Milken Institute Review Q2

The Milken Institute Review • Second Quarter 2010 • volume 12, number 2

PEOPLE. IDEAS. SUCCESS.

Second Quarter 2010

Sunk by

Debt? w w w. g u g g e n h e i m p a r t n e r s . c o m

Global Conference. It’s not just once a year.

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contents

3 from the president 4 editor’s note 6 charticle People power.

by William H. Frey

73

8 trends

Brazil ascendant.

by Albert Fishlow

book excerpt

90 institute view

Chinese medicine.

by Tong Li and Perry Wong

95 institute news 96 lists

Radical, Religious and Violent Eli Berman tackles terrorism with economics.

16 countdown to catastrophe Debt bomb.

by Leonard E. Burman

26 illicit drug policy The least-worst fix.

by Peter Reuter

36 russia’s economic prospects Putinomics 101.

by Robert Looney

46 health care inflation

The cancer on living standards.

by Steven A. Nyce and Sylvester J. Schieber

58 paying the piper

Facing up to global warming.

by Joel B. Smith

66 getting from here to there Railroad .

by Randy Garber and Amiya Setu

page 46

Second Quarter 2010

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the milken institute review second quarter 2010 volume 12 , number 2 the milken institute

Whatever your objective, we can bring it to life.

Our goal is simple – to help your company perform. With our full range of investment banking capabilities, we have the resources, insight and expertise to help you achieve your financial objectives. In 2009, our

corporate finance bankers completed or announced 695 transactions worth over $200 billion. From advisory services and capital raising to committed financing and restructurings, we help develop and execute the strategies and transactions to meet your growth objectives.

Michael L. Klowden, President and CEO Michael Milken, Chairman publisher Joel Kurtzman editor in chief Peter Passell art director Joannah Ralston, Insight Design insightdesignvt.com design assistance Linda Provost managing editor Larry Yu ISSN 1523-4282 Copyright 2010 The Milken Institute Santa Monica, California The Milken Institute Review is published quarterly by the Milken Institute to encourage discussion of current issues of public policy relating to economic growth, job creation and capital formation. Topics and authors are selected to represent a diversity of views. The opinions expressed are solely those of the authors and do not necessarily represent the views of the Institute.

Requests for additional copies should be sent directly to: The Milken Institute The Milken Institute Review 1250 Fourth Street, Second Floor Santa Monica, CA 90401-1353 310-570-4600 telephone 310-570-4627 fax info@milkeninstitute.org www.milkeninstitute.org

advisory board Jefferies & Company, Inc. Jefferies.com Investment Banking Sales & Trading Research Asset Management

Member SIPC Š 3/2010 Jefferies & Company, Inc.

Robert J. Barro, Gary S. Becker, Jagdish Bhagwati, George J. Borjas, Daniel J. Dudek, Georges de Menil, Claudia D. Goldin, Robert Hahn, Robert E. Litan, Burton G. Malkiel, Van Doorn Ooms, Paul R. Portney, Stephen Ross, Isabel Sawhill, Richard Sandor, Morton O. Schapiro, John B. Shoven, Robert Solow Cover: Hugh Syme

from the president

As we go to press, it is still unclear whether a major health care reform bill will be enacted this year. Whatever the outcome, the debate has put the focus squarely on cost control – but unfortunately, without enough emphasis on the ways to address this issue head on.

At the Milken Institute, we think it’s important to take a more holistic look at what “health care” really means. While ensuring everyone access to decent care has to be a key goal, reform must encompass more than just deciding who pays for treatment. Costs won’t stop skyrocketing until we put more emphasis on accelerating medical research that promises to reduce morbidity and on altering the lifestyle choices that put millions of Americans at risk of chronic disease relatively early in life.

The current model for drug development is simply unsustainable: The process takes too long, costs too much and discourages investment. Just when breakthroughs seem to be within our grasp, financing for early-stage biomedical research has fallen off a cliff. We have to find ways to jump-start medical innovation by designing more efficient ways to raise capital and manage risk, by helping donors target philanthropy more effectively, and by making sure that FDA oversight procedures keep pace with rapid advances in scientific discovery. The payoff, both in terms of breakthrough treatments and cost saving

would be immense.

In late 2007, the Institute issued a groundbreaking report, “An Unhealthy America,” which made headlines around the nation. We calculated that preventable chronic diseases cost the U.S. economy a staggering $1 trillion in medical treatments and lost productivity alone. The cost to America’s GDP will hit $6 trillion annually by mid-century if we don’t take decisive action.

Getting serious about prevention will require a sea change in attitude. Convincing Americans to eat healthier and exercise regularly – not to mention cut down on drinking and smoking – will be no easy task. But if we don’t make a serious attempt to address the root causes of the obesity epidemic, all the insurance reform in the world won’t contain the spiraling costs of diabetes, heart disease and cancer. Government officials, health care professionals, employers and educators alike have important roles to play in this monumental effort.

The twin strategies of prevention and cure not only contain costs, but also boost productivity, and improve the quality and length of life. And, best of all, the power to effect this sweeping change is within our grasp.

Our chairman, Mike Milken, has been working for years to highlight these issues and to mobilize action. We invite you to take a look at our research and our call to action by visiting http://www.milkeninstitute.org/ healthreform/.

Michael Klowden, President and CEO

Second Quarter 2010

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e d i t o r’s n o t e

My loyal correspondent, JG of Passadumkeag, Maine, writes to ask why I always feel compelled to introduce the editor’s note with a joke. Insecurity, I think – a fear, just out of reach of my conscious mind, that I’m unworthy of being taken seriously. But please don’t be mad at me.

Better to contemplate the terrific lineup of articles in this issue…

Len Burman, an economist at Syracuse University’s Maxwell School, thinks the unthinkable about Washington’s addiction to deficit finance. “Distressingly, none of the possible courses of events in which Americans wake up one day and decide that enough is enough seem very plausible,” he writes.

“That suggests it might take a traumatic event – a debt crisis that delivers a one-two-three punch in the form of inflation, deep recession and the collapse of the dollar – to alter the politics of deficit reduction.”

Peter Reuter, an economist at the University of Maryland’s School of Public Policy, contemplates the fundamental dilemma in policies governing illicit drugs.

“It is easy to describe what rational people don’t like about the War on Drugs: half a million drug prisoners; the transformation of Afghanistan, Myanmar, Bolivia and, arguably, Mexico, into narco-states,” he writes. “But it is hard to describe what an unambiguously better drug policy would look like because every path has pitfalls.”

Steven Nyce of Watson Wyatt Worldwide and Syl Schieber, chairman of the Social Security Advisory Board, explain the connec-

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tion between health care inflation and wage stagnation. “The ballooning cost of employer-paid health insurance has claimed much of the gain associated with rising labor productivity in this decade,” they conclude.

“Unless Washington gets serious about containing health care inflation in the process of reforming the insurance system, escalating medical bills could easily absorb all the fruits of the future productivity gains of lower- and middle-income workers.

“To put it another way, if we fail to contain health care costs, the living standard of the American middle class will almost certainly stagnate.”

Al Fishlow, a former deputy assistant secretary of state for inter-American affairs, is cautiously optimistic that Brazil is finally coming into its own. “A center-left government has made great strides in correcting the injustices that stranded millions of Brazilians on the edge of subsistence in the midst of a culture that celebrates material excess – and it has managed that task so far without undermining the economy’s stability or productivity,” he observes. “Enduring evolutionary change in the 21st century, under a democratic Nova República, no longer seems an impossible dream.”

©matthew diffee/the new yorker collection/www.cartoonbank.com

Robert Looney, an economist at the Naval Postgraduate School in California, offers a sobering view of Russia’s future under Putin.

“The most ominous scenario would be a retreat to ultranationalism, along with a drive for autarky that insulates the ruling interests from economic failure and manages internal discontent with a mix of authoritarianism and the distractions of a pugnacious foreign policy,” he writes. “A more likely scenario is another try at Putin’s Russia Inc. model. In its most optimistic incarnation, the state would enhance its role in social protection, prop up compliant enterprises and invest heavily in modernizing industrial capacity while keeping the lid on corruption and the grossest abuses of state powers.”

Joel Smith, a principal in Stratus Consulting in Colorado, shines a light on the little-considered issue of how to help poor countries cope with the consequences of climate change. “Without an aggressive effort – and a tolerance for error as adaptation projects get up to speed – the challenges of global warming could become unmanageable [for developing nations],” he writes. “There could be widespread suffering from droughts, storms and the inundation of coastal areas. And what happens in developing countries could indirectly affect the developed world by increasing political instability and driving mass migration.”

Randy Garber and Amiya Setu of A.T. Kearney, the Chicago-based management consulting firm, make the case that railroads

are a critical part of the answer to what ails America’s transportation system.

“We estimate that every $1 invested in the intermodal transportation network – the infrastructure for seamlessly shifting freight from truck to rail to ship and back – would yield $5 to $8 of benefits in terms of less congestion, reduced shipping costs and fewer traffic injuries.”

While you’re consuming all this meaty policy analysis, be sure to save room for the des-

sert tray: an excerpt from Eli Berman’s new book on the economics of terrorism, Tong Li and Perry Wong on China’s third try at a national health care system, and a new charticle from the supple mind of demographer Bill Frey. Peruse in good health.

— Peter Passell

Second Quarter 2010

5

charticle by william h. frey

While most of the forms have already been mailed in, we won’t get the first results from the 2010 Census until December. But we can speculate: It’s quite washington

likely that the total U.S. population has

3

reached 309 million, just four decades after

montana

-1

we tipped the 200-million mark.

Of course, the main purpose of the Cen­ sus is to reapportion Congressional seats.

In 1970, the Snow Belt states held 225 seats, compared to 210 for the Southern and Western states of the Sun Belt. A dec­ ade later, this 15-seat advantage turned into a 19-seat shortfall – and by 2000 had morphed into a whopping 69-seat deficit.

Richard Nixon’s 1968 “southern strategy” for Republicans looks brilliant in hindsight.

The 1980 and 1990 censuses greatly re­ warded the mega-states – Florida, California and Texas – at the expense of hollowed-out industrial behemoths New York, Pennsylva­ nia, Ohio, Illinois and Michigan. Thereafter, the Sun Belt diversified: Arizona and Georgia shared multiple seat gains with standbys Flor­ ida and Texas in 2000, while California’s take dropped to one.

Texas will likely win four seats in 2010 – at least one of which will come at the expense of Louisiana (heck of a job, Brownie). California, by contrast, stands to come up empty for the first time. And, thanks to the housing bust, Florida and Arizona will likely eke out just one seat each. All told, the Sun Belt will prob­

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oregon

1

idaho

wyoming

nevada

3

utah

2

california

10

colorado

2

arizona

5

hawaii

alaska

new mexico

1

michael a. murphy/txdot

ably stretch its House margin to 89.

Time – and political power – are thus still marching south. Just how that will play out in terms of public policy is unclear. What is clear, though, is that the money follows the marchers: Some $400 billion in federal goodies are handed out annually on the basis of census m statistics.

B i l l F r ey is a senior fellow in demography at the Milken Institute and visiting fellow at the Brookings Institution in Washington.

maine

north dakota minnesota

-1

vt nh

south dakota

wisconsin

-1

-11

michigan

-5

illinois

-6

kansas

-1

-7

ohio

indiana

-7

-2

west virginia

missouri

-1

-1

kentucky

north carolina

2

arkansas

south carolina

-1

12

de

1

1

mississippi

texas

nj

virginia

-1

oklahoma

ma ct ri

-3 md

tennessee

-1

-1

pennsylvania

iowa

-2

nebraska

-3

new york

alabama

georgia

1

4

louisiana

-2

States Gaining and Losing Congressional seats, 1970 to 2010 gaining

florida

11

Losing no change

source: William H. Frey analysis of U.S. Census Bureau population estimates and University of Michigan Population Studies Center Apportionment Calculator

Second Quarter 2010

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trends by albert fishlow

In his 2007 book,Forgotten Continent, Michael Reid, the Americas editor of The Economist, reported that Brazil “continued to grapple with relatively slow economic growth, a bloated state, social injustice, violent crime and political corruption.” Just two years later, the magazine’s tune had changed. In a special section entitled “Getting It Together at Last,” The Economist opined that “Brazil used to be all promise. Now it is beginning to deliver.”

