Contents 2 3 5 8 86 95 96

contents

8 der tagesspiegel

2 from the ceo 18 where did all the men go? 3 editor’s note The weaker sex. by Nicholas Eberstadt 5 charticle Population bust. 34 the rigged labor market by William H. Frey Adam Smith would be ashamed. by Alan B. Krueger 8 letter from germany Europe’s conscience? 46 public pension plans by Charles Castaldi A trillion here, a trillion there… by Ed Bartholomew 86 letter from tôhoku Six years after Fukushima. by Ramona Bajema 78 still digging out Palestinian blues. 95 institute news by Jacob Udell and Glenn Yago Busy as ever.

96 lists Two all-beef patties… 59 book excerpt Beating the Odds: Jump-Starting Developing Countries Justin Yifu Lin and Célestin Monga explain why development economists are just plain wrong. Second Quarter 2017 1 from the ceo

In 1998, the Milken Insti- Eric Cantor and then-Senate Majority Leader tute had an idea: what if we Harry Reid shared a stage and discovered that brought together serious, they agreed on much. Or the time former influential people with Vice President Al Gore jauntily dodged a widely varying backgrounds, question by hugging his co-panelist then-Fox but a shared desire to ad- News chief Roger Ailes. dress the world’s most press- But even more satisfying are the moments ing challenges? From that when connections made at Global Confer- acorn has grown a mighty ence led to concrete steps that improved lives. oak in the form of the an- I remember the prominent executive who, nual Milken Institute Global Conference, after learning about the deadly impact of a which in 2017 marks its 20th year. tropical disease, invested considerable time This year, the event will bring 3,500 partic- and resources to conquering it. Or the alter- ipants to Los Angeles from 50+ countries for native energy producer from Israel who met nearly 200 panels and private sessions over representatives from Rwanda, leading to that four days of intense activity. The wealth of country’s first solar energy initiative. Or the discussion, the diversity of our panelists and investment banker who, inspired by the pre- the relentless focus on issues crucial to the fu- sentation of Nobelist Muhammad Yunus of ture of the planet have made the Global Con- Bangladesh’s Grameen Bank, became the ference a vital meeting place for those with founding president of Grameen America, to the mind and the means to make a difference. bringing micro-lending to the United States. From early on, the topics at the conference I am often asked what makes the Global have included: Conference unique, and why has it become • The impact of revolutionary changes in such a success. The answer to both questions technology on the economy – and on our – in part, at least – is that, since its beginning, lives. the conference has emphasized moderated • The promise of biotech and advances in discussion among panelists with varying medical research. views. That’s not only the best way to ensure • How best to create well-paying jobs that lively, substantive exchanges, it’s a metaphor sustain and grow the economy. for a core conviction driving the larger enter- • Educational innovation that keeps Amer- prise of the Milken Institute: the best solu- ica innovative and productive. tions are found when people with different • How to create a financial system that perspectives collaborate to find solutions to works for all. problems that affect us all. Some of my favorite recollections of the Global Conference are the moments when presumed opponents have found common ground. Once, then-House Majority Leader Michael Klowden, CEO

2 The Milken Institute Review editor’s note

Our ever-loyal reader JG of Passadumkeag, Maine, writes to ask why we never publish queries from other correspondents in this space. Good question, JG! Cynics would say it gives us a chance to repeat the charming name of your hometown ad infinitum. But that would be beneath our dignity. And in any event, Passadum- keag’s reign may be ending: we just got mail from a fan in Carne Assada, Portugal, who wonders why everybody misspells the name of her town.

Enough food for thought. Some of our ity, even as they reduce both wages and readers are itching to know what we’ve got employment. “Countering anti-competitive lined up in this issue. employer behavior could be a win-win for the Alan Krueger, President Obama’s former economy,” he writes. “But it would take a fun- chief economist, takes aim at barriers to com- damental shift in perceptions – one that is a stockfood/jeff sarpa stockfood/jeff

Second Quarter 2017 3 editor’s note this pickle, alas, is much easier than whacking to look closely at how everyday labor prac- a pathway out.” tices undermine workers’ prospects for mov- Charles Castaldi, a former foreign corre- ing up the income ladder.” spondent for NPR, samples Germans’ reac- Nick Eberstadt, a political economist at tion to Angela Merkel’s decision to take on the the American Enterprise Institute, ponders mantle of moral leadership eschewed by the the consequences of the great exodus of men United States in the Syrian refugee crisis. from the American workforce, and brain- “Germany’s open door came at a steep cost,” he storms ways to bring them back. “The pro- writes. “First, the direct financial outlay ran to gressive detachment of ever-larger numbers $23 billion – just in 2016. And then there’s the of adult men from the reality and routines of political cost. Most polls show that over half regular paid labor can only result in lower liv- of Germans view the refugee issue as the most ing standards, greater income inequality, serious problem Germany faces today.” higher social-welfare bills and larger budget Jacob Udell and Glenn Yago, of the Milken deficits,” he writes. “The first priority is to Innovation Center at the Jerusalem Institute bring this invisible crisis out of the shadows for Israel Studies, revisit the problem of con- and into the glare of public scrutiny.” structing a viable Palestinian economy from Ramona Bajema, a Japanese historian, re- the ruins of permanent war. “Developments turns to Fukushima six years after the tsunami on the international stage have a way of dis- and the subsequent nuclear power disaster that tracting from solutions to pressing fiscal, killed 20,000 and left the Tôhoku region to face trade, environmental, business and infra- a grim future. “No amount of earth moving structure issues that could improve daily life,” and concrete pouring is going to fix what ails,” they write. “It would serve neither Israelis nor she writes. “What Tôhoku needs most now Palestinians to cling single-mindedly to the is help in adapting to rapid economic and de- goal of European-Union-style integration. mographic dislocation. And that is not an easy Normalization of economic relations be- sell in a contemporary Japan that’s struggling tween Israel and an independent Palestinian with all manner of unwanted change.” state will surely depend on an agreement that Ed Bartholomew, a pension consultant facilitates trade and capital flows, but that who was the CFO of the Inter-American De- need not imply full integration of labor or velopment Bank, explains why the looming capital markets.” pension liabilities of states and localities are That’s not all, folks. In a chapter from their far worse than the officials in charge acknowl- new book, Beating the Odds, Justin Yifu Lin edge, or apparently even understand. “Future and Célestin Monga argue that development retirees are in the uncomfortable position of economics requires a thorough makeover to depending on contractual rights that may re- bring lagging nations into the mainstream. quire courts to enforce – a position made The eminent demographer Bill Frey explains more uncomfortable by the fact that millions why U.S. population growth is heading for of them don’t have Social Security as a back- zero. And your humble editor investigates stop,” he explains. “It’s human nature to delay whether The Economist magazine’s Big Mac difficult decisions, especially if the current Index is a reliable guide to international dif- generation of deciders can dump the deci- ferences in the cost of living. Browse wisely, sions on the next. Figuring out how we got in my friends. — Peter Passell

4 The Milken Institute Review ALEC: Headline is “Population Growth Hits Bottom” Caption for Home page is: “But there’s a silver lining.” charticle Main topic: Demographics Other topics: Immigration Home page and main article page: use the Charticle general image. Use the image on this page for the dedicated article intro by william h. frey

The United States hit a new low in 2016. No, I am not talking about the raucous, divisive election. It’s the demographic nadir we reached, as population growth slowed to just 0.69 percent – the lowest since the Great Depression. That’s down from a peak of 2.1 percent in 1950, when the post– World War II baby boom was in high gear.

The marked decline over the past decade was tied to one short-term factor – the blow- back from the 2007-9 recession – and the long-term reality that America is aging. The recession exerted a double whammy, slowing immigration and narrowing the difference between births and deaths. Immigration has largely recovered, but not the natural increase. Some of the recent fertility decline could prove temporary, though, a recession- related delay in family formation among young millennials. If there’s silver lining in the recent num- The mortality trend, by contrast, is here to bers, it’s the recovery of domestic migration stay. And in the decades ahead, population as victims of the Great Recession again see aging will also lower fertility rates. By 2040, their way clear to chasing a better life in Sun- the Census Bureau projects annual growth belt states. Utah (aided by high Mormon fer- will sink below 0.5 percent. tility rates) tops the list with growth above 2 That figure will still dwarf the rates in percent. But Nevada, Idaho, Florida, Wash- most other rich countries. Some, including ington, Oregon, Colorado and Arizona are all Japan, Germany and Italy, have already en- growing faster than 1.7 percent. tered negative population growth territory – Of course, internal migration is a zero- though Germany may get a temporary boost sum game: for the first time since the 1980s, from its uniquely generous policy toward ref- eight states registered population losses, most ugees (see page 8). notably New York and Illinois. But a restless citizenry is a hallmark of American particu- BILL FREY is a senior fellow at both the Milken Institute larism, and a return to higher migration lev- and the Brookings Institution, and author of Diversity els – when they’re voluntary, anyway – has to Explosion: How New Racial Demographics Are Remaking this page: juice images/alamy; following page: picture fotostock partners/age following page: juice this images/alamy; page: America. be seen as a plus.

Second Quarter 2017 5 ALEC: Use this figure table directly and call it “Frey-William-PopulationBust.”

U.S. ANNUAL POPULATION GROWTH, 1937-2016

2.0%

1.5 PERCENT

1.0

0.5

0 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973

source: William H. Frey analysis of U.S. Census Bureau historical population estimates

6 The Milken Institute Review ALEC: Use this figure table directly and call it “Frey-William-PopulationBust.”

RATES OF GROWTH NET MIGRATION FROM SNOWBELT NATURAL INCREASE AND IMMIGRATION, 2000-2016 TO SUNBELT REGIONS

1.0 600 Population Growth

Natural Increase 400 .6 RATE .4 Immigration 200

.2 NUMBER OF PEOPLE (THOUSANDS)

0 0 2000 02 04 06 08 10 12 14 16 2000 02 04 06 08 10 12 14 16

1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015

Second Quarter 2017 7 letter from germany

ALEC: by charles castaldi Headline is “Letter from Germany” Caption for Home page is: “It’s hard to do the right thing” Main topic:The Europe Stasi headquarters in the former East Berlin stands as a monument to a Other topics: Immigration, Human Capital certain Teutonic penchant for authoritarianism – not to mention as a symbol of the contradictions that abound in modern Germany. A building as imposing as it is plain, it housed thousands of agents who kept track of East Germans at a mind-numbing level of detail. After the Stasi files were opened, the scope of the surveillance was revealed: it seemed almost the entire East German population was spying on itself.

On the top floor of the principal building, known as “the man without a face.” Widely I walk through a metal door constructed to considered one of the most effective spies of thwart electronic eavesdropping and into the all time, he was only identified following the office of Markus Wolf, the mythical spy reunification of Germany, after which he managed to avoid any meaningful prison time. He subsequently embarked on a writing CHARLES CASTALDI, a former NPR correspondent, is a

regular contributor to the Review. career that included (along with his memoirs) images wolfgang kumm/afp/getty

8 The Milken Institute Review Secrets of Russian Cooking, in which he drew a human wave that has swept over a largely un- parallel between the culinary arts and espio- prepared Europe over the past few years. nage. Needless to say, both the Russians and “Right now we have around 1,000 refugees the Germans are better known for the latter. housed here,” Zick notes. His tone is matter of Looking out the window onto the court- fact, but it’s clear this is an arduous undertak- yard nine floors below, I can see children ing. And over the past few years, I’ve run into playing soccer. They scream for the ball in Ar- a surprisingly large number of people pre- abic and Pashtun: the Stasi building has been pared to make similar commitments all over turned into a refugee shelter. Germany. When they were confronted with The symbolism is not lost on Hartmut “the pain and the problems of the refugees, we Zick, a 50-something ponytailed native of knew we must help,” Zick says. Berlin who manages this center. “We saw the While other European countries have been misery, the need,” he says. “To be able to use generous, Germany is unique in the number this building, of all places, made it especially of refugees it has accepted and the scale of the significant.” The building had been unoccu- government and volunteer programs created pied until a benefactor bought it from the city to aid them. Of course, this has generated a

for one euro and, instead of turning it into a backlash. But I was struck over and over again condo, transformed it into a refugee shelter. by the number of people willing to step up. We wander through corridor after corridor The refugee crisis grew to massive propor- of offices that now serve as tiny apartments for tions in 2015, after Chancellor Angela Merkel four. There are classrooms for German lessons, declared that Germany would have an open- and art projects on the walls. The languages – door policy and more than a million people

der tagesspiegel and the faces – reflect the huge and varied took her up on the offer. The pictures of people

Second Quarter 2017 9 letter from germany Before leaving the Stasi building, I run dying by the thousands in Mediterranean wa- into Diab, a 30-year-old refugee from Syria, ters spoke of the desperation of those escap- who’s come to visit a friend. Diab left Damas- ing wars and poverty. For many, Germany cus alone in 2015 and made his way through was the destination of choice for its strong Turkey, Greece and the Balkans before reach- economy and generous government support ing Germany four months later. “Even when system. But it was hard to reach, protected by it looked impossible,” he says, “I always told a ring of less-welcoming countries on its myself I would make it.” southern border. In a sense, Diab is lucky. He is educated, he Germany’s open door came at a steep cost. worked as a banker, his family pitched in to First, the direct financial outlay ran to $23 bil- help pay for his journey, which he says cost lion – just in 2016. And then there’s the polit- “many thousands of dollars.” And he was able ical cost. Most polls show that over half of to find an apartment, which he shares with Germans view the refugee issue as the most four other Syrian men, after spending only six serious problem Germany faces today. And months in the shelter. He studies German six even though Merkel’s approval ratings have hours a day – “such a hard language,” he says remained above 50 percent, her Christian – and hopes to get a master’s in finance. Democratic Union lost ground in Berlin state Diab is also Christian – something he kept elections in 2016 to the Alternative for Ger- secret in the shelter. “Most of the people here many, a right-wing party headed by Frauke are Muslim,” he says in a whisper. “They are Petry. Petry’s platform, beyond pulling Ger- very, very religious – very old fashioned.” many out of the EU, focuses on closing the Zick confirms this, adding that a great door to more refugees, particularly those majority are from the poorer, less-educated from Muslim countries. Sound familiar? strata of their respective countries. Indeed, Merkel, who is sometimes referred to as part of what makes the refugee crisis so “leader of the free world” in the wake of Pres- thorny is that ISIS is drawing recruits from ident Trump’s election, is, at this point, the the same strata. And even Germany now faces key player in keeping the European Union a very real threat from terrorists. Germans together. aren’t likely to soon forget the Dec. 19 attack There’s some irony here: a few years ago in Berlin by a Tunisian who drove a truck she was widely condemned for destabilizing through a crowded traditional Christmas the EU by taking a hard line on the fiscal prob- market, killing 12 and wounding 60. lems of Greece (and Portugal and Spain and Italy). But she’s since been openly critical of worms Trump’s immigration policies and Vladimir Over the past couple of years I’ve driven Putin’s efforts to divide the Western alliance, thousands of miles around Germany (which, and she offered no solace to Brexit promoters on autobahns – a few of which still don’t have who think they can convince the EU to main- speed limits – takes less time than you might tain open trade with Britain once the U.K. jet- suppose). After a while, the fact that it’s one tisons open immigration. Merkel is still of the most developed countries in the world favored to be re-elected later this year. One becomes manifest, whether in infrastructure can only hope that German pollsters are more that makes the United States look shabby or accurate than their American counterparts. in renewable energy – wind turbines and

10 The Milken Institute Review solar panel arrays are to be seen everywhere. German economy. Sure, we all know about And just as obvious as what you see is what the Volkswagens and the Siemenses and their you can’t see: poverty, which is not to say that global market dominance. But smaller com- it doesn’t exist. But it’s German poverty, a far panies produce half of Germany’s $4 trillion cry from the American variety, because the GDP and are credited with much of the ro- German safety net is much more generous bustness of the German economy. and encompassing. I ran (literally) into an example in Worms, What is less obvious until you travel off a picturesque town of 85,000 on the Rhine the beaten path a bit is that Germany remains that vies with Trier for the title of oldest city a nation of small and midsized towns sur- in Germany. The Celts founded it, Romans rounded by a surprising amount of agricul- built it up, Jews turned it into a cultural ture. Only four cities – Berlin, Hamburg, mecca and Luther took his stand against the Munich and Cologne – have over a million Catholic Church here. Jogging out of the old inhabitants. Compare that to Italy, which has city toward the Rhine brings me to an indus- 10 cities with over a million, yet a total popu- trial area where I meet Timo Bernhard, who lation that’s 20 million smaller, and you get is monitoring a barge that is unloading ingots the picture. Indeed, it is a surprisingly bucolic of what appear to be metal. picture, even if agriculture represents a mere “Plastic,” he corrects me drily, when I ask 2 percent of GDP. what the steel is for. Undaunted, I ask what Interspersed in this mostly rolling land- the plastic is for. He eyes me warily and sud- scape are midsized businesses – called mittel- denly switches tone – which Germans will do sven martson/thesven image works

Second Quarter 2017 11 letter from germany “I didn’t even vote for Merkel,” she adds, clueless – and delivers a detailed description “but after her courageous stand on the refugees, of the specialized plastics needed to make I am prepared to vote for her next time. Here precision-machined plastic parts. in Worms, as in the rest of Germany, there are Bernhard and his brother own a small people who are against refugees and immi- company with 34 employees that exports grants. That is why I use my pulpit to get out much of its output. “Nobody makes parts the word, to stay ahead of the curve.” with such precision, such resistance,” he says. But while many churches in Germany “We are having to say no to many inquiries.” have been active in supporting refugees and Both brothers learned their trade across building relations with mosques, the hard re- the street from the docks where we’re stand- ality is that German natives are becoming less ing, as apprentices in Rochling Automotive, a and less religious. And the churches, be they much larger family-owned company that Protestant or Catholic, are struggling to at- makes – you guessed it – plastic parts for cars. tract young parishioners. “Ironically, I think “We learned on the job, starting at the bottom,” the refugee crisis has served to get more peo- Bernhard says. ple interested in coming to church,” Herbert That is another keystone of the German says. “They see this as a place where we can economy, and mittelstand in particular: ap- build community.” prenticeships to produce a highly skilled labor force. I ask Bernhard if he has any invited guests workers who are immigrants. “Of course,” he The Holocaust is the tectonic horror that un- says. “Very good workers. From Turkey. Not derlies any discussion of assimilation or of like these ones coming in now, who just want German identity. What greater failure of as- the government to pay for everything.” similation could there be than taking a popu- When I mention Merkel, he frowns. “A big lation of half a million of its own citizens who mistake,” he says. “Letting in all these people. happened to be Jewish, forcing more than Most of them aren’t educated. How will they half into exile and exterminating the remain- get jobs?” I ask whether he’ll vote for the anti- ing 180,000? immigrant Alternative for Germany in the After the war, Germany and its industries next election. He gives me a look, which I take lay in ruins, but the combination of Ameri- to be my cue to leave. can cheerleading, currency reform and Chan- Later that evening I am dining with Jutta cellor Konrad Adenauer’s careful economic Herbert, the pastor of Magnuskirche Lu- management created what came to be known theran church, where Luther himself is said to as the economic miracle. Construction of the have preached. Herbert is a voluble woman in Berlin Wall in 1961 and the restrictions it im- her 60s who explains that the challenge in posed on East Germans crossing to the West Worms, which has taken in 400 refugees from created a labor shortage. The German gov- Syria and North Africa, not to mention the ernment turned to Turkey – not so surprising, challenge to the rest of Germany, is twofold: since the Ottomans allied with Germany in “We’ve had a Turkish community here for World War I – inviting Turkish laborers to many years. They have been assimilating, es- come to Germany as “guest workers.” pecially the children. But it hasn’t been easy While they were expected to remain only for all of them. temporarily, it didn’t turn out that way. Today,

12 The Milken Institute Review Today, about four million people of Turkish descent live in Germany. It’s a relationship that remains fraught, and serves as something of a litmus test for how newer immigrants will fare.

about four million people of Turkish descent are German citizens. Molthagen explains that live in Germany. It’s a relationship that re- until 2000, obtaining German citizenship was mains fraught, and serves as something of a very difficult. “This was a watershed moment,” litmus test for how newer immigrants will fare. he says. “Germany accepted being a country I went to Berlin’s Friedrich Eberts Founda- of immigrants. tion to talk to Dietmar Molthagen, a specialist “The Turkish government also made it dif- in immigration. “Germany has a very compli- ficult,” he says, because Turks were not al- cated history with foreign workers,” he says. lowed to have dual citizenship. “So there are “Apart from the terrible things that happened Turkish guest workers who have lived here for with the Nazis, there have been waves of bring- 50 years who don’t have German citizenship ing people in and then pushing them out. In because they say they don’t want to give up the case of the Turks, there were long debates being Turkish.” about whether to let them stay or send them There are plenty of shining examples of as- back, but most of them ended up staying.” similation, Molthagen points out, but he sees Staying, however, does not necessarily trouble on the horizon. “The connection to

martin meissner/associated press martin meissner/associated mean assimilation. Today, only half of them the old country has been growing in the last

