiple ways debt-focused policy and how we could give to make it easier to own a house without re- greater weight to equity. sorting to high leverage. Let me give one ex- ample of a subsidy that focuses on building Down Payments equity, not debt. Current policy works to minimize down pay- The Federal Home Loan Banks, which pro- ments and rewards borrowers with the bonus vide liquidity for mortgage lenders, are re- of larger interest deductions. FHA-guaranteed quired by law to set aside 10 percent of their mortgages require 3.5 percent down, but offset income to fund affordable-housing. A por- even that by allowing buyers to finance closing tion is set aside by each Bank to subsidize low- costs. The VA, for its part, requires no down and moderate-income first-time homeowners. payment. And my own modest effort to in- This subsidy is provided directly to the home- crease Fannie Mae and Freddie Mac down pay- buyer in the form of a matching payment to ment requirements from 3 percent to 5 percent the buyer’s own down payment. (when I was the acting director of the agency In some cases, the match is 3 or 4 times the overseeing them) has already been reversed. borrower’s contribution. These combined It was not always this way. In its early de- funds are then available to the homebuyer to cades, the FHA program had strict under- make a down payment and pay closing costs. writing rules and down payment requirements. The program also requires borrowers to at- A generation ago, saving for a down payment tend a homebuyer education program. Not was an accepted discipline for young families surprisingly, mortgagees benefiting from set- seeking mortgages, and 20 percent down was asides proved to be more likely to weather the the basic rule of thumb. No longer, of course. financial crisis. This seems both curious, given the wealth- State housing finance agencies offer simi- building policy objective at stake, and danger- lar programs and are leading sources of down ous, given the risks involved. For anyone who payment assistance, especially for first-time doubts these risks, consider that the default buyers. And numerous other local programs rates in the FHA program often exceed 10 exist as well to supplement down payments. percent and during the crisis reached 33 per- There are two bonuses with this approach. cent. More generally, negative equity (that is, First, it is simple to establish and enforce eli- a loan balance exceeding the value of the gibility guidelines, such as income restric- house) at the time of default is a powerful tions, for the program. That means the predictor of the likelihood of foreclosure, subsidy is actually delivered to the intended particularly if the borrower’s ability to repay beneficiaries. It can be narrowly targeted at has been diminished. first-time homebuyers. Subsequent steps up To be fair, the VA program, with its even- the ownership ladder could be unsubsidized. weaker down payment requirement, has bet- Second, enhancing the credit quality of ter loan performance than the FHA program. borrowers lowers their cost of credit. What’s

54 The Milken Institute Review There is a way out – indeed, multiple ways to make it easier to own a house without resort to high leverage.

more, lenders’ requirements for borrowers to the median-valued house in that area. pay for private mortgage insurance if they are Not all down payment assistance programs highly leveraged may be waived sooner if the work equally well. The FHA suffered substan- assistance gets the borrower to a 20 percent tial losses from a program focused on seller- equity stake faster. funded down payment assistance. But the DownPaymentResource.com provides a flaws in that approach are now well understood. clearinghouse for researching such programs. Down payment assistance, by the way, need In June 2016, it had 2,500 down payment as- not come at the time of purchase. It could be sistance programs in its database, with an av- provided over the first several years of owner- erage down payment benefit of $8,260. In 82 ship, contingent on the borrowers’ staying percent of the 513 counties it studied in con- current on their payments. Should a borrower junction with RealtyTrac (a private firm that become delinquent, the subsidy could be redi- provides information on the foreclosure mar- rected to offset losses to the lenders. ket), the average down payment assistance The cost (personal and political) of shifting

andy katz/pacific via press/lightrocket getty images andy katz/pacific available exceeded 3 percent of the price of toward equity subsidies is that families can’t

Fourth Quarter 2016 55 Shorter amortization might mean that people buy less expensive houses and market prices don’t inflate quite as much as when they are dominated by high-leverage 30-year financing. But the benefits are substantial.

buy houses until they have enough savings for More broadly, according to the National a down payment. But isn’t that better than Association of Home Builders, the average watching families hit a personal or financial owner changes houses every 13 years. After 13 bump in the road and then try to avoid fore- years, a homeowner may have paid down a bit closure when they have no equity in their more than 30 percent of the original loan homes? Promoting more of a savings culture amount – a better cushion, but one still leav- shouldn’t hurt either – millions of Americans ing nearly 70 percent of the loan unpaid. are failing to plan adequately for their chil- Note, moreover, that there is reason to believe dren’s college education, not to mention their that the turnover rate in ownership could in- own retirement. crease because younger workers appear more apt to change jobs, and even careers, than Mortgage Terms their parents or grandparents. One reason, apart from lower monthly pay- To be clear: a 30-year amortization sched- ments, that the 30-year mortgage endures in ule is not good or bad per se, and I am not ad- an increasingly volatile economy is that the vocating its elimination as a contractual government-backed secondary market sup- option. I am suggesting we be more thought- ports this product. So, we find interest groups, ful about using public policy to steer buyers ranging from non-profits promoting afford- toward 30-year obligations. able housing for marginal buyers to realtors Shorter-term mortgages, by the way, can be to the big participants in the secondary mar- made more attractive to buyers with limited ket all pushing for government support. But means. Two years ago, Edward Pinto, a fellow it is surely time to challenge our devotion to at the American Enterprise Institute (and ear- the path of least political resistance, particu- lier in his career, the chief credit officer for larly because the 30-year mortgage is often a Fannie Mae), introduced something he calls bad fit for borrowers today. the “Wealth Building Home Loan.” This is Many first-time buyers remain in their simply a 15-year mortgage, with little or no houses for five years or less. That’s a period in money down and some combination of subsi- which loan amortization on a 30-year mort- dy to “buy down” (that is, to lower) the inter- gage may not even be enough to pay the clos- est rate and prudent underwriting standards ing costs when the house is sold, much less that make it possible to bring the monthly leave an equity cushion. After five years at to- payment within shouting distance of the pay- day’s rates for a 30-year mortgage, just 9 per- ment on an equivalent 30-year mortgage. cent of the mortgage is paid off. And even a The rapid amortization offsets the lack of thin equity cushion is not assured, since it de- initial equity and the low interest rate means pends on house prices remaining stable. Yet both that the loan is unlikely to be refinanced typically, it can cost a family 8 to 10 percent and that most of every payment pays down of the value of the house to sell and relocate. principal. After 15 years, the loan is paid off

56 The Milken Institute Review and the family has that monthly payment Even more simply, borrowers could be ed- amount to deploy for a child’s college educa- ucated on the equity-building benefit of mak- tion or to plow into retirement savings. ing additional principal payments each That is just one idea; here’s another. Sup- month on a 30-year loan, or of obtaining a 15- pose a 30-year mortgage were divided into or 20-year mortgage rather than a 30-year two distinct payment obligations, one with one. Or lenders could promote 5/1 or 7/1 or a monthly payment needed to amortize up 10/1 adjustable rate mortgages – mortgages in to 80 percent of the house cost in 30 years, which the interest rate is fixed for an initial the other a monthly payment calculated to period (here, five, seven or 10 years) and then amortize the remaining portion of the total turn into adjustable rate mortgages for the re- loan in five years. That way, in five years the maining term. The idea would be to appeal to borrower would have more than a 20 per- borrowers not intending to live in the same cent equity stake to rest on, provided house house for more than five to ten years. Such a prices did not decline. And the borrower loan would have lower interest rates and fast- would get the equivalent of a pay raise at er equity accumulation than 30-year fixed the five-year mark because one payment rate mortgages. stream would be completed. It would be I hear the objections – shorter amortiza- like saving for a 20 percent down payment tion would still mean higher monthly pay-

nancy nehring/getty images after buying the house. ments. It might even mean that people buy

Fourth Quarter 2016 57 homeownership The previous paragraph is heresy to slightly less expensive houses and market housing-policy specialists who aren’t wed to prices don’t inflate quite as much as when market-driven pricing. But I expect most they are dominated by high-leverage, 30-year Americans would read it and say “duh.” If financing. But the benefits are substantial: eq- we substituted autos for houses, housing uity would build faster and, over a working specialists would mostly say, well of course, life, families would have a lot more money to riskier drivers should pay more for auto insur- finance other consumption or to save for re- ance than safe drivers. Yet, for reasons of iner- tirement or health care or education. Note tia and political expedience, we use housing that financial markets, which process enor- finance as a hidden vehicle for income redistri- mous volumes of securitized mortgage debt, bution based on creditworthiness, with the would be less risky, too. least creditworthy getting the biggest benefit. The FHA, rather than being the govern- Prudent insurance pricing and underwrit- ment’s poster child for highly leveraged hous- ing standards aren’t meant to punish, nor are ing finance, might take a leadership role in they meant to deny access to homeownership. exploring such options. They can serve as a means of signaling quali- fications that give people clear information as Mortgage Pricing to what they need to do to get into a sustain- Today, you hear complaints about pricing able homeownership position. But asking mortgage credit risk – the insurance premium families (including lower-income families) built into the mortgage rate to compensate the that manage their money prudently to pay lender for default risk. Some say that the FHA the costs for families that do not do so seems charges too much for mortgage insurance or arbitrary and unfair. that Fannie’s and Freddie’s guarantee fees are This is an essential problem in housing too high – notwithstanding that mortgage policy. The entrenched interests relying on rates (including the fees) are lower than most the hidden income transfers embedded in of us thought we would ever see in our life- charging low-risk borrowers more for mort- times. So how should these fees be set, and how gages so higher-risk borrowers pay less than is this relevant to the debate over leverage? their costs are numerous. Not surprisingly, we Government-backed lenders should differ- end up with more high-risk borrowers and entiate among borrowers in a manner com- more defaults. If we really want to help less patible with taxpayers’ interests and sound creditworthy borrowers on a path to home- financial practice. That is, eligible families ownership, let’s start with better financial ed- should pay rates commensurate with their in- ucation, budgeting, and fixing credit problems, dividual risk profiles. Those with lower credit while improving credit scores. Then help scores and higher debt loads should pay higher them save for a down payment and perhaps rates, other things equal, than borrowers with provide matching funds as a subsidy. stronger credit records and lower debt loads. That would ensure taxpayers and credit-risk- Second Liens bearing investors are protected. It would also A 1982 federal law precludes holders of first help families and neighborhoods because it liens from limiting second liens – that is, would reduce the incidence of default and the claims against the house that are subordinate consequent spillover costs. to the first mortgage. Given the enormous