The magazine was responding to surprisingly strong economic growth in 2007 and 2008, quick recovery from the current global recession, progress in reducing the country’s shameful income inequality and brighter prospects for the oil industry. One must wonder whether the changes will endure: in the past, Brazil has always managed to disappoint the optimists. But this time around, the auguries look good – provided, that is, Brazilians accept the necessity of consuming less today in order to ensure prosperity down the road.

For starters, there has been evidence that Brazil’s economic and political cultures have grown into the task of managing an advanced economy. Indeed, the cumulative impact of changes in recent years has been nothing less than dramatic. A left-center government with impeccable populist credentials has allowed the central bank to do its job, containing credit growth in the name of price stability.

Budgeting, at both the federal and state levels, A l b e rt F i s h low, a former deputy assistant secretary of state for inter-American affairs, is professor emeritus at Columbia University.

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has become more transparent. And Brasilia has resisted the siren song of trade protectionism, keeping the economy open to the competitive pressures of global markets. The payoff: rising productivity and an inflation rate below 5 percent.

a leader for his times Much of the change dates to 1999, when Brazil responded to economic crisis with a sophisticated mix of policies: a monetary regime based on inflation targeting, a flexible exchange rate that allowed exporters to prosper, and a commitment to maintaining a “primary” fiscal surplus – that is, a surplus excluding interest payments on the government debt accumulated over past decades. Critically, the policies survived a shift in 2002 from a centrist coalition government to one led by the legendary populist Luiz Inácio Lula da Silva. The central bank and the president’s ministers still, on occasion, duke it out in public. But both seem committed to sustaining a stable macroeconomic environment.

The way government is organized and power asserted is also changing in subtle but

Šviviane moos/corbis

Second Quarter 2010

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position to manage. Now that the economy seems stable, however, the process is accelerating. States and municipalities are actively seeking authority to administer social-policy initiatives, and Brasilia is now inclined to give them the resources to make that possible.

What has yet to happen – despite frequent false starts – is simplification of the complicated tax structure. But the body politic is deadlocked over the issue of the states’ right to tax at the point of production or the point of consumption.

Changes in the social safety net – Lula’s priority from the day of inauguration – have also altered the political and economic climate.

The bolsa família, his beefed-up welfare system based on cash grants to the poor, that is, conditional only on children’s attendance at

reuters/paulo whitaker

important ways. The executive branch has become slightly weaker as the medida provisório – the authority to impose temporary legislation – has been progressively curtailed. Meanwhile, Congress and the judiciary have been trying to fill the gap.

The Brazilian governance system, it should be noted, includes a fourth branch: the Ministério Público. This prosecutorial authority has broadened its focus, becoming an active participant in legal matters well beyond its customary portfolio. No matter of significance seemingly eludes its engagement.

Moreover, power is devolving to state and local levels. This decentralization was encouraged by Brazil’s 1988 Constitution, but was effectively stalled by a series of economic crises that only the central government was in a

school, has improved the lives of some 40 million Brazilians and cut poverty by one-quarter.

The hope, in this country that has long tolerated outrageous levels of inequality, is that the higher standard of living will pay dividends to all in the form of greater economic mobility, as poor families manage to invest more in their own health and education.

Everyone expected the antipoverty initiatives. What is more striking is how Lula’s support of macroeconomic fundamentals, combined with a big dose of fiscal stimulus, allowed the Brazilian economy to skate through the worst of the global recession with relatively little hardship.

Lula and his supporters were energized by the crisis – in particular, by the opportunity it afforded to show that the left-center could manage a market economy well even in difficult times. Activism was the order of the day.

The government created tax incentives to promote sales of automobiles and other consumer durables. The National Bank for Economic and Social Development filled the gap left by the inability of private banks to offer credit to businesses. The Programa de Aceleração do Crescimento, Lula’s flagship publicinvestment program, increased spending. An expanded version was unveiled in March 2009.

Not surprisingly, the combination of increased spending and tax incentives blew a bit of a hole in the budget. However, Lula paid more than lip service to fiscal discipline: in 2009, the government could still report a primary fiscal surplus, albeit one that required some accounting gimmicks to work.

economic insulation Meanwhile, regulatory reforms put in place in the 1990s successfully insulated the Brazilian financial sector from the worst consequences of the global meltdown. Two big banks, Itaú and Unibanco, were merged to create Brazil’s

the brazilian economy at a Glance GDP ($ at official exchange, 2009): $1.48 trillion

GDP per Capita ($ of purchasing power, 2009): $10,200 GDP Share Lowest 10% (2007): 1.1% GDP Share Top 10% (2007): 43%

Life Expectancy at Birth (years): 72

Total Fertility Rate: 2.2

Population in Cities: 86% Literacy Rate: 89%

Infant Mortality (per 1,000 births): 23 Public Debt (% of GDP, 2009): 47% Exports (2009): $159 billion

Imports (2009): $136 billion

Oil Production (millions barrels/day, 2008): 2.4 million

Oil Consumption (million barrels/day, 2008): 2.5 million source: CIA World Factbook

largest financial institution; others were incorporated into the Bank of Brazil.

And thanks to international reserves of more than $200 billion accumulated during the years immediately preceding the global recession, there was never much question of domestic financial woes triggering capital flight. In fact, Brazil remained a favorite of international investors through the crisis – so much so that exporters worry appreciation of the Brazilian currency (the real) is putting them at a disadvantage in competing with Asian manufacturers. Thus, while Lula’s proclaimed goal of decoupling the Brazilian economy’s fate from that of its international trade and investment partners could not be entirely realized, the downturn did prove to be mild and short in comparison with recessions in developed economies.

While there is broad agreement that the economy will expand at a healthy 5 to 6 percent rate in 2010, predicting what will happen thereafter is problematic. The forecasters at the new bank, Banco Itaú Unibanco, argue that an increase of 2 percentage points in interest rates will be sufficient to contain inflation, leaving enough room for healthy economic

Second Quarter 2010

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trends

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The Milken Institute Review

to host the World Cup in 2014 and the Rio Olympics in 2016.

a gamble on oil Meanwhile, the oil industry will need tens of billions of dollars to develop offshore reserves. The chances of success are excellent – Brazil will likely emerge as a major oil producer. But large-scale production from these reserves will only be forthcoming after a decade of investment, and then only if Brazil

reuters/paulo whitaker

expansion. Indeed, the bank predicts a rosy decade, with a combination of rising domestic savings and foreign investment sufficient to maintain 5 percent growth without upsetting macroeconomic stability. This pretty much echoes the views of government policymakers.

Goldman Sachs, by contrast, sees mounting signs of disequilibrium. In the firm’s view, Brazil’s fiscal and current-account deficits are not sustainable and will force the central bank to increase interest rates by a whopping 4 percentage points – a major deterrent to private investment. “Growth is being fueled by a spending boom without the corresponding increase in investments, all of which is being financed by larger external savings,” Goldman’s prognosticators concluded.

My heart is with Lula, but my head is with the skeptics. More generally, I doubt that the left-center’s hopes of raising the living standards of the poor and lower-middle class – and at very little cost to powerful economic interests – are consistent with sustainable growth in the long run.

To maintain 5 percent growth at plausible rates of return on capital would require an investment rate of about 25 percent of GDP, considerably higher than the current 18 percent rate. By comparison, China has an investment rate exceeding 40 percent, while India and Indonesia top 30 percent. Chile, the economy in Latin America with the most successful record of growth since 1990, invested 29 percent of its GDP in 2009.

To make the leap to modernity, Brazil needs to spend vast sums on infrastructure – port facilities, highways and urban transportation come to mind. Note, too, there is a well-documented shortage of housing for the growing lower-middle class. And one should not forget the investments Brazil must make

has access to the state-of-the-art technology needed to extract oil from formations that lie far below the ocean floor in deep water. And here, nationalism may get in the way: Congress is planning to restructure the petroleum sector, giving greater control to the national oil company, Petrobrás, and relegating foreign firms to a secondary role. Managing that relationship sensibly will be of the essence.

The value of the oil to Brazil will also turn on the world price of petroleum. Production

costs from these deep-water platforms are expected to run in the vicinity of $60 a barrel.

So Brazil is effectively betting that competing technologies for making liquid fuels – everything from biofuels to synthetic oil from tar sands – will stumble on considerations of cost or environmental damage.

All this suggests a problem that has long dogged Latin America – low rates of saving – could prove Brazil’s undoing. The economy needs humungous amounts of capital to

Second Quarter 2010

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trends reach developed-country living standards, and a reading of the global record of the last half-century suggests that international capital flows are fickle – that Brazil would do well to generate a lot of that capital from domestic savings.

Yet the country seems to be headed in the other direction: Brazilians don’t seem aware that the savings rate must rise to meet the ambitious spending plans of the government without crowding out private investment.

Changing the perception that Brazil can grow rapidly without sacrifice won’t be easy.

For one thing, it flies in the face of recent experience: Brazil, after all, coasted through this last recession on the strength of governmentinduced consumption. For another, the focus on the primary deficit as a measure of the government’s impact on aggregate demand is becoming increasingly misleading. It has been all too easy for policymakers – and the public – to forget that the public sector is a net drain on national savings.

In any event, it wouldn’t be easy to alter the government’s fiscal stance, even if the need were more widely understood. Brazil already collects 36 percent of GDP in taxes – almost double the percentage of Mexico and close to the percentage raised by Europe’s welfare states. Indeed, higher taxes at this point might undermine incentives for private investment and kill the golden gosling. Of course, tax hikes seem a political nonstarter: the public is bitterly opposed.

The most plausible place to start on a quest to raise domestic savings is the public retirement system. It runs huge deficits, and simply requiring it to keep revenues in line with outlays would increase national savings as a portion of GDP by 4 percentage points!

What’s more, some cuts in outlays seem only fair: on average, public-sector pensions are an

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The Milken Institute Review

astounding 10 times larger than retirement benefits in the private sector.

education as catalyst If savings rates can’t be raised, perhaps the return on public investment – in particular, on investment in education – can. Brazil spends a larger percentage of its income on education than most other developing countries.

Yet its ranking in educational outcomes remains at the lower end of the spectrum, even among countries in Latin America. The country has managed impressive gains in primary and secondary enrollment in recent decades, but without a corresponding advance in quality. Equally important, Brazil needs to rework its priorities within the public education budget – priorities that now favor investment in higher education over the provision of decent schools for the masses.

***

Brazil’s recent economic success has been built on a foundation of paradoxes. The economy is better governed today that it has been in the past. A center-left government has made great strides in correcting the injustices that stranded millions of Brazilians on the edge of subsistence in the midst of a culture that celebrates material excess – and it has managed that task so far without undermining the economy’s stability or productivity.

Enduring evolutionary change in the 21st century, under a democratic Nova República, no longer seems an impossible dream.

It has become increasingly clear, however, that Brazil’s future prosperity won’t come cheaply. If it is to achieve European or East Asian living standards, it will have to alter the deeply engrained habit of consuming today at the expense of producing more tomorrow.

And thus far, no government – conservative or populist – seems prepared to ask for the m requisite sacrifices.

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It’s 2030. China has just invaded Taiwan, and things do not look good for the island. Taiwan’s longtime protector, the United States, has responded with passionate rhetoric and a barrage of UN Security Council resolutions – which China has vetoed. But a military response is out of the question. China might counter by cutting off America’s lifeline of foreign capital, tanking the dollar and crippling the economy. And, truth be told, it is not clear that the U.S. Navy, much diminished by decades of penny-pinching, could put up much of a fight against the world’s pre-eminent superpower.

I’m not saying that’s our future; there are alternative (though equally ugly) possibilities. When America’s ballooning federal debt becomes unmanageable, we might simply refuse to honor our obligations, triggering a worldwide financial collapse and an economic downturn that would make the recent unpleasantness seem like a walk in the park. Or we might create enough money to pay back our creditors, domestic and foreign, triggering a hyperinflation reminiscent of failed states like the Weimar Republic in the 1930s (or, more recently, Zimbabwe) that would wipe out the savings of anyone caught holding wealth in dollars.