Second Quarter 2017 13 years, and that can be attributed to Erdogan,” When he changed the law and made it possi- he says, referring to Recep Tayyip Erdogan, ble for Turks living in Germany to be able to the strongman president of Turkey. vote in Turkey, Germany became a campaign Over the past few years, Erdogan has made battleground.” many incendiary statements: calling for Turks Later that evening I found myself being in Germany to learn Turkish first, attacking guided around Berlin by Luis Carlos Kliche. It German immigration laws as racist and tell- was almost midnight as we walked through ing Turks to resist assimilation. He even cam- an eerily deserted Checkpoint Charlie, a more paigns in Germany for the substantial bloc of appropriate atmosphere than the usual day- Turkish votes there. time circus of tourists. Luis Carlos studies in- His relationship with Merkel appears to be ternational relations at the prestigious Freie based more on mutual need than on mutual Universitat Berlin. His father is German and respect. Last year they negotiated a deal his mother is from Nicaragua. He is equally at whereby Erdogan would stem the flow of ref- home in the languages and cultures of both ugees leaving Turkey for Europe in exchange countries. But he clearly looks Latino, and for eliminating visa requirements for Turks this, he says, often marks him as an outsider and providing his government with over $3 to Germans. billion to mitigate the cost of housing mil- “Look, it’s not the case across the board, lions of refugees. But Erdogan periodically but the fact is that if you’re dark-skinned threatens to torpedo the deal. you’re not really considered German,” he says. “The Turkish government has always been “In a sense, for me it’s a bit easier because I do very involved with the Turkish community think of myself as partly German, but for im- here,” Molthagen says. “This was never seen migrants who have no German roots, it’s

as a big problem in Germany until Erdogan. much harder.” kai loeffelbein/laif/redux

14 The Milken Institute Review Kliche is not sanguine about the prospects Between coughing fits and the laughter of that immigrants from the Middle East and my hosts, I manage to steer the conversation Turkey have in becoming assimilated Ger- to their experience in Germany. Mahmoud mans. “Sure, it’s possible, but look at what’s Shadid is the owner of the store. He’s 54, happening here in Berlin,” he says. “Many of Egyptian and he’s been in Germany almost 20 these people live in enclaves with their ex- years. “I was in Cairo five years ago,” he says. tended families. How are they going to assim- “Horrible. I couldn’t take it. The dirt. The ilate that way?” chaos. I was happy to see my family, but I love He says the one group that has managed Berlin.” more than others is the Vietnamese. “I think Shadid says his business selling hookahs I have more Vietnamese in my classes than and tobacco is thriving, especially with the ar- people of Turkish descent,” he says. In fact, rival of new immigrants from the Middle the Vietnamese who came after the fall of Sai- East. “Even young Germans are trying it,” he gon are widely considered an immigrant suc- says proudly. But when I ask him if he feels cess story. But those who came from North German after being here so long, he’s em- Vietnam to East Germany, where they were phatic: “No. I will never be a German. Maybe not taught German and largely left to their my children. They only speak German. Very own devices, have remained much more mar- bad Arabic. But it’s hard. Look at us. To Ger- ginalized after German unification. mans, we don’t look German.” The following evening, after a dinner in an He points to his friends, a newcomer from Afghan restaurant with Kliche, I walk alone Syria and a Turk who was born in Berlin. down Karl Marx Strasse in the Neukolln They continue to ply me with different flavors neighborhood, one of the hippest in Berlin. of tobacco, and as I hover between a nicotine This place has a very different feel from what high and nausea, the Syrian (named Nizar), I’m used to in Germany. Statistically, the who seems younger than the other two, says, neighborhood is supposed to be about half “I would like to come to America. I have fam- people of foreign extraction – the definition ily. Iowa. Sidrah Rapids. They are Americans. of this is not exactly clear. But at night it They like it very much.” seems like the more Germanic-looking people fade away. And when I stop in front of an south berlin Arab market to look at the hookahs in the I drive south of Berlin, where I’ve agreed to window, I find myself being stared at by three meet Alexander Belmadi outside Tempelhof men inside the store. Airport, a Cold War icon when it served as the The store appears to be closed, but proba- hub for the Berlin airlift in 1948. It was con- bly because I look in wonder at the elaborate verted into a refugee center in 2015 after hav- hookahs, one of the men comes out to the ing been abandoned for years. street to ask if I like them. In short order I am “The term of art here in Germany is not as- inside; they quickly identify me as an Ameri- similation, but integration,” he says. Belmadi can and begin to load a hookah with intimi- has worked with refugees for two years now. datingly dark tobacco. It is as much a dare as He’s a dual citizen – his father is French and an invitation, but many adolescent experi- his mother German. ences with bongs delude me into thinking I’ll “The concept of integration is a bit of a be OK. joke, to tell the truth,” he says. “Politicians talk

Second Quarter 2017 15 letter from germany course it’s going to work,” Belmadi says. in terms of ausbildung, meaning you learn a “There’s no other choice. We’ll all adapt.” trade as an apprentice and get a job in a fac- tory. We are very proud of this model, but for trump’s shadow most it just doesn’t work. Learning this lan- Near the end of my last visit to Germany, I sat guage is very difficult to begin with. On top of with Konrad Litschko, a young journalist who that, they’re traumatized. Every day they are works for the left-leaning Die Tageszeitung thinking of the family members they’ve left newspaper. He covers the right-wing parties behind.” He says only a small percentage ac- including Alternative for Germany (AfD) and tually thrive in the system. Pegida, which is an ultranationalist party Beyond the fact that most refugees have founded in 2014 whose less-polished core very little education, Belmadi thinks Ger message is rabidly anti-Muslim and anti-im- man society poses its own challenges. “Unlike migrant. AfD goes to great lengths to stress the French, the Germans have no colonial it’s different from Pegida, but there has been history,” he says. “They’ve never internalized overlap in membership and discourse. the fact that a German can have something The right tends to draw more support in other than white skin and blue eyes. So you areas like Saxony, once part of East Germany, can be integrated, but you are integrated as which still suffer from higher unemployment a foreigner.” and poverty rates. A poll taken at the end of And in what is quickly becoming a com- last year in Saxony showed 25 percent would mon refrain, he points to the Turkish com- vote for Alternative for Germany in the next munity. “Most Turks have never been initiated elections. Attacks against immigrants have into the German concept of consensus, which risen sharply in the past two years, especially is so fundamental,” he says. “Erdogan has en- in cities, including Dresden and Leipzig. ergized part of the community here, and that, “There are also plenty of places in West Ger- in the eyes of Germans and assimilated Turks, many where the right has made inroads,” makes them look like foreigners. They are Litschko acknowledges, “but the numbers supportive of a dictatorial regime, which here tend to be quite small.” in Germany, considering the Nazi past, is an One can’t help worrying that this could extremely delicate issue. It’s like betraying the change. When hundreds of men of largely new Germany.” North African and Arab descent sexually ha- So what does it mean to be German? I ask. rassed as many as 1,000 women in Cologne’s “It’s a difficult question that in the end means train station on New Year’s Eve 2015, the reac- very little,” he answers. “In France, in the U.S., tion was swift – and not just from the right. you can ask that question and get lots of dif- “What happened in Cologne was a watershed ferent answers. But here the question creates moment,” Litschko says. “All the polling shows anxiety, and in the end I don’t think there’s a big change in attitude after that. And even any answer beyond living in Germany. It’s though it later came out that some of these about everyday life, going to your job, having men were not refugees and that there are all friends.” And in another common refrain, sorts of sexual harassments done by Germans after running through the litany of problems at Oktoberfest, the debate had begun.” Germany faces with its immigrant and refu- Even Chancellor Merkel, the architect of gee community, there’s the upbeat coda. “Of the open-door policy, has backpedaled a bit,

16 The Milken Institute Review After running through the litany of problems Germany faces with its immigrant and refugee community, there’s the upbeat coda. “Of course it’s going to work … there’s no other choice. We’ll all adapt.”

vowing to limit the number of refugees this they look at Trump, and they are thinking year, hurrying the process of deportation for their moment has come. those who don’t qualify and calling for a ban “The right is clearly gaining ground,” he of the burqa. “The full veil is not appropriate says. “Still, a large majority of Germans say here. It should be banned wherever it’s legally they support liberal democratic values. So possible,” she said last December. even though there is a shift, I don’t see it hap- The burqa-ban proposal is likely no more pening as fast or as profoundly as in the U.S.” than posturing for her conservative base, since Judging from my recent travels through the German media was unable to find any evi- Germany, I’m inclined to agree. But as we’ve dence of women wearing a full veil anywhere learned, democracy is fickle and unpredict- in Germany. One does see plenty of drab black able. Germany, in spite of its past, now serves abayas, but the face is left uncovered. as a beacon for Western democratic values. Now, to further complicate matters, comes Those values were plainly evident in Merkel’s Trump. “Petry was one of the first in Germany open-door refugee policy, even if the policy to publicly congratulate Trump,” Litschko fell short on the issue of bringing along pub- says. “It isn’t just about going against immi- lic opinion. In the end, the question remains grants, but also going against the establish- unanswered: what does it mean to be

sean gallup/getty images sean gallup/getty ment – what she calls the Merkel regime. Now German?

Second Quarter 2017 17 18 The Rise of Rise The ALEC: The Milken Institute ReviewInstitute Milken The Where Headline is “Where Did theMenAll Go?” Main topic: Demographics by nicholas eberstadt Other topics: Human Capital, Job Creation Caption for Home page is: theunworking” of rise “The the Men Go? Men Did All the All Did

Un working

tk tk

Second Quarter 2017 19 While there are a dozen plausible reasons for the shocking result of the 2016 presidential election, the discontent of white men lacking college degrees ranks high on most lists. And no small part of that discontent is linked to their diminishing role in the workplace.

Over the past two generations, America 2016, household and nonprofit net worth Whas suffered a quiet catastrophe in the col- soared from $44 trillion to just over $90 tril- lapse of work for men. In the half-century lion, while the work rate (for both genders between 1965 and 2015, work rates (the ratio combined) fell by five percentage points – lev- of employment to population) for the Ameri- els last recorded three decades earlier. can male spiraled relentlessly downward – a That contrast offers insight into a number seeming flight from work in which ever- of overarching features of our time, including greater numbers of working-age men exited rising sentiments of anger and despair – and the labor force altogether. America is now the increasing attraction of both right- and home to an army of prime-working-age men, left-wing populism. It also helps to explain some seven million of them ages 25 to 54, why majorities in public opinion surveys tell who no longer even look for work. Consider pollsters that America is still stuck in the a single fact: in 2015, the work-rate of males midst of a recession in spite of the reality that aged 25 to 54 was slightly lower than it had the officially recorded unemployment rate been in 1940, when the official unemploy- (4.7 percent as of January 2017) is close to the ment rate was 14.6 percent and the United record lows enjoyed in 2000. States was just coming out of a decade of de- However problematic America’s employ- pression in which the search for work was ment profile may appear to the unaided eye, usually futile. trends for America’s men are yet more dismal. And the cloud is hardly a passing one: Be- by the numbers tween 1948 and 2015, the work rate for men To understand what’s happened and why, 20 and older (all postwar employment data some perspective is valuable. For good or ill, are for the civilian noninstitutionalized pop- America is living through a period that I ulation) fell from 85.8 percent to 68.2 percent would describe as a second gilded age. Some- – a drop of almost 18 percentage points. To how, in spite of lackluster growth by historical put it another way: while many economists standards, the 21st-century American econ- argue that the economy is currently at or omy has managed to produce markedly more near “full employment,” the work rate for wealth for its elite, even as it generated mark- men 20 and older was over a fifth lower than edly less employment for its workers. Between it was in 1948. the third quarter of 2000 and third quarter of Of course, this particular measure includes men 65 and older – that is, those of traditional retirement age. But the trend doesn’t NICHOLAS EBERSTADT holds the Henry Wendt chair look very different when the rapidly growing in political economy at the American Enterprise Institute 65-plus population is eliminated from the in Washington. This article is adapted from his book, Men

Without Work: America’s Invisible Crisis. reckoning. By 2015, nearly 22 percent of the times jansen-lonnquist/theian york thomas new page: previous

20 The Milken Institute Review age 20-to-64 group of men was reportedly Here’s another way of thinking about the not engaged in paid work of any kind. This current work deficit for men. One reasonable was nearly 12.5 percentage points more than benchmark for measuring that gap is the the 1948 level – meaning the fraction of men mid-1960s, when U.S. labor markets were ap- ages 20-64 not at work was more than twice parently functioning at genuinely full em- as high in 2015 as in 1948. As for prime-age ployment levels. If age-specific work rates men – the 25-54 group, the segment for had simply held constant from 1965 to whom paid employment has always been today, another 10.5 million men age 20-to-64 highest – work rates sank almost 10 percent- would have had jobs in 2015 – including an age points in the same period, from 94.1 per- additional 6 million in the prime 25-to-54

ashley ashley gilbertson/vii/redux cent to 84.3 percent. group.

Second Quarter 2017 21 PERCENTAGE OF CIVILIAN NONINSTITUTIONAL Two big postwar changes in the American PRIME-AGE MALE POPULATION WITHOUT labor market suggest the answer. The first was PAID EMPLOYMENT, 1948-2016 the epochal transformation in the nature of 20% women’s work. Before World War II, the ex- clusive economic activity for the overwhelm- 18 ing majority of American women was unpaid 16 labor at home. Today, the overwhelming ma-

14 jority of women – including those with relatively young children – engage in at least 12 some remunerated employment. And this

10 long upsurge of employment for women has ALEC: effectively disguised the steady decline in Use8 “Eberstadt-Nicholas-Men-Chart1” for work for men, both by generating new sources the web 6 of household income and by replacing men who once held jobs. 4 Second, for complex historical reasons, a PERCENT OF MEN WITHOUT PAID EMPLOYMENT PAID WITHOUT OF MEN PERCENT 2 caste of men has arisen that finds it socially acceptable and financially possible to scrape 0 1950 1960 1970 1980 1990 2000 2010 by in an employment-free existence. Not only are these men not actively looking for work, source: Bureau of Labor Statistics, Current Population Survey but for the past two decades only a small mi- nority of them have reported they are out of Yes, there is one important respect in the labor force because they cannot find jobs which the 10.5 million figure overstates to- (the classic definition of a “discouraged day’s work deficit. It does not take into ac- worker”). Thus, in effect, this flight from count the steady increase in education and work has been possible to ignore because it training for adult men over the past five de- has ostensibly been voluntary. cades. But the magnitude of the relevant ad- Until roughly the outbreak of World War justment is not especially comforting. Census II, the overwhelming majority of nonfarm Bureau data suggest that adult schooling cur- working-age men in the United States were rently takes about a million more working- either working a paid job or looking for one. age men out of paid employment than if There was no third way for healthy, able-bod- 1965-era adult enrollment ratios still pre- ied males. In our America, by contrast, the vailed. So the corrected gap for 2015 is “only” taxonomy of employment includes a third 9.5 million male jobs. category: neither working nor seeking work. The rise of the unworking American man out of sight underscores the deeply antiquated and mis- The devastating drop in employment for leading nature of our primary measure of American men over the past two generations labor-market health: the unemployment rate. presents us with something of a dog-not- By that hoary yardstick, the employment situ- barking question. How can so many millions ation for prime-age men in 2015 and early be absent from payrolls with so little conse- 2016 looks pretty good. But the unemploy- quent sociopolitical upheaval? ment rate, which calculates the percentage of

22 The Milken Institute Review F or complex historical reasons, a caste of men has arisen that finds it socially acceptable and financially possible to scrape by in an employment-free existence.

people in the labor force who are without out of work but looking for a job. At no point work but seeking jobs, was devised in an age in the past two decades – not even during the in which mass withdrawal of working-age Great Recession – have the unemployed ex- men from the labor force was inconceivable. ceeded the economically inactive among Between 1965 and 2015, the number of American prime-age men. prime-age men neither working nor looking America’s declining male labor-force par- for work grew more than three times faster ticipation rate is not typical of modern West- than the number in the workforce. Indeed, ernized societies. While there has been some the economically inactive have come to decline in the postwar prime male labor- eclipse the unemployed as the main category force participation rate in all of them, the of men without jobs. By 2015, in any given flight from work has been more extreme in month, there were on average three “unwork- America than in almost any other economi-

danny wilcox danny frazier/redux wilcox ing” prime-age men for each prime-age man cally advanced democracy. Today, America is

Second Quarter 2017 23 the unworking likely to be not in the labor force than others. 22nd out of 23 in prime-age male labor-force The overrepresented groups include the participation, underperformed only by Italy. American-born (as opposed to immigrants), individuals with less than a high school edu- digging down cation, the unmarried, those without chil- Purely as a matter of arithmetic, the collapse dren and blacks. of work among American males is largely due This suggests that broad social forces are at to the rising numbers of men no longer seek- work here. Such a formulation, however, can ing jobs. Between 1965 and 2015, the prime lead to the conclusion that individual prime- male exodus from the labor market accounted age men have no role in determining their life for fully seven-eighths of their total work- outcomes. And this is manifestly not the case. rate decline – and unlike withdrawal from the Consider race and ethnicity first. The re- labor force at older ages, a mass withdrawal sidual legacy of prejudice and discrimination from the workforce in the prime of life can- might seem to explain why prime-age male not plausibly be attributed to retirement. work rates and workforce participation rates Who are these seven million men who are lower for blacks than whites. But this have left the workforce in what should be doesn’t explain why work rates and labor- their prime working years? As one might force participation rates for white men today imagine, a pool of seven million is large are lower than they were for black men in enough to include all sorts of people. But 1965, at the end of the Jim Crow era. Nor does some groups of prime-age men were more it explain why labor participation rates of prime-age married black men are higher than LABOR-FORCE PARTICIPATION RATE FOR MEN AGES those of never-married white men of those 25-54 BY MARITAL STATUS AND RACE same ages. Consider education next. Important as the 94% advantages of education plainly are, we can Married black also see how behavior and choice also affect 92 labor-market outcomes for men. For prime- age men with less than a high school degree, 90 labor-force participation rates today are roughly 20 percentage points higher for those 88 ALEC: who are married than for the never-married. So consequential are the correlates of mar- 86 Use “Eberstadt-Nicholas-Men-Chart2” for the web riage that workforce participation rates for prime-age men today are essentially indistin- 84 Never-married white guishable for married high school dropouts LABOR-FORCE PARTICIPATION RATE RATE PARTICIPATION LABOR-FORCE and never-married college graduates. 82 Now consider nativity. Regardless of ethnicity, prime-age male immigrants are more 0 likely to be in the workforce than their native- born counterparts. In fact, native-born white Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Jan 16 men are now less likely to be in the workforce source: Bureau of Labor Statistics, Current Population Survey than black men born in other countries.

24 The Milken Institute Review Moreover, foreign-born prime-age male high speak tellingly to motivation, aspiration, pri- school dropouts – a disadvantaged group if orities, values and other intangible character- ever there was one – have labor-force partici- istics that do so much to explain real-world pation rates very close to those of highly ad- achievement. vantaged native-born male college graduates, with whom they arguably share very little the economist’s perspective save their exceedingly low odds of being out Why have prime-age male labor-force partici- of the workforce. pation rates dropped so steeply over the past Why are married men and foreign-born two generations? Economists are inclined to men more likely to be in the labor force (and approach this question by parsing the prob- also to find work), all else being equal? A lem into subsidiary components: demand- wedding ring does not confer innate social side effects (fewer jobs available), supply-side advantage in the competition for jobs; neither effects (less willingness to work at a given does a green card (as opposed to citizenship). wage) and institutional effects (barriers to

steven st. steven john/the new york times Rather, marriage and migration decisions employment for those willing to work).

Second Quarter 2017 25 A recent report by the President’s Council technological advances and globalization, of Economic Advisers offers a thoughtful pre- including import competition and offshor- sentation of the demand-side explanation, ing. … Some economists point to “skill-biased technological change:” advances that benefit focusing particularly on the evidence for de- workers with certain skills more than others. … creasing demand for less-skilled labor in These forces have, among other things, elimi- postwar America: nated large numbers of American manufactur- Economists do not have a singular answer for ing jobs over a number of decades … leaving why demand for lower-skilled and middle- many people – mostly men – unable to find skilled labor is falling. Possible causes include new ones. henning bode/laif/redux

26 The Milken Institute Review Most economists would agree that these RATE OF NON-LABOR-FORCE PARTICIPATION, 1965-2016 structural changes have depressed the de- MALES 25-54 YEARS OF AGE mand for labor – especially for less-educated 14% labor – in the postwar era. The subtler question, however, is quantitative: how much of 12 the overall men-without-work problem do these demand-side factors explain? 10 There are reasons to suspect that structural changes may have had less impact than 8 is widely believed. The first is the uncanny ALEC: linearity of the decline in labor-force partici- Use “Eberstadt-Nicholas-Men-Chart3” for pation rates for prime-age American men: 6the web The great male flight from work has traced out something like a straight line downward 4

for the past half-century, apparently almost RATE PARTICIPATION NON-LABOR-FORCE totally uninfluenced by the business cycle or 2 secular changes in the tempo of economic growth. Second, demand-side effects clearly 0 do not affect all lower-skilled men. Today an 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 extraordinary 24 percentage point gap sepa- rates foreign-born and native-born prime source: Bureau of Labor Statistics male labor-force participation rates for prime male high school dropouts. income of their own these days, they are not Then there is the curious question raised entirely without means. According to the by regional disparities in prime male labor- Census Bureau, households in which a prime- force participation rates. One might expect age male was not in the labor force averaged that regional differences would diminish with $37,000 in annual resources in 2014 – just time, as labor markets sought equilibrium about the same as for homes with working after demand-side shocks. But state-level dis- men, and actually more than for homes of parities in that group have been rising, and unemployed men. steadily so, for the past three and a half de- In addition to being supported by their cades. Moreover, some of the states with the women and by other members of their house- very highest prime-male inactivity levels hap- holds, unworking men today are substantially pen to be right next door to some of those subsidized by Uncle Sam. Indeed, a standard with the lowest levels: West Virginia (20.3 federal government source, the Census Bu- percent in 2014) borders Maryland (8.7 per- reau’s Current Population Survey, notori- cent), Maine (14.3 percent) borders New ously underestimates the dimensions and Hampshire (8.8 percent), and so on. magnitude of such public largesse. A 2015 What, then, is the evidence for “supply- study by Bruce Meyer and Nicholas Mittag of side” explanations – changes in preferences the University of Chicago, for example, used and incentives that encourage men to with- New York City’s administrative records to hold their labor? Even though unworking check the accuracy of the survey’s informa- prime-age men report practically no earned tion on welfare benefits for low-income

Second Quarter 2017 27 MALES 25-54 UNEMPLOYED VS. NOT IN LABOR FORCE JANUARY 1948-MAY 2016, SEASONALLY UNADJUSTED

8,000

7,000 ALEC: 6,000 Use “Eberstadt-Nicholas-Men-Chart4”Not in forlabor force 5,000 the web

4,000

3,000

POPULATION (THOUSANDS) POPULATION 2,000

Unemployed 1,000

1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 source: Bureau of Labor Statistics, Current Population Survey

Disability benefits constitute a major source of public support — and an increasingly important source of support — for working-age men not in the labor force.

households. They found that the survey’s head men appears to have risen substantially over count of program beneficiaries missed “over the past generation. Since 1985, the propor- one-third of housing-assistance recipients, 40 tion of homes with men not in the labor force percent of food stamp recipients and 60 per- that obtained at least one means-tested ben- cent of TANF [temporary assistance for needy efit jumped by nearly 20 percentage points – families] and general-assistance recipients.” much more than for homes with prime-age A better source for information on govern- men who were unemployed but looking for ment benefits may be the Census Bureau’s work, to say nothing of homes with working Survey for Income and Program Participa- men in them. tion. According to this source, as of 2013, Disability benefits also constitute a major over three-fifths of prime-age men not in the source of public support – and an increas- labor force lived in homes that relied on at ingly important source of support – for least one means-tested program for income. working-age men not in the labor force. Alas, Some 41 percent of these men lived on food there is considerable uncertainty and even stamps, while just over half reported using confusion about the true extent of the depen- Medicaid, a noncash benefit program. dence of such men on disability programs. Means-tested benefit dependence for these There is no central authority keeping track

28 The Milken Institute Review of America’s many disability programs (most ment-disability program. That share was notably Social Security Disability Insurance, nearly 20 percentage points higher than in Supplemental Security Income and veterans’ 1985. Roughly a quarter of these same men disability) and the many hundreds of billions reportedly received such benefits from two or of dollars every year that they dispense. But more programs. Nearly two-thirds of prime- the Census Bureau’s survey does offer a age men in that category live in homes that glimpse. get at least one disability check. Moreover, According to that survey, in 2013 some 57 there are reasons to believe that the Census percent of prime-age unworking men were Bureau survey’s numbers understate the true

nina berman/noor/redux getting benefits from at least one govern- extent of such dependence.