58 The Milken Institute Review losses of the past 10 years resulting from monthly payments while withstanding the fi- house owners extracting equity from their nancial bumps everyone faces along the road. properties by means of second mortgages and For those with low or unstable income, home- then defaulting, it seems clear this restriction ownership can pose stark risks. We do these should be reconsidered. I am not aware of an- families no service by encouraging them to other lending arena in which a secured holder stretch their limited or volatile income to buy of a senior lien has no say in subordinate liens houses, then leave them to turn slowly in the that may affect the quality of its collateral. wind when they must sell but are unable to In a free society, people should be able to sell without a loss. make decisions about how to use their wealth, To put a finer point on it, policymakers on including their home equity. But our legal both sides of the aisle should temper their framework governing mortgage lending impulses to promote homeownership be- should not create incentives for families to cause ownership is not for everyone. Owner- put themselves at greater risk; nor should it ship limits one’s options to easily relocate allow borrowers to freely put lenders and tax- – whether to change jobs, respond to new payers in a worse credit position after the fact. family circumstances or reduce monthly ex- Surely we could construct some sensible, pru- penses. And housing investments in low- dent guidelines governing second liens, par- income neighborhoods tend to have lower ticularly when taxpayer-supported lending rates of return and greater price volatility mechanisms are being used. than in other neighborhoods. Those with un- certain incomes may be better off building a role for state and local nest eggs through other forms of savings than governments that created as a byproduct of monthly mort- While I’ve been writing exclusively about fed- gage payments. eral policy, state and local governments also have a significant impact on homeownership. whose housing policy? As already noted, state and local housing Our policy debate should not be about the agencies are a key source of down payment desire of realtors or homebuilders or lenders assistance. Cutting the other way, though, to maximize the number of profitable trans- states and localities impose sizeable taxes and actions. Nor should it be about how to maxi- fees on residential real estate transactions, mize the homeownership rate, regardless of adding to closing costs for buyers and sellers. the consequences. It should be about building As Larry White of New York University noted a sturdier structure all around, with a policy in the Second Quarter 2016 issue of the and legal framework that strengthens family Milken Institute Review, they also add to finances and enhances the capacity of capital homeownership (and rental) costs through markets to lend willingly to creditworthy land-use restrictions and building ordinances borrowers. that are not justified by the public interest. It’s pretty clear that we’ve been sidetracked into policies that make the mortgage market even equity supports should bigger and more volatile. It’s equally clear that have limits we’ve strayed far from the broader public in- Even families that save enough for reasonable terest – and that the route back lies in down payments need to be able to afford the building equity, not debt.

Fourth Quarter 2016 59 Universal Wage Insurance and Lifetime Retraining

60 The Milken Institute Review Good Ideas Whose Time Has Come • by robert litan

illustrations by james yang tk

Fourth Quarter 2016 61 Regardless of who wins the White House in November – and in spite of all the distrac- tions of this bizarre campaign season – it’s a sure bet that the election will be remem- bered as the year voters revolted against globalization in general and open-trade pol- icies in particular. Nor has this reaction been confined to the United States. Britain’s shocking decision in June to abandon the European Union was a product of the same Rforces of reaction to economic integration with anti-globalization overtones. In my view, none of this should come as a the name of the collective good. For others, it’s surprise. What is surprising is that the rebel- a matter of political reality: the assistance pro- lion took so long to break out. gram would serve to weaken organized labor’s For decades, it’s been gospel in Washington opposition to open trade. (and in European capitals) that the gains from In fact, unions supported the original pro- open trade outweighed the losses. This deeply gram, though with time they came to dismiss held belief, reinforced by a mountain of re- assistance as “burial insurance” and now ac- search, powered the negotiators of multiple tively oppose ongoing efforts toward global trade agreements – global ones, like the Tokyo integration – most recently, the Trans Pacific (1979) and Uruguay (1994) rounds of the Partnership. The explanation for labor’s dis- multilateral General Agreement on Tariffs and enchantment is straightforward. In many Trade (which led to the formation of the cases, it’s hard to distinguish workers who lose World Trade Organization), regional deals like their jobs to trade from those who lose them Nafta, and bilateral deals like the ones the for the myriad other reasons that industries United States has with Australia, Chile, Israel, rise and fall in a technologically driven econo- Korea, Panama, Peru and Singapore that cu- my. And the program’s administrators are not mulatively stripped away most protection in the business of giving every displaced from domestic producers. worker the benefit of the doubt. Even the most faithful followers of Adam Moreover, when workers do qualify, com- Smith and David Ricardo, however, under- pensation often seems inadequate. The Trade stand that no trade deal benefits everyone. Adjustment Assistance program provides ex- That’s why most free traders generally favored tended unemployment insurance, which in the Trade Adjustment Assistance program, recent decades has been tied to required par- which provides aid to workers who lose their ticipation in retraining programs – many of jobs. The program was first enacted in 1962 which have poor track records at providing and has been modified multiple times in the jobs at anywhere near the wages displaced intervening years. For some, trade adjustment workers previously earned. is a simple matter of economic justice: affluent More fundamentally, neither the Trade Ad- societies shouldn’t let workers bear the brunt justment Assistance program nor any other of the collateral damage from globalization in federal program has helped workers who were let go because their employers found it cheap- er to automate their work – or simply because ROBERT LITAN, a former deputy assistant attorney gen- consumers’ tastes have shifted away from the eral in the Clinton administration, is an adjunct senior products and services they made or provided. fellow at the Council on Foreign Relations and a partner in the law firm Korein Tillery. The fact that these non-trade factors have

62 The Milken Institute Review surely accounted for far more worker disloca- vide more training – while improving the tion than trade ever did has not deterred crit- chances that more Americans can live the ics of trade deals. Liberalized trade at least is American Dream even in a turbulent economy. something that governments can stop or even reverse. Not so, or at least not so easily, with wage insurance job-displacing innovation and changing con- You can insure against many of the risks in sumer demand. life – damage to property, losses linked to ill Accordingly, any program designed to ease health and so forth. But you can’t buy insur- worker dislocation that is narrowly targeted at ance against losing your place in the econom- cushioning the job loss caused by trade com- ic pecking order. Society’s answer to job loss petition alone is bound to fail in political – temporary (and modest) unemployment in- terms. Trade liberalization has become just surance – is a feeble substitute. too easy for elected officials – or those want- Why this particular limitation? Private in- ing elected positions – to blame for job losses. surance carriers won’t sell you a policy against If the economy were growing rapidly, con- permanent wage losses because of the prob- stantly churning out jobs paying good wages lem of “adverse selection”: The people most for the vast majority of workers, this blame likely to buy the insurance would also be the game would be more difficult to pull off. But most likely to suffer a loss. It’s analogous to with slow growth and widening income in- the adverse-selection problem that led an ini- equality over the past 15 years, the table was tially reluctant President Obama to require set for the backlash against trade that has been so evident this year. Economic headwinds, due overwhelmingly to factors having nothing to do with trade, make it even more important for those who want to preserve (or expand on) current open- trade policies to do a far better job of manag- ing economic dislocation. Moreover, from a purely moral perspective, the country owes displaced workers a leg up, whatever the cause of their distress. This includes addressing the free-rider problem that inhibits firms from doing more worker retraining themselves for their employees. Companies are understand- ably reluctant to spend to improve workers’ skills when those individuals can simply move to other jobs – especially when economic times are good. So, what follows are two proposals de- signed to reduce frictions on both sides of the labor market – to ease workers’ legitimate anx- ieties about economic change from whatever source, and to encourage employers to pro-

Fourth Quarter 2016 63 wage insurance government wage insurance for the entire everyone to buy coverage as part of the Afford- middle-income labor force. able Care Act. If enrollment were voluntary, The details of wage insurance now in place the insurance rolls would be disproportion- and plans urged for wider adoption have es- ately burdened by the sickest individuals, rais- sentially not changed for several decades. ing the cost of providing insurance and Workers displaced by trade who toil for at discouraging everyone else from buying it. least three years on their prior jobs receive The United States first limited the adverse- half the difference between the shortfall of selection problem for temporary income loss their new wages and the pay of their previous arising from involuntary unemployment job, up to a cap of $10,000 per year. So a when it gave the states incentives to provide worker who was laid off a $40,000-a-year job broad-based, employer-financed unemploy- and replaced it with a job paying just $30,000 ment insurance. (Britain, by the way, was the would receive half the difference – $5,000 a first country to adopt unemployment insur- year – from the government. ance, in 1911.) I have spent much of my pro- Importantly, the insurance payments fessional career arguing that government begin only after workers have obtained the ought to extend the protection to include new jobs and end two years from the date of longer-term losses in wages. Back in 1986, initial unemployment, giving them strong in- Robert Lawrence, then an economist at Har- centives to take early offers and not remain vard, and I proposed wage insurance for idle waiting for better offers that may never workers displaced by trade, an idea that Con- come while they collect regular unemploy- gress adopted for workers over the age of ment benefits. 50 in 2002. In the 2016 State of the Union ad- The Obama proposal is basically a much dress, Barack Obama became the first presi- broader version of the wage insurance ele- dent to endorse the broader idea of ment currently embodied in the Trade Ad- tk

