Why charter cities may not take-off?

For sometime now, former Stanford Professor and pioneer of the New Growth theory, Paul Romer has been advocating the setting up of Charter Cities - a new city set up in an unoccupied piece of land, with population, material and financial resources imported from elsewhere, and whose deployment is governed by a set of rules or a charter. One government provides land and one or more governments grant the charter and stand ready to enforce it.

He has proposed three examples of possible charter cities - US handing over the part of Cuban terriroty adjoining Guantanamo Bay to Canadian government which undertakes to develop it along the lines of Hong Kong; Australia could set aside a part of its territory to be populated by Indonesian immigrants and administered by Australia in consultation with the Indonesian government; and development of a special zone with a charter of the Government in India, to be developed by one state government after a competitive bidding process among all states.

In a recent article (via Mark Thoma), Prof Romer clarifies on the tradeoff between faster growth and higher risk that charter cities would face. He draws the distinction between rules (or rule set) which emerges and gets refined through "an evolutionary dynamic based on small, incremental changes or through a new-system dynamic in which an entirely new rule set enters and competes with an existing one", and catch-up growth (based on copying existing ideas) and frontier growth (involves the discovery and implementation of new ideas).

Catch-up growth with an evolutionary dynamic, while being the least risky (in so far as there is least uncertainty about its trajectory and outcomes), is more likely to be very slow and not effective. However, in catch-up growth, the new-system dynamic can be used to copy existing rule sets, thereby allowing for faster growth without the additional risk that comes from using the new-system dynamic at the frontier (which are innovative and hence risky). Therefore, charter cities embrace catch-up growth with a new-system dynamic, and "adopt a new rule set made up of rules that are known to work well... (and) accelerate catch-up growth with little of the risk associated with the development of new systems at the frontier".

Presumably, the main objective of the Charter Cities would be to bring about a faster pace of development (by more effective administration with a set rules outlined in a charter) to areas within or adjoining developing countries by leveraging resources from across the world and the administrative efficiency of certain neighbouring national governments with a creditable track record for delivering on economic and social development.

It would be less of an attraction for many of the developed countries, since their governments already have a competence in effective administration. Further, their private sectors can be incentivized to leverage the local resource strengths and deliver of even frontier growth with a new-system dynamic.

This effectively means that Charter cities are a collaborative experiment between one or more developed and developing countries, which seeks to incentivize developed country governments to participate in a joint development effort (with a developing country) with the attraction of the profit opportunities that exist in such co-operation. I am not willing to countenance any arguement that would bring in attributes like altruism and internationalism into the motivations as driving national governments.

In view of the aforementioned, let me play the devils advocate on charter cities with the following observations.

1. Charter cities lay great faith in the ability and commitment of national governments to formulate charters and enforce them. However, there is little evidence nor sufficient enough economic or political rationale for reposing such huge faith in governments, especially foreign governments to administer and enforce a charter that also benefits another country and its citizens.

Further, there exists the real possibility that the foreign administrators could end up skimming off the cream and a disproportionate share of the benefits of development. No charter, however comprehensively framed to pre-empt all such possibilities, can prevent such an eventuality, should the government of the administering country (or the establishment that controls it) so wish. The possibility of Colonialism 2.0 becomes very real.

2. There is the very strong possibility that charter cities set up beside the poorer countries would end up cherry-picking the skilled human resources and investible capital away from the mainland (of the developing country). It is natural that the skilled professionals - doctors, scientists, teachers, engineers etc - and investors would gravitate towards these new areas, further impoverishing the poor country.

This would be something similar to the new townships (or "gated communities") or satellite towns that are proliferating in the suburbs of many of the metropolitan cities in countries like India, which act as a magnet in attracting the rich and skilled and the major share of investments in institutions relating to education, health care and other services.

Alternatively, the proximity to the under-developed and poorer areas can also have the effect of keeping away private investors, wary of the political repurcussions of events in the mainland and the possibility of spill-over or contagion from disturbances there.

3. The examples of the numerous world-class Chinese cities that have developed in the last two decades is misleading. They are more closer to being examples of catch-up growth cities with an evolutionary dynamic, albeit a break-neck pace of evolution during recent years, than catch-up growth following a new-system dynamic as suggested by Prof Romer. None of these cities emerged from thin air, but were the result of focussed government policies and driven by specific growth engines that catapulted the originally existing small to middling cities into a much higher growth trajectory. To that extent, they are more evolutionary than new-systemic.

4. There is something disconcerting about the fact that charter cities would need more than economic incentives to ensure its success. As mentioned earlier, it is unrealistic and not borne out by historical evidence to place such faith in a foreign government's commitment to the charter and its outcomes. A more practical model would be a partnership with private investors.