Second Quarter 2017 29 To be clear, prime-age men in America who namic underlying the great male flight from are not in the labor force do not typically enjoy work. And yet, even after taking account of lavish lifestyles. But their living standards may the impact of demand-side and supply-side not be as penurious as some assume, either. effects, we are still left with something of a And the evidence suggests their living stan- mystery. dards have been rising steadily. I do not America has the rich world’s very worst contend that the greater availability of social- record of prime-age male workforce partici- welfare benefits (including disability benefits) pation declines, even though many other af- has caused the great male flight from work. fluent democracies have weaker growth rates What is incontestable, though, is that these (think of demand-side effects) and more- benefits have in some measure financed it. generous welfare states (supply-side effects). Changes in mores and incentives – supply- Surely something else must also be at play in

side effects – are thus clearly part of the dy- this grim drama. justin cook/redux

30 The Milken Institute Review PERCENT OF MEN (30-54) OUT OF THE LABOR FORCE BY ETHNICITY, EDUCATION AND CRIMINAL JUSTICE SYSTEM HISTORY (2013)

30%

Total No incarceration or arrest 25 No incarceration ALEC: At least one arrest At least one incarceration 20 Use “Eberstadt-Nicholas-Men-Chart5” for the web

10 NOT IN THE LABOR-FORCE RATE THE LABOR-FORCE IN NOT

0 All White Black Hispanic Less Than High School Some College Bachelor’s High School Degree source: Felony Conviction Rates: Table 4, Percent of Men Out of the Labor Force Using the LFSY79, Price et al., July 2016

That something is what economists wonk- conviction or prison time in their back- ily describe as institutional barriers. Start with ground) roughly quadrupled between 1980 the fact that the past half century has seen an and 2010 – from 5 million to nearly 20 million. explosive rise in criminal sentencing and in- Given the flow of sentencing since then, we carceration in America on a scale unlike any- might expect that population to have topped thing witnessed in other Western societies in 23 million by now. And since roughly two and modern times. Today, the United States a half million people are behind bars today, is home to a vast and largely invisible army this means that 20 million released felons and of felons and ex-prisoners, overwhelmingly ex-prisoners are living outside institutions. men of prime working age. These men are This implies that at least one in eight adult disproportionately high school dropouts, dis- men in the at-large population has been sen- proportionately native born, and dispropor- tenced for a felony. And the ratio for prime- tionately black. These ex-convicts fare very age men could be even higher, given the poorly in the labor market – and their dimin- upsurge of sentencing in recent decades. ished prospects constitute the key missing In light of these ghastly numbers, the obvi- piece to the puzzle of understanding the col- ous question concerns the employment pro- lapse of work for men in modern America. files for men who have served prison time or Few of us today are aware of the staggering have been convicted of felonies but not incar- size of this group. In a forthcoming study, cerated. Try as one might, however, it is im- Sarah Shannon, a sociologist at the University possible today to glean such information of Georgia, and five colleagues estimate that from official statistics. The federal govern- America’s criminal class (people with a felony ment simply does not collect data on their

Second Quarter 2017 31 ESTIMATED POPULATION OF FELONS AND EX-FELONS 1948-2010

20,000,000

15,000,000 Ex-Felons Current Felons

10,000,000 ALEC: Use “Eberstadt-Nicholas-Men-Chart6” for

NUMBER OF PEOPLE the web

5,000,000

1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 source: Shannon et al., The Growth, Scope, and Spatial Distribution of America’s Criminal Class, 1948-2010

social or economic condition. This scandal- be out of the workforce if he has served time ous oversight helps explain why policymakers in prison than if he only has an arrest record and researchers have paid so little attention to – and also much more likely to be out of the institutional barriers in America’s problem of labor force if he has an arrest record than if men without work. he has never been in trouble with the law. For my own research I reconstructed em- These relationships do not tell us why men ployment profiles for sentenced men using who have been through the criminal justice nongovernment data. system fare so much more poorly in the job The National Longitudinal Survey of market. There are multiple possible explana- Youth, for example, asks respondents about tions – discrimination and loss of skills lead delinquency, arrest and prison time in its the list. But the numbers leave no doubt that considerable battery of interview questions. America’s unique trends in criminality and And since the survey began in 1977, some of criminalization are a critical part of Ameri- the youths it has tracked are now well into ca’s unique contemporary men-without-work their 50s. Given the arcane particularities of problem. the survey, its employment figures are difficult to harmonize with official Bureau of if not now Labor Statistics data. But the findings from This problem demands attention and action. NLS are stark, and absolutely unambiguous, Reasonable, well-informed people may dis- nonetheless. agree about the factors that have been re- Regardless of a man’s age, ethnicity or edu- sponsible for the great male flight from work,

cational attainment, he is much more likely to or their relative importance. There should be -

32 The Milken Institute Review no disagreement, however, about its ominous where to start? Without precluding other ap- and far-reaching consequences. proaches, I would propose that attention be Economically, the progressive detachment focused on three broad general objectives: of ever-larger numbers of adult men from the • Revitalizing American business’ job- reality and routines of regular paid labor can generating capacities. only result in slower growth, lower living • Reducing the disincentives to work in ex- standards, greater income inequality, higher isting government-disability programs. social-welfare bills and larger budget deficits. • Facing up to the enormous task of bring- Socially, the detachment compromises mobil- ing released convicts back into the economy. ity, trust and cohesion – and much more I am not suggesting there is a one-and-only since the incapacity of grown men to func- best strategy for tackling the problem. Quite tion as breadwinners cannot help but under- the contrary: this should be a let-a-hundred- mine families. Psychologically, it casts those flowers-bloom moment. The first priority is to who have been raised to view themselves as bring this invisible crisis out of the shadows the strong gender into the role of dependents and into the glare of public scrutiny – and to – on their wives or girlfriends, on their aging create the consensus needed to prevent it parents, on government handouts. from slipping back into the shadows. As long It is imperative for the health of the nation as we allow the crisis to remain invisible,

matthew matthew ryan williams/the new york times to bring back these outcasts. But how and we can expect it to continue.

Second Quarter 2017 33 ALEC: Headline is “The Rigged Labor Market” Caption for Home page is: “Adam Smith would be ashamed” More than two centuriesMain topic: ago, JobAdam Creation Smith, now widely regarded as a cheerleader for freeOther market topics: capitalism, Human Capital, raged Public that thePolicy market for labor was rigged. He argued that self-interested employers manip- ulated the labor market to drive workers’ wages below their competitive level. Smith warned that employers “are always and everywhere in a sort of tacit, but constant and uniform combination, not to raise the wages of labor above their actual rate.” And he rid- iculed naysayers who denied that employers colluded to press their advantage against workers “as ignorant of the world as of M the subject.” He further noted that “we seldom, indeed, The hear of this combination, because it is the usual, and one may say, the natural state of things, which nobody ever hears of.” As in many other areas, Adam Smith’s insights were spot on and prescient. The conspiracy that he warned us about is alive and well in the 21st century, Rigged and it still receives little attention from policymakers, economists or the media. Much research in labor economics over the past quarter century has confirmed Adam Smith’s fear that employers routinely use anticompetitive practices to reduce pay and curtail worker mobility. Research has further expanded our understanding of how “frictions” in the job market, such as imper- fect information or costs associated with changing jobs, can Labor give employers anticompetitive advantages even in situations where many employers are vying independently to hire workers. New practices have emerged to facilitate employer collusion, such as noncompete clauses and no-raid pacts, but the basic insights are the same: employers often implic- Market itly, and sometimes explicitly, act to prevent the forces of competition from enabling workers to earn what a competitive market would dictate, and from working where they would prefer to work.

by alan b. krueger

34 The Milken Institute Review tk

Second Quarter 2017 35 rigged labor market This was clear in professional sports before free agency enabled athletes to earn what the market would bear. And it remains the case in many other less glamorous and lower-paying industries. Even professional economists have faced a rigged labor market. The heads of several leading U.S. economics departments used to regularly confer at the Annual Meet- ing of the American Economic Association to jointly agree upon starting pay and teaching requirements for assistant professors until the Justice Department started nosing around and raising concerns about the legality of the practice. In one sense, this is encouraging news. It suggests that relatively simple corrective measures would improve the lot of many workers without undermining productivity, growth or job creation. Indeed, countering anticompetitive employer behavior could be a win-win ImageMovers, became the last of the major for the economy, raising both pay and em- film companies to reach a settlement in an ployment. But it would take a fundamental antitrust suit brought on behalf of movie an- shift in perceptions of how labor markets imators. Along with Sony, Blue Sky and work – one that is a hard sell in an America DreamWorks, they agreed to pay $169 mil- seemingly disinclined to look closely at how lion to settle charges that they

everyday labor practices undermine workers’ conspired to suppress compensation by prospects for moving up the income ladder. agreeing not to solicit each other’s employees, to take special procedures when contacted let’s make a deal by each other’s employees, and to coordinate Adam Smith could not possibly have antici- compensation policies through direct, collu- pated Buzz Lightyear, Nemo or Dory, but the sive communications. animated movie industry provides concrete The evidence against the film studios, evidence of the conspiracy that he warned captured in emails, internal documents and about. In early 2017, the Walt Disney Com- sworn testimony, suggests that it was business pany and its subsidiaries Pixar, Lucasfilm and as usual to conspire to avoid bidding away employees from competitors and to coordinate on pay setting to keep a lid on compen- ALAN KRUEGER, a professor of economics at Princeton, sation costs. The conspiracy apparently began served as chairman of President Obama’s Council of Economic Advisers and a member of his cabinet from 2011 with a “gentleman’s agreement” between to 2013. Previously, he was assistant secretary for economic Pixar and Lucasfilm to avoid bidding wars policy and chief economist at the Treasury Department over employees. George Lucas testified that, (2009-10) and chief economist at the Department of Labor

(1994-95). as a matter of policy, Lucasfilm “would not xinhua/eyevine/redux page: previous

36 The Milken Institute Review Walt Disney Company and its subsidiaries Pixar, Lucasfilm and ImageMovers agreed to pay $100 million to settle charges that they conspired to suppress compensation. The antitrust action had its roots in a Department of Justice investigation of anti-poaching practices used by the tech companies.

actively go out and recruit from other compa- that Lucasfilm would not “recruit actively or nies.” Emails from Lucasfilm human re- passively from DreamWorks … for any posi- sources personnel indicate that the company tions.” Emails also documented that Pixar, even withdrew job offers to Pixar employees Disney, Lucasfilm, Sony and Blue Sky had whom Pixar deemed “essential.” gentleman’s agreements to not recruit each For its part, Pixar refused to be drawn into other’s employees. bidding wars with its competitor. In an inter- The court ruling that certified the anima- nal document, Pixar stated it would “never tion workers’ class action suit against the film counter if the candidate comes back to us companies concluded: “In addition to the with a better offer from Lucasfilm.” documentary evidence that defendants agreed The collusion encompassed other major not to recruit from each other, the documen- filmmakers as well. An email from a Pixar ex- tary evidence supports plaintiffs’ allegations ecutive to Steve Jobs, for example, noted that that defendants colluded on compensation Pixar had an “agreement with DreamWork[s] policies through industry surveys including to not poach their people.” And a 2006 list of the Croner Survey, annual closed-door in-

jerry watson/pixar studios/camera jerry watson/pixar press/redux jerry watson/pixar studios/camera jerry watson/pixar Lucasfilm’s “gentleman’s agreements” stated person meetings, and emails.” Lucasfilm’s

Second Quarter 2017 37 rigged labor market the tech companies agreeing to avoid “pres- president, Jim Morris, once invited Pixar’s suring any person in any way to refrain from president, Ed Catmull, to participate in a sal- soliciting, cold calling, recruiting or otherwise ary survey because he knew Catmull was “ad- competing for employees of the other person.” amant about keeping a lid on rising labor Subsequently, a separate class-action civil costs.” Not unlike the economics department suit was brought on behalf of more than chairs, the film company officials often met 64,000 software engineers and other employ- during industry conferences over meals to ees of Adobe, Apple, Google, Intel, Intuit, discuss compensation issues. At one such “in- Pixar and Lucasfilm. The evidence that the timate dinner” in 2006, human resources of- tech companies colluded to restrict labor ficials from DreamWorks, Disney, Pixar, Blue market competition was overwhelming. Be- Sky, Sony and Lucasfilm collectively agreed fore going to trial, the various parties settled. on average salary increases. Human resources In an unusual move, Lucy Koh, the judge

After Google’s co-founder Sergey Brin tried to hire a programmer from Apple’s browser team, Steve Jobs wrote in an email, “If you hire a single one of these people, that means war.”

officials also routinely shared their employees’ hearing the case, ruled that the initial cash set- salary ranges with their counterparts at other tlement was inadequate. The lawsuits were companies. eventually settled for a total of around half a The antitrust action on behalf of the film billion dollars in 2015. animators had its roots in a well-publicized High-tech employees are not the only ones Department of Justice investigation of anti- to have won civil suits alleging anticompeti- poaching practices used by the tech compa- tive conduct by employers in recent years. nies Adobe, Apple, Google, Intel, Intuit and Several suits have been successfully brought Pixar. That investigation revealed some color- on behalf of nurses against hospitals, for ex- ful evidence. For example, after Google’s ample. On Sept. 16, 2015, the Detroit Medical co-founder Sergey Brin tried to hire a pro- Center became the last of eight major Michi- grammer from Apple’s browser team, Steve gan hospital systems to reach a settlement in Jobs wrote in an email, “If you hire a single a suit alleging that the hospitals colluded to one of these people, that means war.” When reduce their pay. The hospitals apparently en- Intel’s chief executive, Paul Otellini, was asked deavored to share information about nurses’ by a recruiter about the no-raiding agreement salaries and pay increases. With pay pushed his company had with Google, he responded below competitive levels, the hospitals often in words that would ring familiar to Adam turned to temporary staffing firms to hire Smith: “We have nothing signed. We have a workers (at salaries above those of existing handshake ‘no recruit’ between Eric [Schmidt staff) and made do with vacancies. of Google] and myself. I would not like this Similar cases are in various stages of reso- broadly known.” The Justice Department lution in Albany, Chicago, Memphis, San An- complaint was quickly settled in 2010, with tonio and Arizona.

38 The Milken Institute Review change for signing a noncompete agreement. However, for a vast majority of employees whose work does not entrust them with trade secrets or provide much training, such agreements undoubtedly restrict worker mobility, reduce labor market competition, and suppress pay and productivity by preventing workers from moving to jobs that offer better compensation and working conditions. Nonetheless, according to survey research by Evan Starr of the University of Maryland and J.J. Prescott and Norman Bishara of the Uni- versity of Michigan, 18 percent of American workers are currently constrained by noncompete clauses. Moreover, nearly 40 percent have signed noncompete agreements at some point in their careers. These figures greatly exceed any plausible estimate of the share of workers with access to trade secrets that could justify noncompete agreements. And the fact that a 2016 Treasury Department report found that the age-earnings profile is steeper for workers in states that do not enforce noncompete agreements than in states that vigor- ously enforce them strongly suggests that you’re mine for a long time noncompete agreements do not lead to Another tactic that employers frequently use greater job training; instead, they suppress to tilt the balance of bargaining power in their wage growth. favor and restrict competition in the labor Although noncompete agreements are market is to require employees to sign non- more common in higher paying jobs, there are compete agreements that prevent them from plenty of instances in which low-paid service working for rivals for an extended period. workers are caught in the net. Amazon, for ex- Note at the start that mutually-agreed-upon ample, requires its warehouse workers, includ- noncompete agreements can sometimes be ing seasonal hires, to sign an agreement that justified as a means to increase labor produc- seems to cover everything but the kitchen sink: tivity. They may give employers incentives to During employment and for 18 months after share trade secrets with employees, secure in the separation date, employee will not … en- the knowledge that they won’t decamp for a gage in or support the development, manu- facture, marketing or sale of any product or competitor. And noncompetes may give em- service that competes or is intended to com- ployers and employees incentives to invest in pete with any product or service sold, offered expensive firm-specific training. In both or otherwise provided by Amazon. these situations, workers could presumably Noncompete agreements have even be-

jim wilson/the new york times/redux negotiate for higher compensation in ex- come common in the fast food industry. For

Second Quarter 2017 39 example, the sandwich chain Jimmy John’s, dom of McDonald’s workers to seek better with 2,000 restaurants, used a noncompete pay and working conditions. clause that prohibited its employees from working at any other restaurant that sells how labor markets work “submarine, hero-type, deli-style, pita and/or in practice wrapped or rolled sandwiches” within two In the idealized version of a perfectly compet- miles of a Jimmy John’s shop while they were itive labor market, many employers freely employed at a Jimmy John’s and for up to compete to hire workers from a large pool. three years afterward. The company agreed to Thus, neither employers nor workers have drop this practice in New York and Illinois “market power,” meaning the ability to dictate last year after being challenged by the attor- terms of employment that differ meaning- neys general in those states. fully from the terms offered (or received) by While Jimmy John’s prohibited its employ- others to workers with comparable skills. In ees from working for competitors, McDon- this world, employees can freely (and cost- ald’s came at the issue from the other side. lessly) change jobs when better opportunities The company prohibits its own franchisees arise. For their part, employers are able to from hiring workers away from other Mc- seamlessly fill job vacancies by simply offer- Donald’s restaurants; nor can they hire working the going wage rate. This wage is deter- ers who left another McDonald’s within six mined by the market – by the intersection of months. With approximately 14,000 McDon- the supply and demand curve for labor; no- ald’s restaurants employing 420,000 workers body has discretion to set pay. Thus, in econ across the United States, this restrictive hiring jargon, the supply curve to any firm is “infi-

covenant could significantly curtail the free- nitely elastic,” implying that if it paid just a press david goldman/associated

40 The Milken Institute Review penny below the going wage it would lose its however, is higher – perhaps much higher – entire workforce, and if offered just a penny than the wage paid to that additional worker. more it would be inundated with able job ap- Thus, paradoxically, while a monopsonist plicants. An individual employer in a com- is likely to pay less, on average, for labor, than petitive labor market is not subject to the an employer in a competitive market, the mo- usual law of supply, as there is no upward- nopsonist’s cost of labor at the margin is sloping supply curve to the firm: paying the likely to be higher. So, in aiming to maximize going wage attracts all the workers the firm profits, a monopsonist will hire less labor and demands. make do with vacancies. And an economy full The opposite of a competitive labor mar- of monopsonists will be less productive be- ket is one with a single employer. That em- cause employers will fail to hire workers who ployer, called a monopsonist, is in a peculiar could contribute more value to output than position because she is subject to the law of they received in wages.