The bottom line here (and I do mean bottom): while nobody knows exactly how or when catastrophic budget failure will play out, disaster is assured unless the federal government reins in its profligate ways.

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all: ©brian hubble 2010, levy creative management, nyc

by leonard e. burman

tk

Second Quarter 2010

17

catastroph e the bad news The Great Recession has provided a taste of budget deficits to come. In the 2009 fiscal year, the U.S. Treasury borrowed $1.4 trillion, nearly 10 percent of GDP, and it is expected to borrow even more this year. Those giant deficits are financing a massive effort to avoid a repeat of the Depression of the 1930s – something most economists believe to be a good investment. But the borrowing will hardly end when the economy recovers. President Obama’s 2010 budget projects almost $9 trillion in additional deficits in 2011-20. By 2020, trillion-dollar deficits will become the norm even in years of solid economic growth and low unemployment, rather than an unpleasant aberration linked to a deep recession.

Absent wrenching changes in fiscal policy, things will only get worse after that. The retirement of the baby boom generation and the growth of health costs at a rate far faster than the growth of GDP mean that government spending on Social Security, Medicare and Medicaid (which pays for most nursinghome care for the elderly) is likely to explode.

By the nonpartisan Congressional Budget Office’s reckoning, spending on those three programs alone is expected to reach 18 percent of GDP in the year 2040. That is the average level of revenues, measured as a portion of GDP, that the federal government has collected over the past 50 years. So, in this scenario, there would be nothing left to pay for everything from defense to interest on the debt.

Thus, unless those entitlement programs (and other spending) can be drastically curtailed L e n B u r m a n is the Daniel Patrick Moynihan professor of public affairs at the Maxwell School at Syracuse University.

This article draws heavily on more technical collaborative work with Jeffrey Rohaly, Joseph Rosenberg and Katherine Lim of the Urban-Brookings Tax Policy Center, which will be published in The National Tax Journal.

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The Milken Institute Review

or taxes raised significantly, large and growing deficits are a certainty.

But the auguries aren’t good. Both political parties have become advocates of low taxes.

President Obama’s State of the Union address was a veritable panegyric to the virtues of tax cuts (although he is willing to raise taxes a bit for the rich in general, and rich bankers in particular). And now that Republicans have become defenders of spending every last dollar that Medicare recipients are currently promised, the prospect of reining in entitlement programs seems more remote than ever.

In a politics-as-usual scenario, with no changes in the current policy of low taxes and unrestrained entitlement growth, the federal debt is projected to reach 100 percent of GDP by 2023. By 2038, it would reach 200 percent of GDP. Note, moreover, that these CBO projections – as bleak as they seem – rest on wildly optimistic assumptions. They presuppose that interest rates on government securities will remain historically low, and that the economy will grow at a historically healthy clip. Indeed, in these projections, the average real interest rate (the nominal rate less the rate of inflation) actually falls from 4 percent to 3 percent from 2013 to 2024 and remains there throughout the period – this in spite of the projection that the annual deficits will increase steadily from 2013 onward.

That relatively rosy chain of events is unlikely to pan out. Bill Gale (Brookings Institution) and Peter Orszag (the current White House budget director) estimated back in 2004 that interest rates go up by 0.4 to 0.7 percentage points for every one percentage point increase in the deficit as a portion of GDP. By that calculation, one would expect rates to increase by at least four percentage points between 2013 and 2083. So interest payments on the debt – and thus the average annual

CBO deficit projections for obama’s budget $0 -200

3.1% of gdp

9.9%

9.9%

6.5%

4.0%

3.9%

4.2%

4.3%

4.7%

4.8%

4.9%

5.5%

2018

2019

US$, BILLIONS

-400 -600 -800 -1,000 -1,200

2010-2019 cumulative deficit: $9.1 trillion

-1,400 -1,600

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

source: CBO, An Analysis of the President’s Budgetary Proposals for Fiscal Year 2010 (June 2009); “Monthly Budget Review,” Fiscal Year 2009 (November 6, 2009)

federal deficit – will almost certainly be far, far higher than CBO is projecting.

The CBO also assumes that GDP growth will resume its long-term trend rate after the current recession is just a bitter memory. If interest rates respond as Gale and Orszag predict, however, growth will surely stagnate because businesses will find it much more expensive to finance capital investments, and households will have to stretch to borrow money to buy houses and cars. Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard) estimate from the experience of other economies that debt in excess of 90 percent of GDP cuts growth by an average of 1.3 percentage points annually. Using that gloomier projection, GDP in the United States in 2073 would be just half of the CBO’s current projection.

As Herb Stein, President Nixon’s economic adviser, famously put it, “If something cannot go on forever, it will stop.” And one must wonder how the tautology applies here. Perhaps, if government borrowing noticeably increased interest rates, the debt would become salient to voters in their daily lives, and politi-

cians and policymakers would respond. That happened in 1983: interest rates soared and voters connected the higher borrowing costs with growing deficits. Wall Street complained to Ronald Reagan that high interest rates were stifling investment, and he reacted by supporting a significant tax increase to reduce the deficit.

The first President Bush and President Clinton sustained the fiscal restraint, but George W. Bush aggressively pushed tax cuts and new spending initiatives (notably for homeland security, defense and the Medicare prescription drug entitlement) even as deficits soared. And in contrast to the early 1980s, credit markets sent no clear signal of distress – in large part because a flood of capital from overseas (from both private investors and central banks eager to maintain the exchange value of the dollar) kept interest rates near historical lows. Deficit finance seemed almost free of political or economic consequences, while tax increases or significant program cuts entailed clear political risks.

Although they criticized Bush’s fiscal stewardship in general terms, both Barack Obama

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catastroph e and John McCain failed to offer plausible plans for stanching the cash hemorrhage.

Obama promised to extend most of the Bush tax cuts and to enact a host of other populist tax breaks and spending programs. McCain, for his part, was more restrained on spending, but the enormous tax cuts he proposed would have blown an even bigger hole in the budget.

The candidates were plainly convinced that there was no gain to be had in specifying how they would manage ongoing deficits.

President Obama has since said the right things (though in general terms) about the long-run fiscal problem, and he did make the gesture of supporting a freeze on some forms of spending in his 2010 budget. But there are good economic reasons for staying deep in the red in the near term – big deficits are needed to recover from the recession – and even more potent political reasons to tread cautiously in this arena.

I haven’t been in the relevant room since I worked in Clinton’s Treasury, but I can imagine a discussion among Obama’s advisers going something like this: Mr. President, if you raise taxes or cut popular programs, you and your party will be defeated in the polls and the bad guys will take over. The bad guys do not share your priorities and they do not care about the deficit.

Therefore, you cannot effectively deal with the deficit; all you can do is undermine your agenda.

Conclusion: it is impossible to deal with the deficit, so don’t even try.

I suspect that Republicans willing to entertain a compromise on taxes to reduce the deficit are hearing a similar message. Certainly McCain, whose program was fiscally responsible when he ran in the Republican presidential primaries in 2000, became convinced that prudence had no political traction in 2008.

So if the pretzel logic of pandering politi-

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cians prevents leadership on the issue, what about the financial markets? Shouldn’t they start pricing the risk of fiscally driven inflation into interest rates in their bids for freshly minted Treasury bonds? Probably, but I’m not certain they will. Remember, the markets are led by the same geniuses who staked the future of their firms on the premise that housing prices could only go up.

There’s an analogy between the market for government bonds and the market for mortgage-backed securities. Specifically, it is tempting to assume that the U.S. government will always be able to roll over its debt when the debt comes due. And while endless deficits imply growth in the amount of interest that must be paid out as a portion of tax revenues and GDP, the payments will remain manageable for decades at a real interest rate of 3 or 4 percent. So bond buyers can be lulled into believing that, while the gravy train may someday stop, there’s still time to profit from the ride.

This creates the potential for a classic bubble in the market for government bonds. As long as interest rates remain low, the bonds are safe – which seemingly justifies the low rates. The bubble bursts when something causes investors to worry about the risk of default, and the prospect becomes self-fulfilling.

A small perceived risk that Washington won’t make timely payments on the debt would cause investors to demand higher interest rates on new bond issues. But higher interest payments mean higher deficits and a greater risk that the Treasury would be forced to default on its obligations – which in turn would increase interest rates further, creating a vicious cycle. In the extreme, investors might decide overnight that the government couldn’t possibly repay its debts and lending would skid to a halt. (The subprime mortgage market in 2008, flourishing one day and dead the

next, is a great example of how this happens.)

At that point, we would face a crisis. Even if Washington remained absolutely committed to meeting its obligations to its creditors, it wouldn’t be able to sell bonds in private financial markets. That would leave the Treasury with the unpleasant option of printing money – in modern terms, this means selling bonds to the Federal Reserve and increasing the reserves of the banking system – and thereby spiking inflationary expectations.

There are other courses of action that could produce this kind of bubble in the market for Treasury securities. For example, in economists’ “herd” models, everyone might know the market is experiencing a bubble,

but there is a market leader who thinks he or she can make more money before the bubble bursts. Others follow, until the leader pulls out. At that point, the bulls all turn to bears and the market collapses.

A further complication is that the herd leader may well be China – holder of roughly $800 billion in Treasury IOUs and another half-trillion in federally guaranteed securities.

Now, China has motives, other than the prospect of profit, for lending to the United States.

Our borrowing pays for our imports from China – purchases that sustain economic growth and create jobs in that Asian country.

Other investors in dollar securities have, to date, concluded that China is stuck in this

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catastroph e dysfunctional relationship with America. But if China signaled a change of heart – either because it feared taking big losses on its holdings of Treasury bonds or because it decided that the Chinese economy had reached the level of diversification to make do without U.S. export markets – investors would rush for the exits.

Most disconcerting is the prospect that China, or some other large creditor in Asia or the Persian Gulf, might decide to use our financial dependence for strategic advantage.

The Chinese, for example, might use their lev­ erage to demote the United States from the ranks of the financial superpowers, figuring the political gains were worth the costs of losses on its bond holdings and temporary disruption in its export markets.

paying the piper We might look to history for analogies. My favorite: In 400 BC, Dionysius of Syracuse (a Greek colony on Sicily) was proving to be fiscally irresponsible. He liked parties, gold and palaces (not to mention costly military adventures), and eventually found himself unable to pay his debts. He commanded his citizens, on pain of death, to turn in their one-drachma coins. He then stamped them as two-drachma coins and repaid citizens with the debased currency. Other profligate rulers achieved similar ends by shaving metal from the edges of coins or by diluting gold with base metals in order to expand the money supply.

In their wonderful compendium of budget-disaster stories, Reinhart and Rogoff found that, through history, expanding the money supply (“monetizing the debt”) was the favored response to a debt crisis. There are less crude ways of doing this than the method chosen by Dionysius. And while the 22

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Federal Reserve would, of course, not willingly give up its ability to contain the money supply as a means of maintaining price stability, it might not have a choice.

The alternative, default on debt payments, would be a disaster for the member banks of the Federal Reserve System since they hold their reserves in Treasury securities. So default would very likely cause a systemic financial market collapse. Ironically, the “riskless asset,” rather than subprime mortgages or other high-risk investments, would be the culprit.

While creating money “works” in the limited sense that it makes it possible to pay off government creditors, the cost of the resulting inflation should not underestimated. All owners of assets that paid returns in fixed amounts of dollars (including all U.S. financial institutions) would experience a decline in wealth. Indeed, financial institutions would suffer much greater losses than in the 2008 financial crisis, and the insolvent federal government would be powerless to help them.

The “wealth effect” of depreciating asset holdings would significantly cut domestic consumption, compounding the recessionary impact of the tax increases and spending cuts that would be necessary to cope with the budget deficit.

Since most business contracts create obligations in dollars and lack provisions for adjustments for inflation, many firms would suffer huge losses and many would fail. More generally, the economy would become far less efficient at delivering the goods and services that people value most because the price signals that drive resource allocation would lose their utility.

Whether we defaulted on the debt explicitly, or implicitly through inflation, further borrowing would become impossible or prohibitively expensive. Washington would thus suddenly need to start paying bills upfront.