64 The Milken Institute Review justment Assistance program. It would cover real concerns of tens of millions of Ameri- all workers who lose jobs paying no more cans – and perhaps give Washington some than $50,000 for any reason (not just trade) backbone in defending an open-trade system and take new jobs at reduced wages. The pres- that generates net benefits for the economy. ident’s proposal is hardly a panacea, but it If it were up to me, I’d be more generous would go some distance toward addressing than the Obama proposal, covering workers the fears of the large portion of the electorate making up to $100,000 on their previous jobs, worried about being pushed off the economic perhaps even if they held those jobs for less ladder by trade or other forces beyond their than three years. I would also be more com- control. fortable if the annual payments were more Several analyses made before the Great Re- generous, tying them to inflation or raising cession indicated that such a broader wage in- the maximum annual payment to $15,000 or surance program would cost in the $20,000. neighborhood of $3 billion to $5 billion a One reflexive objection to wage insurance year. The Congressional Budget Office has is that it would extend benefits to all middle- provided the most recent cost estimate, post- income earners with full-time jobs, some of 2008, of just $27 billion over 10 years, or less whom would resent handouts from Uncle than $3 billion annually. That’s lower than Sam. But this objection hardly bears close ex- prior cost estimates, primarily because of the amination. For one thing, wage insurance is a $50,000 earnings eligibility cap. Outlays of hand up, not a handout, for people who are al- these amounts could easily be financed by a ready helping themselves to recover from job small increase in the federal unemployment displacement by accepting less-lucrative em- insurance tax. But even if the program had to ployment. Conceptually, it is no different than be financed out of general revenues, it would the subsidies the government has awarded be a small price to pay for addressing the very buyers of electric cars in order to slow climate tk

Fourth Quarter 2016 65 66 wageinsurance yet be found if the right interest-group theright coali- yet found be if welcome extension insurance asalegitimate The Milken Institute ReviewInstitute Milken The new jobs quickly. ty, which is potentially threatened by the tion were mobilized. business The communi- recognize thatincome losseslinked to astep program createsprogram for displaced workers to find bypart, theincentives attracted shouldbe the if any,if thegreen buyers of resented. of the social safety net. safety thesocial Republicans,of for their down inemployment isoften asgreat aworry change “help” –asource of few, thatIsuspect gridlock, just notget sweet reason alone will antigrowth populist backlash,antigrowth shouldback appeal.strong bipartisan should Democrats any idea good enacted. But consensus might unemployment is,short-term andsoshould among low- andmiddle-income workers as In principle, wage insurance shouldhave Of course in this era of Congressional course of inthis era Of Wage insurance would notonly thedis- help with thewage-insurance payments inhand,with accounts My second atwist. proposal with isretraining modest amount of money,modest amount of which some of the program wouldthe program cost itsmembers avery that pasttheobjection get can it the idea if this world). So, too, offi shouldtheelected - for providing –themost on-the-job training from it, but would like act asubsidy to firms ily on exports. pay to workers lack theprecise who skills placed workers would who directly benefit higher prices (therehigher are few free lunches in lifetime retraining-loanlifetime cials of states thatdepend heav andlocalities - cials of slightly could on passed of in the form be cept thelower canafford wages thatfirms to displaced workers would more be likely to- ac all.effective That’s of job training because

tk needed to reach peak productivity on day one. college, and the federal tax code allows indi- Federal wage insurance would thus consider- viduals of any age to claim a lifetime learning ably augment the tax credits that some states tax credit of up to $2,000 per year against tu- now make available to firms for retraining ex- ition and fees for attending a qualified educa- penses to offset the free-rider problem of tional institution. There’s a catch, though: training workers who are subsequently free to they don’t provide the cash upfront for those take their new skills elsewhere. lacking the means to pay in the first place. But finding a new job more quickly with Loans can bridge this gap. But traditional the aid of wage insurance wouldn’t help dis- bank loans for going back to school, especial- placed workers who want to train for new ca- ly for those past traditional college years, can reers, but don’t have the means to pay for that be difficult if not impossible to get without training. According to a 2016 Federal Reserve collateral and may be restricted to people study, roughly half of American adults have who are enrolled at least half-time in an edu- less than $400 (no misprint) in ready cash to cational program. It’s much harder to get a meet an emergency. So relatively few would conventional bank loan if you’re going to be able to drop out of the labor force and go night school, taking, say, one course a semes- back to school for an extended period, even if ter, and working during the day. they had working spouses. Moreover, private-sector college loans The federal government has well-estab- have conventional terms. I have looked, but lished programs for providing grants and can’t find, private bank loans whose repay- subsidized loans for young adults going to ment is tied to income, as is the case with tk

Fourth Quarter 2016 67 wage insurance amounts borrowed in order to cover the costs income-contingent repayment options that of borrowers who don’t earn enough to repay are an available (if rarely used) option on reg- the full amount. It is even possible that the ular federal college student loans. Such loans government would make money on the pro- are especially advantageous for students wor- gram if most workers do well after retraining. ried about their ability to make their loan It is more likely, however, that the costs of payments if they are laid off, or if their new under-payers would exceed the gains from careers don’t prove as lucrative as they hoped. the full payers. But again, like wage insurance, With income-contingent repayment, at least this would be a cost worth bearing because it they won’t go bankrupt or have their credit would ease friction in the labor market and ruined if their plans don’t work out or if forc- very likely contribute to an overall improve- es beyond their control – an economic reces- ment in the productivity of the labor force, sion, a personal medical crisis – prevent them generating tax receipts and gains to consum- from climbing the career ladder. ers and producers not directly attributable to But even with these limitations, the De- the program. partment of Education estimates that as many This spillover effect raises a Bernie Sanders as 90 million Americans, a significant portion question: if society as a whole benefits, why of whom have aspirations for new careers, shouldn’t lifetime retraining be free? One an- take part in some form of adult education swer: given the budget math showing increas- each year. Let’s have the federal government ing deficits over the next several decades due make income-contingent repayment loans to rising entitlement costs, it would be fiscally available to all adults throughout their work- irresponsible to add even more to the deficit. ing lives, up to the age at which people qualify Yes, in theory, taxes could go up to pay for this for full Social Security benefits. Repayment particular idea, but Democrats in particular schedules could be calculated and easily en- already have pledged rising taxes to pay for forced using a few extra lines on households’ other new programs. annual federal income tax forms. Deficits and taxes aside, there is something Federal retraining loans, like other college to be said for requiring people to pay for their loans, would be funneled through the educa- education or retraining. Knowing they are on tional institutions that the trainees attend; the hook for at least some amount would cre- this would remove the temptation to divert ate an incentive for workers to shop for train- loan funds for non-education expenses. To ing more carefully, as well as encourage minimize the potential for rip-offs by fly-by- educational institutions to compete by provid- night trade schools, federal loans would be ing top value for their students’ dollars. Note, available only through institutions meeting too, that the proposed income-contingent minimum standards – among them, a thresh- old placement rate for new grads, plus full disclosure to prospective students of where grads have been placed and at what salaries. As with the current income-contingent re- payment student loans, the lifetime income- contingent repayment loan accounts should have a cap on repayment somewhat above the

68 The Milken Institute Review repayment system would limit repayments by ter schools to limited minimum-wage in- borrowers who, for one reason or another, are creases to expanded earned-income tax unable to recoup their investments. credits for low-wage workers. Arguably most important, we need to dis- the ills that wage insurance and pense with the idea that government is the retraining cannot cure natural enemy of efficiency and economic Some perspective is warranted here. Wage in- justice. There are certainly plenty of ways surance and lifetime retraining focus on the in which government intervention can back- issue of income insecurity – the reality that it fire, reducing the size of the economic pie by is far too easy to slip off the economic ladder means of ill-considered regulation or by de- and never fully recover. Neither program is fending the privileges of incumbent business- designed to make much difference for Ameri- es that find it cheaper to compete in the cans who enter the labor market with mar- “political market” than in the markets for ginal education and skills. goods and services. I don’t have a silver bullet to fix the daunt- But the pendulum has swung too far. To ing moral and political problems associated manage the consequences of the sorts of eco- with income inequality and inadequate social nomic displacement that seem inevitable in a mobility. But I am confident that we need to rapidly changing global economy, we be more open to changes, ranging from char- need smarter government – not less of it.

Fourth Quarter 2016 69 tk

70 The Milken Institute Review For centuries, Bolivia has been the poor cousin of its neighbors in the southern cone of Latin America. An outpost of the Inca empire in the 16th century, the area endured a brutal Spanish conquest that provoked the indigenous population into a string of uprisings, each of which was met with bloody repression. After independence in 1825 – the victors named the country after Simón Bolívar, the Venezuelan father of Latin America’s anti-colonial struggle – it enjoyed an all-too-brief period of enlightened rule. But within a Ffew years it was at war with its neighbors Peru, Paraguay and Letter From Chile. In the process, Bolivia lost both its access to the sea and the rich load of minerals under the Bolivia coastal desert. by charles castaldi Except for a few attempts to improve the lot of indigenous people in the middle of the 20th century, corruption, electoral fraud and inept military rule seemed to define Bolivia’s destiny. In the late 1980s, sweeping macroeconomic reforms combined with a rapid conversion to free markets – the “shock therapy” that made then-Harvard economist Jeffrey Sachs a star of his profession – tamed Boliv- ia’s hyperinflation, which had reached an unfathomable 24,000 percent. But shock therapy fell short in meeting its broader goals. Bolivia’s indigenous population remained among the poorest on the planet, and the country remained best known

federico parra/afp/getty images federico parra/afp/getty for its signal export, coca.