Jimmy John’s used a noncompete clause that prohibited its employees from working at any other restaurant that sells “submarine, hero-type, deli-style, pita, and/or wrapped or rolled sandwiches” within two miles of a Jimmy John’s shop while they were employed at a Jimmy John’s and for up to three years thereafter.

supply in the way that an entire industry is in If the government forces a monopsonist to a competitive market. If she wants to hire an increase the wage that it pays – by, say, impos- extra worker, she must pay a somewhat higher ing a minimum wage that is modestly above wage since the supply curve she faces is the wage it currently pays – the monopso- sloped upward. And, as a practical matter, she nist’s marginal cost of labor will fall. And this will need to pay that higher wage to the rest of cost at the margin may become low enough her workers, too. Thus a monopsonist with, to give the monopsonist an incentive to hire say, 100 employees who finds it necessary to more workers. In other words, without a min- pay an extra dime an hour to hire one more imum wage the monopsonist operates with worker, must shell out a total of $10 an hour vacancies, unwilling to raise the wage it offers (100 times 10 cents) more to the existing to hire additional workers because it would workforce as part of the price of hiring that have to pay that higher wage to existing work- additional worker. ers as well. However, with a binding mini- Note the critical difference: an employer in mum wage – that is, a minimum wage above a perfectly competitive market, who is one the rate the monopolist was already paying – among many, can always hire more workers a monopsonist can fill its vacancies without at the currently competitive wage. So, for this worrying about having to increase everybody employer, the added cost of one more worker else’s wages, because that was already re- is exactly what she pays that worker. A mo- quired by the minimum wage. A monopso- nopsonist’s marginal cost of hiring a worker, nist would not be happy with this situation

Second Quarter 2017 41 rigged labor market on the wage ladder and their employee turn- because the minimum wage would cut its over rate. Employers can choose a low-wage profits. But once there is a minimum wage, strategy and make do with high turnover and the firm would find it possible and in its in- chronic vacancies, or a high-wage strategy terest to fill its vacancies, provided the mini- with low turnover and few vacancies. Requir- mum wage wasn’t set too high. ing employers who choose the low road to in- The canonical example of monopsony is a crease their pay would raise total employment one-company town – say, a remote coal min- by making jobs more attractive and reducing ing town. While few labor markets are char- turnover. acterized by pure monopsony today, if In another model of the labor market de- employers collude to suppress competition – veloped by Mortensen, Chris Pissarides of the either by restricting labor mobility or con- London School of Economics and Chris Flinn spiring to fix pay – they jointly exercise of NYU, firms and workers bargain over the monopsony power. This should be evident value that each unique worker-firm match because employers are exercising discretion creates. Factors that determine their relative

Smart interventions to redress the imbalance between companies and workers, such as a prudently set minimum wage, or vigorous enforcement of antitrust restrictions on anticompetitive employer behavior, could result in more employment as well as higher pay.

to set pay, and in a perfectly competitive labor bargaining power, such as the ability of work- market, employers have no discretion what- ers to take other job opportunities, influence soever to set pay. where the bargain ends up. Although it remains unclear how pervasive Yet other models recognize that, even ab- or effective employer collusion is in restrict- sent search frictions and idiosyncratic value ing competition, recent economic analysis of worker-firm matches, individual workers suggests that employers often have monop- value nonwage features of jobs differently. For sony-like power over workers even when example, some workers may live very near a there are many employers who operate inde- McDonald’s where they work. Those who live pendently. In part, that’s because employers close by would presumably be willing to work have some discretion over what they pay be- for a lower wage at that outlet than those who cause of labor market frictions, such as job live far away and must spend time and money search costs. on commuting. For example, in the “wage-posting job It turns out that this very minor and real- search” model pioneered by the economists istic tweak coverts a perfectly competitive Kenneth Burdett at Penn and the late Dale labor market to one in which employers have Mortensen, and expounded on in Alan Man- monopsony-like power because firms no lon- ning’s book Monopsony in Motion, employers ger face a perfectly elastic labor supply curve. consider the tradeoff between their position If a firm were to cut its wage in this situation,

42 The Milken Institute Review it would find that some workers would leave common features of the labor market give (namely, those with a long commute), while them discretion over what they pay, they will others would stay because it is more conve- have incentives to pay less and hire fewer nient working at this restaurant than another workers. Smart interventions to redress the one. To recruit new workers, every firm imbalance between companies and workers, would have to pay more than the going wage such as a prudently set minimum wage or vig- (to attract workers who live farther away), just orous enforcement of antitrust restrictions as in the case of a single monopsonist. And, as on anticompetitive employer behavior or in the case of a monopsony, a minimum wage steps to enhance employee bargaining power, could lead to higher employment. The take- can result in more employment as well as away: monopsony-like incentives can intrude higher pay. on what might otherwise look like a competi- The reality that many, if not most, markets tive labor market, even when there are many for labor have some of the characteristics of employers. monopsony helps explain a persistent puzzle The details of these models are less impor- in labor economics: studies have not found tant than the general result. A perfectly com- strong or even consistent evidence that a petitive labor market operates on a knife edge, higher minimum wage reduces employment, on which employers have no choice but to as would be expected to be the case in a per- pay the going market-determined wage. If fectly competitive labor market. Indeed, the they collude to restrict competition and sup- most comprehensive summary of the recent

reuters/brendan mcdermid reuters/brendan press pay, as Adam Smith predicted, or if very literature, by Dale Belman of Michigan State

Second Quarter 2017 43 and Paul Wolfson of Dartmouth, finds that faster in sectors with rising job openings. This the average study shows essentially no effect suggests that companies are resisting raising of minimum wage increases on employment. wages as a means to attract more workers – as Although some companies may respond to a one would expect in an imperfectly competi- higher minimum wage by reducing employ- tive market. ment, this is apparently offset by others who increase employment – as would be expected labor economics 2.0 if some firms have monopsony-like power. An important first step in rethinking how Other evidence at the national level sug- labor markets work – and how they could be gests monopsony-like power is restricting pay made to work more efficiently and fairly – is increases. For example, job openings and to change the default assumption from the posted vacancies have steadily risen in recent perfectly competitive model we all learned in years, but hiring has not kept pace. This pat- Econ 101 to one in which employers have tern is sometimes cited as evidence of an some discretion to set pay. This discretion can economy-wide shortage of skilled workers. come about because, as Adam Smith pre- Yet, in a competitive labor market, one would dicted, it is the “natural state of things” for expect the phenomenon to be fleeting: em- employers to collude, or because of frictions ployers would bid up wages for skilled work- in the job market. We can begin to change the ers until vacancies were filled or firms were default by changing how we teach economics. discouraged from posting vacancies because Introductory economics textbooks rarely dis- of the higher competitive wage. Consider, too, cuss the role of monopsony or collusion in the that contrary to what one might expect in the labor market, although market power is stan-

face of skill shortages, wages have not grown dard fare when it comes to product markets. new librado romero/the york times

44 The Milken Institute Review While it is difficult to determine at this opponent, the political system, big donors, stage if the antitrust cases brought on behalf bureaucrats and big businesses. Although the of animators, software engineers and nurses fact of his election suggests the political sys- indicate widespread employer collusion, the tem is not rigged in quite the way he claimed, fact that the behavior spans diverse industries he undeniably tapped into a significant vein and employee skills suggests that collusion of discontent – and, to mix metaphors, a large may be common. At a minimum, the accu- grain of truth – in arguing that the economy mulation of cases suggests that more re- is “rigged against you, the American people.” sources should be devoted to enforcing the If he is serious about addressing this prob- antitrust laws when it comes to employers’ lem, there would be no better place to start HR practices. than by unrigging the labor market by (a) Toward the end of Obama administration, raising the federal minimum wage, which has the Department of Justice and the Federal remained at $7.25 an hour since 2009 and Trade Commission issued new guidelines for which Mr. Trump pledged to raise to $10 an human resources professionals to help iden- hour during the campaign; (b) reining in the

While it is difficult to determine at this stage if the antitrust cases brought on behalf of animators, software engineers and nurses indicate widespread employer collusion, the fact that the behavior spans diverse industries and employee skills suggests that collusion may be common. tify and report wage fixing and hiring collu- excessive use of noncompete clauses; (c) vig- sion among employers, and created a hotline orously enforcing antitrust laws to prohibit to report instances of collusive behavior. employer anticompetitive practices; and (d) Moreover, for the first time, the Justice De- increasing worker bargaining power. partment threatened to bring criminal (as If President Trump does not try to reverse opposed to civil) cases against individuals the ways in which the labor market is rigged and their companies for entering into no- against American workers, there is an alterna- poaching and wage-fixing agreements with tive: the states could step up. Many have al- competitors. The Obama administration also ready begun to raise their own minimum called on the states to adopt a set of best prac- wages and to prohibit the use of noncompete tices to ensure that noncompete agreements agreements for low-wage workers, and their are narrowly targeted and appropriately used. attorneys general have been on the vanguard With the change in presidential adminis- at challenging excessive use of noncompete trations, though, the fate of these initiatives is clauses. The states could also pursue means to uncertain. While running for president, Don- improve worker bargaining power and pass ald Trump was fond of declaring, “We will tougher laws to penalize employer collusive never be able to fix a rigged system by count- behavior that restricts worker mobility and ing on the same people who rigged it in the suppresses pay. first place.” He used this line to rail against his After all, workers deserve a break too.

Second Quarter 2017 45 tk

46 The Milken Institute Review ALEC: Headline is “Public Pension Plans” Caption for Home page is: “A trillion here, a trillion there…” Main topic: Pensions Other topics: Public Policy, Finance, Labor

Public Pension Plans The $5 Trillion Misunderstanding by ed bartholomew

Second Quarter 2017 47 According to the 2013 annual report for Detroit’s general retirement system, the city’s pension plan “is stable and secure and expects to meet all future retirement obligations to its members.” Wait. Isn’t Detroit bankrupt?! Well, I too badly. The bankruptcy judge blessed a fudged here just a bit. The annual report settlement (at the expense of other creditors) quoted preceded the city’s bankruptcy by that preserves the lion’s share of their benefits. some months. In fact, though promised pen- At least for now. Asion payments were cut, the retirees didn’t do But the mess in Detroit, alas, is only the be- carlo giambarresi/theispot page: previous

48 The Milken Institute Review ginning of a great unraveling of retirement be changed so the funds are sure to deliver. plans for state and local employees in much The answer requires a dip into financial the- of the United States. And even relatively ory. But don’t let the minor technical hurdles happy endings can hardly be taken for granted. prevent you from understanding a pretty The first question that occurs is who is straightforward idea. going to be stuck with the bill. Taxpayers? Pensioners? Residents who will have to make first, some facts do with lower-quality public services? Going Not many of us work for employers who still forward, there’s also the question of how the offer “defined benefit” pension plans, which

jim west/report digital-rea/redux process of funding promised benefits should promise monthly income for life in retirement. In the private sector, such plans have largely been replaced by defined contribution plans – typically 401(k) plans that are less costly to employers and shift most of the risk of saving enough for retirement to employees. But if you’re a state or local government employee, you probably still have a defined benefit plan. What’s more, the plan may well have been a big factor in convincing you to work for the government because government jobs often make up mediocre pay with generous benefits. That puts future retirees in the uncomfortable position of depending on contractual rights that may be contingent on courts willing to enforce them – a position made more uncomfortable by the fact that millions of them don’t have Social Security as a backstop. This, for example, is the case for the failing Dallas police and fire pension system, which actively resisted attempts to include pensioners in the Social Security system. Consider, too, that, unlike private pension benefits, state and local pension benefits are not insured by the Pension Benefit Guarantee Corporation, which was set up by Congress in 1974 to insure private pension funds. This exclusion was based partly on a Constitu- tional objection. But it was also assumed that state and local taxing power would be sufficient to ensure that all promises would be kept. Now, in 2017, that assumption doesn’t seem quite so solid.

Second Quarter 2017 49 Making Sausage

Suppose you participate in a defined benefit secure the promise? In deciding that, profes- plan offered by your employer. During your sional pension actuaries make several assump- working years, you earn, in addition to wages, tions – most critically on how much the plan the right to an annuity when you retire – a will earn on its investments and on how long monthly check for life. For example, suppose participants will live. your employer’s plan promises a monthly pen- If the actuary knew precisely how much each sion equal to 2 percent of final pay for every year participant would receive annually in retire- worked. So, if you have worked for 40 years, your ment and for how long, as well as the return on Spension will equal 80 percent of final pay. the pension plan’s investments, the math would But what if your employer doesn’t have be straightforward. But since this information the money when the time comes? To mitigate is not known, it must be estimated. And this is that risk, pension plans are typically prefunded. where risk creeps in on little cat feet. During your working years, funds are set aside The actuary’s calculation is based on expect- and invested, so there will be enough to pay the ed values, where “expected” is the estimated promised pension. statistical mean for a distribution of possible How much, then, does your employer need outcomes. If there’s an equal chance that the to contribute each year to fund the plan and realized outcome for each assumption will fall

when the unthinkable must bilities, like those in New Jersey, to employers be thought about paying less than their actuaries calculate they Detroit pensioners learned the hard way that, should – and, presumably, hoping for a wiz- despite soothing messages repeated over and ard investment adviser to save them. over in the annual reports, a guaranteed pen- Financial economists, as opposed to the sion annuity is only as good as the guarantor. professional actuaries who are paid to tell While outright defaults have been rare, they pension funds what they need to contribute, may or may not be so rare going forward. It would agree that is a big problem and a dis- depends on whom you ask. tinguishing characteristic of the worst- Keith Brainard, the research director of the funded cases. But they do not agree with National Association of State Retirement Ad- Brainard’s assessment that there’s no systemic ministrators, notes that unfunded pension li- underfunding problem with the “vast major- abilities vary widely among plans but believes ity” of public pension plans. that “for the vast majority of states, cities and Joshua Rauh, professor of finance at Stan- plans,” these liabilities are manageable. He at- ford University, notes in a recent research re- tributes the cases of the largest unfunded lia- port that public pension funds still commonly estimate that they’ll earn returns on investments of 7.5 to 8 percent annually. ED BARTHOLOMEW, an independent pension consultant, Those numbers, based on past earnings on is the former chief financial officer of the Inter-American Development Bank. pension portfolios, are probably unrealistic

50 The Milken Institute Review on either side of what’s expected, then there ance companies that sell fixed annuities, which will be a one-in-two chance that the calculated function very much like defined benefit pen- funding will be less than what’s required to pay sions, follow an investment strategy much like the promise. Maybe a little less, maybe a lot less, this. depending on how much uncertainty there is The only reason pensions – especially public around each assumption. pensions – deviate from this approach is that it Now, while any individual’s life expectancy is lets their actuaries assume a higher investment highly uncertain, the average life expectancy for return, thereby reducing funding requirements. a group becomes increasingly less uncertain as But this approach comes at a cost: a higher risk its size grows. And so, defined benefit plans for of falling short, perhaps by gigantic large companies that have thousands of partici- sums. A trillion here, a pants are effective vehicles for diversifying this trillion there… type of risk. Other risks, however, are linked to the discretionary behavior of the plan managers – for example, investment risk. Pension plans could hold low-risk bonds with cash flow matched closely to the profile of the benefit that will be owed. And indeed, insur-

going forward. But, like virtually all financial economists who have studied the issue, he has a more fundamental beef with the actuaries’ approach. He argues that “this practice obscures the true extent of public-sector liabilities” because it crued liabilities – what’s owed for benefits treats an uncertain expected return as though earned, but not yet paid. it were a sure thing. It’s not hard to understand why this ap- Under rules set by the Government Ac- proach is popular. Investing in low-yielding counting Standards Board, pension liabilities but ultra-safe government bonds, which are valued by discounting promised benefits could absolutely ensure the payouts on guar- at the expected rate of return on plan assets. anteed pensions, would vastly increase the Public pension actuaries employ a similar cost of plans to employers and, arguably, approach for estimating plan cost and fund- make pension plans unaffordable. ing requirements. Under this standard, if tak- But this way of justifying business-as- ing more investment risk allows a pension usual rubs financial economists the wrong plan to expect a higher return on those in- way because it implicitly treats investment vestments, employer contributions can be risk as costless. A universal principal of finan-

michael austin/theispot smaller. The same goes for the value of ac- cial valuation is that systematic risk – what’s

Second Quarter 2017 51 public pension plans Financial economists, however, say the un- left after diversifying as much as possible – has derfunding problem is much worse. Rauh, a cost because risk-averse investors would not using a much lower interest rate to discount li- otherwise be willing to bear it. Treating the abilities, put the total fiscal 2014 gap at $3.4 risk premium as earned before the risk has trillion, nearly three times the $1.2 trillion re- been borne is fundamentally flawed. But that’s ported under Government Accounting Stan- what the official accounting rules permit. dards Board rules. If this larger estimate is the So why should you care about this in-the- true funding gap, state and local plans are weeds technical difference over the cost of barely 50 percent funded. Moreover, adjusting

What you don’t know can hurt you – whether you’re a taxpayer who may be asked to pay more later, a municipal bond investor who may discover she’s last in line trying to collect behind a large hidden debt or a pension plan participant who may be at risk for what bankruptcy specialists euphemistically call a haircut.

risk and what that implies for the right way to for weak investment performance along with measure pension costs? Because what you even lower interest rates on riskless invest- don’t know can hurt you – whether you’re a ments in the two years since Rauh made his es- taxpayer who may be asked to pay more later, timate, financial economists guesstimate that a municipal bond investor who may discover the fiscal gap in 2016 is $5 trillion to $6 trillion. she’s last in line trying to collect behind a That implies the plans have only 40 percent of large hidden debt or a pension plan partici- what they need to meet their obligations. pant who may be at risk for what bankruptcy The main cause for this large difference is, specialists euphemistically call a haircut. as noted above, the discount rate, which de- For fiscal 2014, the total unfunded pension termines the present value of a dollar owed in liability for U.S. state and local pensions, re- the future. Higher discount rates make that ported under the official Government Ac- future dollar owed less costly, and lower discounting Standards Board accounting rule, count rates more costly. According to finan- was $1.2 trillion. This $1.2 trillion gap is the cial economics, the appropriate discount rate difference between the board-estimated lia- for a future cash flow is the rate on a default- bility of $4.8 trillion and plan assets of $3.6 free bond (like a U.S. Treasury) due at the trillion. That means public plans have only 75 same point in time, plus a spread for any risk percent of the assets needed to cover future of nonpayment. Returns expected on assets obligations, leaving a 25 percent gap to be cov- used to fund the liability simply aren’t rele- ered by future taxpayers. And that 25 percent vant for the purpose of valuing the liability. estimate assumes the pension funds will earn So, if a pension promise is thought to be the high returns hoped for on a risky invest- free of the risk of default, a financial econo- ment portfolio – returns of 7.6 percent on av- mist would discount it at a default-free rate. erage into the distant future. And this is what Rauh did.

52 The Milken Institute Review But wait, you say. We just looked at the put it another way, saying that pension debts failing pension plans in Detroit and Dallas. If are smaller because they might not be paid benefits are at risk, they’re not default-free. should give no one comfort. Right, but note that’s not what Keith Brainard Advocates for the Government Accounting and others advocating for expected-return Standards Board’s approach (a group that in-

laif/redux discounting are basing their argument on. To cludes most public-pension actuaries) think

Second Quarter 2017 53 public pension plans they are answering a different question. They aren’t asking what the market value of the liability is – something they consider mostly ir- relevant – but how much needs to be set aside today to pay the promise when due. And if they can reasonably expect a higher return by taking more risk, why can’t they assume that’s what the plan will get? Resolving the discount rate debate hinges, in the minds of many, on whether risk stays risky in the long run. If investment risk van- ishes – or at least significantly diminishes – over the very long time horizons in which pensions operate, advocates for the standards board’s approach claim that allows using the expected return on risky assets to discount liabilities, which would remain secure.

in the long run If we think of risk only as the bumpiness of the ride, not as uncertainty about where the ride will end, then the so-called equity premium – the extra return expected for stocks – is merely compensation for fortitude and patience. And if earning an equity premium is guaranteed if we only wait long enough, there’s no risk in the long run. Can this be right? You’ve probably been told by some financial advisor that a long- term investor – say one investing for retire- You would not claim that insuring your ment 20 years away – should invest mostly in house against fire is a waste of money because stocks, because over long periods stocks out- houses don’t burn down – that’s clearly false. perform bonds. Framed more carefully, the ra- But you’d also not justify forgoing insurance tionale is not because stocks outperform over because your house will likely not burn down, long periods, but because stocks will likely or because, historically, no houses in your outperform – or because they have in the past. neighborhood have burned down. Framing is important: saying simply Forgoing insurance is unwise, even though “stocks outperform” leaves no room for un- doing so would almost certainly save you certainty, while inserting “will likely” ac- money. You insure not because you expect knowledges they may not. Consider an anal- your house to burn down, but because it ogy to another type of risk, the risk your might. And you prefer a sure loss you can af- house will burn down. ford – the insurance premium – to the small

54 The Milken Institute Review chance of a huge loss you can’t afford. Only if equities, then, to the extent the investor can you could afford the loss – say, because you’re afford the potential loss. rich – might forgoing house insurance make For financial economists, the above para- sense. graph seems a no-brainer. To see why, let’s as- We can (and should) think about invest- sume the opposite and see that it implies ment risk the same way. It’s not correct to say something that makes no sense. stocks outperform as a timeless truth, like Suppose that over a sufficiently long hold- “the sun rises in the east.” While acknowledg- ing period – say 30 years – there is no chance ing that equities have historically outper- that a diversified portfolio of stocks will re- formed bonds and likely will do so in the fu- turn less than a 30-year default-proof U.S. ture, there’s still a nontrivial risk they won’t Treasury bond. If that were true, one could – and not just over short periods, but over obtain what financial economists call riskless

eva haeberle/laif/redux eva long ones as well. It only makes sense to hold arbitrage – a sure profit with no money down

Second Quarter 2017 55 public pension plans after paying off the bond for the same reason. and no risk, the financial equivalent of a per- Having put no money down, the bank is cer- petual-motion machine. tain to make a profit. Can this be possible? Imagine a bank that borrows $1 billion by Even if this were possible at some point in issuing a 30-year bond, and invests the pro- time, the very act of exploiting the opportu- ceeds (but none of its own money) in stocks, nity – buying stocks and borrowing – would held in a legal trust with dividends reinvested bid up stocks and interest rates, until it was

to secure repayment of the $1 billion plus ac- no longer possible. Thus, the assumption that cumulated interest on the bond in 30 years. stocks can never underperform a default-free First, recognize the bond is free of default risk bond ultimately cannot be true. So, stocks are in this scenario since it’s guaranteed by the risky, even over the long run. In addition to stock portfolio, which in 30 years is sure (by the one-in-two chance they’ll return less than assumption) to be worth more than principal expected, there is a nontrivial chance they’ll and interest owed on a default-free bond. Sec- return less than a default-free bond.

ond, recognize there will be money left over To see why this is not a small problem for via getty images richard levine/corbis

56 The Milken Institute Review pension funds, consider how badly underper- incorrectly thought saved in smaller govern- formance compounds over the long periods ment contributions today is just the unac- that pensions must operate. Suppose you’re counted-for market price of risk. That leaves expecting to earn 7.5 percent per annum on a the risk itself to be borne by someone in the risky asset portfolio over 30 years, but instead future. earn 4.5 percent. If you were looking out just Consider, too, that since taking investment one year, you’d have 3 percent less than ex- risk justifies assuming a higher asset return, it pected – a manageable problem. But what if makes benefits appear cheaper. This creates a the difference in returns is compounded over bias in favor of taking risk. And since the ex- 30 years? pected return is an assumption, not an ob- Investing $1,000 and earning the 7.5 per- servable parameter, there’s a bias to be opti- cent expected every year for 30 years would mistic. Note that, if contributions were based result in an end balance of $8,755. If instead on an unbiased expected return – and suffi- you earned 4.5 percent, the end balance ciently large to track actuarial estimates – would be only $3,745 – 57 percent less than there would still be a 50 percent chance of expected. Now, suppose your average annual shortfall. However, since the average public return over 30 years is an even-worse 1.5 per- plan is only about 75 percent funded – and

The true cost of providing a secure pension benefit is more than what is reported, so funding is insufficient.

cent. In this case, you would end up with only this is based on an optimistic 7.6 percent ex- $1,563, or 82 percent less than expected. pected return – the reality is a much greater While such a dismal return is not likely, it is than a 50 percent chance of shortfall. For the certainly possible. Indeed, Japanese equities public plans in Illinois, New Jersey and Ken- have performed much worse than that over tucky, which are just 40 percent funded, the the nearly 30-year period since 1989. situation is more grave. Yet another complication of ignoring the no free lunch economist’s view of risk: decisions about ben- Return now to what’s wrong with the finan- efit increases are based on lowballed cost esti- cial management of public pensions in the mates. For example, given a choice between United States. It boils down to this: the plans, offering bumped-up pension benefits or as currently managed, do not account for the higher salary in union contract negotiations, cost of investment risk. As a result, the true sponsors will be more inclined to improve cost of providing a secure pension benefit benefits since future benefits are cheap. And if is more than what is reported, so funding is a plan seems to be more than 100 percent insufficient. funded following several years of good asset This means benefit payments down the returns, then benefit enhancements may seem road will depend to a significant degree on covered, not requiring additional payment by the ability of future governments to make up the sponsor. Many plans did just this follow- potentially significant shortfalls. The money ing the long bull market of 1982 to 1999.