The longer it takes for the crisis to manifest, the greater the tax increases and spending cuts needed to manage the task because the structural budget deficit is growing all the time. For example, in 2030, the primary deficit (the deficit not including interest) will amount to about 6 percent of GDP – almost one-third of total federal tax collections under current law.

Since either default or runaway inflation would impose huge costs on all lenders, they would be tempted to try to work out some sort of concessionary payment arrangement for the Treasury.

Other governments and international agencies would probably agree to lend us money for a while in exchange for guarantees that we would slash spending and raise taxes to eliminate the large structural deficit. This, after all, is what the United States and the International Monetary Fund have done on numerous occasions as the price of financial bailouts for other countries. But the resulting fiscal adjustments would themselves magnify the short-term economic damage. Indeed, massive spending cuts and tax increases on top of a financial crisis would be a recipe for a recession or depression. Combined with sharp reductions in borrowing (and in access to foreign capital), this would translate into a large drop in U.S. demand for imports, which could easily spread the economic crisis to the rest of the world.

In any event, the United States might simply decide that the economic and political costs of default or hyperinflation were less than the costs of the draconian fiscal tightening required by our lenders. So an acceptable workout arrangement might not be feasible.

Reinhart and Rogoff ’s survey of past debt crises suggests that they lead to slower growth and higher unemployment for several years – a bleak enough outcome. However, it is not

clear how relevant the historical experience would be to a debt crisis of this severity in an economy that produces one-fifth of the world’s GDP and is home to the world’s largest financial markets. It could easily take a generation or longer to recover from the disaster.

Neither liberals nor conservatives would be able to take solace in this outcome. Yes, government would be radically downsized and out-of-control entitlement programs

If senior citizens, who will make up a growing and very powerful voting bloc, resist major cuts to Social Secu­ rity, Medicare and Medicaid, we could experience taxes so high they would make even Scandinavians revolt. would finally come under the knife, fulfilling a wish of the Tea Party crowd. But the eviscerated government would have to generate higher taxes than we have ever paid in this country. Indeed, such a denouement might provide the answer to the question: When will the United States follow the lead of Europe and adopt a massive value-added tax?

And if senior citizens, who will make up a growing and very powerful voting bloc, resist major cuts to Social Security, Medicare and Medicaid, we could experience taxes so high they would make even Scandinavians revolt – at the same time that other priorities like national defense, education, infrastructure and services to working-age families and children were gutted.

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catastroph e

when will the crisis occur?

It would be nice to pinpoint a date when our fiscal policy is slated to pass from reckless and irresponsible to crippling and irreparable.

But there is no magic threshold. It depends on the era and doubtless other factors, including the attitudes of the big creditors.

That said, nearly one-fifth of countries that have defaulted or required debt restructuring had external debt of less than 40 percent of GNP, and more than half of countries experiencing debt crises had debt levels below 60 percent of GNP. Thus, 60 percent might be viewed as a rough threshold.

It’s true that the United States amassed a debt of 109 percent of GDP by the end of World War II, which we were able to pay

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The Milken Institute Review

down fairly quickly and without great trauma.

However, the process was helped along by an enormous peace dividend: Simply removing millions of soldiers from the federal payroll and slashing spending for war materials created fiscal surpluses. Moreover, the fiscal retrenchment had a relatively modest impact on aggregate demand because the end of wartime rationing led to an explosion of private spending on houses, cars and the like. Even so, there was a recession in 1946, which was probably precipitated by the sudden cut in government spending.

In contrast, the next time our debt hits 100 percent – 2023 by CBO’s projections – the government will be spending 23 percent more than it takes in before counting interest.

Draconian and unprecedented spending cuts or similarly disruptive tax increases would be necessary to eliminate such an imbalance.

And a highly contractionary fiscal policy would most likely push the economy into a very deep recession, which would further depress revenues and increase demands for government services and transfer payments (for example, unemployment insurance and food stamps). Thus, our economy will be much more vulnerable the next time our debt hits 100 percent of GDP.

can we avoid budget catastrophe?

President Obama and his senior advisers are clearly concerned about the long-term budget situation, and recent opinion polls suggest that the public would support a more prudent fiscal policy – at least until the sacrifices the change entailed were spelled out. Jens Henriksson, who served several ministers of finance in Sweden as that country dealt with its own debt crisis, advises that liberals could signal commitment by offering to cut spending, and that conservatives could do likewise by offering to support tax increases. For example, the president could offer to pare spending by a dollar for every dollar that taxes increase. But for better or worse, America is not Sweden.

The president promises to establish a blueribbon commission to make recommendations on deficit reduction. The idea is to provide bipartisan cover for politically unpopular tax increases and spending cuts. But most Senate Republicans (along with a good number of Democrats) have already rejected the idea of setting up a deficit commission, and Republicans have vowed to reject the recommendations of any commission the president sets up on his own.

Perhaps the public would be galvanized to sacrifice by tangible evidence that the debt is weakening America’s capacity to project

projections of debt held by the public percentage of GDP 800% 700 600 500

including macro response

400 300 200

cbo projection

100 0

1960

1980

2000

2020

2040

2060

2080

source: Congressional Budget Office and author’s calculations

power and to influence the behavior of other countries. Some would argue that this is already happening: President Obama softpedaled human rights issues during his first visit to China, reportedly because he was reluctant to alienate America’s largest creditor.

Distressingly, none of the possible courses of events in which Americans wake up one day and decide that enough is enough – that treasured entitlements, including Medicare and Medicaid, must be trimmed and that taxes must be raised in order to protect the economy (and our grandchildren’s living standards) from deep decline – seem very plausible. That suggests it might take a traumatic event – a debt crisis that delivers a onetwo-three punch in the form of inflation, deep recession and the collapse of the dollar – to alter the politics of deficit reduction.

Like the proverbial frog that fails to jump out of the soup pot as the temperature slowly rises, Americans seem terrifyingly unwilling to act until the pain of debt can no longer be ignored. As the frog learns in its final mom ments, by then, it’s too late.

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tk

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The Milken Institute Review

Illicit Drug Policy

tk

F

For the past three decades, our nation’s policies toward illicit drugs have been a source of despair to most thinking people.

Federal, state and local governments have all been committed to harsh enforcement of prohibition, and the result has been, at a minimum, disappointing, and, at worst, disastrous. The War on Drugs has left us with the West’s most serious drug problem, as measured by rates of addiction, violence and deprivation of civil liberties – not

By Peter Reuter to mention the humongous bill for police and prisons. Perhaps most dispiriting, it highlights America’s shameful willingness to be tough at the expense of poor urban minorities, while forgiving the lapses of the elite.

Neither political party has shown much inclination to deviate from the path of failure. The difference between the Clinton administration and the Republican administrations before and after amounted to rhetorical nuance. President Clinton managed

An Economist’s View of the LeastWorst Options

Second Quarter 2010

27

to sound a bit empathetic about addicts’ problems, perhaps reflecting his brother Roger’s experiences with heroin. But he made no effort to fight policy inertia.

The only hint of recent progress at the federal level has been at the margin, where racial inequity is most glaring. With support from the Obama Justice Department, a number of members of Congress from both sides of the aisle are pushing to correct the outrageous disparities in sentencing between crackcocaine and cocaine-powder offenses. But no senior member of Congress – Democrat or Republican – has made drug policy a priority.

There have been efforts to build a coalition of libertarians and liberals to press for drug reform. But, so far, it has been effective only on the niche issue of medical marijuana, where 14 states have defied federal authorities by legalizing access.

Barack Obama’s election offers some hope of a fresh look at drugs. He, after all, has acknowledged using marijuana and cocaine in his youth. And he chose Gil Kerlikowske, the former police chief of Seattle, to head the Office of National Drug Control Policy (to the media, the “drug czar”). Kerlikowske has already called for a shift in emphasis from punishment to treatment.

It is easy to describe what rational people don’t like about the War on Drugs: half a million drug prisoners, who are even less white than the overall prison population; threequarters of a million arrests for marijuana possession annually; the spraying of coca fields in the Andes, damaging the environment with no apparent success in diminishing cocaine supplies; aggressive efforts to inP ete r Re ute r is a professor in both the School of Public Policy and the department of criminology at the University of Maryland.

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The Milken Institute Review

terdict illicit drugs at the border, making cultivation incredibly profitable and transforming Afghanistan, Myanmar, Bolivia and, arguably, Mexico, into narco-states. But it is hard to describe what an unambiguously better drug policy would look like because every path has pitfalls.

the siren call of legalization Ask any card-carrying economist whether addictive drugs should be legalized, and you’ll get a resounding “yes” – perhaps accompanied by snide remarks about dumb questions.

Those seeking a formal statement of the case can read the classic article on the market for illegal goods by the Nobel laureate Gary Becker, along with Kevin Murphy (University of Chicago) and Michael Grossman (City University of New York), in Journal of Political Economy.

But the case is easily summarized: • Most of the damage to society from drugs is a result of prohibition, not a consequence of drug ingestion.

• Criminal sanctions are more expensive than any other plausible method of controlling the “externalities” of drug use.

• A combination of taxes and the regulation of suppliers could fix most of the remaining problems.

There’s a catch, however – well, really three catches.

First, economists assume that all the effects of legalization are captured in prices. In truth, legalized cocaine would not simply sell for less, but would be more accessible and more attractive to some because the activity would no longer put them at risk of criminal penalties. In economics parlance, legalization would most likely shift the whole demand curve “to the right,” implying that the resulting increase in consumption would be greater than that suggested by estimates of the current elasticity of demand with respect to price.

previous page: ©john berry/syracuse newspapers/the image works

illicit drug policy

Second, America’s long experience with other legalized vices suggests that the political economy of regulation is fragile: once a legal industry is created, it will organize to undercut restrictions that reduce its profitability. In the half century after repeal of Prohibition, the alcohol industry successfully pushed for a more permissive system with lower taxes. Besides, it is unclear whether, in a highly regulated regime for selling addictive drugs, the government would be part of the solution or part of

to prevent the advocates from oversimplifying the issue. In weighing the pros and cons, three factors are salient.

1. Uncertainty of benefits. The evidence from other countries, times and drugs strongly suggests that legalization will result in an increase in both drug use and addiction.

But past experience offers little basis for even crude estimates of the increase.

An increase of 50 percent in heroin addiction might be acceptable since the harm asso-

Ask any card-carrying economist whether addictive drugs should be legalized, and you’ll get a resounding “yes” — perhaps accompanied by snide remarks about dumb questions. the problem. Consider, for example, the experience of the states that have created lottery monopolies for themselves. In search of revenue, they have aggressively advertised lotteries, inviting the poor and those with gambling problems to spend more on the game.

Third, the analysis ignores the extent to which the problem of drug addiction, like cigarette smoking, has its origins in adolescence. State-based paternalism in the name of protecting the young against their own bad judgment is a well-established tradition. The decision to raise the legal drinking age to 21 reflects a view that even those aged 18, 19 and 20 need protection from themselves. Given that most drug use begins before age 21, and that some share of those who start will become addicted in ways that only an economist could call “rational,” legalization poses societal threats broader than Becker et al. contemplate.

This is not to say that legalization is clearly a bad idea; after 10 years of study, I remain genuinely agnostic. My principal concern is

ciated with each instance of heroin addiction would fall sharply: most of the adverse consequences – crime and disease – are largely a result of the circumstances of drug use in an environment that keeps prices high and needles dirty. But what if the increase in heroin addiction were 500 percent? That figure sounds high, but even with an increase of that magnitude, three times as many Americans would be addicted to alcohol as were addicted to heroin.

Easy access to cheap drugs would sharply reduce costs, as measured by violence, innercity collapse and, of course, law enforcement.

But Rosalie Pacula, a senior economist at the RAND Corporation, reminds us that the cost to new addicts could be very high. For example, she estimated that the total cost of methamphetamine use in the United States was $23 billion in 2005 – more than half of which was borne by users suffering the intangible burdens of addiction. The bottom line, then: legalization might well reduce the net harm to society, but that is hardly a certainty.