In recent years, there have been a growing number of cities similar to the aforementioned charter cities, most notable being the spectacular Palm Islands in Dubai and the grandiose New Songdo City in South Korea. However, both these, and other similar developments, have been done by private investors with enabling policies set in place by governments. There is nothing mis-aligned about incentives in the development of such cities. Private developers who sense a profit opportunity leverage investments from investors looking for attractive long term returns, and governments benefit by the economic development and tax revenues (and also the rents by way of contracts).

The Special Economic Zones, Technology Parks and so on, that are part of economic development promotion policies in many countries, seek to build on precisely such partnerships with private investors and developers to develop and promote economic growth and development.

5. And finally, there is the issue of political acceptability that will come in the way of charter cities even if all the aforementioned challenges are surmounted. For example, a charter city in India administered by one state government will surely come up against local politics, in its various dimensions (for simplicity assume a city located in one state and being administered by another, with both states belonging to two opposing political parties). The possible incentive distortions that can derail such projects are manifold.

Unemployment and growth update

The graphics below tell all the story

Eight million jobs or 5.8% of all jobs have been lost in the 21 months of the current recession, the worst in any recession since the War.



The employment-population ratio (the ratio of employed Americans to the adult population) and the Labor Force Participation Rate (the percentage of the working age population in the labor force) fell to 58.8% and 65.2%, both being the lowest since early eighties. When the job market starts to recover, many of these people will reenter the workforce and look for employment - and that will keep the unemployment rate elevated for some time.



As a share of employment, this recession is easily the worst. Since the recession began in December 2007, the economy has had a net loss of about 5.2% of its non-farm payroll jobs.



The state and local government payrolls have turned pro-cyclical, dropping off, while the spurt in federal government payrolls appears to be falling.



Even at the worst points of the worst recessions of the 1970s and 1980s, never has the number of hours worked per US person been lower than it is now. It is believed that many of those jobs will never come back, and if they are replaced at all it will be with lower-wage, lower-skill service-industry jobs.



Macroblog compares the lags between peak unemployment and end of recession, and that between the start of federal funds rate tightening and the peak unemployment rate and finds considerable variations in previous recessions and no discernible trends. However, it is clear that unemployment will continue to lag behind substantially even as the recovery gathers steam. See also this, this, this, this, and this.

Update 1
October unemployment report shows a rise in joblosses by 190,000 and puts the unemployment rate at a 26 year high of 10.2%. Inclusive of all forms of joblosses, the unemployment rate is 17.5%. Since the recession began in December 2007, the economy has had a net loss of about 5.3% of its nonfarm payroll jobs or more than 7 million jobs, and nearly 16 million people are unemployed now.




See also this, this, this, this, this, and this.

Casey Mulligan on why it is likely to be a "jobless recovery". Graphic indicating the periods for which people have been out of work. Economix on work sharing programs wherein employers reduce their workers’ weekly hours and pay, often by 20 or 40 percent, and then government make up some of the lost wages, usually half, from their unemployment funds. Under implementation in mainland Europe, mainly Germany. Paul Krugman makes the case for such programs in US which seek to temporarily save jobs.

Update 2

Floyd Norris provides more evidence that the current recession in the US is the worst since the Great Depression, atleast from the unemployment front. Over the last three years — since October 2006 — the overall unemployment rate has risen by 5.8 percentage points, the largest such increase since the Great Depression, providing another indication of the rapidity and severity of the current downturn.

Peer comparison feedback as a behavioural nudge

Sometime back, I had blogged about a random-assignment experiment by a Californian electricity utility in "nudging" its customers to optimize on their electricity consumption by sending out personalized report cards, which rated them on their energy use compared with that of their neighbors.

Now in an NBER working paper, Ian Ayres, Sophie Raseman, and Alice Shih examined data from the Sacramento Utility experiment and a electricity and natural gas (Puget Sound Energy), and conclude that "by providing feedback to customers on home electricity and natural gas usage with a focus on peer comparisons, utilities can reduce energy consumption at a low cost". They find that monthly or quarterly mailed peer feedback reports to customers led to reductions in energy consumption of 1.2% in the latter and 2.1% percent in the former, with the decrease being sustained over time indicating the durable nature of the change brought about.