Second Quarter 2017 57 public pension plans cannot manage credit risk – the risk of not Of course, once granted, benefit enhance- getting fully paid – by diversifying. ments are owed and cannot be rescinded fol- No bond investors would sensibly bet all lowing market setbacks – unless, of course, their savings on the credit of a single issuer if the plan goes belly up and a judge is in charge. there were any risk of default. But pensioners There seems no limit to the ways in which with underfunded pension plans are unwit- ignoring risk undermines pensioners’ security. tingly doing exactly that, and in many cases One example: the deferred retirement option the credit of the sponsor is deeply suspect. plan, under which some pension plans allow To fix this large and growing problem, two retirees to keep working while investing their things need to be done. First, government ac- pension checks in accounts earning a guaran- counting standards and public pension actu- teed rate equal to what the plan expects to arial practice need to recognize the cost of risk, earn on its risky portfolio – say 7 or 8 percent. thereby revealing how much a secure pension The Dallas police and fire pension offered benefit really costs. Second, public pensions such a program. When the plan’s solvency need to be governed by independent trustees was questioned, participants sought to with- who (a) are technically qualified to exercise draw their funds before the window shut – oversight, (b) have no conflicts of interest and as it ultimately did. Indeed, thanks to the un- (c) have a clear mandate to represent the inter- funded liabilities created by the plan, even ests of the beneficiaries. basic benefits are now seriously at risk. While taxpayers and other stakeholders (including the aforementioned professional reality bites pension consultants) may still find it less An income for life in retirement – the core painful to accept the risks than to come up feature of public defined-benefit pension with the cash to secure pensions, the conse- plans – is a wonderful benefit, provided it is quences of kicking the can down the road secure. It’s also an expensive benefit, becom- would at least be more transparent. ing more so by longer life expectancies and If the sponsors were committed to making lower interest rates. But reducing funding public pension benefits secure, they could and taking on more investment risk does not transfer risk currently borne by pensioners, make it more affordable, just less secure. who can’t manage that risk, to bondholders Following the path of least political resis- who can. If the government sponsor is not so tance, pension plans are typically guilty of (a) committed – perhaps because the shortfall is assuming a discount rate that makes payouts already too large – it would be better to have less than certain, and (b) allowing pension the discussion about default sooner rather funds to slip far below 100 percent funding, than later. Then all could consider how the even when the estimate is based on ill-advised obligations might be restructured to preserve assumptions about the discount rate. as much value as possible, as fairly as possible. The commitment of a future government It’s only human nature to delay difficult to make up any shortfall is like the commit- decisions – especially if the current genera- ment behind a bond. And like a bond, a pen- tion of deciders can dump the decisions on sion obligation may not be fully met if the the next. Figuring out how we got in this burden is too great, as in the case of Detroit. pickle, alas, is much easier than whacking But public pensioners, unlike bondholders, a pathway out.

58 The Milken Institute Review book excerpt

Beating the Odds: Jump-Starting Developing Countries

Justin Yifu Lin and Célestin Monga, the illustrations by authors of Beating the Odds: Jump-Starting arthur e. giron Developing Countries,* are distinguished economists trained in elite Western universities. Lin’s PhD is from the University of Chicago, while Monga has degrees fromJ MIT and Panthéon-Sorbonne University. Moreover, they’ve both held positions of considerable responsibility in Western- oriented institutions. Lin served as the chief economist of the World Bank, while Monga is a managing director of the UN’s Industrial Development Organization. ¶ But

their current views certainlyALEC: don’t reflect the standard model of Western development economics, which asserts thatHeadline growth is in “Beating poor countries the Odds” isand closely in smaller tied type,to the “Jump-Starting adoption Developed Countries” of Western-style good governanceCaption practices. for Home Indeed, page is: “BeatingWhy development the Odds can be seen as a economists are just plain wrong.” declaration of independence from routine emulation of high-income economies’ best Main topic: Books practices in areas ranging fromOther rule topics: of law Governance, to banking. Economic ¶ Here, Development, we excerpt the Economic chapter Growth that offers a skeptical view of the importance that Western development economists place on suppressing corruption and building financial systems on the American and . all 2017 . rights reserved. European model. Many readers, I suspect, won’t be convinced. But all should understand that, as it becomes increasingly clear just how difficult sustained economic development has become for countries yet to achieve middle-income status, alternatives to

*princeton university press Western approaches will be taken ever more seriously outside the West. — Peter Passell

Second Quarter 2017 59 Thomas Edison, the intrepid American inventor who brought to the world the lightbulb and held more than a thousand patents, had a simple rule for recruiting his engineers. He always invited the short-listed candidates (whom he assumed to all be technically capable of doing the job at hand) for lunch and carefully observed their behavior.

His objective was not to check their table dom that low-income countries should there- manners, but to deduce their decision-making fore start their development with the process from their most anodyne acts. A key governance institutions of high-income Tindicator was his guests’ propensity to add countries is both a non sequitur and a histor- salt and pepper to their dishes without first ical fallacy. tasting them. That very common and often This chapter acknowledges that institu- unconscious gesture would disqualify any tional development problems are indeed prospective candidate: it revealed a tendency major impediments to economic growth. But to blindly act on one’s instincts and to decide contrary to conventional wisdom, it argues without checking the evidence. that they are often simply correlated with the Many researchers and policymakers work- level of economic development – and correla- ing today on institutional development in de- tion is not causation. Seen from that perspec- veloping countries are guilty of the Pavlovian tive, the well-known weaknesses in the behavior despised by Edison. They assume governance and financial sectors of many that, by simply looking at the current state of poor countries today often reflect their low institutional development in industrialized level of development and the results of failed countries, they know precisely what it means state interventions and distortions originat- and how it can be measured. They mechani- ing from erroneous economic development cally compare political, administrative and fi- strategies. nancial institutions of countries regardless of Instead of posing first-world governance their economic development levels. They nat- and financial institutions as the main pre- urally find gaps between poor and rich coun- scription for sustained growth in third- tries, and derive from those a generic reform world countries, economists should design agenda not based on evidence. policies that offer the maximum likelihood They also neglect lessons from the history of success because they are consistent with of highly industrialized economies, all of comparative advantage and existing firm which started their development success sto- structure, while minimizing opportunities ries with suboptimal political, administrative for rent-seeking and state capture. The dy- and financial institutions. The broad (and namic development of competitive firms and somewhat abstract) intuition on the need to industries will eventually lead to institu- improve governance in all countries has tional development. strong moral and theoretical foundations: it is the right thing to do to sustain growth, en- the mystery of governance sure shared prosperity and build social trust Institutional development is generally ac- and stable societies. But the conventional wis- knowledged to be the reflection or result of

60 The Milken Institute Review “good governance.” Yet as A. Premchand, an They define governance as: economist at the International Monetary The traditions and institutions by which Fund once observed, governance is like ob- authority in a country is exercised. This in- scenity “because it is difficult to define.” cludes the process by which governments are Perhaps the most comprehensive and au- selected, monitored and replaced; the capacity of the government to effectively formulate thoritative intellectual source on the subject and implement sound policies; and the respect are the Worldwide Governance Indicators, of citizens and the state for the institutions produced in conjunction with the World that govern economic and social interactions Bank and widely respected in policy circles. among them.

Second Quarter 2017 61 They identify six dimensions of gover- sality.” Both camps have some intellectual le- nance: government effectiveness, regulatory gitimacy. The reality that some who reject the quality, rule of law, control of corruption, good-governance agenda as a hidden attempt voice and accountability, and political stabil- to Westernize the world may be defenders of ity and absence of violence. That conceptual authoritarian practices hidden behind the framework is then given empirical life claim of cultural relativism does not necessar- through the use of data produced by a variety ily invalidate all their arguments. of think tanks, survey institutes, international The WGI and other indicators of good organizations, nongovernmental organiza- governance or democratization do not really tions and private-sector firms. The WGI are help escape the universalist-versus-relativist therefore aggregate indices that combine the impasse. Moreover, even if one could come views of a large number of respondents, up with an ingredient list that satisfies both including those representing enterprises, the universalists and the relativists, the belief

Aggressive prosecution of corruption is taking place in many low-income countries, yet in those countries such legal actions are paradoxically considered further evidence of terrible governance.

citizens and experts in industrialized and de- that good governance can be captured quan- veloping countries. titatively and measured through surveys will Such a valiant effort to give meaning to the remain subject to debate. complex notion of governance is certainly re- Behavioral economics shows that people spectable. But the theoretical and philosophi- often err when asked to identify the con- cal underpinnings of the WGI are highly straints that affect even their most important questionable. First, assessing the quality of activities. Econometric analyses show, for in- the traditions and institutions by which au- stance, that popular survey results such as the thority in a country is exercised is bound to World Bank’s Doing Business indicators do be a subjective exercise. It is therefore suscep- not correlate well with the actual constraints tible to being a reflection of ethnocentric – if on private-sector performance. In other not paternalistic – perspectives. There is no words, even the most successful businesspeo- reason to believe that such an assessment ple in the world generally fail to intuitively should be performed uniformly in China, identify the real obstacles to productivity Alaska and Zanzibar. growth and enterprise development. If that is There will always be those who claim that all the case, how confident can one be about per- human societies share the same goals and have ceptions of others’ well-being? adopted global standards and broad principles In fact, there are fundamental discrepan- of good governance embodied in internation- cies between indicators of what is perceived ally agreed covenants. Yet there will also always as good governance and indicators of actual be the perception that these global standards economic performance. These discrepancies are actually evidence of the Westernization of also reveal fundamental issues of subjectiv- human values under the pretense of “univer- ism and ethnocentrism that are reminiscent

62 The Milken Institute Review of the “orientalism” analyzed by Edward Said, ficult to rigorously define what corruption the Palestinian-American who pioneered the means every time and everywhere, and to field of post-colonial studies. compare it across time and place. Many open A good illustration of the problem can be transactions between lobbyists and policy- found in countries’ corruption-scale rankings, makers in the United States, for example, always one of the key pillars of the good gov- would be considered corruption in other ernance agenda. Transparency International places in the world. Consider, too, that ag- surveys basically show that the world is di- gressive prosecution of corruption is taking vided into two categories: the highly corrupt place in many low-income countries, yet in countries and the least corrupt, with a “good- those countries such legal actions are para- governance” Western world surrounded by a doxically considered further evidence of ter- “bad-governance” non-Western world. Trans- rible governance. A case in point is that of parency International is a reputable organiza- Cameroon, where dozens of politicians and tion that does good work. But its surveys, civil servants at the highest levels of power which display a Manichean view of the world, (including a former prime minister) have are deeply disturbing. been convicted for embezzling public funds. Given that the fight against corruption is Yet few analysts would consider Cameroon a an important part of the good-governance good-governance country. To the contrary, agenda, it is perplexing that corruption has the more senior government officials sent to been prevalent throughout human history jail, the more experts are convinced that and still exists, often on a wide scale, in high- Cameroon is profoundly corrupt. income countries. In recent years, France gave its former president Jacques Chirac a two- Defining Corruption year suspended prison sentence for diverting The first clue to the inextricable difficulties of public funds and abusing public trust. In the corruption analytics is the vagueness of the United States, four of the past seven Illinois definitions that one can find in the technical governors were convicted and imprisoned – literature. The most commonly used defini- among them, Rod Blagojevich, who was con- tion is the one by Andrei Shleifer and Robert victed of numerous corruption charges Vishny, who define government corruption as: including for trying to “sell” President Barack The sale by government officials of govern- Obama’s former Senate seat to the highest ment property for personal gain. For example, bidder. In Japan, many high-ranking govern- government officials often collect bribes for providing permits and licenses, for giving ment officials have been forced out of office passage through customs or for prohibiting throughout the postwar period amid corrup- the entry of competitors. In these cases they tion scandals. The problem has extended well charge personally for goods that the state of- beyond the political sphere and into a bu- ficially owns. In most cases the goods that the government officials sell are not demanded reaucracy often considered one of the better for their own sake, but rather enable private managed in the world. agents to pursue economic activity they could The typical response to the unflattering not pursue otherwise. Licenses, permits, pass- truth is to argue that high-income countries ports and visas are needed to comply with laws and regulations that restrict private economic are “less” corrupt than others and their insti- activity. Insofar as government officials have tutions are “stronger.” But those arguments discretion over the provision of these goods, are hard to empirically validate. First, it is dif- they can collect bribes from private agents.

Second Quarter 2017 63 The obvious question that this well-estab- Corruption can be disaggregated along lished definition raises is that of legality. several dimensions. First, one must distin- What if there are no laws in place preventing guish its prevalence, especially in large coun- government officials from making excessive tries with decentralized political systems, or arbitrary use of their discretionary power? where corruption can be widespread at the Does corruption intrinsically imply illegality? local government level, even if it is controlled If it does, then the logical inference from the at the central government level. Second, the definition is that some practices may be con- purpose of improper actions characterized as sidered “corruption” in some countries and corruption must also be taken into account. not in others. Bribes intended to influence the design and

64 The Milken Institute Review content of laws and regulations (state cap- No one knows how much the loss of an ener- ture) must be differentiated from those in- getic entrepreneur or an acclaimed scientist tended to change or circumvent their costs a country. Moreover, any estimated social implementation (administrative corruption). costs in dollars would be inadequate to the task of measuring the human tragedy behind resig- Third, there is a need to distinguish among nation, illiteracy or inadequate medical care. the actor categories involved in various forms of corruption: when poor people are involved, In fact, much of the research on gover- it is often referred to as petty corruption as nance implicitly suggests that corruption can opposed to grand corruption, which involves be observed only on a wide scale in countries high-level officials and political figures. under a certain income level. Although there Fourth, corruption may be of a different scale is obviously recognition that corruption also and nature depending on the administrative occurs in high-income countries, it is treated agency in which it takes place (schools, cus- as poor behavior by public officials or busi- toms, health centers and so on). nesspeople who represent the exception and Transparency International has chosen a not the rule. These high-profile, headline- more focused operational definition of the grabbing cases are considered outliers and term: “the abuse of entrusted power for pri- therefore are either ignored or discounted vate gain.” The organization further differen- by mainstream economic research. Nothing tiates between “according to rule” corruption could be more misleading. and “against the rule” corruption. Facilitation Defining and measuring corruption is a payments, where a bribe is paid to receive difficult task, not least because the definitions preferential treatment for something that the differ not only between countries but within bribe receiver is required to do by law, consti- them. For instance, while all of Japan is sub- tute the first. The second is a bribe paid to ob- ject to one penal code, the United States has tain services the bribe receiver is prohibited 50 different penal codes (one per state) as from providing. well as a national (federal) code. Moreover, While Transparency International’s defini- Japan keeps detailed statistics on corrupt acts, tion of corruption is much clearer, it raises whereas the United States has no centralized another series of problems. First, since bribe record-keeping for such acts. payments are not publicly recorded, it is vir- Still, consider these statistics: between tually impossible to calculate their frequency 1987 and 2006, U.S. federal courts convicted or magnitude. Second, bribes do not always more than 20,000 government officials and take monetary form – favors, presents, ser- private citizens involved in public corruption. vices and even threats and blackmail are just The total convicted in the whole country is as common. These factors highlight other is- higher, since these numbers do not include sues, such as the strength of the judicial sys- convictions by states. tem and its ability to effectively handle complaints at the lowest possible cost, the Changing Perceptions prevailing cultural and behavioral norms, By focusing on global governance standards and so on. that often reflect particular political, philo- Corruption’s social costs are even less sophical and ideological concepts of power, quantifiable. As Transparency International the traditional literature on governance has points out: so far yielded few results. It has failed to offer

Second Quarter 2017 65 actionable policies that poor countries could has focused on the negative effects of corrup- implement to foster inclusive growth in a tion (and bad governance more generally) on pragmatic and incentives-compatible way. economic growth. Kevin M. Murphy, Andrei In fact, good governance has been an elu- Schleifer and Robert W. Vishny suggested that sive quest. Since the United Nations Commis- increasing returns on unproductive rent- sion on Human Rights identified transparency, seeking may eventually crowd out productive responsibility, accountability, participation investment. Paolo Mauro offered empirical and responsiveness to the needs of the people evidence that the prevalence of perceived cor- as key attributes of good governance, the fight ruption may negatively affect economic per- against corruption has become the most re- formance. Such problems are said to be even vealing and the most widely discussed aspect worse in countries rich in natural resources – of governance. The academic pendulum on especially those in the developing world – the subject has shifted from praising the in- where opportunities for rent-seeking creased economic efficiency that follows from activities are typically very high. corruption to stressing its many economic, Despite the insights from all these various sociopolitical and even moral costs. waves of research, the problems of corruption Initial theoretical work on corruption un- and governance and their implications for derlined its positive role in development. Re- economic development remain unresolved. nowned scholars such as Nathaniel Leff (then Empirical demonstrations of the impact of at Harvard) and Samuel P. Huntington ar- governance on economic growth are often gued that corruption may make businesses based on subjective perception indices, the more efficient by allowing them to circum- limitations of which are well known. Policy- vent bureaucratic procedures. makers in developing countries still have few A second strand of the literature has at- actionable prescriptions for how to design tempted to invalidate these previous analyses. policies to achieve their economic and gover- Gunnar Myrdal, the Nobel Prize-winning so- nance goals. Moreover, a traditional recom- cial scientist, argued that bribes may actually mendation for improving governance often allow civil servants to reduce the speed with involves curbing the power of political lead- which they process business transactions, or ers – some of whom are not democratically that bureaucratic procedures should be seen selected. For low-income countries, a poten- not only as causes of rent-seeking activities tially more fruitful approach to tackling the but as their consequence. problem would be to examine the possible Others have argued that, even taking at determinants of good governance and to infer face value the suggestion that the most able from these determinants which policies could economic agents in corrupt societies generate limit opportunities for rent-seeking that in efficient allocation of resources through their ways are compatible with political leaders’ actions, such talent allocation cannot be eco- personal goals. nomically efficient. For instance, Susan Rose- Ackerman of Yale Law School observed that, The Cost of the Good Governance Rhetoric once corruption is entrenched, it becomes so The obsession that low-income countries pervasive that it cannot be limited to areas in must have the same political institutions as which it might be economically “desirable.” high-income countries is perhaps well ex- A third and most recent strand of research plained through the story of a fake corrup-

