The "inevitable superpower"?

Arvind Subramanian bites the bullet and takes his call on the inevitability of China setting the pace in the years ahead, just as America did for the past half-century or so. He questions the persistent conventional wisdom in the US that "if the United States can get its economic house in order,it can head off the Chinese threat". He writes,

"During the 1956 Suez crisis, the United States threatened to withhold financing that the United Kingdom desperately needed unless British forces withdrew from the Suez Canal. Harold Macmillan, who, as the British chancellor of the exchequer, presided over the last, humiliating stages of the crisis, would later recall that it was "the last gasp of a declining power". He added, "perhaps in 200 years the United States would know how we felt". Is that time already fast approaching, with China poised to take over from the United States?"

He defines economic dominance thus,

"Broadly speaking, economic dominance is the ability of a state to use economic means to get other countries to do what it wants or to prevent them from forcing it to do what it does not want. Such means include the size of a country’s economy, its trade, the health of its external and internal finances, its military prowess, its technological dynamism, and the international status that its currency enjoys.

My forthcoming book develops an index of dominance combining just three key factors: a country’s gdp, its trade (measured as the sum of its exports and imports of goods), and the extent to which it is a net creditor to the rest of the world. GDP matters because it determines the overall resources that a country can muster to project power against potential rivals or otherwise have its way. Trade, and especially imports, determines how much leverage a country can get from offering or denying other countries access to its markets. And being a leading financier confers extraordinary influence over other countries that need funds, especially in times of crisis. No other gauge of dominance is as instructive as these three: the others are largely derivative (military strength, for example, depends on the overall health and size of an economy in the long run), marginal (currency dominance), or difficult to measure consistently across countries (fiscal strength)."

He analyzed the world economy, beginning from 1870, based on these factors and finds that by 2030, the "relative US decline will have yielded not a multipolar world but a near-unipolar one dominated by China". In fact, based on his index, he already finds China ahead. It will have close to 20% of world GDP compared to below 15% for the US; and will generate 15% of global trade, twice that of America; and the yuan will be a credible rival to the dollar as the world’s premier reserve currency. His assessment of the gap between China and the US by 2030,

"My projections suggest that the gap between China and the United States in 2030 will be similar to that between the United States and its rivals in the mid-1970s, the heyday of US hegemony, and greater than that between the United Kingdom and its rivals during the halcyon days of the British Empire, in 1870."

He addresses the conventional explanations of how China may find it difficult to focus its energies externally given the need to improve the living standards of its citizens (even if it reaches half the US per capita income), raise resources for projecting its military power, or in the absence of any soft power. In particular, he points to China's already considerable influence among many Latin American and African countries, where the Chinese government has not hesitated to use its massive foreign exchange resources to virtually buy off these countries.

More convincingly, he points to a scenario where the US economic conditions do not improve much, China continues to grow at about 7% a year and satisfactorily maanges its transition to a stable middle income country, yuan becomes an accepted global reserve currency. In such conditions, he argues, the fate of the world economy, including that of the US, will be largely determined in Beijing.

Update 1 (14/9/2011)

The Economist has this review of Arvind Subramanian's book.

Moral hazard, systemic risk, and financial markets

It is increasingly evident that the regulators and policymakers have learnt little from the bitter lessons of the sub-prime mortgages meltdown induced global financial market crisis.

As Simon Johnson points out in an excellent post, the numbers of too-big-to-fail banks looks set to grow as more mergers are in the pipeline, despite growing signs of risk build-up. He points to the recent decision of beleaguered Bank of America (BofA) to court and accept $5 bn from America's most credible investor, Warren Buffet, as sure sign of serious troubles at the bank.

The bank is the largest bank-holding company in the United States, with assets at the end of June of more than $2.26 trillion. It services one in five home loans, and with 5,700 branches assembled through decades of mergers, it counts 58 million customers. Investors are worried at BofA's long-term health, despite the roughly $20 billion set aside to atone for its mortgage misdeeds at the height of the housing bubble, in light of the $ 9bn in losses suffered by the bank over the past 18 months.

He also points to an interesting NBER working paper by Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburgh who highlight the distortions in the price of put options for the financial sector stock index relative to put options on individual banks' stocks. Put options, which are effectively an insurance against price collapses, are cheaper if investors percieve less risk of such eventualities. They write,

"Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks... The government’s collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis."

The authors find that index puts were a lot cheaper than the appropriately weighted sum of put options on individual bank stocks, especially during the recent financial crisis. They argue that because "investors price in substantial government bailout guarantees for the financial sector as a whole", they find little need to insure privately against overall collapse. This disproportionately benefits the TBTF institutions (over smaller institutions), since any problems individually affecting each of them will translate into a risk for the financial sector as a whole.