Fourth Quarter 2016 71 letter from bolivia come a major supplier to Colombian narcos in the 1980s, who processed the leaves to feed the robust American appetite for what was jocularly known to party animals as Bolivian marching powder. In 1997, Morales was elected national dep- uty from Cochabamba, a city in the Andes. The powers-that-were did all they could to stymie his rise. However, the Aymara and Quechua Indian poor, who are a majority of the population, had seldom seen a politician who not only spoke for them, but actually looked like them. The United States declared him a threat to stability and Bolivian democ- racy, giving him a helpful boost among his constituents. Those were also the halcyon days of the IMF’s and World Bank’s push for privatizing inefficient public sectors in developing coun- tries. So, in the Bolivian town of Cochabamba, the municipal water authority was sold to a private consortium in which Bechtel, the multinational construction firm, was a major shareholder. The newly privatized utility doubled rates. But in the bone-dry altiplano, the Andean highlands around La Paz, water and access to it are not to be trifled with. The rate increases were met with stiff opposition that morphed into what came to be known as the Cochabamba water wars. Evo and his In the mid-1990s, Juan Evo Morales Ayma, cocaleros joined the protests, which were met an Aymara Indian who had risen out of pov- with violent government repression. erty to become the leader of the coca growers Just a few years later, another myopic union, took an essentially defunct right-wing move added credence to the view of many party called MAS (Movement Toward Social- Bolivians that the white-skinned folks who ism) and reoriented it left. Evo, as he is known ran the government were only interested in to one and all, began protesting against the lining their pockets. This time, it was the sale U.S. funded attack on coca growing, which of natural gas assets to American companies, was the only source of income for many allegedly at below-market prices. (Bolivia has impoverished Bolivians. The country had be- the second largest reserves in Latin America.) More protests erupted, answered by yet more repression. But by awakening the fury of the CHARLES CASTALDI is a former National Public Radio

reporter in Latin America, who now lives in Nicaragua. Indians, the political establishment signed its reuters

72 The Milken Institute Review own death warrant. One president after the change the constitution so he could stand for other resigned in the face of ever-deepening a fourth term. The “no” votes won by eight crises. In 2005, Evo won the presidency by a percentage points and Morale’s government landslide. lashed out at opponents and the press, blam- The initial take in Washington was that ing them for manufacturing the Zapata story the populist leader was cut from the same au- to besmirch his reputation. thoritarian cloth as Hugo Chávez in Venezu- ela and was sure to drive the economy santa cruz (further) into ruin. In fact, this government My first stop in Bolivia was Santa Cruz de la has had an economic track record that is the Sierra, which lies in a fertile lowlands plain envy of its neighbors. east of the Andes and is a geographic meta- Growth for the last five years has averaged phor for the division that has riven the coun- above 5 percent; all told, since Morales took office in 2006, GDP (adjusted for inflation) is up by 55 percent. Meanwhile, the central B y awakening the fury of the Indians, bank had stashed away sufficient foreign cur- the political establishment rency reserves to pay for a year and a half’s worth of imports before the commodity signed its own death warrant. boom ended in 2012. Only China can make the same claim. try for much of its existence. Santa Cruz has Equally important, the income gains have historically been dominated by land-owning been shared; the percentage of the population oligarchs of European descent, whose race- living in poverty has been reduced by one- based dislike of the “indios” from the western third during Morales’ years in office. highlands is, even today, barely concealed. When I arrived in Bolivia, one story was This translates into an Obama-like phenom- monopolizing the headlines: a scandal in­ enon: when some people criticize Evo, saying volving Gabriela Zapata, an ex-girlfriend of that the Zapata scandal confirms their worst Evo – he’s not married – and her seemingly fears about his corrupt and authoritarian miraculous rise in a Chinese company that leanings, it’s hard to parse out how much this did $500 million worth of business with the has to do with his being a dark-skinned man Bolivian government. Beyond the corruption of indigenous blood. narrative, the story included a son she had But it doesn’t take long to see that the eco- with Evo, who he claimed had died as a baby. nomic boom on Evo’s watch has remade Santa Then, miracle of miracles, she revealed Cruz from a sleepy agricultural backwater to that the baby was alive and grown up, where- the economic engine of Bolivia. Construction, upon the government charged she had made both multistory office buildings and housing, up the story. She was subsequently arrested is booming. Indeed, Santa Cruz is one of the for money laundering, fraud and influence fastest growing cities in the world. Big money peddling. To top things off, the government has been made virtually overnight, explaining also jailed her lawyer. the scads of Porsches, Mercedes and Audis This outline for a telenovela – oops, this that cruise the streets. news – first dropped in February, just as Evo For decades, agriculture was the mainstay was asking voters to approve his proposal to of the economy of the department of Santa

Fourth Quarter 2016 73 letter from bolivia giant buildings housing cane crushers, boilers Cruz, with mostly rice, corn, wheat, sugar, and miles of pipes exuding steam, Eduardo meat and poultry on the menu. (A “depart- Guttierez Jr complained about the restric- ment” is the equivalent of a state in Bolivia.) tions Evo had imposed, requiring producers Today, 70 percent of the food consumed in to set aside enough sugar for domestic con- Bolivia is grown in the department. But it’s sumption before exporting the residual at natural gas and the infrastructure to support higher prices. What’s more, he said, the refin- extraction that have brought boom times to ery is now required to pay an extra month’s the eastern region of the country, where Santa wages to workers on top of the previously re- Cruz serves as de facto capital. quired 13th-month bonus common in Latin America. In spite of this, he conceded, the sugar Earnings on fuel exports rose from business has thrived. While one member of less than $1 billion to over $6 billion his family called Evo “a dictator surrounded last year. And in spite of the fact that by terrorists,” Guttierez Jr sounded more bal- anced. “Evo was lucky, he was handed a good Evo has chosen to let the golden economic situation,” he said, referring to the goose survive – even prosper – locals favorable gas export terms that were obtained just before Morales came to power. “At the aren’t inclined to give him credit. same time, I wonder if another administra- tion wouldn’t have misspent those profits.” When Morales came to power, he made It’s a variation on a refrain I will hear over good on a promise to nationalize the hydro- and over again in Santa Cruz: we don’t like carbon and mining industries. He flipped the the guy … still, we’re doing pretty well … but government’s cut of gas sales from 20 percent things could be better. … to 80 percent. The Brazilian, Spanish and Outside the facility, bulldozers add to a French oil companies operating in Bolivia giant mountain of cane residue from the mill- cried foul but stuck around, wagering that in- ing process. A cloying sweet smell permeates creased prices and greater volumes would the air. Beyond the mill, hundreds of acres of make up for their lower share of the take. cane fields belonging to the Guttierez family It was a good bet. Earnings on fuel exports form a giant rectangle in the middle of the rose from less than $1 billion to over $6 bil- city. Imagine Central Park as a private farm. lion last year. All told, Santa Cruz depart- In the afternoon, I drive south through ment’s oil and gas production, added to all its neighborhoods that look much like poor bar- other goods and services output, equals al- rios in any Latin American city: tin roofs, most 40 percent of GDP. And in spite of the some houses of brick, others of rough boards, fact that Evo has chosen to let the golden rutted dirt roads, chickens free-ranging for goose survive – even thrive – locals aren’t in- urban detritus. That makes it all the more clined to give him credit. surprising to come across large, modern brick One morning, I toured a giant sugar mill buildings that seem out of place amid the in Santa Cruz that belongs to the Guttierez blight. Not one or two, but many. These are family, one of the oldest and most prominent schools, built in the last few years, that would families in town. As we made our way through look at home in any American suburb.

74 The Milken Institute Review Marbella Villalobos Mesa is waiting to pick than most Latin countries, there’s no denying up her child at the entrance of the Cupesi that the educational system has problems re- errado Primary School. “Before, there was taining students who reach working age. nothing here,” she said. “There was nothing Villalobos tells me she cleans homes and for poor people like us. But since Evo, things her husband is a mason. They make a com- have really changed. We have ended up much bined income of about 3,500 bolivanos a better off.” month, which works out to about $500, not She receives a government stipend for counting the children’s stipend. It could be each child who attends school – a conditional worse: the minimum wage in Bolivia is $260 stipend system for the poor of the sort that a month. has swept across Latin America. Under Evo, Inside the front gate, Sergio Rivera, a literacy has climbed about 10 percentage young teacher, wonders (somewhat ag- points to a respectable 96 percent of the pop- gresively) why I was asking questions. When I ulation. But even though the government explained, he said: “How could we possibly

epa/martin alipaz epa/martin spends more proportionally on education complain about the way things are going?

Fourth Quarter 2016 75 Álvaro García Linera, Vice President of Bolivia

This wasn’t Argentina or Venezuela, which position. Mayor Percy, by the way, is no Boy had periods of great wealth. We come from Scout. He has been taken out of circulation by abject poverty.” members of his own party for issuing death Rivera points around. He, like everyone threats against journalists and groping around me in and out of the school, has an women at public events. indigenous complexion. “Most people have Everywhere are reminders of the social di- experienced the racism that predominated in vision and its origins. The council chamber, this part of the country,” Rivera said. “Our where members of Evo’s party are in the mi- parents certainly did. But with Evo, things are nority, is adorned with a large mural depict- different. And some people here aren’t happy ing Spanish soldiers bristling with swords and that their skin color no longer gives them a lances accompanying priests who are con- position of privilege.” verting almost naked Indians to Catholicism. As I exit, the school another parent, Irina It’s a throwback to an era in which the Span- Gil, stops me. “Don’t forget, Percy has also iards were seen by Latin American elites as done a lot for us poor,” she said. bringers of civilization. The Percy in question is Percy Fernández, The next day, I’m in Colinas del Urubó, a the popular mayor of Santa Cruz and a mem- new development north of the city where ber of an opposition party. Democracy at the many of the mansions rival those of Beverly municipal level seems alive and well – all the Hills in size and architectural crassness. We’re jose lirauze/abi/xinhua/alamy live news jose lirauze/abi/xinhua/alamy

largest cities are ruled by members of the op- talking 10,000 square feet and millions of ©