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illicit drug policy

rect benefits of eliminating the black market might look small compared with the costs of generates many different kinds of damage increased drug use, particularly among adothat make aggregate measurement of the bill lescents. For liberals (including me), redistribproblematic. How, for example, does one uting the damage away from the poor would weigh the costs of increased addiction resultbe desirable, and might justify some worsening from legalization against the benefits of ing of the overall problem. But even econoreduced crime and corruption? How does mists understand they are on shaky ground one balance the benefits of reductions in viowhen they make judgments about who gets lence against the costs of the likely increases the benefits and who pays the bills. in accidents and other behavioral risks of A further complication here is that the ledrug use? While economists are adept at galization arguments are drug-specific. There weighing such intangibles – what other prois a strong case to be made for not only elimfession would dare to estimate the dollarinating the penalties for marijuana possesvalue of life? – the dimensions here are dauntsion, but also allowing people to cultivate the plant for their own use – the approach currently taken in four Australian jurisow does one balance the benedictions. The downside risks (mild behavioral changes and respiratory illness fits of reductions in violence from increased use) seem modest while against the costs of the likely the potential gains look large: the elimincreases in accidents and other ination of 750,000 marijuana possession arrests annually and the potential behavioral risks of drug use? for weakening the links between softand hard-drug markets. But the downing. The catastrophic violence surrounding side risks for heroin and methamphetamine, the drug trade in Mexico would vanish, while where the health and behavioral consequences the power of the Taliban in Afghanistan of regular use are much greater, make them would wane if marijuana, heroin and cocaine tougher calls. were legalized in the United States and their So, how about decriminalization? prices fell sharply. How should we factor in such intangibles?

The case against legalization largely turns on 3. Distribution of benefits. Another comthe difficulty of restricting promotion by the plication is that the advantages and disadvansellers of drugs in licit markets. Removing tages of different approaches would be uncriminal sanctions against users without creevenly distributed. Any substantial reduction ating rights of commercial free speech would in illegal drug markets would yield immense avoid that, but still get the government out of benefits to urban minority communities, the ugliest of the drug war’s activities – where drug sales now cause so much crime namely, locking up drug users. and disorder. And that’s likely to be true even There’s some evidence that decriminalizaif the levels of drug use and addiction were to tion works. Portugal decriminalized the use increase in those communities. of all drugs in 2001 with no apparent ill effect For the middle class, however, these indito date, according to a recent study for the 2. Non-comparability of benefits. Drug use

H

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Cato Institute by the lawyer and columnist Glenn Greenwald. However, decriminalization of possession alone wouldn’t go very far to reduce societal costs in the United States.

Of the half million people in prison for drug offenses at any one time, a vast majority are drug sellers. The center-city street markets, overdose rates and conflict among dealers would all continue unabated. Colombia and Mexico would still be racked by drug-related corruption and violence.

©paolo siccardi/age fotostock

Or cutting prison populations and expanding treatment?

If one accepts the above arguments, legalization of hard drugs is risky because we don’t know how many addicts would be created, while decriminalization would not constitute a big enough change to make much of a difference. Is there anything that can be done to make prohibition less harmful without altering the legal status of drugs?

A lot of what troubles observers of our drug policy is the extraordinary incarceration rates, which have grown more than tenfold – that’s right, tenfold – since 1980. Sweden, often held out as the tough boy of European drug enforcement, imprisons one-quarter as many drug offenders per capita. A sentence of two years, the median sentence in the United States for drug crimes, is the upper limit in Sweden.

Would the United States really be worse off if it contented itself with keeping just 250,000 drug offenders in prison rather than 500,000?

Jonathan Caulkins, a Carnegie-Mellon drugpolicy analyst, notes that halving incarceration rates would hardly constitute going soft on drugs: the regime would still be a lot tougher than the one in force in the Reagan years. Furthermore, keeping fewer drug offenders in the slammer need not mean that a minority who are especially violent or otherwise dangerous would get out earlier. Indeed, with less pressure on prison space, they might

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The Milken Institute Review

it is much less effective than much-scorned drug treatment – even taking into account the notoriously high dropout and relapse rates. There’s simply no question that cutting sentences for drug dealers would make minimal difference in the price or availability of cocaine, heroin or methamphetamine.

I offer no magic formula here; there’s no reason to believe that halving the incarceration rate, as opposed to, say, cutting it by onethird or by two-thirds, would be optimal. The point is simply that drastic reductions in incarceration – and thus reduction in costs to both society and to the many drug users who are locked up because they sell to support their habits – would be possible without embarking on the uncharted waters of legalization.

Cutting prison populations is especially attractive right now because of the desperate plight of state budgets – and, in the case of

©gary knight/vii

serve more time, not less.

Paring the numbers incarcerated could be usefully complemented by greater efforts to target incarceration more effectively. Lowlevel dealers are now locked up on the rationale that it makes drugs harder to get and more expensive. Yet, as is well known (by everyone, apparently, except the policymakers), the prices of cocaine and heroin have fallen over the decades. The only published effort to estimate the effects of increased incarceration on cocaine prices, co-authored by Steven Levitt of Freakonomics fame, found that during a period in which incarceration for drugs (mostly cocaine) rose from 82,000 to 376,000, the retail price rose by 5 to 15 percent. A simple calculation of the cost-effectiveness of locking up drug offenders, as measured by the reduction in cocaine consumption per $1 million spent by the government, shows that

California, because the prison system is under a federal court injunction driven by the failure of the state to provide safe and humane conditions for inmates even when it could afford the cost. It would be ironic if the only reason that this nation cut the number of individuals imprisoned for selling drugs was to avoid tax increases. But history suggests that any argument adding a touch of rationality to drug policy should be exploited.

Drug treatment has become the standard alternative to incarceration – though one talked about more than implemented. Drug courts that use the threat of jail to compel offenders to enter and remain in treatment have proved useful. But they currently cover only about 5 percent of drug-involved offenders because the screening criteria exclude all but the least problematic. Proposition 36, the ballot initiative adopted by Californians in 2000, ensured that most of those arrested for drug possession for the first time were not incarcerated. Even though most of those directed to treatment rather than jail never reached the treatment program door, it seems to have been reasonably successful in the sense that it cut the number imprisoned without raising crime rates or drug use. But, needless to say, these interventions don’t have much impact on the market for drugs or the violence illicit markets create.

The problem is, oddly, linked to both inadequate demand and supply: Not enough of those who need treatment seek it, and too many of those who seek it face long delays and poor service.

The demand-side problem could be easily solved by transforming the criminal justice system into a recruitment mechanism for treatment. Over the last decade, the British have doubled their population in treatment – mostly for heroin addiction – by aggressive use of legal carrots and sticks. Some police of-

ficers now see treatment recruitment as an important part of the job, while a dizzying array of post-arrest programs encourage heroin addicts to enter treatment rather than prison.

On the other side of the equation, it would be no great feat to increase both the supply and quality of drug treatment services as long as expectations were realistic. But to get from here to there, Americans would have to adopt a more sympathetic view toward illicit drug users.

A more important change would be to impose shorter sentences and then coerce abstinence by linking parole to staying clean. Coerced abstinence, long the crusade of the UCLA drug policy specialist Mark Kleiman,

Cutting prison populations is especially attractive right now because of the desperate plight of state budgets. simply means doing what citizens assume is already being done by the criminal justice system: detecting drug use via frequent mandatory testing and providing immediate sanctions when the probationer or parolee tests positive.

Kleiman has been promoting this sensible idea for 20 years, noting that pretrial detainees, parolees and probationers account for a large share of the nation’s cocaine and heroin consumption. The primary obstacle has been bureaucratic resistance. But thanks to the help of an entrepreneurial judge in Hawaii named Steven Alm, supporters of coerced abstinence can now point to some striking results in that state. Few of those subject to the monitoring system over the past five years

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illicit drug policy have failed to comply, and their recidivism rates after they are free from the immediate threat of jail are much lower than those not forced to undergo testing.

harm reduction and cost-benefit analysis If prohibition remains the law of the land, is there much else one could do to make illicit drugs less problematic for both users and society as a whole? The notion of “harm reduction” – acceptance of the practical limits of a free society to control drug consumption and to focus on cutting the harmful consequences of drug use – has become the approach of choice in many Western countries.

And for good reason. The evidence that governments can cut the number of users is depressingly slight. Prevention remains a slogan and aspiration, rather than a set of proven programs. Treatment, while cost-effective in the sense that it is cheaper than incarceration, apparently can make only a modest difference in recidivism. And, as already noted, draconian enforcement to raise prices and reduce availability has failed abysmally.

China, whose government has seemed unable to tell the difference between a labor camp and an addiction-treatment center, is showing signs of a pragmatic move toward harm reduction. Even Iran, with its huge opium/heroin market and indifference to individual rights, has tilted in this direction.

The iconic harm-reduction program is needle exchange, in which no-questionsasked access to clean needles, along with collection and destruction of used needles, minimizes the risk that addicts will spread AIDS and hepatitis. A dozen countries, including the Netherlands, Australia, Norway, Denmark and Canada, offer these services – as do 33 states in this country.

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The logical extension to needle exchange is legal access to drugs solely for established addicts. This service has been available for heroin addicts in Switzerland for 15 years and in the Netherlands for five. Legal access remains a niche program, however. While it brings large benefits for those enrolled, only 5 percent of the heroin-dependent population in Switzerland have chosen to enroll.

Harm reduction need not be restricted to consumption-oriented interventions. Robert MacCoun, a social psychologist at University of California (Berkeley), and I have argued that harm reduction is best seen as a benchmark for judging policies and programs rather than a class of interventions. Indeed, harm reduction is merely standard cost-benefit analysis applied to a policy area that has so far been left in the hands of true believers. Cost-benefit analysis requires that the decision maker list and value all of the consequences of the decision, both positive and negative. Harm reduction can be seen as analysis-lite, since it does not claim to be able to monetize all the benefits and costs.

The distinct and disturbing feature of bringing this lens to drug policy is that most of the effects of supply-side interventions are negative. For example, aerial spraying of Colombian coca fields has led to other fields being planted with coca, which itself causes serious damage to fragile ecosystems. Moreover, spraying is predictably inaccurate, so legitimate farmers are also hurt by it. And as Vanda Felbab-Brown, a fellow at the Brookings Institution, shows in her forthcoming book, Shooting Up: Counterinsurgency and the War on Drugs, the historical record in Afghanistan, Colombia and Peru suggests that eradication increases peasants’ willingness to collaborate with insurgents like the Taliban, FARC and Shining Path. The benefits from spraying, however, are elusive, since the most one can

associated press

hope for is a modest increase in production costs – and a much, much smaller increase in retail prices back home.

Neither I nor anyone else has tried to weigh the costs against the benefits here, but it is not possible that spraying makes sense in these terms. Labeling the above analysis as harm reduction rather than cost-benefit analysis merely acknowledges that it is a stretch to put dollar values on the costs and benefits of drug policy initiatives.

All that said, using the harm-reduction framework to assay the whole array of programs and laws that we use to control drug use in the United States might make a large difference. It might even force the deeply entrenched drug enforcement system to collect data and to provide some analysis to defend prohibition-as-usual. We have no idea, for example, of the consequences of the federal government’s multibillion dollar program to interdict drugs in international waters. Perhaps it raises prices enough and captures enough high-level dealers to meet the criteria set by proponents. But if it does, it must also lead to higher export demand for cocaine from Colombia – and that effect ought to weigh particularly heavily in our decisions. Doing certain harm to other nations for questionable domestic benefits is, at best, morally problematic.

muddling on It would be nice to be able to make a slamdunk case for legalizing drugs since so much of the harm done by drugs is linked to their legal prohibition. But as long as we lack a clear sense of the consequences of legalization in terms of greater drug use, to my mind, the case will remain unconvincing.

What’s left, if one dismisses legalization,

hardly adds up to a bold initiative. But incremental steps in the name of increasing the bang for a buck spent on drug programs may be all that can be expected from policymakers, who will face fierce resistance from interests whose jobs (or claims to the high moral ground) are at stake.

Certainly the nation’s first African-American president and attorney general might reasonably be expected to pay particular attention to policies that lead to the incarceration of a large percentage of young, poorly educated African-American males on the basis of deeply flawed logic. And any president committed to fighting the rise of narco-states that threaten global security must acknowledge that only a shift in policy lowering the value of illicit drugs at our borders would do much m to undermine their power.