66 The Milken Institute Review tion scandal surrounding the visit of the repay it. His government was also talking to president of Congo to New York in Septem- the Paris and London Clubs, informal groups ber 2005. His official purpose was to give a of official and private creditors respectively, 15-minute speech to the UN General Assem- whose role is to coordinate sustainable solu- bly. But questions arose when the hotel bill tions to debtor countries’ payment difficulties. for the president and the 56 people in his en- The news was received with shock and tourage was leaked to the press. President anger, especially by people in Congo, who Denis Sassou-Nguesso had spent $295,000 for probably would have liked their tax money an eight-night stay at the Palace Hotel on spent on other priorities. Leaders of non-gov- New York’s Madison Avenue, including some ernmental organizations and anticorruption $81,000 for his own suite. movements wrote letters to the World Bank’s The suite featured a master bedroom with president urging him to oppose any debt re- a king bed, two additional bedrooms and six lief operation for Congo until the country’s bathrooms. It also had its own private eleva- leaders could demonstrate better public fi-

A traditional recommendation for improving governance often involves curbing the power of political leaders – some of whom are not democratically selected. tor. Media reports noted that the suite had a nance management skills. Global Witness, a whirlpool bathtub and a 50-inch plasma tele- well-known anticorruption group, issued a vision, and that room service charges on Sep- report claiming that Congo’s oil wealth has tember 18 alone came to $3,500. “for too long been managed for the private The hotel did not itemize the charges, leav- profit of the elite rather than for the benefit of ing reporters to speculate about the room ser- its entire population.” vice menu, which included Dungeness crab, Not surprisingly, Paul Wolfowitz, then truffle crumbles, Scottish langoustines, pan- president of the World Bank, was more than seared foie gras and braised snails in chicken inclined to bow to the pressure. It took a mousse. They also made a big deal of the forceful response from the office of the execu- Congolese mission at the UN paying only a tive director for francophone Africa on the $51,000 deposit by check to secure the rooms. board of directors of the World Bank to refo- Presidential aides pulled out wads of $100 cus the debate on Congo’s debt relief on the notes to settle the bill. real issues at hand. All the more stunning to reporters was that Let’s step back and look at the situation in President Sassou-Nguesso was at the time the the context of normal diplomatic practices. chairman of the African Union, representing Why the outrage about a hotel bill of a few the continent’s 53 countries, and also negoti- hundred thousand dollars for a large presi- ating with the World Bank and the Interna- dential delegation on an official visit to the tional Monetary Fund for the cancellation of United Nations? After all, hotel suites are ex- a large fraction of Congo’s debt on the pensive in New York in September, especially grounds that the country could not afford to in the small number of luxury hotels where

Second Quarter 2017 67 foreign heads of states are forced to reside for vated by ignorance, class prejudice, racial security reasons when they attend the annual prejudice and so on? UN meetings. Would those who cried foul Perhaps because he had read news reports about the hotel bill have preferred that the and briefing memos on issues such as the Sas- president of Congo and his entourage settle sou-Nguesso hotel bill story, Barack Obama in a two-star hotel somewhere in New Jersey used his first official trip to Africa (Ghana in or Connecticut while attending the summit? July 2009) to speak out against corrupt leaders: No country is going to create wealth if its lead- Is Incompetence Worse Than Corruption? ers exploit the economy to enrich themselves There are certainly many important eco- or if police can be bought off by drug traf- nomic and even governance issues to be dis- fickers. No business wants to invest in a place where the government skims 20 percent off cussed about Congo and other low-income the top. … No person wants to live in a society countries. But the focus on the hotel bill ob- where the rule of law gives way to the rule of scured the real questions of whether the pub- brutality and bribery. ... And now is the time lic policies implemented by his government for that style of governance to end. were sound enough to bring strong economic Those words were met with polite ap- growth and prosperity to his people. While plause. But many African leaders and intellec- the hotel bill might have been high, the only tuals objected to the paternalistic tone and reason it was disclosed to the press was that the perceived double standard that under- some of Congo’s creditors had filed lawsuits lined Obama’s public ethics lecture. Festus G. over business debt repayment. Mogae, the former president of the Republic These were all “vulture” investment funds of Botswana, observed that Obama’s critique that make profits by buying up poor countries’ of African corruption on his first official visit debt at discount prices. Using a judgment there seemed quite selective: from two British High Court judges that [Obama] has been to the Middle East, to found Congolese officials to be “dishonest” Turkey, to Russia, to Europe, to Britain – about their country’s debt, the fund managers Britain where Parliamentarians have been had subpoenaed President Sassou-Nguesso’s doing their own thing – [to] Germany where hotel bill and leaked it to the media. Yet few Siemens has been indicted for corruption, [to] Russia and the Middle East, [places] which are newspapers that reported the sensationalist not known for their anti-corruption probity. … tale devoted time and resources to investigate So, while it is right and proper that the presi- the vulture investment funds – what they are, dent should have raised the issue of corruption, how they function and how poor countries the fact that he only raised it when he got to around the world should deal with them. Africa has the effect of perpetuating the mis- Would the media have shown the same in- conception that corruption exists only in Africa. terest in the story if the hotel bill was run up The story of President Sassou-Nguesso’s by a leader from a country with a better repu- hotel bill illustrates the confusion and fanta- tation? Would these questions have arisen if sies that have too often plagued public policy the president of an industrialized country when the good governance obsession leads to had spent the same amount of money for a distracting public discourse and focus on the stay in the city? Was the problem merely wrong development objectives. Such stories Congo’s intolerable poverty level? Or were sideline the much bigger economic issues of the attacks against Sassou-Nguesso moti- public investment priorities, flawed debt

68 The Milken Institute Review management strategies and economic policy 60–80 percent in the Persian Gulf countries mistakes throughout the decades that are and African countries such as Algeria. Hon- much costlier to Congo. est incompetence and bad economic strate- Similar stories can be told about many gies are neglected, despite their potentially other countries. In the neighboring Demo- serious consequences on productivity and cratic Republic of Congo (DRC), the public growth. debate about corruption and good gover- Likewise, the African Union has devoted nance was dominated in 2013 by the story many resources to promoting the findings of of 15 government officials who pocketed its Report on Corruption released in 2012, $52 million in mining fees in 2012. Again, which indicates that an estimated $148 billion that was a valid issue. But the public debate annually is lost to corruption. Clearly, such never tackled the much bigger problem: the waste deserves publicity and reflection. But DRC receives less than 5 percent of reve- the sum should be put in the context of the nues generated by mining firms operating much larger sums of money wasted on un- in the country, while the ratio is as high as productive public expenditures.

Second Quarter 2017 69 An Incentives-Compatible Policy the costs of running a well-functioning na- Framework for Governance tional judicial system are often far beyond Most studies on the determinants of good what the public sector can afford. The prob- governance go back to arguments similar to lem is compounded in many African coun- those made by either Gary Becker or Anne tries where corruption is embedded in Krueger. Becker analyzed corruption as a societal, economic and power relations, and purely illegal activity and suggested that virtually all state institutions, including the criminal offenses must be viewed as “eco- judicial system, are caught in the low-equilib- nomic activities” with external effects, and rium dynamics of what Richard Joseph called with punishment conceived as a form of taxa- “prebendal politics.” tion. From that general framework he conjec- But corruption isn’t just something that tured that the probability of committing a happens to poor countries. If one looks at cor- crime depends essentially on the penalty im- ruption in historical perspective, it is clear that Good political governance should not be seen a precondition for good economic performance. Sustained economic growth, employment creation and poverty reduction can be achieved even in very poor governance environments.

posed and on the probability of being caught. today’s high-income countries went through Furthermore, the penalty’s deterrent value the same – or even worse – bad governance ep- depends on the authorities’ willingness and isodes now observed in sub-Saharan Africa. In capacity to enforce laws and on people’s ac- the fascinating book Corruption and Reform, ceptance of the country’s institutions. This Harvard’s Edward Glaeser and Claudia Goldin implies that effective corruption enforcement analyze various patterns of bad governance in rules, and good governance in general, can the history of the world’s greatest democracy. take place only in countries with political sta- The results are disconcerting. bility and transparent rules. Conventional histories of 19th- and early In Becker’s insightful analysis, corrupt 20th-century America portray its corrupt agents expend resources to steal, and society, elements as similar, and at times equal, to the victim, experiences negative external ef- those found in many of today’s modern fects. He suggests that prohibition rules be transition economies and developing regions. Nineteenth-century American urban gov- combined with fines or other punishment to ernments vastly overpaid for basic services, internalize the negative externality. such as street cleaning and construction, in Unfortunately, this kind of after-the-fact exchange for kickbacks garnered by elected of- remedy to corruption may arrive too late. ficials. Governments gave away public services And it may be ineffective in countries where for nominal official fees and healthy bribes. the externality-generating activities (that is, These elements provide a crucial clue to corruption) are not easy to identify owing to the problems of corruption and governance: prevailing social norms and practices, or may they are endogenous to the level of economic be costly to curb. In almost all poor countries, development. In other words, low-income

70 The Milken Institute Review countries are by definition places where (per- Following the policy-oriented approach ceived) corruption is a problem, while their suggested by Anne Krueger, the empirical lit- governance indicators improve with their erature has identified seven factors as the economic performance. It is unrealistic to ex- main causes of corruption: pect the Democratic Republic of Congo, a • Trade restrictions, which make the neces- country with less than $500 income per cap- sary import licenses very valuable and en- ita, to build governance institutions that are courage importers to consider bribing the perceived as effective as those of Norway, officials who control their issuance. where per capita income exceeds $70,000. • Government subsidies that are appropri- What is crucially needed, then, to fight cor- ated by firms for which they are not intended. ruption and improve governance in a low- • Price controls whose purpose is to lower income country is a development strategy that the prices of some goods below market value offers few opportunities for state capture and (usually for social or political reasons) but rent-seeking activities. If a government adopts create incentives for individuals or groups to a comparative-advantage strategy, firms in bribe officials to maintain the flow of such the priority sectors will be viable in an open, goods or to acquire an unfair share at the be- competitive market, and the government will low-market price. not need to protect or subsidize them. • Multiple exchange rate practices and for- What does this leave us? Good political gov- eign exchange allocation schemes. Differen- ernance should be an important public policy tials among these rates often lead to attempts goal and be set freely by the all countries’ peo- to obtain the most advantageous rate, al- ple and leaders. It should not, however, be seen though that rate might not apply to the in- as a precondition for good economic perfor- tended use of the exchange. Multiple exchange mance. Sustained economic growth, employ- rate systems are often associated with anti- ment creation and poverty reduction can be competitive banking systems in which a par- achieved even in very poor governance envi- ticular bank with strong political ties makes ronments. Moreover, good political gover- large profits by arbitraging between markets. nance is always an unfinished process. • Low wages in the civil service relative to Good economic governance is a noble goal, wages in the private sector, which often lead and its general principles can be widely shared civil servants to use their positions to collect across nations and cultures. But operational- bribes as a way of making ends meet – partic- izing it is likely to vary widely across place and ularly when the expected cost of being caught time. To succeed, a policy agenda is needed is low. that focuses on using limited state resources • Natural resource endowments. strategically and wisely. Focus areas should • Sociological factors such as ethnolinguis- include setting economic policy to ensure that tic fractionalization. only activities that are consistent with com- Given that virtually all governments in the parative advantage are encouraged; ensuring world – including those in successful demo- that government at all levels has the tools, cratic countries – regularly intervene in their incentives and discipline to facilitate public- economies, the important question is which private partnerships in the development of particular policy circumstances provide the competitive industries; and setting rules of best incentives for good governance? Lin’s the game that are enduring and effective. book New Structural Economics attempts an

Second Quarter 2017 71 answer. It suggests the gradual lifting of trade where firms are viable in open, competitive restrictions, price controls and multiple ex- markets and whose survival do not depend change rates, recognizing that such interven- on large subsidies, or direct resource alloca- tions may be temporarily needed to protect tions through measures such as high tariffs, firms in sectors that lack a comparative ad- quota restrictions or subsidized credit. In the vantage. It advocates carefully targeted incen- absence of large rents embedded in public tives (of limited amount and time), allocated policies, there will not be distortions that be- in a transparent manner to compensate for come the easy targets of political capture. The the externality generated by pioneer firms likelihood of the pervasive governance prob- (even in industries that are consistent with lems that are observed in many low-income comparative advantage). countries can be much reduced if govern- Such a framework ensures that corruption ments facilitate the development of new in- opportunities are minimized. It favors gov- dustries that are consistent with the country’s ernment intervention only in industries changing comparative advantage, determined

72 The Milken Institute Review by its changing endowment structure. ments to growth and poverty reduction. The goals of most political leaders every- Following the pioneering work of Raymond where are typically to stay in power as long as Goldsmith, Ronald McKinnon and Edward possible and to leave a positive legacy. Most Shaw, a rich research literature has advanced leaders understand that promoting economic the view that the amount of credit the financial prosperity is the best way to achieve these sector can intermediate is an important deter- goals. Development policy based on new minant of economic performance. structural economics, which advises govern- Here again, the theoretical case seems ments to facilitate the entry of private firms quite strong. Economic prosperity, the result into sectors with comparative advantages, can of improvements in physical and human cap- reduce corruption and bring growth. Good ital and productivity, depends on the efficient governance will be the result of such a strategy, use of productive assets – and on including because there is no need to create rents that large portions of the population in that pro- subsidize and protect firms in the priority sec- cess. Effective financial intermediation is tors. Therefore, it is an incentives-compatible therefore essential, as agents with net savings way for political leaders in developing coun- (whether domestic or foreign) should be en- tries, including those in poor countries, to ad- couraged to provide funding at optimal cost dress challenging governance issues. to support private investment. Both savers and investors face risk and uncertainty, and “underdeveloped” finance: the financial system can help them mitigate it the illusions of mimicry – or capitalize on it. By the same token, savers On the list of the most recurrent obstacles to are generally unable to select the investment growth and poverty reduction, the next cul- projects that best match their personal risk prit often singled out in the literature is lim- tolerances, and without pooling their money ited access to capital. Credit appears to be a they cannot take advantage of increasing re- major bottleneck for business creation and turns to scale in investments. development. Moreover, bankers and finan- Asli Demirgüç-Kunt and Leora Klapper ciers are universally considered villains whose sum up the intellectual consensus on finan- greed and shortsightedness are such that en- cial systems’ capacity to reduce poverty: trepreneurs cannot expect their support in Inclusive financial systems – allowing broad the drive for value creation. access to financial services without price or In her compilation of jokes about them, non-price barriers to their use – are especially Anna White (the City Diary editor of The likely to benefit poor people and other disadvantaged groups. Without inclusive financial Telegraph) recounts the widely shared belief systems, poor people must rely on their own that “bankers are people that help you with limited savings to invest in their education or problems you would not have had without become entrepreneurs – and small enterprises them.” She also tells the story of a man who must rely on their limited earnings to pursue visits his bank manager and asks, “How do I promising growth opportunities. start a small business?” The manager replies, But empirical research tends to show that “Start a large one and wait six months.” the relationship between financial develop- It is not surprising, then, that the weak ment, economic growth and poverty reduc- financial systems that are so prevalent in low- tion depends on many other factors, such as income countries are perceived as impedi- the country’s development level, the financial

Second Quarter 2017 73 structure and existing regulations. Stephen the causal relationship between financial Cecchetti and Enisse Kharroubi investigate structure and economic growth – that is, one key question: whether a market-based or bank-based finan- Is it true [that financial development is good cial structure is more conducive to growth. for economic growth] regardless of the size Banking partisans argue financial markets and growth rate of the financial system? provide much weaker incentives for agents to Or, like a person who eats too much, does a collect information relevant to investors’ bloated financial system become a drag on prospects before the fact or to monitor bor- the rest of the economy? rowers (or stock issuers) after the fact. Thus From a sample of developed and emerging securities markets are at a disadvantage in al- market economies, they show that financial leviating the asymmetry of information be- development promotes growth only up to a tween providers and users of capital. It point, after which it actually reduces growth. follows that a bank-based structure should Strikingly, they also show that a fast-growing perform better in allocating resources and financial sector is detrimental to aggregate promoting economic development. productivity growth in advanced economies. Not surprisingly, those who favor market- These findings raise a host of important based financial systems focus on the prob- questions for policymakers ranging from the lems created by powerful banks. Banks may criteria under which financial institutions are gain huge influence over firms, undermining established and allowed to expand, to the in- firm productivity and economic growth. In struments they can use to mobilize savings. addition, banks tend to be more cautious Financial intermediation, everyone agrees, by nature, and so bank-based systems may creates strong externalities that can be either stymie financial innovation and impede positive (such as provision of information economic growth. Furthermore, financial and liquidity) or negative (such as excessive markets are often seen as providing richer risk-taking and systemic crises). and more flexible tools for risk management – derivatives and the like – while banks can The Quest for Appropriate Financial provide only basic risk-management services. Institutions The technical literature on banking tends There is a vast literature analyzing the relative to focus on whether competitive or monopo- advantages of various banking structures. But listic banks are better for economic growth. there is no consensus on the strengths and Some authors suggest that monopolistic banks weaknesses of alternatives in promoting eco- tend to extract too much rent from borrowers nomic growth. Nor is there consensus on the (by charging above-market interest, etc.), un- strengths and weaknesses of different financial dermining investment incentives. By the same regimes in different country settings. The rea- token, monopolistic banks tends to pay lower sons for these gaps are the neglect of the spe- rates of interest to depositors, and thus reduce cific characteristics of the real economy at each the amount of capital they intermediate, level of development and the corresponding which in turn slows economic growth. needs in terms of financial intermediation. But others argue that monopolistic banks Research shows that financial markets have more incentive to collect information, tend to outpace banking activity as income screen and monitor borrowers, and form per capita rises. The literature has focused on long-term relationships with borrowers. Such

74 The Milken Institute Review borrower-lender relationships are especially banks by size does affect allocative efficiency. valuable to startups. In a competitive banking A few studies have looked at the issue from sector, by contrast, borrowers can more easily a very different perspective, examining the shift between lenders, so banks may have less mechanisms that determine financial struc- incentive to forge such long-term borrower- ture. Raghuram Rajan and Luigi Zingales, for lender relationships. As a consequence, mar- instance, apply interest group theory to ex- ket concentration in banking may give the plain differences in financial structure in most productive projects a better chance to countries at similar stages of development. get financed. Others have emphasized the legal system’s Empirical studies on this topic are far from importance in shaping financial structure, ar- conclusive. Some show a positive relationship guing that effectively implementing the law is between banking concentration and stability. more critical to the operation of financial Others find that new firms grow faster in markets than of banks. Thus a bank-based

The impact of financial systems on growth may not be appropriately determined if the analysis is separated from the examination of how the financial structure itself is determined. economies with a more concentrated banking system will have advantages in countries with sector, while old firms benefit from a more weak legal systems. competitive banking structure. This logic does not, however, explain why Despite their diverging conclusions, these financial structure is usually different in two schools of thought share a similar – and countries with similar legal origins but at dif- flawed – research perspective. They typically ferent development stages. Or why the finan- start from an examination of various insti cial structure in a given country changes as tutional arrangements and then discuss the the country’s economy develops. In fact, any possible impact of financial structure on effective theory should take into consider- economic development. Yet the impact of fi- ation the financial structure’s endogeneity nancial systems on growth may not be appro- when analyzing the relationship between fi- priately determined if the analysis is isolated nancial structure and economic development. from the examination of how the financial To sum up, much of the literature adopts a structure itself is determined. supply-side approach. It starts from an exam- While the research on the impact of banking ination of the characteristics of various finan- structure on market concentration is quite cial arrangements and then discusses the substantial, the topic of how the size distribu- likely effects of different financial systems on tion of banks affects growth has been neglected. economic growth. We think it is important This flies in the face of the well-established fact to pursue a radically different demand-side that small businesses, the dominant form of approach – one that starts from the analysis business operations in developing countries, of the real economy’s characteristics and the usually have difficulty obtaining loans from real economy’s demand for financial services. big banks – implying that the distribution of A financial structure’s effectiveness should be

Second Quarter 2017 75 measured by one important criterion: whether cially lending services, for different size firms. it can best mobilize and allocate financial re- Banks were long regarded as central to pro- sources to serve the real economy’s needs. moting growth and poverty reduction. But in the face of widespread corruption and bank Redefining Optimal Financial Structure failures in the 1970s and 1980s, there was dis- Empirical research shows that there is virtu- illusionment with their role, most notably in ally no country – even among industrialized developing countries. As a result, many influ- ones – where securities markets actually con- ential development institutions, such as the tribute a large part of corporate financing. In- World Bank, shifted their policy advice and deed, Colin Mayer studied eight developed advocated the use of both security markets countries and concluded that the average net and banks in promoting growth. In fact, a contribution of their securities markets was central feature of the economic reform im- close to zero. This does not necessarily imply plemented in the Washington Consensus

The financial-sector reforms were expected to raise savings and investment levels, reduce macroeconomic instability, increase the rate of growth and create employment. These objectives have generally not been achieved.

that equity markets do not perform an im- framework was the dismantling of the tradi- portant function, Mayer writes. “They may tional development finance model (based on promote allocative efficiency by providing bank-based systems, directed credit, public prices that guide the allocation of resources … development banks, closed capital accounts, through reallocating existing resources via, capped interest rates and active monetary in- for example, the takeover process.” tervention) that had been established in de- Two dimensions of financial structure crit- veloping countries in the postwar era. ically affect financial systems’ efficiency in Small banks with very limited assets can- economic development: first, the relative im- not afford to make large loans; they would portance of banks and financial markets, and have to bear much higher risk resulting from second, the distribution of banks of different concentrated investments. Large banks are sizes. Banks are the predominant type of fi- able to make larger loans and achieve better nancial intermediary in low-income coun- risk diversification. Since the transaction cost tries. Their mechanisms for mobilizing for making a loan is, at least to some degree, savings, allocating capital and diversifying independent of loan size, large banks under- risks are very different from those of financial standably prefer making loans to large firms markets. Therefore, the relative importance rather than small ones. Large banks tend to of banks and markets constitutes the most focus on large businesses, while small banks important dimension. specialize in lending to small businesses. Thus Among banks, there is an obvious distinc- the distribution of big banks and their smaller tion between the way in which big banks do counterparts can have a substantial effect on business and how small banks operate. This the banking sector’s performance. has implications for access to services, espe- The new received wisdom aims to reflect

76 The Milken Institute Review the imperatives of financial development. It may cause financial crises, a serious mismatch has been influenced by financial market liber- between the financial structure and industrial alization that is unfolding in the advanced structure will reduce efficiency in mobilizing economies, which have moved away from na- and allocating financial resources. In devel- tional bank-based systems toward open capi- oped countries where large, capital-intensive tal markets – at least until the 2008 Great firms and high-tech firms lead, financial sys- Recession when the pendulum switched to tems dominated by securities markets and big the other extreme. Conservative governments banks will be more efficient in allocating fi- in the United States and Europe abruptly nancial resources and promoting economic changed gears and adopted new laws and reg- growth. In developing countries, where small ulations to rein in financial markets. and less risky labor-intensive firms are the The financial-sector reforms implemented main engines of growth, the optimal financial in developing countries around the world structure will be characterized by the domi- over the past decades were expected to raise nance of banks, especially small local banks. savings and investment levels, reduce macro- The optimal financial structure for any coun- economic instability, increase the rate of try changes as the economy develops. growth and create employment. These objec- The major policy challenge is selecting the tives have generally not been achieved. In- appropriate framework for developing sus- stead, the years since the mid-1990s have been tainable and effective financial institutions. In marred by several financial crises and a de- this regard, governments have an important cline in funding for productive enterprises – role to play. Both equity markets and banks especially small and medium-size enterprises. require regulation and supervision to reduce Recent analytic work by Justin Yifu Lin, the occurrence and severity of financial crises. Xifang Sun and Ye Jiang shows that each insti- Although a country’s endowments and the re- tutional arrangement in a financial system sulting optimal industrial structure are the has both advantages and disadvantages. Eq- most fundamental force shaping its financial uity markets become more active relative to structure, government policy will also affect banks as a country becomes richer; small the evolution of the financial system. In fact, businesses have no access to equity markets strategies promoted by governments are and generally have less access to large banks’ among the most important factors leading loan facilities. industrial structures and financial structures The factor endowment in an economy at to deviate from optimality in terms of growth each stage of its development determines the potential. optimal industrial structure in the real sector, Policymakers in developing countries which in turn constitutes the main determi- should be mindful of a particularly costly nant of the size distribution and risk features type of hidden distortion that follows from of viable enterprises, with implications for replicating the financial systems in developed the appropriate institutional arrangement for countries without fully considering the real financial services. Therefore, there is an en- economy’s demand for financial services. Just dogenously determined optimal financial like perception-based indicators of good gov- structure for the economy at each develop- ernance, financial development is a function ment stage. of a country’s economic development While poor regulation and supervision level – not a prerequisite to performance.