76 The Milken Institute Review dollars. And the lots are selling like hotcakes, executive editor of El Deber (which loosely with buyers coming from the growing ranks translates as “duty”), the most influential of both well-heeled Bolivians and foreigners newspaper in Santa Cruz. These days, he said, who suddenly see Bolivia as a safe haven. freedom of expression in Bolivia is a mixed bag. Later in the day, as a light rain falls, I go You can find plenty of critical programs on running along the forest that borders the television. Likewise, there are plenty of news- Piray River, which snakes through Santa Cruz. papers that report on government corruption Soon, I’m following a trail into dense woods or publish anti-Morales opinion pieces. and as I come to a clearing, a pack of dogs “It would be a fallacy to say there’s no free- and a woman with a rather unfriendly coun- dom of expression here,” Rivero said. “How- tenance intercept me. At first, I’m more con- ever, the spaces are diminishing and there’s cerned about the woman than the snarling dogs. But the sight of an older American in running gear in the rain has her perplexed. Vice President Álvaro García Linera, Her name is Amalia Osinogo, and she has depending on whom one talks to, is lived in this ramshackle neighborhood for decades. When Evo first ran, she campaigned either one of the brilliant intellectuals for him and registered everyone in the com- behind Evo’s ascent or a terrorist munity to vote. “We were all for him here,” she said. “He was a candidate like we had turned Machiavelli. never seen before.” She thought that, in return, the new gov- more and more intimidation.” He wonders ernment would help them obtain titles to the what will happen if the economy turns south land on which they had squatted. “They came or, as is inevitable, more cases of corruption and put in electricity,” she said. “But after that surface. “We’ll see how they handle things,” we never saw them again. It turns out Evo is he said. “But I’m not optimistic.” like all politicians: once he gets your vote, you Rivero, who died at age 84 before this arti- stop existing.” cle went to press, was particularly worried She finds his efforts to change the consti- about the designs of Vice President Álvaro tution to get re-elected objectionable. “If Evo García Linera, who, depending on whom one is not careful,” she said, “if he keeps pushing talks to, is either one of the brilliant intellec- for these types of changes that are against our tuals behind Evo’s ascent or a terrorist turned constitution, he’s going to lose the support of Machiavelli. His statements about the fourth people like me.” estate lean more toward the latter. Regarding She invites me to walk through the neigh- the journalists who uncovered the Zapata borhood along the river. We reach the river- scandal, García Linera said, “Those responsi- bed, which, at over a mile across, consists of ble [whom he labels ‘political media mafia’] strands of beige water lacing through depos- will have to go to jail. The law will be applied its of silt from the Andes. Along one bank, a to all of these liars.” cowboy moves his cattle through high grass. Across the river, I can make out the mansions la paz of Colinas del Urubó. After the tropics of the eastern lowlands, La A day later, I talk to Pedro Rivero Jordan, the Paz, the de facto capital of Bolivia – the actual

Fourth Quarter 2016 77 letter from bolivia capital is Sucre – is geographic shock. First, there’s the sight of the Andes, with glacier- topped 21,000-foot-high Mount Illimani dominating the horizon. The altiplano is a harsh, almost Martian, landscape. La Paz it- self sits in what appears to be an eroded can- yon at 12,000 feet – an altitude that leaves all but the most acclimatized visitors puffing along the vertiginous streets. But it is the in- habitants of La Paz, not the topography, that make the strongest impression. Unlike Santa Cruz, this is the heart of Aymara indigenous culture. Indian faces are everywhere, their ex- uberant clothing offering a contrast to the dull gray of the city. I had last been in La Paz in 1980 during the brief but brutal rule of Gen. Luis García Meza Tejada. Even the military found him reprehensible and removed him after a 13- month reign. The city was a sad and frighten- ing place in those days. Now I saw indigenous women everywhere in their colorful multilay- ered skirts and bowler hats, a fashion state- ment introduced by European railroad workers in the 19th century. The women are called cholitas, which used to be a derogatory term. In the 1980s, they were not even allowed to enter parts of the That evening, I visit Arce on the top floor city, ride public transportation or enter most of a 20-story building in the heart of La Paz. establishments. Bolivia, before Evo, was, for Even at 8 p.m., there are people milling about all practical purposes, an apartheid state. But and holding meetings. One cholita in tradi- cholita has since morphed into a term of in- tional garb introduces herself as part of his digenous pride. planning staff. Arce’s own large office has a Another change that strikes me as I move spectacular view of the city below, not to around the city is the plentiful commerce on mention a bunch of conference tables over- the streets. The government has let the infor- flowing with files. mal sector flourish as a way to put money Arce, a former central banker who began into the pockets of indigenous people for advising Evo before he was elected, is in his whom it’s the only source of income. It’s part mid-50s, but his laid-back manner and easy of an economic policy that is largely the laugh make him seem younger. He’s one of brainchild of Luis Alberto Arce Catacora, the the few original cabinet members who re- economy and finance minister of Bolivia. mains in the government. In the beginning of

78 The Milken Institute Review his administration, Evo filled his cabinet with he said. “There was just a penetration of for- like-minded activists with no administrative eign capital for the exploitation and pillaging experience. But it didn’t take long for him to of our natural resources.” realize he needed ministers who could actu- The first phase in his plan, which he calls ally administer. the New Bolivarian Model, was to regain con- Arce’s rap is full of Marxist terminology. trol of Bolivia’s natural resources through re- But it’s camouflaged in a modern analysis of nationalization and increased taxes. Then the economy that would not sound alien to came the second phase, industrialization. your average ivory tower liberal academic. “We sold our gas to Argentina and Brazil, and He persuaded Evo to throw out the IMF/ they converted it to petrochemicals,” he noted. World Bank playbook as soon as he was “We’ve since built two petrochemical plants, elected. Then came the nationalization of one to export to Brazil and the other to Ar- natural resources. gentina. Now we’re reaping the profits; we are “The sales of our state-owned companies creating industry and adding value on our

reuters/david mercado reuters/david in the ’90s never produced any profit for us,” side of the border.”

Fourth Quarter 2016 79 He sees big potential for Bolivia with a His policies, which Evo’s critics grudgingly new fertilizer plant, with plastics, with elec- label as prudent, have made the Bolivian tricity. “Why are Argentina and Brazil buying economy healthier than it has ever been and our gas to produce electricity?” he asked. obviously played a big part in Evo’s re-elec- “Why don’t I sell them electricity? We have the tions. Leftist governments in Venezuela and natural resources to sell energy to all of our Nicaragua have spent heavily to score populist

neighbors.” points. But Evo has been downright thrifty shanti hesse/alamy

80 The Milken Institute Review inequality with the redistribution of profits,” he said. “We’ve about 10 million inhabitants in Bolivia, and we’ve taken about two million of them out of poverty. And we’ve been able to do this without making the rich poorer.” There is some fear that, with gas prices low, Bolivia will find itself hard-pressed to con- tinue its generous redistributive policies. But Arce appears unperturbed. “Prices of miner- als have been falling since 2011 and prices of gas have been falling since 2014,” he said. “But we’ll continue to do well, because we are keeping the profits in the country.” It helps, of course, to have stashed away $13 billion in foreign reserves (as of April 2015), which is being spent down slowly to buffer the energy-price shock. Indeed, while Arce talks the lefty talk, his stewardship is praised by the financial estab- lishment in Washington and New York. “Now even at the IMF they admit that all is not well with neo-liberalism,” he chuckled. “We had the great fortune of being able to think about our model, plan it, dream it,” he said. “And thanks to the political will of Pres- ident Evo, we’ve had the opportunity to see it crystallize. Not too many economists get that opportunity.” The next morning, I take a ride on one of Morales’s infrastructure investments that has been a big hit with the public: a $250 million gondola system with three lines that connect far reaches of this chaotic, mountainous city. The government simply wrote a check to an Austrian company, which built the first three lines. Four more are planned. from the beginning, when he acceded to Arce’s My 40-cent ticket gets me on the red line pleas not to double state salaries. The windfall to El Alto. The gondolas are full, the faces from higher taxes on the sales of gas went to around me entirely indigenous. The ride feels a mix of industrialization, savings for the in- like flying over the red brick houses stacked evitable rainy day, and targeted aid to the poor. tenuously up the sides of canyons. “The primary focus of our economic poli- In La Paz, as a general rule, the higher you cies has been to attack unemployment and go, the poorer the neighborhood. That seems

Fourth Quarter 2016 81 letter from bolivia thousands of square feet per floor. And 30- the case when traveling to El Alto, an incor- foot ceilings. The typical price tag these days porated city that sits on the 14,000-foot plain is upward of $500,000. above La Paz. It’s a place that the whiter folks The bottom floor will go to retail space, he who live in the south of La Paz generally don’t explained, and above that, one floor will be- visit, although it’s now just two gondola rides come an AstroTurfed sports arena. “I’m like away. Evo, I love soccer,” he said, when he sees my El Alto has grown sharply in recent decades, surprised look. “I want my grandchildren to drawing in immigrants from the countryside. have a safe place to play. We have no parks in It’s a stark, otherworldly mix of truck stops, El Alto. I’ll also rent it out.” construction sites and mostly poor homes. He’ll also rent out space on the upper two Outside the center, the streets are dirt; it’s often floors, which he plans to decorate in wild col- hard to tell if behind the walls there are homes ors for weddings and parties. On top of the or empty lots. But then one spots a cholet, a flat roof is his residence, which bears no ar- mansion to which no verbal description can chitectural resemblance to the rest of the fully do justice. Suffice it to say that the most building and looks like a chalet that was famous cholet – the word combines chola and dropped in by helicopter. For the moment, chalet – is called Optimus Prime. That’s right, it’s just an empty shell, but Choque beams from Transformers. It’s an architectural style with unaccustomed emotion. “Things are that was introduced by a local Aymara builder going well for us in El Alto,” he allowed. named Freddy Mamani Silvestre, and it com- In Choque’s case, that’s plainly an under- bines colorful indigenous themes in a baroque statement. Two of his brothers are also build- style that seems oddly modern. ing cholets. I ask him how he has managed to The cholets mirror the mansions I saw in make so much money. He runs through a diz- Santa Cruz, except these mansions are being zying list of businesses and family links that built for Aymara Indians who have become cover everything from traditional fabrics, to wealthy since the rise of Evo. Along with re- cheap imported Chinese fabrics, to bars and peated warnings not to wander around El food stalls, to trucking. “I grew up poor, just Alto alone, I was told that Aymaras are very like Evo,” he said. “And now look, he’s indig- reluctant to talk to strangers – not uncom- enous just like me and he’s president.” mon for an indigenous people. But when I For the immediate future, it appears that spotted a cholet under construction and Arce’s handling of the economy has left the began asking about building methods and country in the enviable position of enjoying rebar sizes, the owner, Mario Choque, a com- growth even in the teeth of the big commod- pact Aymaran in his early 60s, began to share ity price declines. Arce said he has a plan to complaints about errant plumbers and incor- remake the Bolivian economy by 2025. rectly sized electrical wire. Therein lies the challenge. Evo’s current Building woes turn out to be an icebreaker (and last constitutionally mandated) term in any culture, though Choque’s accent posed runs out in 2020. But the government’s image a bit of a challenge to me. In El Alto, the lin- and popularity is firmly anchored in his per- gua franca is Aymara, not Spanish. son, and he has yet to cultivate a successor. Soon enough, Choque was showing me Can the New Bolivia survive the depar- around his half-done cholet. We’re talking ture of its iconic leader?