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Russia’s Economic Prospects OR

Dmitri and Vladimir’s not-so-fine adventure

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by robert looney

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I

In the decade bookended by the collapse of the ruble in August 1998 and the global economic crisis in 2008, Russia enjoyed the fastest growth in its history. Real GDP dou-

bled in just 10 years, and while this still left the country far behind the West in living standards, the growth spurt raised hopes that Russia was finally putting the Soviet past

behind it. Declines in unemployment and poverty complemented rising productivity,

near-Asian rates of investment and a balanced government budget. Meanwhile, years of current account surpluses permitted the accumulation of some $600 billion in foreign

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currency reserves to protect the economy from the sort of crisis that laid it low in 1998.

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previous pages: gerd ludwig/institute; opposite page: ©thomas dworzak/magnum photos

In the spring of 2008, the polity voted for continuity by naming Dmitri Medvedev, Vladimir Putin’s chosen successor, as the new president. Medvedev promptly returned the favor by naming Putin prime minister. But the impression that Russia was over the hump was shattered in the fall of 2008. Few countries seemed as unprepared to cope with the global financial crisis. And in August 2009, Medvedev belatedly acknowledged that the path taken over the decade offered little hope of sustained growth – that business as usual would lead to an economic dead end.

Why so stunning a reversal of perceived fortunes? More important, what does the reversal say about the long-term prospects of this perplexing nation, which challenged the hegemony of the West for half a century and still remains a geopolitical player by virtue of its abundant natural resources, vast nuclear arsenal and imperial pretentions?

wounded bear With hindsight, it’s plain that the sources of Russia’s current economic woes go beyond the global crisis. Investors (domestic and foreign) proved to be far less willing to stick by Russia than might have been expected. In July 2008, Putin chose to attack Mechel, the giant metal and mining conglomerate, for alleged price gouging in domestic markets, suggesting that the company would soon feel the boot of state power for its errors. The value of Mechel’s stock plummeted 38 percent overnight.

More significant, the price of oil peaked in July at $147 a barrel and headed south quickly, raising fears about Russia’s ability to chart its own course. Then, in August, Russia and Georgia fought a brief war that ignited passions in the cause of an ethnic satellite group, worrying analysts that Putin had resorted to waving the bloody shirt in an effort to distract Russians from the economy’s problems. The

stock market imploded in slow motion, falling by three-quarters over the next six months.

Even the value of Gazprom, Russia’s highprofile natural gas monopoly and the largest company in the nation, dropped 74 percent.

With the cost of capital soaring, the real economy slipped into free fall. From January to July 2009, industrial output declined at an annualized rate of 14 percent, and GNP fell at a 10 percent rate. Officially measured unemployment reached 8.3 percent by mid-2009, up from 5.6 percent before the crisis.

there’s no there there For some time after the crisis hit, Putin maintained that Russia’s economic fundamentals remained sound and that its problems were simply the consequence of the greater global malaise. But analysts pointed to what now seems obvious: Growth built on a commodity price boom is a house of cards. During the decade, oil and gas had accounted for 40 percent of budget revenues and two-thirds of export earnings. Once energy prices returned to earth, the Russian economy’s daunting structural deficiencies were exposed for all to see.

The private financial system was woefully inefficient and laced with corruption. Much of the capital for investment was coming from foreigners rather than Russia’s immensely wealthy elite – and one-third of that investment was plowed into oil and gas ventures. By no coincidence, Russian banks and industrial corporations were excessively leveraged, doing business almost entirely with other people’s money.

A variety of missteps by the central bank exacerbated the economy’s immediate problems. The decision to slow the growth of the money supply in the name of fighting inflation reduced the liquidity of both the financial and industrial sectors on the eve of the crisis. Moreover, the government central bank

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r u s s i a’s p r o s p e c ts had allowed energy export revenues to increase the effective exchange rate of the ruble by 145 percent since 2001, undermining efforts to build markets for Russian exports other than oil and gas.

But the deepest, most troubling problems revealed by the crisis – the problems that resist straightforward solutions – are related to Russia’s political and economic cultures.

The Bad Old Ways

Even as the economy was triumphantly recovering from the 1998 crisis, Russia was brushing aside nascent democratic institutions and increasing state control over the economy.

The World Bank’s Governance Index measures these trends by tracking six factors. And few countries that fare badly on the index manage sustained growth.

In voice and accountability, a broad measure of democratic attainment, Russia scored in the 35th percentile among all countries in 1998 and slipped to the 22nd percentile in 2009. In contrast, Brazil, China and India (which with Russia make up the up-andcoming bloc of large developing countries known as BRIC) managed scores in the 40s.

Russia tallied a 24th percentile ranking in political stability; by comparison, the non-Russian BRICs were all in the mid-30s.

Although Russia posted a respectable 51st percentile in government effectiveness in 2003, it was plainly heading the wrong way: the figure was down to the 45th percentile in 2008.

(The other BRICs maintained scores in the high 50s.) Similarly, nascent reforms in regulatory quality pushed Russia from the 19th percentile in 2000 when Putin took the reins of government from Boris Yeltsin, to the 47th rob e rt loo n ey teaches economics at the Naval Postgraduate School in Monterey, Calif.

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percentile in 2003. But by the time Putin left the presidency, the figure had retreated to the 31st percentile.

Russia’s performance in rule of law has been a particular embarrassment: the country scored a miserable 20th percentile in 2008, compared with a 49th percentile average for the other BRICs. By the same token, Russia is lagging miserably in control of corruption, ending up in the 15th percentile, versus 48th for the other BRICs. Lack of progress in the quality of governance has had the expected consequences.

The Heritage House Index of Economic Freedom – an ideologically charged source to be sure, but one that offers insights into the efficiency of economies – is indicative. By Heritage’s reckoning, Russia ranked 146 out of 179 countries in 2009, trailing such stalwarts of economic freedom as Vietnam, Ethiopia and Burkina Faso. Likewise, Russia ranked a mere 58th out of 122 countries on the Milken Institute Capital Access Index in 2008, behind Peru, Egypt and Belarus.

Why did the development of Russian institutions lag so badly behind the growth numbers? Two reasons: • The oil and gas boom, which ironically undercut incentives to improve governance and reduce corruption, undermined balanced economic development.

• Vladimir Putin’s willingness to sacrifice medium-term growth prospects to bolster his own power and to increase Russia’s resilience to short-term currency shocks.

The Curse of Oil

Study after study has found that economies underpinned by energy exports are unlikely to sustain growth once prices decline. One reason is that a surfeit of cash during the boom reduces the government’s will to exact taxes – and thus the need to earn citizen sup-

©iain masterton/age fotostock

port by providing valued services and effective economic management. Instead, oilbased wealth tends to create an implicit social contract in which state-provided welfare is substituted for political rights. By the same token, all that easy money is an invitation to corruption (public and private), further undermining incentives to deliver good government at minimum cost.

Dependence on resource exports, it’s worth noting, damages economies in more direct ways, through a mechanism that economists call “Dutch disease” after the experience of the Netherlands during its natural gas boom in the early 1960s. Bountiful earnings from energy (at least during periods of high commodity prices) tend to increase the exchange value of a nation’s currency, making it

more difficult for exporters of other goods and services to compete both at home and abroad. And Russia certainly fits the description: The world’s largest exporter of natural gas and second largest exporter of oil has failed miserably to build world-class manufacturing and service sectors.

Putinism

A casual observer might assume that Putin is working from Deng Xiaoping’s template, attempting to build an advanced free-market economy without giving up his monopoly on political authority. But while the Russian leader no doubt envies China’s success, he is hardly managing the economy on the Chinese model. Indeed, Putinomics seems based on an unusual strategy (in recent decades, anyway)

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r u s s i a’s p r o s p e c ts of keeping a largely privatized economy on a short leash, offering little prospect of better governance or high productivity, which typically evolves organically from decentralized markets and open economic competition.

Putin’s strategy is, in part, a reaction to the currency crisis of 1998, in which Russia found itself at the mercy of foreign creditors.

To avoid such dependence in the future, private enterprise must defer in choosing be-

Like the CEO of a large corporation, Putin apparently sees himself free to change the operations of subsidiaries and to fire operating managers who fail to meet his expectations. tween profit maximization in risky global markets and the broad interests of the motherland – as interpreted by the Kremlin.

An obvious question here is why Putin bothers with the facade of capitalism. Why not just go back to government ownership and Soviet-style planning? Clifford Gaddy, an economist at the Brookings Institution, argues that Putin sees himself as a corporatist rather than a socialist – that he is the chief executive of Russia Inc., not the chief functionary of a centrally planned economy. The goal is to keep the economy on a course broadly mapped by the government, but to leave the operations to the private sector in order to avoid the wretched inefficiency characteristic of state ownership.

Like the CEO of a large corporation, Putin apparently sees himself free to change the operations of subsidiaries and to fire operating managers who fail to meet his expectations. So

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while Russia remains a nation of laws on paper, control of the private sector is based less on formal regulation than on extralegal threats – as in, “we can dismantle your company just as we did Yukos,” the giant oil company that was buried under a blizzard of tax claims and criminal prosecutions in 2004 to 2006.

In an environment of minimal economic freedom, no real protection under the law and immense oil revenues, the owners of large enterprises were presented with a unique ultimatum: You can keep your properties if you make them productive. Of course, you must also be prepared to share your wealth with the government and with other private parties favored by the government. Last but hardly least, you must defer on strategic decisions that could affect Putin’s power or Russia’s interests as interpreted by the Kremlin.

Once Putin consolidated authority, the way the strategy would work in practice became clearer. The government took advantage of the oil boom to pay off its foreign debts. And it consolidated its grip over business, demanding an increased share of the earnings of raw material exporters, which were reaping the fruits of the broader global commodity boom. The government thereby accumulated a vast war chest, with $200 billion set aside to support domestic investment and to sustain the Kremlin’s power to reward compliant businesses. Most of the accumulated reserves, it should be noted, were held as the short-term debt of Western governments – an effort, presumably, to give the government clout in central banking circles and to contain the ravages of currency appreciation (i.e., Dutch disease). This, ironically, opened up a large market for Western investors to supply capital to Russian businesses suffering from a shortage of domestic credit.

The Kremlin judged Western financial institutions to be better at finding productive

reuters/ria novosti

uses for capital than their inefficient Russian counterparts. The government’s apparent intent was to use foreign banks to provide financial intermediation services on the basis of free-market principles rather than have the country’s wealth frittered away through corruption and ineptitude.

For a time, the result was rapid growth, reduced unemployment and fiscal stability as envisioned in Putin’s Russia Inc. model. However, when oil revenues dropped and private capital inflows atrophied, the consequences of this odd hybrid economic strategy became all too apparent.

Russia had, in effect, wasted a decade in which reform might have made the domestic financial system more efficient and resilient to external shocks. With the loss of access to private credit, domestic or foreign, during the global crisis, only the state had the resources to support demand. And while the government possessed humongous financial resources and wielded unchecked authority, it

lacked the competence to implement an effective stabilization plan. As a result, the country’s economic contraction has been much greater than that of most countries.

The effect on Russia’s growth prospects became increasingly apparent once the oil-price declines of late 2008 stripped away the facade of success. The government had focused disproportionate wealth and attention on the big conglomerates that it could and did control.

In the process, it had neglected small- and medium-sized enterprises – or, more to the point, it had neglected the reforms of private capital markets and the legal system that were needed to fertilize the ground for their growth.

This reality is particularly ominous, since smaller firms have played a leading role in the transition of the more successful former Soviet economies of Central and Eastern Europe.

what next?

Winston Churchill’s characterization in 1939 of Russia as “a riddle, wrapped in a mystery,

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inside an enigma” may not quite apply today.

Still, the economy’s future remains exceptionally difficult to predict. It continues to be tied to the vagaries of the global market for oil, natural gas and other raw materials – but not in straightforward ways. On the one hand,

high commodity prices would provide the revenue needed for fiscal and social stability in the near term, as well as the means to invest in long-delayed infrastructure and industrial modernization. On the other, it would sustain Putin’s vision of Russia Inc. – a vision that most economists (and perhaps Russia’s current president) believe will inhibit the evolution of the sorts of institutions needed for balanced long-term growth.