Second Quarter 2017 77 ALEC: Headline is “Still Digging Out” Caption for Home page is: “Palestinian Blues” Main topic: Middle East Other topics: Economic Development

The Israeli-Palestinian struggle reached the front burner of global geopolitics once again this winter, when the departing Obama administration declined to veto a UN Security Coun- cil resolution condemning Israel’s settlement construction and the incoming Trump administration responded with a show of solidarity with the Netanyahu government. But, as this latest episode in more than a decade of diplomatic frustration Tsince the 2005 disengagement from Gaza has illustrated once Still again, what happens below the diplomats’ radar may have more to do with eventual economic Digging outcomes than the latest efforts to untangle the Gordian knot. Developments on the inter- Out national stage have a way of distracting from The Economics of a pressing fiscal, trade, environmental, business and infrastructure issues that, if managed well, Palestinian Future could improve daily life and even make a politi- by jacob udell cal deal more plausible. and glenn yago Under the mantra of “nothing is agreed until every- illustrations by hanna barczyk thing is agreed,” economic development is given short shrift. Yet development through market building on the ground is central to the success of nascent states. Job creation and growth buttress diplomatic initiatives and provide incentives for negotiated solutions. More than ever, then, an economic plan laid out by common Palestinian and Israeli interests could make a bigger difference in building transactional trust than another roll of the political dice.

78 The Milken Institute Review tk

Second Quarter 2017 79 palestinian future funds promised to the Palestinian Authority Addressing growth is long overdue for the for Gazan reconstruction have been delivered. Palestinian economy, which has experienced Yet, overall, despite the shifts and shocks, for- a lost decade. Since 2005, real average wages eign aid in 2015 continued to make up more have decreased by some 10 percent, while un- than 30 percent of the PA’s $4.3 billion annual employment remains at around one-quarter budget. This aid model distorts Palestinian of the labor force, and average GDP growth economic development and hampers growth. lags behind population growth by 2.6 percent Robust development requires investment, lev- per year. eraged and strengthened by aid. That last number is arguably most dispirit- In the absence of a political breakthrough, ing. The Palestinian Authority’s economic investment – everything from housing to performance is at the bottom of the Arab waste treatment – must propel aggregate de- world and less than the average growth rate mand and provide the base for economic de- among what the World Bank defines as heav- velopment. The needs of the Palestinian ily indebted poor countries. economy are urgent and will only grow more Donor and public sector expenditures – at intractable with delay. the top of the agenda of ways to buffer the political pain of compromise for the Palestinians job creation and – are currently not designed to sustain eco- private sector finance nomic expansion. International aid and dona- While the poverty rate in the West Bank and tions shift rapidly from year to year, leading to Gaza has fallen slightly in the past decade, the uncertainty and inefficient allocation of funds. improvement is largely a result of public and After the Israeli disengagement from Gaza in private transfers, not job creation. Indeed, the 2005, the rise in donor aid, which reached al- West Bank and Gaza remain highly depen- most 32 percent of GDP in 2008, initially fu- dent on cash remittances from Palestinian eled rapid economic growth. However, the workers in Israel and abroad, as opposed to subsequent decline of aid and the failure to local employment and production. From apply systematic efforts to replace it with mar- 1993 until 2013, remittances have run as high ket investment have exposed the fundamental as 34 percent of the GDP, making this the vulnerabilities of the Palestinian economy. If economy with the second greatest reliance on donor grants simply fill the gap left by a lack cash remittances (as a portion of income) in of efficient market incentives, they do little to the world. help private investors build management ex- Looking further, it’s worth noting that re- pertise or bring about sustainable job creation. mittance inflows for investment amount to Exacerbating the instability, donor aid only about 13 percent of the total, whereas pledged to the Palestinian Authority often household transfers – money sent back home does not materialize. For instance, only 35 per- by family and friends for expenses – consti- cent of the $3.5 billion in Cairo Conference tutes 30 percent, and workers’ compensation, which are paychecks from Israel or abroad

JACOB UDELL is a research analyst and GLENN YAGO used for domestic consumption, represents is senior director at the Milken Innovation Center at the over half. These data illustrate the extreme de- Jerusalem Institute for Israel Studies. This article updates pendence of residents of the West Bank and an earlier analysis published in the Review in the third quarter of 2005. Gaza on work in Israel and financial support

80 The Milken Institute Review ALEC: Use this this table directly and call it “Yago-Glenn-Udell-Jacob- Palestine-Table1.” PALESTINE’S LOST DECADE KEY DEVELOPMENT STATISTICS IN THE WEST BANK AND GAZA

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

GDP Constant. . . . $4,796 7...... 4,609 .6...... 4,913 .4...... 5,212 .1 ...... 5,663 .6 . . . . . 6,122 .3...... 6,882 .3...... 7,314 .8 . . . . . 7,477 .0...... 7,449 .0. $US (Millions)* GDP Per Capita. . .$1,459 4...... 1,360 .1...... 1,406 .0...... 1,449 .1...... 1,529 .8 . . . . . 1,606 .4...... 1,752 .5...... 1,807 .5 . . . . . 1,793 .3...... 1,734 .6. Constant $US* Population ...... 3,508,126. . . . 3,611,998. . . . 3,719,189. . . . 3,825,512. . . . 3,935,249 . . . . 4,048,403. . . . 4,168,860. . . . 4,293,313 . . . . 4,420,549. . . . 4,550,368 Population ...... 2 .96%...... 2 .96...... 2 .97...... 2 .86...... 2 .87 ...... 2 .88...... 2 .98...... 2 .99 ...... 2 .96...... 2 .94. Growth GDP Per Capita...... 7 .5%...... -6 .8...... 3 .4...... 3 .1...... 5 .6 ...... 5 .0...... 9 .1...... 3 .1 ...... -0 .8...... -3 .3. Annual Growth Poverty Rate...... 29 5%...... 30 .8...... 31 .2...... 26 .2 ...... 25 .7...... 25 .8 Unemployment. . . . 26 0%...... 23 .6...... 21 .6...... 26 .0...... 24 .5 ...... 23 .7...... 21 .0...... 23 .0 ...... 23 .4...... 26 .2. Rate Real Wage Index*^. . . . 66 8...... 66 .1...... 68 .2...... 66 .5...... 63 .1 ...... 64 .1...... 60 .4...... 58 .6 ...... 58 .5...... 58 .0

source: Palestinian Monetary Authority & World Bank * Assumes a base year of 2004. ^ Uses PMA’s Consumer Price Index.

from family members living abroad for their UNEMPLOYMENT RATE IN WEST BANK basic consumption. AND GAZA, 2015

By the same token, a close look at labor 60% statistics reveals a number of additional trou- bling trends. Though the labor force participation rate is currently at its highest since 50 Males 2000 (at an unimpressive 46 percent), it has ALEC: Females been accompanied by an overall spike in un- 40 Use “Yago-Glenn-Udell-Jacob-Palestine- employment – implying that the net entry of Chart1” for the web job seekers into the market exceeds the ability 30 of the economy to create employment. Meanwhile, the Palestinian Authority has also become the employer of last resort, with 20 23 percent of the workforce on its rolls. The wave of youth entering the labor market in 10 the past decade, coupled with the frictional and structural unemployment of the adult 0 population and almost nonexistent job 15-24 25-34 35-44 45-54 55-64 65+ growth, has left youth unemployment at AGE GROUPS alarming levels. Since 2001, for instance, unemployment among males aged 15-24, which source: The authors seems to function as a leading indicator of matic opportunities of the past decades. As civil unrest, has averaged 35 to 40 percent and the IMF recently pointed out, the combina- reached 43 percent in 2014. tion of volatile donor aid, political uncer- Job creation remains the most pressing tainty and limited policy innovation is imperative to make up for the missed diplo- creating a situation in which likely growth

Second Quarter 2017 81 ALEC: Use this this table directly and call it “Yago-Glenn-Udell-Jacob- Palestine-Table2.” FINANCIAL INCLUSION IN WEST BANK consisted of loans to the public sector: the AND GAZA AND NEIGHBORS government relies upon the funds of the Pal- PERCENTAGE OF POPULATION OVER AGE 15 estinian banks to cover its budget deficits. HELD AN BORROWED FROM SAVED AT ACCOUNT A FINANCIAL A FINANCIAL AT A INSTITUTION INSTITUTION separation versus integration FINANCIAL IN THE IN THE INSTITUTION PAST YEAR PAST YEAR Oslo-driven visions of a Palestinian state as a viable economic entity were premised on the Egypt ...... 14 3%...... 6 .3%...... 4 .1% Israel...... 90 0%...... 40 .5%...... 53 .5% eventual integration of the Palestinian and Is- Jordan...... 24 6%...... 13 .6%...... 3 .8% raeli economies. But the Second Intifada and Lebanon ...... 46 9%...... 15 .6%...... 17 .5% the ill will built up over the past decade have West Bank. . . . . 24 2%...... 4 .2%...... 5 .1%. led to a reconsideration of the united-we- and Gaza stand/divided-we-fall assumption. In our view,

source: World Bank Financial Inclusion Data it would serve neither Israelis nor Palestinians to cling single-mindedly to the goal of Euro- (around 3 percent) remains insufficient to ab- pean-Union-style integration. Normalization sorb the ballooning numbers of Palestinians of economic relations between Israel and an of working age. The resulting rise in unem- independent Palestinian state will surely de- ployment and fall in living standards can only pend on an agreement that facilitates trade complicate initiatives toward a political set- and capital flows, but this need not imply full tlement. So improvements in Israeli-Palestin- integration of labor or capital markets. ian economic cooperation should remain a Focusing on the years of relative calm high priority, whether one sees the goal as before the Second Intifada, it becomes clear peace or just the improvement of Palestinian that Palestinians’ economic dependence on living standards. Israel was a mixed blessing. During the Oslo One key to job creation is structural change period (1993-2000), the GDP of the Palestin- in both capital and labor markets. As it cur- ian economy grew by 20 percent – a seem- rently stands, the Palestinian economy is ingly reasonable number until one remembers driven mostly by consumption, which repre- that truly explosive population growth led to sented over 90 percent of GDP in 2014 – a dis- a reduction in output per person of 8 percent. turbingly high figure by the standard of By the same token, the higher wages paid to successful developing countries. Production, Palestinians by Israelis certainly pleased the not consumption, is the true source of the recipients. But it also put pressure on wages wealth of nations, especially new ones, and the and prices in lower-productivity businesses Palestinian private sector must create condi- in the territories, making it more difficult for tions in which businesses can accelerate wealth homegrown Palestinian enterprises to take creation to finance future production. Yet the root or to compete on an arm’s-length basis Palestinian financial sector, while expanding, in foreign markets. Gross capital formation, does not have the depth or breadth to meet le- the key to productivity growth, remained gitimate private credit demand. Private lend- dangerously low in the years since 2006 – being represents just one-quarter of total credit tween 20 and 25 percent of GDP. in the West Bank and Gaza, as opposed to The Palestinian territories’ trade deficit is three-quarters in Jordan and 95 percent in Is- also a product of dependence on Israel and a rael. In fact, most of the growth in credit has lack of diversification of its trade partners. Is-

82 The Milken Institute Review rael is the biggest market by far for Palestinian • Looking outward to its competitive ad- goods, accounting for some 85 percent of Pal- vantages in the region estinian exports, which highlights the lack of • Looking inward to locally led investment Palestinian business development in the mar- in key sectors kets of Europe and the rest of the Middle East. • Looking up to ensure that the financial Israel is also the territories’ major supplier, ac- infrastructure exists for private sector growth counting for 60 percent of total imports. There is some evidence that local economic development built on sound institutions is possible. For instance, the Palestinian Investment Fund, a sovereign wealth fund with close to $800 million in assets, has become more transparent since it was mired in corruption scandals a decade ago. The fund has recently engaged in renewable energy financing, with the goal of investing $150 million in 10 solar plants in the West Bank and Gaza. Nevertheless, investment figures remain discouraging. And while considerable sums flow into the territories from overseas Pales- tinians, there are no “diaspora bonds” or other vehicles to facilitate investment by Pal- estinian ex-pats (whose wealth estimates by the World Bank have varied from $40 billion to $80 billion). One mark of a lack of confidence in the economy: Palestinian investment abroad in 2015 was $5.9 billion – $1.3 billion Looking Outward: Sources of more than foreign investment in Palestine. Competitive Advantage A future Palestine could take a leaf out of Isra- an economic road map el’s playbook, focusing on its strengths to for a future palestine overcome its weaknesses. Like Israel, Palestine More than a decade ago, at the 2005 Milken lacks natural resources. But it does have a Institute Global Conference in Los Angeles, wealthy diaspora, a cultural commitment to we asked a spectrum of business and political education, and strong entrepreneurial and leaders from the United States and the Mid- trading traditions vital to a modern, skills- dle East to brainstorm ways in which business based economy. Palestine could also capitalize could effectively privatize the peace process. on the good will and proximity of the Arab Today, those ideas, together with lessons world; if it built efficient capital markets in a learned from economic development else- politically stable setting, Palestine could be- where, can still provide the outline of an eco- come a financial and commercial-services nomic road map for a future Palestine. We hub for the Arab East. It could also take advan- divide the strategy in three: tage of historically low interest rates and the

Second Quarter 2017 83 palestinian future estinian areas, including state-of-the-art in- ability to leverage bilateral and multilateral dustrial parks, incubators for tech startups guarantees to develop infrastructure in water, and accelerators supported by international alternative energy, environmental protection, businesses, would facilitate technology trans- tourism, transportation and communications. fers. Ideally, much of the effort would focus Consider, too, that the area has favorable on intermediate and finished products with conditions for developing high-value agricul- export potential. ture and agricultural technologies – fruits, vegetables, animals and high-value growing Looking Inward: Local Investment in practices. Technology transfers from Israel, a Economic Development country that has figured out how to grow One approach to locally led economic devel- food and fiber in unlikely places (in an envi- opment harks back to the investment-lever- ronment similar to those found in Palestinian aged-by-aid model. The idea is to employ areas), could sharply improve Palestinian ag- donor funds more effectively by using them ricultural productivity. Currently, the average to shelter private projects from the systemic agricultural yield in the Palestinian Authority risks inherent in operating in the region. Spe- is just half of that in Jordan and 43 percent of cifically, donors could provide credit en- that in Israel. The information and communi- hancement and risk insurance, as well as cations technologies sector, which has been a underwriting the planning phase for private bright spot over the past decade, can continue investment in a variety of important eco- to develop as a key driver of economic growth. nomic developments: It’s important here to emphasize that de- Water. A handful of specific river basin veloping strong economic ties between a new projects would have an immediate impact on Palestinian state and Arab countries would living standards in Palestinian cities and vil- serve the interests of the Israelis as well as the lages, as well as provide water for higher pro- Palestinians, reducing the pressure on Israel ductivity agriculture and industry. to go out of its way to nurture the develop- Energy. Natural gas production, electricity ment of the latter. Arab states, along with the cogeneration and alternative fuels produc- United States and Europe, could also offer tion (solar, biomass renewables) would re- preferential trade and tariff agreements to duce the need to spend scarce foreign kick-start employment and production in exchange on imports and in some cases have special economic zones, as they have done in the potential to be highly profitable. These Jordan and Egypt over the past decade. projects would also generate stable, predict- Tourism agreements between Israel and able revenues that could be used to leverage Palestine that make it convenient to visit both added private fund-raising. Israel and Arab sites in single trips could also Trade, tourism and transportation. Here, play an important role in driving economic we would include regional inter-urban rail, development. Tourism, especially high-value- port and, eventually, air facilities, as well as added tourism, is, after all, a labor-intensive destination tourism at religious, archeologi- industry with great potential for absorbing cal and recreational sites. It could be time to the large and rapidly growing numbers of un- revisit the RAND Corporation’s attempt in employed Palestinians. the Arc Project to plan infrastructure to sup- Finally, industrial development inside Pal- port commercial and residential development

84 The Milken Institute Review in an increasingly urbanized country – and CAPITAL FORMATION IN THE WEST BANK AND GAZA offer viable alternatives to continuing life in 40% refugee camps. Housing construction and finance. The expansion of markets for mortgages would 30 stimulate homeownership and urban revital- ALEC: Use “Yago-Glenn-Udell-Jacob-Palestine- ization, as well as invigorate focus on green 20 buildings and sustainable housing in this Chart2” for the web fragile semi-arid environment. 10 Looking Up: Capital Ideas

Even carefully refined projects designed to 0 harvest the low-hanging fruit first will not get 1995 2000 2005 2010 off the ground unless the drought of private- Gross Capital Formation as a Percentage of GDP sector credit in the Palestinian territories Of Which Buildings as a Percentage of GDP ends. Though Palestinian banks have become more sophisticated in terms of underwriting source: Sebastian Welisiejko, “The Palestinian Economy,” presentation at Milken Innovation Center, Jerusalem Institute, August 2015; Palestinian Central standards and post-loan monitoring, they Bureau of Statistics Data still lack tools needed to reach the scale of private sector credit available in other develop- have generally responded favorably during ing countries in the region. periods of stable commerce. By the same token, there has been little effort to employ the many successful models for the window of opportunity raising investment funds in high-risk environ- Despite good intentions, donor-driven devel- ments. Among the possibilities: partnerships opment in the context of constant political with multinationals for private concession- tension offers little evidence of progress. But, aires to run public facilities, privatization of as we argued a decade ago, identifying and public utilities ranging from power genera- supporting specific projects provides a way to tion and distribution to border-logistics man- take concrete steps toward cooperation and agement, and venture capital funds for stability. Success lies in the pragmatic use of targeted growth sectors like food processing. the economists’ toolbox to facilitate growth, Establishing a strong legal and regulatory plus an understanding that the Palestinian infrastructure for the Palestinian Authority’s economy must be able to stay afloat without financial markets is, of course, a prerequisite tethers to Israel. Ultimately, the past two de- for leveraging donor funds for project finance. cades have proved that only by structuring And there is much to be done – for example, shared economic interests will a political so- fewer than 50 companies are listed on the Pal- lution become feasible. And when the history estinian Securities Exchange. Creating diverse of this long, grinding phase of the Israeli- securities that could be traded at low cost, Palestinian conflict is written, the accounts possibly with enhanced credit via donor could emphasize how economic strategy, fi- funding, would increase the total pool of cash nancial leverage and the creation of jobs and for development projects. Note, moreover, income help manage disruptive forces in that investors in Israel, Palestine and Jordan the effort to form a new state.