In simple terms, the moral hazard created by the sub-prime bailouts and the the resultant market expectations have had the effect of lowering the price of risk for the TBTF institutions. The cause of this risk reduction being the effective bailout guarantee for TBTF institutions that governments provide. The handful of TBTF institutions are so large that they have become proxies for the financial market itself. As Simon Johnson writes, "No other sector in the United States economy gets anything like this kind of insurance". I would call it subsidy.

The "Tax Us More" movement

In a case of supreme irony, as the sovereign debt crisis lurches on, atleast some of the super-rich Europeans and Americans have appropriated the leadership mantle vacated by their political leaders and are advocating higher taxes on themselves.

Consider this. On the one hand, the political leaders and economists have been arguing that higher taxes will distort incentives, discourage people from working, and therefore lower total tax revenues. On the other hand, now the same rich target group, who the former have been trying to protect from higher taxes, comes forward and says, "why are you molly-coddling us, we want you to impose higher taxes"!

Warren Buffet took the leadership role in the US with his remarkable NYT op-ed a few days back. In Europe, the voices for higher self-taxation has been growing. A group of 16 of the richest people in France - Liliane Bettencourt, the billionaire heiress of L’Oreal; Christophe de Margerie, the head of oil giant Total; Frederic Oudea of bank Société Générale; and Jean-Cyril Spinetta, president of Air France KLM SA - signed a petition asking the French government to increase their taxes.

Their offer of a "special contribution" to tide over the difficult times is a refreshingly candid acknowledgement of their desire to perpetuate the existing system,

"We are conscious of having benefited from a French system and a European environment that we are attached to and which we hope to help maintain... When the public finances’ deficit and the prospects of a worsening state debt threaten the future of France and Europe and when the government is asking everybody for solidarity, it seems necessary for us to contribute."

Taking cue from them, a group of 50 rich Germans, who claim that they have "more money than they need", have joined the "tax me harder" movement and called on Chancellor Angela Merkel to "stop the gap between rich and poor getting even bigger". The German group, Vermögende für eine Vermögensabgabe (The Wealthy for a Capital Levy), consisting of not the super-rich, but inheritors of fortunes, claims Germany could raise €100bn (£88.5bn) if the richest (individuals with more than €500,000 in capital wealth) paid a 5% wealth tax for two years. One of them said,

"I would say to Merkel that the answer to sorting out Germany's financial problems, our public debt, is not to bring in cuts, which will disproportionately hit poorer people, but to tax the wealthy more. We are always hearing about savings packages, but never tax rises. Yet tax increases are a way out of this mess. That's where the money is: rich people... Something needs to be done to stop the gap between rich and poor getting even bigger."

An Italian, Luca di Montezemolo, President of the iconic Ferrari Group, too has joined in offereing to pay higher taxes. It is the strongest indictment of the absence of leadership among governments facing an extraordinary sovereign debt crisis. Given the fact that very few will volunteer to have higher taxes on them, these voices are surely a reflection of a much broader willingness of these people to take higher taxes. It would be a great opportunity missed to turn back the tide on lower taxes if the politicians do not act on this.

The offer from Europeans is all the more surprising given the already high taxes in these countries. The French pay a top rate of 40%, plus annual wealth and other taxes on their total assets. The richest Germans are taxed a maximum of 42%. This is yet another empirical nail in the coffin of those who argue that higher taxes crowd-out incentives among those taxed to generate more wealth.

This movement has greater significance for countries like India, where clearly by any yardstick, the rich benefit disproportionately more directly from government expenditures of all collected tax revenues and enjoy the indirect benefits of crony capitalism (how many of the big business success stories in the country does not have a few skeletons?).

So, when is this global movement by the rich themselves coming forward to pay higher taxes going to reach India? When are our rich willing to show some leadership and have their carpe diem? A good place to start would be the progressive "young turks" of the second and older generation of businessmen, who have inherited rather than created their wealth.

Economic growth and high density areas

This blog has been a strong and consistent advocate of urbanization, arguing that it is the most effective strategy to address the issue of economic growth in developing countries. In fact, it is not so much the demographic constructs called cities that are important, but its distinguishing characteristic of large populations residing in high density areas.