The Russian government began to lay out a course for the country in the summer of 2006, when it put forth the preliminary designs of its Strategy 2020 program. The plan, formally adopted in November 2008, acknowledged the adverse consequences of liv-

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ing on the oil-price roller coaster and the need for greater economic diversity nurtured by market-friendly institutions. But it was more a wish list than a practical plan for economic development.

Strategy 2020 imagined a handful of situations. The favored “innovation scenario” anticipated growth rates in the 6 to 7 percent range. This course presupposed far-reaching market and governance reforms and human capital initiatives – developments that would require high oil prices that recent history suggests are inconsistent with the painful process of subjecting business to competitive pressures, rooting out corruption and delivering government services efficiently. Similarly, the government’s “inertia scenario” assumes that 3.9 percent growth would be possible without significant reforms – a prospect few neutral observers think is plausible without oil prices above $75 per barrel.

Equally problematic, the model was based on unrealistic demographic assumptions. The country is rapidly aging thanks to exceptionally low birth rates, and the total population is actually declining because death rates are very high for a middleincome country. Fewer young people are entering the labor market, while widespread health problems make it difficult to extend the productive life of workers. Nonetheless, the model assumes a stable population and work force – rosy projections for an economy that almost certainly faces a future of both chronic labor shortages and high dependency rates that will overwhelm the pension system.

So, what future is consistent with reality?

The country’s reserves of oil and gas represent

reuters/alexander natruskin

r u s s i a’s p r o s p e c ts

a huge patrimony, albeit one that complicates economic development. But many of its oil and gas fields are quite mature, implying that sustaining very high levels of production will require enormous investments along with the application of sophisticated Western technology. Meanwhile, the Kremlin’s lack of respect for the rule of law and willingness to use natural gas exports for geopolitical leverage has alienated foreign investors and led Europe to rethink its dependence on Russian energy.

On the liability side of the growth equation, Russia has inherited an industrial black hole from the Soviet era: hopelessly inefficient manufacturing and distribution systems, an environmental toxin load that threatens public health, and a managerial culture out of touch with modern business practices. More generally, it lacks many of the intangible cultural assets found in rapidly developing economies, not least of which is confidence that hard work and investment in human capital will lead to a better world for the next generation.

In this context, one might imagine a variety of plausible futures. The most ominous for Russia (and the rest of the world) would be a retreat to ultranationalism along with a drive for autarky that insulates the ruling interests from economic failure and manages internal discontent with a mix of authoritarianism and the distractions of a pugnacious foreign policy. Arguably, a more likely scenario, at least in the medium run, is another try at Putin’s Russia Inc. model. In its most optimistic incarnation, the state would enhance its role in social protection, prop up compliant enterprises and invest heavily in modernizing industrial capacity while keeping the lid on corruption and the grossest abuses of state power that alienate foreign partners. Perhaps this would allow Russia to muddle through, provided energy prices behave.

There is a more optimistic third possibility, though, one associated with Medvedev’s asserting his own technocratic instincts. The president has called for more political competition, tougher measures to combat corruption and limits on the centralization of economic power, while openly acknowledging that “we haven’t done anything in the last 10 years because oil kept rushing higher and higher.” A cynic might conclude that Medve-

It now seems naïve that we ever expected Russia to erase centuries of misrule and decades of economic stagnation so easily. dev is simply playing the good cop to Putin’s bad cop, giving the Kremlin a convenient way to tack toward liberalism when foreign investors or unhappy domestic interests must be pacified. But cynical or not, it suggests a pragmatic flexibility, offering hope that when Russia Inc. fails, the ruling elite will shift toward decentralized markets and political pluralism rather than retreating toward Russia’s familiar authoritarianism.

After the collapse of the Soviet Union, it was widely hoped that “shock therapy” in the form of the overnight adoption of the trappings of pluralism and capitalism – free elections, wholesale privatization – would quickly yield fruit. With hindsight, it now seems naïve that we ever expected Russia to erase centuries of misrule and decades of economic stagnation so easily. But, by the same token, the fact that the dream was largely unfulfilled doesn’t imply that incremental progress is impossible. m In short, the game is not over.

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Health Care

all: stephen savage

Inflation

T

Must Workers Bear the Brunt?

By Steven A. Nyce and Sylvester J. Schieber

The long recession that began in December 2007 has taken a heavy toll on American workers. Unemployment, which averaged 4.9 percent over the prior decade, exceeded 10 percent at the end of 2009, and has only recently dropped backed to single digits. Moreover, millions of workers who kept their jobs through the crisis have been asked to do more for less pay.

But long before the recession took hold of the economy, there was a sense that middle-income earners were increasingly getting the short end of the stick. Jared Bernstein, senior economist at the Economic Policy Institute, estimated that average annual earnings of families in the middle fell by nearly $800 in 2000 to 2006, after adjustments for inflation.

Hourly wages, he noted, hardly rose despite an average increase

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h ealth care i n flation in productivity of 19.2 percent over the period. Bernstein calculated that if hours and wages had grown at the rate they did in the 1990s, incomes would have risen by nearly $3,800.

Where did all the fruits of those gains go?

Bernstein and the economists Lawrence Mishel and Heidi Shierholz at the Economic Policy Institute argue that virtually all of the

health insurance costs is another matter, however. It has claimed much of the gain associated with rising labor productivity in this dec­ade. And unless Washington gets serious about containing health care inflation in the process of reforming the insurance system, escalating medical bills could easily absorb all the future productivity gains of lower- and middle-income workers. To put it another way, if we fail to contain health care costs, the

If we fail to contain health care costs, the living standard of the American middle class will almost certainly stagnate. productivity rewards accruing to workers since the beginning of the new millennium have gone to the very top of the income scale.

They conclude that as the economy recovered in the early 2000s and grew through 2007, as much as $400 billion in pretax earnings that would have gone to the bottom 95 percent of earners if wages had risen in lockstep instead went to the top percent.

These calculations are accurate as far as they go. But by focusing on wages rather than total compensation (the amount that employers actually paid out of pocket), they missed a crucial point: Much of the apparent shortfall in wages was absorbed by other elements of worker compensation – specifically, pension and health care benefits.

The rapid rise in the cost of funding private retirement plans was very real, but almost certainly transient. Inflation in employer-paid Stev e n Nyc e is a senior research associate at Watson Wyatt Worldwide. Syl Sc h i eb er chairs the Social Security Advisory Board. The conclusions of this analysis do not necessarily represent those of Watson Wyatt or the Social Security Advisory Board.

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living standard of the American middle class will almost certainly stagnate.

anatomy of a misunderstanding For most workers, pay is only part of their remuneration. Most also receive health insurance coverage and some sort of retirement benefit financed at least in part by employer contributions. Furthermore, employers pay a share of the costs associated with Medicare and Social Security benefits. So when employers decide how much they are willing to pay for labor, it makes no difference if a compensation dollar is paid as wages or benefits.

They are equivalent.

In 1995, total compensation per hour averaged $19.40 in 2000 dollars. Of that, 82 percent was paid in the form of cash wages, salaries or bonuses; 12 percent was in health and retirement benefits; and 6 percent was in contributions for social insurance coverage.

Given widespread concern that some groups of workers were doing worse than others in the contemporary market for labor, for purposes of analysis we divided the work

Average Annual Growth in Hourly Wages, Full-Time Workers 3.0% 2.5

1990-99

2.0 1.5 1.0 0.5

-.05

2000-7

1980-89

0 1

2

3

4

5

6

7

8

9

10

EARNINGS DECILE (10=HIGHEST EARNERS)

source: Watson Wyatt Worldwide tabulations of the Current Population Survey

Average Annual Growth in Hourly Compensation, Full-Time Workers 3.0% 2.5

1990-99

2.0 1.5 1.0 0.5

-.05

2000-7

1980-89

0 1

2

3

4

5

6

7

8

9

10

EARNINGS DECILE (10=HIGHEST EARNERS)

source: Watson Wyatt Worldwide tabulations of the Current Population Survey

force into deciles according to their earnings for the years 1980 through 2007. The highestearning group, it should be noted, excludes the top 1 percent. While we understand that these elite earners are of particular interest and that their economic fate may well have diverged from those of other groups, there simply isn’t adequate information to analyze their compensation separately.

The top figure shows the average annual growth rates in the real average hourly pay for each of the 10 groups by decade. During the 1980s, there was negative wage growth at the bottom of the earnings spectrum, modest but flat growth across the middle segments of the distribution and progressively higher growth across the top 30 percent of the distribution.

The 1990s, by contrast, were characterized by

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Average Annual Growth in Employer-Paid Social Insurance Taxes, Full-Time Workers 5.0% 1980-89

4.0 3.0 2.0

1990-99

1.0 0

2000-7

1

2

3

4

5

6

7

8

9

10

9

10

EARNINGS DECILE (10=HIGHEST EARNERS)

source: Watson Wyatt Worldwide tabulations of the Current Population Survey

Average Annual Growth in Employer Pension Contributions, Full-Time Workers 6.0% 2000-7

4.0 2.0 0

1990-99

-2 1980-89

-4 -6

1

2

3

4

5

6

7

8

EARNINGS DECILE (10=HIGHEST EARNERS)

source: Watson Wyatt Worldwide tabulations of the Current Population Survey

significant wage growth across all 10 groups, but with disproportionately greater gains at the top. Thus, concerns that pay is not keeping up with productivity, especially in the middle-earnings range, may simply reflect the reality that workers are not converting their rising contribution into cash wages at the pace they did during the 1990s. And the fact that the early years of the 2000s represent an improvement over the 1980s may be of little solace as workers struggle to meet current budget needs.

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In the lower figure on page 49, we substitute total compensation for wages by adding in employer costs for retirement plans, employer-sponsored health care and social insurance. The result may surprise: Where wage growth in the 2000s falls short of that achieved during the 1990s, total compensation growth across much of the earnings spectrum in this decade actually exceeds that achieved during the 1990s. Middle earners did not realize the sorts of increases in wages they did in the 1990s, but only because an increasing share of

their compensation has gone to finance retirement and health benefits. Note, too, that the only period in which the highest earners radically outstripped other workers in terms of total compensation was the decade of the 1990s – a period in which all the earnings groups were doing well.

sorting out the benefits As noted earlier, there are three major elements of compensation that are not paid directly in cash: employers’ payroll tax contributions to cover half of Social Security and

contribution rates have been linked to increased real earnings.

Retirement Benefits

Employer contributions to retirement benefits shrank across the board in the 1980s and 1990s. The story, though, for 2000-7 is not at all pretty, as employer contributions exploded. The explanation for this erratic pattern is somewhat complicated, but is worth telling because it bears lessons for the future.

During the early 1980s, Congress reacted to the growth in tax breaks accorded em-

The pension cost crunch is likely to get even worse before it gets better because of declines in pension fund portfolios during the 2008-9 financial crisis.

Medicare obligations, employers’ contributions to employer-sponsored retirement plans, and employers’ costs associated with the sponsorship of health care plans. To get a better sense of what’s happening to benefits, we estimated the costs of each component separately (see the figures on pages 50 and 52).

Payroll Taxes

The increases in this component were quite significant during the 1980s because of legislative changes in 1977 and 1983 to deal with the financing crisis facing Social Security. The effect was larger for high earners because Congress made the tax changes progressive in the upper range. Payroll tax inflation moderated during the 1990s because the phase-in of these earlier rate increases had been completed. But the extension of the Medicare tax to all earnings in 1993 did lead to a somewhat higher growth rate for higher-wage workers during the decade. In the 2000s, increased

ployer-sponsored retirement plans by passing legislation to curtail contributions. As a result, the financing of the baby boom generation’s retirement benefits was fundamentally altered. Employers were given incentives to push the funding toward the latter part of the boomers’ careers. Thus, from the late 1980s well into the 1990s, many pension plan sponsors went years without making any contributions. Then, in the mid-1990s, funding was depressed by another phenomenon: rapid appreciation of pension portfolios because of the skyrocketing stock market. The net appreciation of pension trusts extended the period in which sponsors were not required to contribute to their pension plans.