Second Quarter 2017 85 letter from tôhoku

by ramona bajema

March in Japan is the time for graduation ceremonies and end-of-year accounts. It is a time of flux, waiting for full-blown spring, with the cherry blossoms still two months away. ButALEC: in the northeastern region of Tôhoku, it is also a time for horrific Headline is “Letter From Tôhoku” memories. Caption for Home page is: “The sun also sets” Main topic: Asia On March 11,Other 2011, topics: a 9.0 Economic magnitude Development pre-tsunami days. Given the scale of the disas- earthquake triggered a tsunami with 40-foot ter, it is hard to see how restoration of the area waves along 300 miles of coastline. Entire could pay for itself in purely economic terms. towns were wiped away in minutes. And the An ambitious reconstruction does, how- subsequent failure at the Daiichi nuclear plant ever, provide an opportunity for fiscal stimu- in Fukushima forced the evacuation of hundreds of thousands otherwise safe from the natural disaster. The catastrophe killed almost 20,000 and forced the relocation of half a million survivors. It was by far the costliest natural disaster in material terms in world history. The Tôhoku region is part of Japan’s rural hinterlands, with twice the area of Kanto (home to Tokyo and Yokohama) but just one- fifth as many residents. And though Tôhoku’s population (now nine million) had been de- creasing before the disaster, the erasure of coastal towns and contamination of others has sped up the process. As expensive as the disaster has been for the Japanese government and the owner of the Daiichi plant, the Tokyo Electric Com- pany (also known as Tepco), Tôhoku’s economy wasn’t large to begin with. It generated only about 6 percent of Japan’s total GDP in

RAMONA BAJEMA, who holds a PhD in modern Japanese history from Columbia University, managed the Americares recovery program in Tôhoku from 2011 to 2015.

86 The Milken Institute Review lus, which has long served Japanese horses that drowned. Others trembled when governments’ objectives in the countryside. describing how they left their dairy cows to Until recently, Tôhoku was a stronghold of starve when radiation contamination pre- the Liberal Democratic Party, which still vented them from returning to their farms. claims a disproportionate share of patronage. Six years later, relatives and rescue teams con- Instead of building more bridges to nowhere tinue to search for the remains of the nearly to provide local jobs and profits for construc- 3,000 people still categorized as “missing.” tion companies, post-disaster projects have Suicide rates, alcoholism, domestic violence been recast as “recovery highways,” and their and clinical depression have risen at alarming budgets have been approved without debate. rates since 2011. I moved to Sendai, Tôhoku’s largest city Today, the fear of decline permeates Tô and its economic and political capital, in June hoku. While Sendai has experienced a popu- 2011 to run the tsunami recovery effort of the lation boom as construction companies and private nonprofit Americares. While newspa- administrators rushed to participate in the pers around the world printed stories about reconstruction, the region’s overall popula- the survivors who stood in orderly lines with tion has dropped by 6.7 percent. It is likely blank expressions, I saw a less stoic side of the that some areas have even fewer residents Japanese. Men in the small city of Minami- than official numbers show because many

gianni giosue/anzenberger/redux Soma sobbed when they talked about their have left without re-registering in their new

87 locations in hopes of returning later. ing through the Fukushima countryside, you Some public intellectuals – such as Akemi see giant piles of stacked black plastic bags Yamauchi of Taisho University – have exhorted full of contaminated soil. These bags are on locals to focus on quality-of-life issues rather their way to “temporary” storage sites near than population decline, arguing that con- the decommissioned plant (a permanent site tracting markets matter less in the long run has not been agreed upon). than preserving local culture and traditions. The Japanese government has thus far When I echoed that sentiment to Japanese spent $226 billion on recovery and recon- friends, they responded with consternation, struction, an amount that does not include fi- although they thanked me for “loving Japan.” nancial support paid by Tepco to those affected by radiation contamination nor the very big numbers Daiichi plant’s ongoing cleanup. And these I returned to Tôhoku earlier this year to see payments may in the end nearly double the for myself what progress had been made in total outlay. By comparison, the cost of Hur- the region’s recovery. I drove from the town ricane Katrina, which flooded New Orleans of Soma (in Fukushima Prefecture) north and destroyed swaths of the Gulf Coast, some 140 miles along the coast to Ofunato. topped out around $110 billion. When I first arrived in 2011, mountains of de- bris, partially destroyed homes and remnants a task for sisyphus of boats (some stuck on rooftops) greeted me. My road trip along the coast stayed well out Now, the route is the axis of what must be the of the area that absorbed the worst of the ra-

largest construction project on record. Driv- diation blown inland by prevailing winds. I ikuru kuwajima/luzphoto/redux

88 The Milken Institute Review grew accustomed to highways jammed with dump trucks moving earth from one location to the next. But I was able to ditch my car north of Sendai, thanks to the reopening of the Joban rail line that connects Sendai with Fukushima Prefecture’s northern coastal cities. The rail line is (and was) more than a matter of convenience, though, as it provides easy access to the commercial center of the region. In spite of this “symbol of hope,” as Prime Minister Shinzo Abe described the railway at its reopening, anxiety still plagues Fukushi- ma’s residents. A recent report showed that radiation levels deep within the destroyed re- actors remain at levels that could kill a person in a minute and destroy a robot within two hours. Inevitably, then, the last phase of the cleanup will be very slow. In any case, radiation might not be the biggest threat to residents’ health. As in Chernobyl, the premature deaths from other causes (including suicide) outnumber those that were directly caused by the events of March 11. Nonetheless, residents’ economic concerns identity because their dates might think they apparently far outweigh their fears of ill won’t be able to bear healthy children. health. People are conscious of the threat The word “Fukushima” printed on a food from radiation, but are resigned. What Fuku- product means that consumer demand will shima residents feel more directly is the im- be nil for the foreseeable future. Hence, Ja- pact the catastrophe has had on the pan’s postwar “rice basket” must find another Fukushima “brand.” use for the land. Massive amounts of former Although the government is trying to re- farmland have been set aside for renewable package Fukushima as safe on television energy production. Still, it would be (yet an- commercials and train advertisements that other) monumental task to cover all the for- show popular actors eating Fukushima mer rice paddies with solar panels. peaches, the radiation-spooked Japanese Some effort has been made to convert public largely remains unwilling to ingest local agriculture to nonfood products. One Fukushima products or sightsee in the area. little farm near the town of Kawamata spe- I heard anecdotes about farmers giving gifts cializes in a bloom that is popular at Tokyo’s of rice to relatives in Tokyo, later to find out funerals. The Fukushima Organic Cotton that it had been tossed. Another variation on Project sold T-shirts at Tokyo’s Mitsukoshi the theme: eligible young women from Fuku- department store last year. And project orga- shima feel they must conceal their hometown nizers celebrated how the store advertised

Second Quarter 2017 89 letter from tôhoku Tokyo drew a line around areas that were them simply as “Fukushima cotton” rather determined to be uninhabitable, where resi- than as disaster relief charity. dents would be fully compensated. People But the gloom persists. Several towns that who move back to surrounding “decontami- had previously been designated “no entry” nated” areas continue to get support. Resi- were scheduled to reopen in March 2017 after dents of Minami-Soma, Futaba, Namie and a $35 billion cleanup. It is unclear, though, other towns close to the Daiichi plant have re- whether the massive cleanup will be effective ceived monthly allowances that include $1,000 in eliminating the long-term risks of radia- for “mental suffering.” But residents in places tion exposure – and, equally to the point, like Soma, a few miles outside the forced evacu- whether people will believe that it was effec- ation circle, haven’t gotten cash from Tepco – tive. Mountainsides, for example, could not and resent those who have. (“Did you see that

There is little incentive for young families to return to towns that are largely populated by the elderly and have no operating schools.

be bulldozed, and rainfall will wash unspeci- guy from Minami-Soma the other day? He’s fied amounts of contaminated soil down to driving a Mercedes-Benz.”) the inhabited areas. After six years and mounting cleanup costs The cleanup did create a welcome bubble at the plant, funds are running out. There are of commerce. According to the owner of a 48,000 evacuees living outside Fukushima roadside restaurant, the greatest change since and 41,000 who relocated to safer areas we met years ago has been the lunchtime on- within the prefecture. Many have not suc- slaught of construction workers, engineers, ceeded in finding affordable housing, locat- administrators and managers who came to ing new jobs or negotiating their family the area to work. The crowd, whom he called logistics. Yet Tokyo declared that, as of March the “unknown faces,” was tapering off, though 2017, voluntary evacuees would no longer re- – the bubble is deflating. ceive government funds. A young man who has opened a beauty In part, the cutoff is intended to encourage salon in Soma, which is on the coast south of people to return to Fukushima, since the gov- Sendai, hoped that his livelihood would not ernment is insisting that cleanup efforts have be affected by the undertow of departures. made the area safe. However, there is little in- After all, his business, like that of a dentist I centive for young families to return to towns spoke to, catered to locals. He returned to the that are largely populated by the elderly and coast out of obligation – he knew Soma was have no operating schools. struggling to keep its young people and Frustrations with the rate of recovery led wanted his children to share his upbringing. to a political backlash in Tôhoku. In the sum- Was he nervous about radiation? Not re- mer of 2016, the ruling Liberal Democratic ally. As with most of Fukushima’s residents, Party lost five of its six upper house seats in government funding was by far the bigger the region. Voters further objected to the ex- concern. pected reduction in protection for uncom-

90 The Milken Institute Review petitive domestic agriculture that’s part of the changes to the landscape. Where houses, post Trans-Pacific Partnership trade deal signed by offices, gas stations, supermarkets and schools Abe (and thereafter abandoned by President once stood, the land is barren, with only con- Trump). “Stop TPP!” signs dot the landscape. crete foundations marking what used to be One ray of high-tech hope is the idea of neighborhoods. Near Yuriage, a particularly transforming Fukushima into a laboratory for devastated area south of Sendai, I noticed renewable energy funded by public-private that a few factories dot what had been an investment. In January, to take one example, empty landscape. Much of Miyagi’s southern Toshiba, Tôhoku Electric and the Iwatani coastline has been designated as too danger- Corporation announced a feasibility study to ous for housing, but some areas will host in- build the world’s largest facility for synthesiz- dustrial sections, along with sterile parkland ing hydrogen gas to power fuel-cell vehicles. with lonely benches and fields of solar panels. Tôhoku’s own commitment to renewable energy (and rejection of nuclear power) is im- finding housing for thousands plicit in the proliferation of solar panels on Some 470,000 were evacuated to shelters scat- rooftops throughout the region. tered around the country. Four months after Traveling north from Fukushima along the disaster, 330,000 of them had moved

q. sakamaki/redux q. Miyagi Prefecture’s coast, I reflected on the into subsidized apartments or small, boxlike

Second Quarter 2017 91 letter from tôhoku away in the tsunami. Municipalities have houses hastily erected by the government. scrambled to identify who owns what, and Roughly half are still there, waiting for public whether it is available for purchase. But their housing or the go-ahead to build their own. scramble might be too late: current popula- While they wait, though, construction tion trends suggest that the demand won’t be costs have soared – in part, because of de- there by the time property rights are clarified. mand created by the 2020 Tokyo Olympics. In the meantime, backhoes move moun- Japan’s public broadcasting company, NHK, tains and pat, pat, pat down mounds of red reported the case of an 83-year-old man who earth to accommodate the diminished popu- had intended to rebuild his house after the lation. The town of Rikuzentakata built a land under it was elevated by some 60 feet, two-mile-long conveyer belt system costing safely beyond the reach of the next tsunami. over $100 million to carry some 40,000 tons He now believes that it would be a waste of of soil and gravel a day to create a high- his limited savings to rebuild. ground residential area for 61 apartments. In Scattered across the landscape are plots Ishinomaki, public housing has been built on that are truly ready to build on. However, top of elevated land near an area that was inland deeds are often hard to find in rural undated by the tsunami. But the apartments Japan – or simply do not exist because the are proving to be an especially hard sell be- land passed on through generations without cause people don’t want to live in an area written record. The problem here is even where so many drowned in the tsunami. worse since a lot of official paperwork washed One consequence of the housing gridlock tk

92 The Milken Institute Review was an epidemic of depression among the dis- would be almost 50 feet high and 30 feet thick. placed – especially the elderly, the poor and No environmental impact report was filed the sick – who are stuck in temporary housing. before construction at any point along the Early on, support groups of various stripes of- seawall. Although many residents voiced ob- fered both recreation and the myriad services jections, believing that clearly defined escape otherwise provided by friends, family and routes would be sufficient in future disasters, neighbors in tight-knit rural communities. landowners where the wall was to be built re- Kodokushi, dying alone from social neglect or ceived inflated sums and allowed the project self-neglect, was a particular concern. to proceed. And in a narrative familiar to Jap- Outside support groups, public and pri- anese citizens over the decades, construction vate, have largely stopped coming. But this companies gorged on government contracts withdrawal of psychosocial services has been even as allegations of price collusion clouded partly offset by an assertion of community the process. identity, with residents stepping in to care for Prime Minister Abe’s wife, Akie, visited Ri- their neighbors. In the same vein, local groups kuzentakata and engaged in informal discus- used the disaster to bring attention to social sions with evacuees about plans for the wall. needs that predated the tsunami. For example, These conversations prompted her to host a when multiple generations routinely lived 2014 conference in Sendai (miles from the under the same roof, the older women took coastline) with the title “What Do You Think

The government is moving mountains and building concrete monuments, but economic benefits are not immediately obvious.

responsibility for infant care. That piece of about the Monster Seawall?” According to a the social fabric has been fraying for years. survey at the event, 84 percent of respondents But the disaster has catalyzed female leaders felt that the plan had been too rushed and re- to organize and provide a host of services for quired further discussion. By that time, how- isolated new mothers. ever, the protest was moot; construction was I used to gaze at the surf as I drove along well under way. the coast road (Route 45), thinking about When I rounded a familiar bend on how cruel the ocean had been on March 11, Route 45, I saw Rikuzentakata’s seawall for yet how vital it was to the region’s identity and the first time, the height of a four-story economy. Driving the road this winter, con- building. Some residents described the wall crete walls largely blocked the view of the sea. as being “prisonlike,” though the city intends Before the government started communal to plant lines of pine trees to camouflage it. reconstruction, it developed a plan to build a When asked about the wall, residents seem seawall as a first defense against future inun- resigned: “It’s built now. There is nothing we dations. The wall was to more or less run the can do about it.” Although their livelihood is 250 miles of coastline at greatest risk, at a cost most threatened by the concrete, fishermen exceeding $8 billion. For example, one por- have vowed to work around it and continue

aflo co. ltd./alamy aflo co. tion guarding the fishing town of Kesennuma to operate their mollusk and seaweed farms.

Second Quarter 2017 93 letter from tôhoku stay home rather than be institutionalized. The government is moving mountains and A variety of grassroots organizations have building concrete monuments, but economic also emerged with their own visions for the benefits are not immediately obvious. The region’s reconstruction. Next Commons Lab government reported in the summer of 2016 is, in the words of its founder, Atsushi Hayashi, that 80 percent of businesses affected by the a “post-capitalist” model for cooperative disaster (setting aside those in Fukushima’s business enterprise. While idealistic, the exclusion zone) were up and walking. Directly group has had some success in revitalizing after the tsunami, the economists Anil Kashyap small, seemingly unsustainable for-profit en- and Takeo Hoshi warned against revivifying terprises elsewhere in rural Japan. And with “zombie” businesses that had been failing long Minami-Sanriku in Miyagi Prefecture as its before the disaster. But from the government’s entry point, Next Commons Lab is expecting perspective, delays to review plans before re- to begin operations this summer. leasing funds would have appeared insensitive. The list goes on. AP Bank, a nonprofit that Nevertheless, of the companies that received funds businesses with an eye on environmen- recovery subsidies, less than half are generat- tal and social impact, has opened an office in ing sales at predisaster levels. Ishinomaki, the site of the largest number of tsunami casualties. The group is sponsoring moving forward an art festival this summer that will feature Tourism was long a mainstay of the Tôhoku national and international avant-garde artists. economy. Yet, while Japan is experiencing a More Trees, a group founded by the musician foreign tourism boom, particularly from and activist Ryuichi Sakamoto and the archi- China, few visitors are venturing into the re- tect Kengo Kuma, is also seeking opportuni- gion. Major efforts are now under way to draw ties to maximize the resource potential of tourists to Tôhoku. Sendai will host the 2020 Tôhoku. Kuma, who won the bid to design the Olympics’ soccer events, and Kamaishi, a Tokyo Olympic Stadium, has designed a shop- hard-hit industrial town in Iwate Prefecture, ping district in Minami-Sanriku to be filled will host the 2019 Rugby World Cup. After the with local stores now stuck in prefab buildings. cheering dies down, though, the coastline’s With the advantage of hindsight, it’s plain natural beauty should be Tôhoku’s sustaining that the inclination to roll back the clock to attraction. And far too much of it is now hid- the pre-tsunami era in Tôhoku is misguided. den behind thousands of tons of concrete. The region, like most of the rest of rural I believe that the region’s hopes for a come- Japan, was in economic and social distress back turn less on splashy government-funded long before the waves hit. And no amount of projects than on individual savvy and initia- earth moving and concrete pouring is going tive. Consider Emi Takahashi, director of a to fix what ails. day care center for the elderly, who (rightly) What Tôhoku needs most now is help in fears too many resources will be spent on fa- adapting to rapid economic and demo- cilities for aging baby boomers that will all too graphic change accelerated by the disaster, soon become white elephants. She has started buffering the dislocation at the grass roots. a program to train elderly husbands who lack And that, alas, is not an easy sell in a contem- confidence in their household skills to care for porary Japan that’s struggling with all wives suffering from dementia so they can manner of unwanted change.

94 The Milken Institute Review institute news

Coming Together of metros: employment opportunities and In December, in one of the few instances level of community engagement. of bipartisanship in 2016, President Obama “Cities are on the front lines of the largest signed into law the 21st Century Cures Act. demographic shift in history,” says Paul Ir- The legislation provides $4.8 billion of new ving, executive director of the Institute’s Cen- funding for the National Institutes of Health, ter for the Future of Aging, which released the along with additional funds for the Food and report. “Older adults increasingly seek life- Drug Administration and a comprehensive long engagement, and expect their communi- suite of policy provisions to strengthen the ties to support their changing needs.” biomedical innovation system. FasterCures, The top seven ranked towns: Provo (Utah), the Institute’s D.C.-based center dedicated to Madison (Wisconsin), Durham-Chapel Hill, accelerating medical research, worked with Salt Lake City, Des Moines, Austin, and leaders in Congress, the NIH and the FDA, Omaha. Read the Institute’s report in its en- reaching out to stakeholders throughout the tirety at successfulaging.milkeninstitute.org. medical research system to help translate the best ideas into law. Financial Deregulation in the “This landmark legislation will accelerate Time of Trump cures for many life-threatening diseases and With a new president in the White House, the help advance precision medicine,” explained financial community is assessing the pros- Institute chairman Mike Milken. “It ensures pects for significant changes – even a com- patient-focused drug development, adds plete overhaul – of financial regulation. In a rigor to clinical trials, expands compassion- recent paper, “Financial Deregulation: Repeal ate use of new drugs by dying patients, speeds or Adjust?” Institute researchers Claude the review of vaccines, addresses antibiotic Lopez and Elham Saeidinezhad provide a resistance, responds to the opioid crisis and timely overview of the landscape of agencies strengthens the research infrastructure.” that compose the U.S. financial regulatory structure. Available on the Institute website, Where to Age Gracefully the report is an eye-opener for anyone trying In March, the Institute released the latest up- to handicap the regulatory horserace in D.C. date of one of its widely watched indexes. Best Cities for Successful Aging ranks 381 U.S. met- ropolitan areas on how well they serve the needs of America’s rapidly growing population of older adults. The index is not another guide to the best places to retire. Rather, it provides 83 indicators that determine overall quality of life for seniors. Among the key fac-

talking eyes talking media eyes tors often ignored in assaying the attractions

Second Quarter 2017 95 lists

ALEC: Cheap Beef? Headline is “Cheap Beef?” If you didn’t sleep through EconCaption 101, you for probably Home pageremember is: “South the Big Africa Mac is Index a bargain. – The” Economist magazine’s charminglyMain simple topic: way Indexes to predict and whether rankings a currency is overval- ued or undervalued (in terms ofOther purchasing topics: power) Monetary with Policy respect to the dollar. An example: if the average price of that mostUse thisfamous this oftable burgers directly is $5.06 Along in with the Unitedthe burger States, and but the stripes) and just $3.04 in Hungary at the currentcall itdollar-forint “Lists-Big-Mac-Index-Table1.” exchange rate, the Big Mac Index implies that the forint is 40 percent undervalued with respect to the dollar. What’s especially cool is the fact that the back-of-the-envelope Big Mac Index doesn’t do a bad job as a stand-in for the highly technical index the World Bank uses to adjust estimates of GDP in local currencies to “purchasing power parity” estimates in U.S. dollars. Here is a sampling of countries showing the latest Big Mac Index, along with the comparable World Bank conversion factor for 2015 and the Big Mac Index for the middle of that same year (2015). No matter how you slice it, it seems the dollar is overval- ued. Or to put it another way, for those of us paid in dollars, the rest of the world is a pretty cheap place to buy Big Macs (and a whole lot else).

BIG MAC BIG MAC WORLD BANK JAN 2017 JULY 2015 CONVERSION 2015 (OVER/ (OVER/ (OVER/ UNDERVALUED %) UNDERVALUED %) UNDERVALUED %)

Brazil...... +1%...... -11%...... -40%

Canada ...... -11 ...... -5 ...... 0

China ...... -44 ...... -43 ...... -40

France ...... -15 ...... -11 ...... -10

Germany...... -22 ...... -11 ...... -10

India ...... -51 ...... -61 ...... -70

Israel...... -13 ...... -3 ...... 0

Japan...... -36 ...... -38 ...... -10

Mexico...... -56 ...... -35 ...... -50

Norway...... +12 ...... +18 ...... +20

Russia...... -58 ...... -61 ...... -60

Saudi Arabia. . . . -37 ...... -33 ...... -60

South Africa . . . . -63 ...... -56 ...... -60

Switzerland. . . . +26 ...... +42 ...... +30

Vietnam ...... -48 ...... -43 ...... -70