82 The Milken Institute Review book excerpt

The Euro and the Battle of Ideas

Most non-European economists, it’s fair to illustrations by pierre-paul pariseau say, were deeply skeptical that a common currency would work well in Europe, argu-

ing that the countries contemplating union didn’t meet the theoretical criteria for suc- cessful monetary integration. ButM the impasse on approaches to repairing the damage after the Eurozone’s near-unravelling

in 2008-09 suggests that the problems were even more funda-

mental. ¶ In their new book, The Euro and the Battle of Ideas,*

Marcus K. Brunnermeier (Princeton), Harold James (Princeton)

and Jean-Pierre Landau (Sciences Po in Paris) look to the dif-

fering national economic cultures for an explanation of why

the Eurozone was constructed on such an unstable governance

foundation in the first place and why member governments have seemingly fiddled

while Greece burned. Here, we excerpt the chapter on the schism between German and

French approaches to running their economies for clues to why the euro experiment

was so badly handicapped from day one. — Peter Passell *princeton *princeton university press all ( 2016 ). rights reserved.

Fourth Quarter 2016 83 In the 19th century and for the first half of the 20th, France could generally be characterized as dominated by economic liberalism (in the European, free-market sense) and Germany as largely statist. Then, quite abruptly after 1945, the pattern reversed.

The old traditions in both countries were Economic planning, as Hayek recognized, discredited as a consequence of the political was inherently discriminatory: “It cannot tie Icatastrophes of the mid-20th century. The ex- itself down in advance to general and formal tent of the catastrophe, on both sides of the rules which prevent arbitrariness. … It must Rhine, indicated the necessity of a basic change constantly decide questions which cannot be of course. German writers could see how the answered by formal principles only, and in prominent role accorded to the state in tradi- making these decisions it must set up distinc- tional economic theories might have favored tions of merit between the needs of different Nazi statism. By contrast, younger French people.” thinkers blamed the do-nothing non-inter- The issue of arbitrariness applies in a partic- ventionism of the traditional liberal school for ular way to the actual implementation of capi- sluggish economic growth, but specifically for tal controls. They were implemented in both fiscal austerity and consequently the failure to Austria and Germany from 1931 – that is, be- coordinate a viable defense economy in the fore Hitler came to power in January 1933 and 1930s. Thus, after World War II, France re- Austrian conservatives created the reactionary acted against old-style laissez-faire and em- corporate state in 1934. But the dictatorship phasized the desirability of systematic plan- provided more means of enforcing controls. ning, while Germans recoiled from the idea of Hayek cites the German classical liberal the state because its actions were arbitrary. thinker Wilhelm Röpke, to the effect that “while the last resort of a competitive econ- german economic tradition omy is the bailiff, the ultimate sanction of the Hayek’s Critique of a Planned Economy planned economy is the hangman.” If he had The most far-ranging critic of the German at the time known Hitler’s table talk, Hayek model of statism was the Austrian Friedrich might have cited the musings of the dictator Hayek. Hayek accurately identified that the himself: “Inflation does not arise when money interventionist approach of the Weimar Re- enters circulation, but only when the individ- public (which had its origins in wartime ual demands more money for the same ser- planning) created a sort of path dependency, vice. Here we must intervene. That is what I in which the answer to failure was not an had to explain to Schacht [the president of abandonment of the approach but rather a the Nazi central bank], that the first cause of more radical version. In The Road to Serfdom, the stability of our currency is the concentra- he asserted that Walter Rathenau, the intellec- tion camp.” tual who devised Germany’s innovative plan- ning regime of World War I, “would have Ordoliberalism shuddered had he realized the consequences A considerably softer version of the Hayekian of his totalitarian economics.” critique of the old German tradition, known

84 The Milken Institute Review Fourth Quarter 2016 85 as Ordo-Liberalismus, was deeply influential not burn down). On these grounds, the in Germany and had a major political impact. Freiburg School (another name for ordoliber- Chiefly expounded by Wilhelm Röpke and alism) even worried about the limited liabil- Walter Eucken, rules needed to be formulated ity principle for corporations. “Unlimited li- in general terms; the state’s actions should be ability is part of a competitive system,” Walter confined to the enforcement of such general Eucken wrote. In his eyes, too many and too laws – for instance, the laws on competition complicated laws breed moral hazard, and and against cartels, which had been an im- the economic agents are given incentives to portant part of the older German tradition of game the system. business management. Unlike Hayek, who The antitrust thinking of the new German more and more insisted on the spontaneous economists also meshed well with the think- creation of order and rules, the ordoliberals ing of the U.S. military administration. One of the German ordoliberals, Franz Böhm, “Economics professors” in Germany wrote that there was “no influential and so- cially strong group” supporting competition came to have a sort of ideological “excepting the American occupation authori- definition. They were the five ties.” Competition law thus became a crucial part of the new German philosophy and, as professors (only one of whom was advanced by Walter Hallstein, the German really an academic economist, and he economist and civil servant who became the first president of the European Commission, was retired) who complained about also of European law. the Greek rescue package in 2009. Ludwig Erhard, the economics minister who pushed Germany’s liberalization pro- emphasized the need for an initial elabora- gram, made the link between competition tion of an appropriate framework. policy and European priorities explicit. In Their vision of order included both a sys- 1952, at the launching of the European Coal tem of general rules and a mechanism by and Steel Community, he stated, “We plan to which those rules define the responsibility of create a common European market. The aim individuals and economic agents. The system is incompatible with a system of national or fundamentally depends on the accountability international cartels. If we want to create a of market participants. Any measure that lim- higher standard of living through technical its accountability by promising some sort of progress, rationalization and an increase in contingent rescue would create destructive production, we have to be against cartels.” incentives that would lead to the accumula- The resulting vision did not completely re- tion of unfulfillable expectations on behalf of move the state. The rejection of the past was the economic actors and unfulfillable liabili- not as extreme as it appeared in some of the ties on the part of the government as the ulti- ordoliberal manifestos. Indeed, the economic mate insurer. historian Albrecht Ritschl has argued (con- As a consequence, ordoliberals worried troversially) that a large part of the distinc- greatly about “moral hazard,” a term taken tively German and rather corporatist ap- from insurance (a well-insured person may proach to the state-business relationship was not take sufficient care that his house does inherited from the Nazi era.

86 The Milken Institute Review Ordoliberalism in Today’s Germany mously called “the gradual encroachment of In the 1960s, the German model incorpo- ideas” that rendered politicians and practical rated a good deal of Keynesianism, but was men as “slaves of some defunct economist.” formulated in terms of a foundation of stabil- As the Bundesbank had a major input in the ity, or a rule-based order. In academic eco- design of the European monetary union, nomics, ordoliberalism was largely replaced some commentators speak of the “ordoliber- by a U.S.-style neoclassical synthesis. Most alization of Europe.” modern ordoliberal academics are lawyers German officials in some Berlin ministries rather than economists. like to voice their dissent from alleged “funda- Some ordoliberalism survived in think mentalists” in the Bundesbank. The govern- tanks and in the economic research institutes ment also started to distance itself from the that are a feature of the German intellectual Council of Economic Advisers, complaining landscape and constitute a bridge between ac- ademia and politics. The German Council of Economic Experts, which was set up by Lud- wig Erhard in 1963 and is intended to educate the public rather than specifically to advise the government, sees itself as embodying the legacy of ordoliberalism. But in general, or- doliberalism has a bad reputation, especially outside Germany, with the Financial Times journalist Wolfgang Münchau excoriating “the wacky economics of Germany’s parallel universe.” As he put it, “German economists, roughly fall into two groups: those that have not read Keynes, and those that have not un- that the economists there were inflexible and derstood Keynes.” were looking “too much through German But the traditions of the postwar era cer- spectacles.” The Social Democratic Party eco- tainly exercise a substantial, almost subcon- nomics minister Sigmar Gabriel pointedly de- scious, appeal to many Germans, and espe- layed supporting the renomination of Chris- cially to policymakers in the Bundesbank and toph Schmidt as chairman of the council. perhaps also the Finance Ministry. It is also In the course of the euro debt crisis, Ger- conspicuously represented in the economics man critics of the various rescue packages pages of the Frankfurter Allgemeine Zeitung liked to present themselves as the voice of the (FAZ), a major German newspaper. The FAZ economics profession. “Economics profes- is generally considered to be moderately sors” in Germany came to have a sort of ideo- right-of-center, but even the moderately left logical definition. They were the five profes- Süddeutsche Zeitung devotes space to the Ger- sors (only one of whom was really an man economic tradition. In particular, since academic economist, and he was retired) who 2009, both these large German newspapers complained about the Greek rescue package have worried about the moral hazard impli- in 2009. They were the 172 professors who in cations of euro rescue measures. July 2012 signed a letter to the FAZ attacking Those traditions represent what Keynes fa- the banking union plan.