NYT has this excellent excerpt, which explains the benefits of large densified population centers using the example of a Vietnamese cuisine restaurant, from Ryan Avent's new e-Book. It is worth reproducing in whole and is a brilliant illustration of the dynamics of large densities - specialization, choice and insurance, productivity increases, competition, cost-effectiveness, quality improvements, innovation etc - and how the larger markets and workforce contribute to economic growth - jobs, consumption, investments, and growth spillovers. It reads,

"Suppose that within a population one person in 100 develops a taste for Vietnamese cuisine, and suppose that a Vietnamese restaurant needs a customer base of 1,000 people to operate profitably. In a city of 10,000 residents, there aren’t enough people to support a Vietnamese restaurant. The only restaurants that can operate profitably are those appealing to considerably more than one in 100 people — restaurants offering less daring fare. In a city of 10,000 people, there is little room for specialization, and less for experimentation.

A city of one million people, by contrast, can support multiple Vietnamese restaurants. Not only will this larger city enjoy a specialty cuisine unavailable in less populous places, but its ability to support multiple producers of this cuisine allows for competition, improving the price and quality.

A city with multiple Vietnamese restaurants may attract sellers of the fresh ingredients used in Vietnamese cooking, who then invest in distribution of those products in the larger city. This, in turn, attracts the sort of discerning eaters who favor authentic, high-quality Vietnamese food, reinforcing the concentration of Vietnamese eateries. The larger market facilitates competition, which again boosts quality and reduces prices. This is good for consumers. But competition also means better service from suppliers and growth in the consumer market, which is good for the restaurants. The result is a stronger, more productive and higher-quality microeconomy than in the city of 100,000, where only one Vietnamese restaurant can survive, or the town of 10,000, where there is none at all.

Density doesn’t work without talent. A small market may only support restaurants producing food that caters to a broad range of tastes. These restaurants will have to hire generalists — cooks who can produce a broad range of cuisines. Specialization and fine-tuning of one’s skills aren’t rewarded; too few patrons will have the specific taste for the particular cuisine to appreciate the quality. Time spent nailing down the nuances of one cuisine is time a chef isn’t using to maintain a good-enough command of a broad range of dishes.

In the larger market, supporting multiple niche cuisines, the calculus is different. Because there may be multiple Vietnamese restaurants competing for patrons, mastery of that specific style is necessary to maintain an edge against the competition. This is particularly true as the concentration of Vietnamese restaurants is likely to attract devotees of the cuisine with a well-developed knowledge of and taste for it. Hence, the larger marketplace pushes for, rather than against, specialization.

Meanwhile, a worker hoping to make a living as a Vietnamese chef will have a much easier time of things in the larger city. Labor turnover may be greater — if there’s only one Vietnamese restaurant in a town, then head-chef spots may only rarely open up — and so the odds of finding employment are higher. The larger city also provides insurance against bad fortune. If you’re a Vietnamese chef working at the one Vietnamese restaurant in a town and the one Vietnamese restaurant goes bankrupt, then you’re obviously in a tough economic situation. You must either take another job for which you’re less qualified, which may mean a reduction in compensation, or move. In the larger city, by contrast, competing restaurants can absorb and reemploy the labor and resources of defunct competitors.

This insurance function is important. It reduces the risks associated with specialization and therefore encourages more of it. By allowing workers to focus on tasks at which they’re relatively better than others, specialization helps drive economic growth. It’s also an engine of innovation. As workers focus on a specific task, they may well find better ways to do it. They might better schedule their days or invent something entirely new — software code written to expedite repeated tasks, or a machine that automates portions of a task. Of course, existing companies can be resistant to innovation. Dense cities, by acting as a source of insurance, enable workers with good ideas to take risks and start new businesses. If these workers fail, they have a good chance of finding employment elsewhere in the city. And if they succeed, the task of staffing the company is made easier by the existing pool of talent, and odds are good that customers and suppliers are close to hand, as well. Big cities provide a climate in which innovation can flourish, and in which innovators have the resources they need to exploit new ideas."

Arguably, the biggest challenge for large developing countries like India is the creation of large numbers of jobs to absorb its massive and expanding labour force. Economic growth is the only way to satisfactorily address this challenge. As economies grow, businesses invest, which in turn creates jobs, which fuels demand, and more investments follow, and the virtuous cycle repeats.

Fragmented and infrastructure deficient rural markets cannot generate these dynamics and therefore cannot be the platforms to replicate growth in the scale required. This virtuous cycle can be replicated on a large enough scale only in densified urban environments. The newly created jobs require a pool of readily available labour and their products demand a large enough consumer base. There is also the need for the entire infrastructure logistics that can support these job creating economic activities.

However, in case of massive countries like India, this densification approach has to be complemented with a strategy that promotes growth of smaller towns and cities, either by themselves or as satellites to larger cities. Infrastructure improvements in these smaller cities will attract immigrants, who in turn form the workforce and the market to sustain an expanded pool of economic activities. Investments and jobs will more often than not follow.