In both experiments, households in the treatment group with lower house values saved more, on average, than households with higher house values, and those with higher pre-treatment energy use saved more than those with lower pre-treatment energy use. Further, in order to avoid backlash, the comparison reporting was confined only to the larger consumers of electricity. They also find relevance for such peer reporting through periodic mailings to be of use in many areas - school attendance, medical check-ups, increase savings etc - to achieve the desired changes in behaviours and maximize on welfare gains. The peer comparison reports were sent in the formats shown below





The success of such peer comparison reporting has relevance for public policy making in addressing the environmental problems like climate change. Such behavioural nudges are much more effective than the conventional awareness creation drives on such issues that focus on highlighting distant and macro-level implications (like melting of glaciers, rise of sea levels, rise in temperatures) of climate change. It may be more appropriate to have rules that mandate vehicles or electronic appliances to prominently display their carbon footprint grading stickers. Even more effective would be nuanced behavioural nudges like that done in the aforementioned studies. How about a "scorn" sticker prominently adorning the back of gas guzzlers like SUVs?

Update 1 (24/02/2010)
National Grid, the electricity and gas provider to several Northeastern US states, announced the expansion of its Home Energy Report program, which delivers energy-use statements to homeowners showing how they stack up against their neighbors in similar-size homes. It follows a successful pilot program, started in October 2009, with a test group of 50,000 customers. Energy use (both electric and gas) dropped by 1 percent for this group since the pilot began, compared to a control group that did not receive the report.

See the National Grid's Home Energy Report program here. See also the Sacramento Municipal Utility District's home energy saving tools here.

Update 2 (26/5/2011)

Progress Energy, a Raleigh-based power company, is the latest to adopt the peer pressure based nudging to reduce residential electrical consumption. Progress will mail notices telling customers how their household power bills compare to their neighbors. The periodic notices will be sent out to random customers who have above-average utility bills. The random sample is intended to cover a range of customer profiles, making the program statistically valid.

On ex-ante evaluation of monetary policy alternatives

In order to address the liquidity trap posed by the ongoing recession and the zero-bound interest rates, the Swedish Central Bank, Riksbank, has been following a policy wherein the deposit rate is always a half percentage point less than the benchmark lending rate, even if that forces the former below zero. Therefore, when the Riksbank lowered its benchmark lending to 0.25% in July, the deposit rates were driven into negative territory, effectively penalizing banks if they simply parked their funds with the Central Bank.

In this context, in an NBER working paper, Lars Svensson, the Deputy Governor of the Riksbank and a former colleague of Ben Bernanke at Princeton, explores the challenges in evaluating inflation-targeting monetary policy, especially the problem of ex-ante evaluation of policy options with inflation targets given the time lags between rate changes and its impact on inflation. Central Banks rarely have control over inflation given the fact that it is affected by shocks that are difficult to identify or predict, and also because central banks with inflation targets conduct flexible inflation targeting so as to both stabilize inflation around its target and to stabilize the economy. In the circumstances, the best policy for Central Banks is in "choosing a policy-rate path so that the forecast for inflation and the real economy stabilizes inflation and the real economy as effectively as possible".

He therefore proposes using a modified Taylor curve, the forecast Taylor curve (which illustrates the efficient tradeoff between stabilizing the inflation forecast around the inflation target and stabilizing the resource utilization forecast around a normal level by representing the tradeoff between the variability of the inflation-gap and output-gap forecasts) to evaluate monetary policy ex ante (and in real time, on the basis of information available at that time). This approach uses the plots of mean squared gaps of inflation and output-gap forecasts for alternative interest rate paths and then compares them in their respective success in achieving (or forecasting the achievement) an efficient stabilization of both inflation and the real economy.

Since monetary policy is mainly about managing expectations, particularly those concerning future policy rates, Central Bank credibility is of paramount importance. The degree of correspondence between expectations and the central bank's forecasts for inflation and the real economy becomes a measure of the credibility of its analyses and forecasts. In the circumstances, the publication of the interest rate path also allows the evaluation of the Central Bank's credibility and the effectiveness of the implementation of monetary policy.

Fiscal multipliers under different conditions

I have blogged here, here, here, and here about the debate on the impact of fiscal stimuluses, more specifically the fiscal multipliers associated with different types of stimulus spending. While conservatives have argued that multipliers are essentially zero and therefore find no merit in fiscal spending, supporters point to substantial multipliers in government spending, especially in deep recessions when demand is weak and business investments have dried up.