Fourth Quarter 2016 87 The phenomenon of the economics pro- of the money stock and of the inflation rate. fessors even eventually appeared as a new po- • A strict approach to government debt. litical party: Bernd Lucke (an economics pro- Germany pioneered an approach that it now fessor from Hamburg) and Konrad Adam (a proposes to Europeanize, with a 2009 law retired FAZ journalist) formed an anti-euro mandating a deficit limit at the federal level protest party, the Alternative für Deutschland of 0.35 percent of GDP by 2016 and an elim- (AfD), which polled surprisingly strongly in ination of deficits for states by 2020. German the European Parliament elections of 2014. think tanks like the idea of a Europeanization These organized mobilizations of economics of fiscal rules enforced by some sort of fiscal professors were not truly representative of or debt council. the profession, but they wanted to give the • The view that growth is not achieved by impression that they were. Later, the eco- the provision of additional money or re- nomic professors were forced out of the AfD, sources, but by structural reforms. Additional which turned in a radical right direction. money is a sort of trickery, doomed to failure The elements of the German economic intellectual tradition can be summed up as follows: • A focus on the legal, moral and political foundation of free markets in agreed rules, which may be treaties or laws, or shared un- derstandings. • A strong emphasis on accountability. For market participants, the responsibility is fi- nancial – they need to pay the price of failure. Politicians are accountable to voters. • A concern with the potential for moral and analogous to trying to pull yourself out hazard arising from lender of last resort activ- of a swamp by pulling on your bootstraps. ities. The IMF’s financial rescue package for • A belief that present virtue – or austerity Mexico in 1994-5 was heavily criticized by – is rewarded by future benefits. German officials as encouraging reckless be- havior by increasing the likelihood of future french economic tradition rescue operations. France, too, began the postwar era by reject- • A concern that lender of last resort (LLR) ing the economic orthodoxies of its past and action may corrupt monetary policy because seeking to Europeanize its new priorities. a central bank that has an LLR obligation Low growth and stagnation had weakened might be forced to give priority to financial- France politically, socially and militarily. The sector stability over price stability. obsession with balanced budgets had led to a • A belief that firm rules are needed to cutting of defense expenditures that made shield monetary policy from fiscal domi- France more vulnerable. nance – namely, that by raising the perma- Part of the picture had been French unwill- nent level of expenditures without raising ingness to take John Maynard Keynes seriously. taxes, government can affect the current and Keynes was not a popular figure in France, future flows of the monetary base and, hence, doubtless because of his well-known criticism

88 The Milken Institute Review of the 1919 Versailles Treaty, and, in pre-1940 proud of their complete ignorance of the eco- French debates, the role of the state was not nomic principles of diminishing marginal seen primarily in terms of macroeconomic utility and the time-value of capital. The stimulus. The new postwar French alternative French planning tradition achieved a new emphasized the need for the state to coordi- momentum in World War I, when Étienne nate and plan investment. An unplanned or Clémentel and Ernest Mercier tried to imitate spontaneous market order was likely to lead the German war planning approach of Rathe- to underinvestment and low growth. nau, and again in World War II. Even this brief narrative of the evolution The Influence of Engineering of the French planning tradition makes it The new French tradition had its roots not so clear how much interaction there was with much in high thought, but in the work of Germany. Frederick the Great in Prussia ad- practical economists who were trained in in- mired French economic planning methods stitutions oriented toward service to the state. and tried to promote similar developments. He imported technicians and engineers from France and England. So did other German In his last pamphlet, in the states, with a famous mining school founded aftermath of the 1848 revolu- in Freiberg in 1765. The École Polytechnique tion, Frédéric Bastiat concluded found many imitators in Germany, from the Technische Hochschule in Karlsruhe (1825) that “legislators and do-gooders onward. Indeed, Germany came to be more [should] reject all systems, and widely regarded as the best-practice model of technical education. try liberty.” Past Liberal Tradition: Say and Bastiat That tradition went back a long way. The The 19th century in France was intellectually Corps of Bridges and Roads had been set up dominated by a passionately articulated eco- in 1716 and organized as a school in 1775. nomic liberalism, with Jean-Baptiste Say The original intention was to provide an ac- (1767-1832) arguing after the French Revolu- curate mapping system so as to allow the con- tion that it was a “gross fallacy” and “produc- struction of a national road network for the tive of infinite mischief” that “what govern- whole of France. In 1794, a parallel École ment and its agents receive, is refunded again Polytechnique was established to train “na- by their expenditure.” He went on to establish tional engineers.” A third school for mining Say’s Law: “Supply creates its own demand.” had been founded in 1783. The journalist Frédéric Bastiat (1801- The products of these schools pushed for 1850) became the most brilliant expositor of elaborate and unified transportation, com- the principles of laissez-faire and the de- munications and eventually energy transmis- nouncer of the fallacies of protectionism. In sion systems. They built roads in the 18th his last pamphlet, in the aftermath of the century, canals and railroads in the 19th and 1848 revolution, he concluded that “legisla- electricity grids and high-speed train net- tors and do-gooders [should] reject all sys- works in the 20th. tems, and try liberty.” Critics observed that the schools were Later, those principles of liberal economics

Fourth Quarter 2016 89 90 The Milken Institute Review were magisterially expounded by Paul Leroy- other side of the Rhine in which France Beaulieu at the new School of Political Sci- should not let herself be outpaced.” ence (Sciences Po) and then at the Collège de Initiatives such as the Marshall Plan also France. The liberal tradition of economics helped to establish the idea that planning had in part evolved – and Sciences Po founded might transform the whole European busi- – as an explicit counterweight to the engineer- ness structure. For steel and coal, planning ing or technocratic vision presented by the was given a European context by the Schuman graduates of the professional schools. plan and the establishment of the European Coal and Steel Community (ECSC). France Planning also Europeanized its preference structure, The first Monnet Plan was already formulated and many political figures saw the primary in 1946. Heavy industry (especially steel) fig- desideratum as the establishment of a mecha- ured prominently in the national investment nism for economic governance that allowed plans, and individual businessmen were Europe to undertake the same coordination frightened of appearing as laggards or sabo- that French policymakers had managed to teurs. The result was massive investment and apply on a national level. quick expansion. The government was ob- The highest achievements of the French sessed with growing more quickly than Ger- tradition were seen in the coordinated nu- man steel and warding off the new and threat- clear power network built by Electricité de ening Italian challenge to its industrial strategy. France, and in some spectacular examples of The French political class saw big steel ingenious but ultimately failed technology. mills as modern cathedrals that gave expres- France built the first medium-range passen- sion to a national revival. The chief architect ger jet aircraft, the Caravelle, in the mid- of France’s postwar plan, the banker and vi- 1950s, and then in the 1960s, the supersonic sionary of European unity Jean Monnet, aircraft project that resulted in the beautiful called for “une politique de grandeur pour and fast (but commercially unviable) Con- l’acier,” and indeed he saw some mechanism corde. In 1978, France’s telephone company for extending French control over the conti- unveiled Minitel, a sort of predecessor to the nental European steel industry as key to post- internet, with online videotext linked to com- war political stability. mercial applications. France’s high-speed In the immediate aftermath of the war, train system, the TGV, launched in 1981, was there was an intense discussion of national- only emulated much later by Italy, Spain and ization as a way of raising production. The Germany – with the United Kingdom still old Colbertist tradition of a state-guided contemplating such a move. economy was augmented by admiration for The aura around France’s attachment to the achievements of Soviet planning. French the plan as an instrument of national revival policymakers believed the Soviet Union had lasted a long time. France’s planning institu- both avoided the Great Depression of the tion, the Commissariat Général du Plan, ex- 1930s and won the war because of planning. isted until 2006, when it was renamed the Gigantism itself was sometimes also pre- Center for Strategic Analysis, which in 2013 sented as a response to the new German chal- was renamed the Commissariat Général à la lenge: In 1956, in a gloriously mixed meta- Stratégie et à la Prospective (CGSP). There phor, Le Figaro referred to a “steel fever on the had already been an attempt to transform the

Fourth Quarter 2016 91 institution in the mid-1980s, but it had been on time consistency and the consequent sig- vigorously resisted. At that time, Pierre Massé, nificance of the correct formulation of rules. an engineer from the École des Ponts et In that sense, they have done more than the Chaussées and the principal architect of plan- German ordoliberals to present a version of a ning in the 1960s, had complained that “sup- system of rules that is really applicable to the pressing the plan in the name of an impulsive complexities of a modern economy, in which liberalism would be giving up the major competition is not an obvious result of eco- weapon in the struggle against the dictator- nomic activity. Jean Tirole and Jean-Jacques ship of the short term.” Laffont, in particular, have been instrumental in developing a new approach to the provision of incentives by regulators, in which the dan- The same sort of public mobilization gers of creating moral hazard play a key role. of economists for a political cause The visions of the past influence the way that took place in Germany against that economics is seen. Most French econo- mists complain – as did Thomas Piketty, the the euro rescue packages occurred in author of the best-selling Capital in the France against the German doctrines Twenty-First Century that “economists are not highly respected in the academic and intellec- and against austerity politics. tual world or by political and financial elites.” In fact, an intellectual culture exists that sees Aspects of the older tradition remained in economists as narrow-minded and soulless one area: the argument that currency stability technocrats who force a dehumanized concept was an important objective of policy and that of rationality on their fellow citizens. something like the gold standard was a desir- Raymond Barre, a European commis- able international discipline had a powerful sioner who was prime minister of France appeal. This case had been brilliantly and per- from 1976 to 1981, was lauded as “the best suasively made by Jacques Rueff, who economist of France” by Valéry Giscard emerged as the economic guru for General de d’Estaing, France’s president at the time.” But Gaulle. But it was also taken up by the left “economist” was a dirty word. As the late quite enthusiastically, above all because it 1970s were a time of increased inflation and could be mounted as a critique of the United unemployment, the end of the postwar eu- States and the manipulation of the dollar in phoria and a period of general disenchant- the Bretton Woods era in the interests of ment with the political elites that had until American foreign policy. then managed the Third Republic, the con- cept of economist as ruler looked sinister Contemporaneous Economic Thinking rather than beneficent. in France Jacques Sapir, a dissident economist who As in Germany, most modern French econo- saw himself in the left-wing, critical and, mists have largely moved away from the tradi- above-all, political tradition, complained that tional concerns of both 19th century liberal economists were undermining democracy. economists and postwar French politics with Bernard Maris, the journalist and economist planning. Indeed, French academics have who was tragically killed in the terrorist at- made a decisive contribution to the literature tack on the satirical magazine Charlie Hebdo,