More on America's jobs market challenge

This may look belabouring the point. But there is clearly a lack of realization of the magnitude of Amerca's jobs challenge. It would appear that American conservatives, both politicians and academics, who see phantoms in inflation and debt and refuse to acknowledge the enormity of its labour market crisis, are being deliberately obtuse.

It is well known that the headline unemployment rate is deceptive and does not represent the true state of the labour market. Some of the figures, highlighted in an excellent recent EPI briefing paper (pdf here), are truly staggering, reminiscent of the economic situation in an impoverished developing country,

"Roughly 31% of U.S. workers experienced unemployment or underemployment at some point in 2009... Though roughly 31% of all U.S. workers experienced unemployment or underemployment at some point in 2009—the rates were higher for African-American and Hispanic workers, at 36% and 41%, respectively. Whereas 14.3% of white children had an unemployed or underemployed parent in 2010, one in four African-American or Hispanic children had an underemployed parent."

For the record, the unemployment rate today stands at 9.1%. But, as the aforementioned figures indicate, the underlying story is very dismal.



In 2010, the unemployment rate averaged 9.6%, but 10.6% of children had at least one unemployed parent.



And the weakness in labour market has not spared anybody, calling to question the conservative theme that the labour market is beset with structural problems. The severity of job scarcity - ratio of job seekers (unemployed) to job openings has been substantially above 4-to-1 for more than two-and-a-half years - and the duration of job search - share of unemployed workers who have been out of work for over six months has hovered around 45% for more than a year - means that the problem is simply one of a severe jobs shortfall. The unemployment has more than doubled for workers in every education group, including those with a college degree or an advanced degree.



The jobs shortfall in the labor market is roughly 11.1 million jobs—there are 6.8 million fewer jobs than there were when the recession started, and 4.3 million additional jobs were needed to keep pace with the growth in the working-age population.



To fill the gap by mid-2014, three years from now, 400,000 jobs would need to be created each month. However, over the last six months, the economy has added an average of 144,000 jobs each month — at that rate, it will take 15 years to get back to the pre-recession unemployment rate. The other estimates too are not encouraging. Even the most oprimistic forecasters expect the unemployment rate to be at least 8.5% at the end of 2012, a rate higher than the worst months of the prior two recessions.



There is another trend with the US labour market that deserves much greater attention. It concerns the widening differential between the productivity growth and wage compensation growth.



The clearest evidence of where this could be going is the widening wage gap between the workers and the executives, and in the current recession, the sharp increase in corporate profits.



Thanks to all this, the US labour market has now slipped below even the much derided European labour market, portions of which have not only managed to stave off the worst of the Great Recession, but even improve.



In the meantime, the August jobs report is yet another confirmation of the gravity of problems facing the US economy. The unemployment rate remained stagnant at 9.1% as the economy failed to add any new jobs, the first time in the past 11 months. The broader measure of unemployment, including those who have looked for work in the past year but have now stopped looking for work and those who are involuntarily working part time instead of full time, fell from 16.3 to 16.1%.

The number of long-term unemployed — people out of work for 27 weeks or more — remained about the same as in July, at 6 million, as did the median duration of unemployment, at 19.6 weeks compared to 19.7 weeks in July. The percent of working-age adults that were employed, already at its lowest rate since 1983, ticked down from 58.6 percent to 58.5 percent. The graphic below clearly conveys the magnitude of the present jobs crisis when compared to the earlier recessions.

China Vs India - India in China's worldview!

NYT has an article that explores the apparent lack of interest in India among Chinese opinion makers. It points to the coverage of each other in the two countries leading newspapers as evidence of the Indo-Sino interest disparity.

"The People’s Daily, the Chinese Communist Party’s house organ, had only 24 articles mentioning India on its English-language Web site in the first seven months of this year, according to the Factiva database. By contrast, The Times of India, the country’s largest circulation English-language newspaper, had 57 articles mentioning China — in July alone."

Most remunerative investment?

Which is the most remunerative, recession-proof investment? No, it is not gold or housing. It is the New York City Taxicab Medallion, a license to drive a New York City taxi!



A Bloomberg report says that the cost of a New York City cab license has risen more than 1,000 percent since 1980, a market that’s outperformed gold, oil, inflation, and the housing market. The medallion, the transferable aluminum plate found on the hood of all cabs, sold for $678,000 in July, up from $2,500 in 1947.

The story attributes its success to a small, tightly controlled supply of licenses and an unwavering demand from entrepreneurial immigrants, coupled with a huge demand for New York taxi cab rides. Econ 101 has another name for this - the power of monopoly!