A Vox post by Ethan Ilzetzki, Enrique G. Mendoza, and Carlos A. Vegh (full paper here) adds a new dimension to the debate by claiming that "fiscal multipliers are much weaker in countries that have high debt, lower income, flexible exchange rates, and greater international openness". They also find that preduicting fiscal multilpiers with any degree of certainty is even more difficult for developing economies. Their findings are

1. The response of output to increases in government spending is smaller on impact and considerably less persistent in developing countries than in high-income countries.
2. Fiscal multipliers are much larger in economies operating under predetermined exchange rate regimes than under flexible exchange rates.
3. Relatively closed economies have much larger multipliers than relatively open economies.
4. The output response to increases in government spending is short-lived and much less persistent in highly indebted countries than in countries with a low debt to GDP ratio.
5. The multipliers for the US in the post-1980 period are small both in the short and long-run. On the other hand, multipliers for government investment are large.

These findings carry important policy implications. They lend weight to the need for globally co-ordinated stimulus spending policies, among atleast the major economies, in an increasingly inter-connected global economy, failing which protectionist backlash is inveitable and some degree of protectionism is even desirable. With fiscal expansions having considerable positive externalities, a substantial fraction of the stimulus spending leaks out to the rest of the world through higher imports etc.

It also supports the important but always-forgotten holy grail in fiscal policy making - follow a counter-cyclical fiscal policy and build up surpluses during good times and unwind them and run up deficits during downturns. Governments, especially in the developing world, who have tended to follow either the populist "spend more when the going is good" or the a-cyclical business cycle neutral tax and spending policies, are left with limited fiscal space when the bad times arrive. India is a case in point.

The authors find evidence of "crowding out" effect in developing countries, where an additional dollar of government consumption crowds out some other component of GDP - investment, consumption, or net exports - in the long run. However, this finding may actually turn out to be the opposite in deep recessions, when household demand and private investments become frozen, and government spending can play the important role of "crowding in" aggregate demand. During the current recession, most of the emerging economies did not experience the same extent of output contraction as the developed economies, and therefore fiscal expansions in these countries may not have supplied the same boost to aggregate demand as in the latter.

Mostly Economics points to the US CEA's latest impact assessment of the $787 bn ARRA stimulus spending plan. It finds that the stimulus spending changed the trajectory of the economy toward moderating output decline and job loss; it added roughly 2.3 percentage points to real GDP growth in the second quarter and is likely to add even more to growth in the third quarter; caused employment in August to be slightly more than 1 million jobs higher than it otherwise would have been; and it added between 2 and 3 percentage points to baseline real GDP growth in the second quarter of 2009 and around 3 percentage points in the third quarter. It estimates a very high fiscal multiplier of 2.3 in Q2 2009 and 2.7 in Q3 2009. It also finds that assistance to states played a critical role in helping states facing large budget shortfalls because of the recession by increasing employment relative to what would have happened without stimulus.

Mark Thoma, as always, captures the debate on stimulus multipliers here. Paul Krugman has this response to Robert Barro's assertion of a multplier less than one. The Economist has a nice summary of the multiplier debate and explains why it is so difficult to make any predictions about them given the wide variations in economic conditions.

A recent NBER working paper by Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo argues that "the government-spending multiplier can be much larger than one when the nominal interest rate does not respond to an increase in government spending". They claim that if the nominal interest rate is governed by a Taylor rule, it rises in response to an expansionary fiscal policy shock that puts upward pressure on output and inflation, and thereby renders the multiplier small. However, when nominal interest rates does not respond to an increase in government spending (when the zero lower bound on the nominal interest rate binds), their model finds that the multiplier is very large. Taking this model and its line of explanation, the effectiveness of fiscal spending is likely to be limited for many developing countries, including India, where the nominal rates are high and where inflationary pressures makes interest rates more sensitive to revisions.

And their conclusion has great relevance for the major developed economies which have nominal interest rates kissing the zero-bound, "In such economies it can be socially optimal to substantially raise government spending in response to shocks that make the zero lower bound on the nominal interest rate binding... for government spending to be a powerful weapon in combating output losses associated with the zero bound state, it is critical that the bulk of the spending come on line when the lower bound is actually binding."

They argue that when the economy is touching the zero-bound and the output falls, a deflationary spiral is unleashed that drives up the real interest rates, which in turn leads to an increase in the level of desired savings. Since investment is zero during such recessions, the aggregate saving must be zero in equilibrium, and the total fall in output required to reduce desired saving to zero is very large. And about how fiscal spending works in a recession when this zero bound is binding, they write,

"This (spending) increase leads to a rise in output, marginal cost and expected inflation. With the nominal interest rate stuck at zero, the rise in expected inflation drives down the real interest rate which drives up private spending. This rise in spending leads to a further rise in output, marginal cost, and expected inflation and a further decline in the real interest rate. The net result is a large rise in inflation and output. In effect, the increase in government consumption unleashes an inflationary spiral that counteracts the deflationary spiral associated with the zero bound state."