92 The Milken Institute Review concluded, “What were economists for, one more general goals than simply price stability, will ask a hundred years from now? To make such as being concerned with economic people laugh.” growth. That kind of critique sat well with a coun- • The lessons of the Great Depression in- try that was increasingly obsessed with the clude the principle that adjustment to inter- parallel stories of national decline and trium- national imbalances should be undertaken phant globalization. The approach of modern symmetrically, with surplus countries doing mainstream French economists does not their part. translate well into the policy debate, which is still dominated by the older and rather eclec- tic visions of how an economy functions. In general, the French press – notably, Le Monde – is committed to the attractions of interven- tionism. French politicians from every part of the spectrum denounce neo-liberalism. Nich- olas Sarkozy criticized “Anglo-Saxon Europe, that of the big market” and repeatedly said that it was his mission to assert the values of French and European humanism as an alter- native to the international economic system. • As multiple equilibria are possible, choos- Even economists like to participate in the ing an unpleasant trajectory for the present is backlash against modern economics. The likely to perpetuate rather than remove con- same sort of public mobilization of econo- straints on growth. mists for a political cause that took place in • Present virtue is self-contradictory and Germany against the euro rescue packages self-defeating. occurred in France against the German doc- trines and against austerity politics. In Sep- international economics tember 2010, more than 700 French econo- Another important dimension of economic mists signed a widely publicized manifesto thinking along which the German and French for “an alternative economic and social strat- philosophies differ markedly is international egy” for Europe, attacking the “false eco- economic relations – in particular as regards nomic platitudes” of “neoliberal dogma.” cross-border capital flows. These disagree- The modern French consensus that presi- ments flared up during the negotiations pre- dents and economics professors alike shared ceding the ratification of the Maastricht may be summarized as follows: Treaty in 1992. German economic philosophy • Rules should be subject to the political calls for free trade, fair (that is, undistorted) process and may be renegotiated. competition, and open international capital • Crisis management requires a flexible markets. Capital controls were considered ar- response. bitrary, favoring certain industries and invit- • Constraining the freedom of the govern- ing political lobbying. ment to act – and to borrow – would be un- Thus, a world in which exchange rates are democratic. free to move, in which no coordinated multi- • Monetary policy needs to be used to serve lateral interventions are necessary to deal

Fourth Quarter 2016 93 Autonomous one side of the triangle. Germans picked the Monetary Policy capital-flow side, while the French preferred fixed exchange rates. This trilemma is, of course, a simplification. In practice, there are

GERMANY varying degrees of commitment to a fixed ex- change rate regime, varying degrees of open- FRANCE ness to international capital, and varying de- grees of monetary policy autonomy. The corners simply represent the boundaries of Fixed Free the possible. Still, the trilemma is useful as a Exchange Rate Capital Flow first-pass organizing device, and history pro- vides us with numerous useful examples of with macroeconomic shocks, and in which how the underlying trade-offs were resolved capital can flow freely is very much in keep- in the past. ing with the German tradition. The French philosophy, in contrast, is much closer to the Gold Standard original Keynesian position (evolved as a re- The gold standard was the dominant interna- sponse to the Great Depression) of fixed ex- tional exchange rate system between the mid- change rates, controlling capital flows and 19th and the early- to mid-20th centuries. fostering multilateral adjustment via infla- And many modern commentators make anal- tionary policies in surplus countries. ogies between the gold standard and the Eu- ropean currency union, in that both sup- Trilemma pressed the autonomy of monetary policy. A useful organizing principle for a discussion Under the gold standard arrangement, the of these differences is the “trilemma” of inter- central bank of every participating country national macroeconomics. Basically, this must stand ready to exchange its currency for states that an economy cannot simultaneously gold at some fixed ratio. have a fixed exchange rate and an independent How do economies in this system deal monetary policy and allow capital to flow with asymmetric shocks – say, an expansion- freely; it must pick two out of three. The ary demand shock in one country and a con- choice has profound implications for its abil- tractionary one in another? In a currency sys- ity to adjust to adverse macroeconomic shocks. tem with gold backing, trade naturally leads The German and French philosophies dif- to a flow of gold into surplus countries. As fer notably in their attitudes toward the desir- long as central banks in the surplus countries ability of capital flows and in how different do not “sterilize” the gold inflows – that is, economies, especially those linked via some prevent the inflows from increasing the do- kind of exchange rate mechanism, should re- mestic money supply – prices will be pushed spond to asymmetric shocks. up. The opposite happens in deficit countries, The trilemma tells us that we have to pick and so imbalances tend to auto-correct.

…this article is continued on the Milken Institute Review’s website: www.milkenreview.org

94 The Milken Institute Review institute news

Third time’s the charm titioners in Africa and other emerging regions Now in its third year, the Institute’s Asia Sum- prepared to lead capital-market development mit has become one of the region’s can’t-miss in their countries. Drawn from the most meetings. Held in Singapore in September, promising professionals, the first group of 18 the Summit convened more than a hundred IFC-Milken Institute fellows arrived in Wash- speakers (and hundreds of other partici- ington in August. They will complete rigorous pants) to explore the whole spectrum of classroom work at GWU, along with hands- forces shaping Asia. Videos of all panels are on work experience at financial institutions in available at no cost on the Institute’s website. the United States, before returning to their Coinciding with the Summit, Institute re- jobs back home. searchers published a blizzard of reports on Asia-related topics, including an assessment of We’re pleased as punch Asian companies for foreign investors, an In September, Edward Greissing took up the analysis of the implications of the changing reins as the first executive director of the balances of China’s foreign exchange reserves, Lynda and Stewart Resnick Center for Public and the latest “Best-Performing Cities – China” Health, a part of the Institute’s burgeoning results. You can find them all (and discover work in the area. Greissing brings nearly the Institute’s surprising conclusion about three decades of leadership experience in which Chinese city is at the top of the list) at – healthcare to his new position, and was re- you guessed it – the Institute’s website. cently the recipient of American Cancer Soci- ety’s Donald H. Gemson Cancer Prevention Freshman class – with class and Public Policy Award. “Ed’s appointment The Institute has partnered with the World allows us to focus powerfully on both ends of Bank’s International Finance Corporation the spectrum,” explained the Institute’s presi- and George Washington University to create dent and COO Richard Ditizio, “combining the IFC-Milken Institute Capital Markets Pro- new efforts in wellness and prevention with gram at the university. The goal of this unique our acclaimed ongoing work in promoting initiative is to create a network of skilled prac- medical research and cures.”

The first group of IFC–Milken Institute fellows. courtesy the of courtesy milken institute

Fourth Quarter 2016 95 lists

Not love, but maybe happiness? Norway is the highest income-per-capita country of any real size, but does that make Norwegians the world’s happiest people? Economists used to brush aside such questions as too airy-fairy to merit a response. No more. Indeed, there is now a veritable cottage industry of economists (and other social scientists) ask- ing who’s happy and why. Here, I list the 10 happiest and 10 least happy coun- tries, as measured by Gallup Poll data, along with their per capita incomes, life expectancies and levels of income inequality as reality checks. And I’ve added the United States to the list … just because. To see the full monty, including a se- ries of essays on what it all means, download the latest World Happiness Report. But back to the question: does income buy happiness? Well … yes and no. (What answer did you expect from a two-handed economist?) — Peter Passell

GDP PER LIFE EXPECTANCY INCOME COUNTRY/RANK CAPITA ($) (YEARS) INEQUALITY

1. Denmark...... 45,700 ...... 79.3 ...... 12.0 2. Switzerland ...... 58,600 ...... 82.5 ...... 8.9 3. Iceland ...... 46,100 ...... 83.0 ...... NA 4. Norway...... 68,400 ...... 81.7 ...... 6.0 5. Finland ...... 41,100 ...... 80.8 ...... 5.7 6. Canada ...... 45,600 ...... 81.8 ...... 9.5 7. Netherlands...... 49,200 ...... 81.2 ...... 9.2 8. New Zealand...... 36,200 ...... 81.1 ...... 12.4 9. Australia ...... 47,400 ...... 82.2 ...... 12.7 10. Sweden ...... 47,900 ...... 82.0 ...... 6.2

13. United States ...... 55,800 ...... 79.7 ...... 15.0

148. Madagascar ...... 1,500 ...... 65.4 ...... 19.3 149. Tanzania ...... 2,900 ...... 61.7 ...... 9.3 150. Liberia ...... 900 ...... 58.6 ...... 12.8 151. Guinea ...... 1,200 ...... 60.1 ...... 21.6 152. Rwanda ...... 1,800 ...... 59.7 ...... 18.2 153. Benin ...... 2,100 ...... 61.5 ...... 9.4 154. Afghanistan...... 1,900 ...... 50.9 ...... NA 155. Togo...... 1,400 ...... 64.5 ...... NA 156. Syria ...... 5,100 ...... 74.7 ...... NA 157. Burundi ...... 700 ...... 60.1 ...... 19.3

notes: GDP per Capita is calculated in terms of purchasing power. Inequality is the ratio of the income of the top 10 percent to the income of the bottom 10 percent (higher is more unequal). sources: World Happiness Report 2016; CIA Factbook; United Nations; World Bank

96 The Milken Institute Review