Update 1 (28/8/2010)
Mark Zandi (via Ezra Klein) has this graphic which examines the bang for the buck for various types of stimulus spending in the US.

A global arms bank as deterrence?

One of the most encouraging trends of the past few decades has been the remarkable decline in the incidence of wars between nation states, especially in comparison to even recent history. However, wars have been replaced with psychological battles of brinkmanship between nation states, resulting in the emergence of a new dimension to the relationship between nations - mutual deterrence. Such deterrence strategies too involve the same massive expenditures on procurement of sophisticated and hugely expensive weaponry as was the case with wars.

The only difference from the earlier era is that instead of using these weapons to actually fighting wars, weapons are now used to deter enemy nation states from any adventurism. In other words, weapons become a hedge against invasion.

In a world where financial market engineering concocts complex products to diversify and hedge against all kinds of risks, it may be appropriate to borrow some of those principles to design a market for achieving mutual deterrence in a more cost-effective manner. SO how about setting up a global arms bank. Here is how it will work.

This arms bank can be a depository of all kinds of weaponry. It can sell customized option products that enable nation states to purchase the right to own specific category of weapons. Like financial options, such options give purchasers the option, but not the obligation, to purchase the weapon products. The terms of delivery, of great importance in case of actual war breaking out, can be formulated in accordance with the requirements of the client. This would mean positioning arms at multiple arms depots, located at different locations across the globe. While this is likely to raise many problems, technological solutions can help overcome most of them.

Membership of this bank should be restricted to nation states, who can purchase the membership (for an annual fee) and buy options of their choice. Taking the model one step further, the arms bank itself can enter into forward contracts with weapons producers, so as to optimize on its own costs. Taking a leaf out of the Swiss banking model, all transactions (and even membership) in this global arms bank can be kept confidential. Since deterrence works by way of increasing the information asymmetry between antagonists, such secrecy will only enhance mutual deterrence.

Such an arms bank would help nation states avoid the massive and wasteful expenditures on amassing weapons to achieve deterrence against their enemies. It would ensure that nations do not spend huge resources to merely stock on weapons it is never likely to use. An arms bank like that envisioned above can be a global public good, in so far as it would help nation states avoid arms spending and divert resources towards development and welfare. Accordingly, a multilateral agency (similar to say, the IAEA) with equal stake for all member nations should administer the bank.

This proposal is never going to work to perfection. For a start, with a few initial credibility creating steps (or confidence building measures, CBMs) it will surely encourage some nations to cut back on their purchases and instead buy options from the bank. A global ban on arms trade will also go a long way in catalysing the development of this arms bank.

Capital markets policy

Standard theories on macroeconomic policy making have focussed on monetary policy, with its objective of controlling short-term interest rates, and fiscal policy, with its risk of impact on long-term rates. However, the present crisis, in which Central Banks and governments have resorted to widespread use of unconventional monetary policy responses (or quantitative easing) - liquidity injections and bank recapitalizations, loan guarantees, nationalizations, bank rescues, asset purchases, lowering of collateral standards etc - highlights the need to revisit academic research on macroeconomic policymaking.

For a start, Brad DeLong makes the distinction by lumping such unconventional responses under the rubric of "capital markets" policy. Broadly, all these actions are aimed at sending signals that alter the expected rate of future inflation and keep interest rates anchored between the short-term rates of monetary policy and the longer term rate expectations unleashed by fiscal policy. Prof DeLong makes the differentiates between monetary and capital markets policy,

"Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What it does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly."

And managing the exit from such expansionary policies would help anchor longer term expectations and keep the bond markets from tightening too much from a fear of inflation and large dficits.

Also, Paul Krugman's recent posts about the "crowding in" effect and lower real cost of the deficits of expansionary policies is relevant. The real costs of deficits in a recession or a zero-bound liquidity trap, are smaller than the nominal deficit incurred for two reasons.

First, as the spending finds its way into the economy, it has the effect of boosting aggregate demand and repaying itself partially through taxes and other government revenues (and lowering of expenditures on say, welfare measures, that government would otherwise have had to incur). It is for this reason that economists advocate that any such expansionary spending is done to get money in the hands of people who are likely to spend (andnot save or merely repay debts) it immediately. Krugman feels that the revenues cause something like a 40 percent offset, leaving the actual csots of fiscal stimulus to be only 60 percent of what it nominal cost.

Second, the expansionary policies boost aggregate demand and economic growth by hastening the return to normalcy and therefore lowers the real cost of both the debt and its servicing burden.