Alas, the chickens came home to roost.

Stock prices tumbled with the dot-com bust early in the year 2000, reducing the value of pension assets even as long-term interest rates fell. That latter phenomenon effectively widened the gap between plan obligations and

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Average Annual Change in Hourly Health Benefit Costs, Full-Time Workers 6.0% 1980-89

5.0 4.0

1990-99

3.0 2.0

2000-7

1.0 0

1

2

3

4

5

6

7

8

9

10

EARNINGS DECILE (10=HIGHEST EARNERS)

source: Watson Wyatt Worldwide tabulations of the Current Population Survey

expected earnings from plan assets, forcing sponsors to increase contributions. In the late 1990s, assets exceeded liabilities by an average of one-third in nearly 85 percent of large private plans. After the fall, two-thirds of plans were underfunded by nearly 20 percent.

Note, moreover, that the baby boomers were inching toward retirement. And the delays in funding in earlier decades (driven by government incentives) now forced sponsors into catch-up mode. The pension cost crunch is likely to get even worse before it gets better because of declines in fund portfolios during the 2008-9 financial crisis.

There are lessons here, albeit painful ones.

It has retaught plan sponsors that the seemingly attractive alternatives to slow and steady accumulation can have unintended consequences – that failure to contribute to plans on a regular basis can be very costly down the road. One can hope that it has also taught workers that the value of financial assets can go down as well as up, making saving for retirement an exercise in risk management as well as thrift.

Health Benefits

The costs of employer-sponsored health plans

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(see the figure above) have grown more rapidly than wages or inflation over virtually the whole period since the end of World War II. Rapid inflation in health costs during the 1980s led employers to focus on controlling costs. And during the 1990s, the effort bore some fruit: the rise of managed care and health-provider reaction to the Clinton administration’s attempt to reform the system slowed the health-cost inflation. Still, benefit outlays grew by an average of 2.5 percentage points more per year than inflation for the bottom two-thirds of the earnings distribution – a period when wages were growing only about 1 percent annually.

By the end of the 1990s, pent-up public anger with managed care had led to abandonment of many of the features of these programs. No surprise, costs escalated – and even faster than the aggregate statistics portrayed here suggest because rising costs led many employers to curtail coverage or even to abandon their plans.

sapping the fruits of productivity growth When the costs of employee benefits are growing more rapidly than total outlays for

labor, something has to give. The table to the right shows what happens when we sum up the total growth in compensation across the earnings spectrum, decade by decade, and calculate the share that has been diverted to benefits.

The 1980s was a decade of discontent for labor. And certainly part of the reason was that most of the productivity bonus built into total compensation was being diverted to cover benefit costs, especially among lowwage workers. The 1990s, by contrast, were perceived as a period in which the rising tide of prosperity was lifting all boats. During that decade, most of the compensation rewards were being delivered in the form of higher wages because the benefits components were under control. In the 2000s, we reverted to a situation akin to the 1980s, albeit one in which the burden of exploding benefit costs was distributed more evenly across the income spectrum. Still, the perception was that lower- and middle-income workers were not getting their due from rising productivity.

Share of Full-Time Workers’ Compensation Gains Absorbed

by Benefits* Earnings decile (10=highest)

1 2 3 4 5 6 7 8 9 10

1980-89

100.0% 100.0 87.0 52.7 61.8 41.7 46.9 35.5 29.0 20.8

1990-99

29.5% 22.2 24.2 20.5 17.2 18.3 12.1 9.5 7.8 6.9

2000-7

29.1% 44.6 48.9 59.6 53.6 54.5 50.2 49.7 43.8 78.0

source: Estimates by Watson Wyatt Worldwide *Total benefit cost increases in the 1980s for the first and second earnings decile actually exceeded 100 percent of compensation growth.

Benefit costs increased significantly, but total compensation growth was negative in the first decile and negligible in the second.

is the middle class losing ground?

Earlier we cited the analysis of Mishel, Bernstein and Shierholz at the Economic Policy Institute, who found that American workers had not been rewarded for their productivity contributions. They argued that the combination of very small increases in real earnings

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since 2000 and declining hours on the job were symptoms of an economic system that has loaded the dice against the middle class.

Indeed, they concluded that the historical link between economic growth and broadly shared income gains had been broken.

The analysis they present in support of their contentions is based on the economic outcomes of traditional families – married

families in the context of policy discussions about how the economy is evolving. But this group represents a minority of the contemporary work force – and one that is not especially vulnerable to economic disruptions caused by economic restructuring.

Our analysis suggests somewhat different conclusions about recent work force dynamics. We found that average hours worked increased modestly across virtually all age and

couples with children in the home. And when we similarly restricted our analysis, we got the same results.

It is unclear, however, what these conclusions imply for the whole economy, and why what happened to this subgroup of working families differs from outcomes for a broader cross-section of the labor force. The total hours worked by married men and women living with children during 2007 represents only 38 percent of all work in that year. We understand the importance of traditional

gender groups in 2000 to 2007. We did not find a disproportionately large share of the productivity contribution of workers across the economic spectrum being diverted from those at the lower end to those at the upper end. We found, though, that substantial shares of compensation gains were going to pay for retirement and health benefit programs – and that these benefits generally take a larger share of the added compensation dollar in the lower- and middle-income ranges than in the higher ranges.

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a grim future?

The most recent report of the Social Security trustees indicates that the short-term surpluses flowing into the Social Security trust funds – the difference between current revenue and current outlays – fell during the 2008-9 recession. There is now a real chance that the system will run a cash-flow deficit as early as 2010, some seven years earlier than previously projected. As a matter of law, policymakers will not be required to stanch the cash hemorrhage for another two to three decades. But as the program slips into the red,

politically untouchable – and thus the greater the likelihood that revenue increases will be the primary source of the program adjustment.

While contributions to employer-sponsored pensions were limited over much of the 1980s and 1990s for reasons mentioned earlier, the big bump-up in the next decade will endure a while longer: plan sponsors must fund their obligations to the baby boomers as they approach retirement. Some of this funding pressure is likely to be offset by the decline in defined-benefit plan coverage in re-

As a matter of law, policymakers will not be required to stanch the cash hemorrhage for another two to three decades. But as the program slips into the red, there will be increased pressure to address this issue from a federal budgetary perspective. there will be increased pressure to address this issue from a federal budgetary perspective. And if past efforts to reduce the Social Security funding gap are any indication, higher payroll taxes will be part (or all) of the fix. One now-familiar consequence: additional claims against labor compensation that crowd out take-home pay and squeeze living standards.

Under current law, the cost of Social Security pension outlays is projected to climb from 12.35 percent of covered payroll in 2009 to 16.76 percent of covered payroll by 2030.

That would represent an average annual growth rate of 1 percent in the share of compensation diverted to Social Security financing if all the money came from payroll taxes.

And the longer policymakers wait to address the financing issues faced by Social Security, the more baby boomers will be retired and

cent years – both by closing plans to new hires and by freezing pension accruals to current employees. But plan sponsors will have to dig deeper simply to make up for the gap in funding created by the steep declines in plan asset values.

Many companies have cut back matching funds for employee 401(k) plans in response to the recession. And, in theory, this will leave room to shift more productivity gains from benefits to wages. But that is hardly in the interest of workers, who are less and less likely to be covered by traditional defined-benefit pensions and who have seen their own retirement nest eggs fall in value with the decline in stock prices. Add to this the reality that Washington will soon be under pressure to trim Social Security benefits for future retirees – say, by raising the age at which retirees are eligible for full benefits – and now hardly seems

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h ealth care i n flation

We assumed that employer-sponsored pension costs would stabilize as a percentage of workers’ compensation by the middle of the current decade, as employers catch up with the deficits in the funding of pensions resulting from the recent declines in the financial markets. Thus, the difference in outcomes for these scenarios is largely determined by the effects of expanded health insurance coverage, health inflation and the rebalancing of the financAnnual Wage Growth Rates for Workers ing of federal entitlement programs.

Under Alternative Scenarios, 2015-2030 The column labeled 2000-7 in

Expand coverage through an employer mandate the table shows the actual results Wage Reduce Maintain Accelerate Maintain recent deciles health plan recent health health inflation that we measured for the work (10= cost health cost and fix entitlement force, as reported in the first exhibit highest) 2000-7 inflation inflation inflation financing in this article [see page 49]. They All

1.06% 0.68% -0.64% 0.43% 1 1.17% 0.47 -1.41 -1.92 * are provided here as a frame of 2 0.69 0.80 -0.16 -4.63 -0.51 reference.

3 0.62 0.88 0.11 -3.08 -0.21 4 0.49 0.94 0.28 -2.25 -0.02 In the first scenario, we assume 5 0.65 0.98 0.43 -1.60 0.15 that employer-sponsored health in 6 0.57 1.01 0.53 -1.21 0.25 7 0.71 1.05 0.63 -0.80 0.37 surance will be expanded to include 8 0.72 1.08 0.71 -0.51 0.45 9 0.86 1.11 0.82 -0.14 0.56 all workers and their dependents, 10 0.14 1.17 0.99 0.43 0.80 but that health inflation will moderate considerably from recent lev*Health care costs would exceed total wages for this first decile. source: the authors els. Specifically, we assume that annual health inflation declines from inflation. In 1980, a median-wage full-time 3.2 percentage points more than wage growth worker’s health benefit costs represented to “just” 1.5 percentage points more than about 4.6 percent of total compensation. By wage growth. Those assumptions generate a 2007, this figure had reached 10.3 percent of fairly rosy outcome in which workers see compensation. And it is simply a matter of more of their gains in compensation in the arithmetic that the higher the fraction of form of take-home pay than they have realcompensation devoted to health benefits, the ized since the 1990s. greater the negative leverage that health care The second scenario assumes that we will inflation exerts on take-home pay. expand access to insurance, but there will be To get a better handle on the implications no tempering of health inflation. In this sceof health reform on the distribution of pronario, wage growth will fall far short of even ductivity rewards down the road, we projected the dreary 2000-7 results for the lower half of earnings and benefits costs to 2030 for the 10 the earnings distribution, and will be no betearnings groups analyzed earlier. The impact ter than the 2000-7 experience for earners in on wages in several scenarios is presented in the top half of the distribution. Some of the the table above for the 2015-30 period. negative impact of rising health care costs on the time for employers to cut back on contributions to 401(k) plans.

Predicting changes in contributions to health benefit programs is more difficult for the intermediate term because reform issues are still on the table. We can say, though, that workers’ living standards are more susceptible than ever to the fallout from health cost

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lower-wage workers might be offset by transferring a portion of the added costs to higherwage workers. But that could be accomplished only through higher taxes on earnings at levels far below those that President Obama has said he would consider in raising income taxes. All told, then, the second scenario with unchecked health inflation would lead to disappointing productivity dividends for many (perhaps most) workers.

The third scenario assumes that health insurance provided by employers will be expanded to include all workers and their dependents, but (presumably as a consequence of increased demand for services) that annual health inflation will accelerate considerably to a rate six percentage points higher than the pace of wage growth. This sort of acceleration in health costs is consistent with the inflation experienced in the aftermath of Medicare’s implementation.

Note that, in this third scenario, declines in take-home pay occur virtually across the earnings spectrum – but that lower-wage workers are hit hardest.

The last scenario shown in the table assumes that we have expanded employerbased health insurance but realized no reduction in health inflation (as in the second scenario) and that Congress raises payroll taxes sufficiently to bring Social Security and Medicare into fiscal balance. In essence, this option assumes that policymakers will deliver on the benefits assured by current law. The consequence: wages would decline in the bottom 40 percent of the earnings distribution, and growth in wages would be meager for other earnings deciles.

plight of our youth If we do not throttle back excessive health inflation, many workers will have to live with stagnant incomes in coming years in spite of

continuing productivity growth. And if health care reform expands employment-based coverage without tackling cost containment, the wage issue will be that much more problematic. Indeed, increased access without cost containment is a recipe for middle-class discontent and increased social conflict.

While containment of medical inflation is a necessary part of policy reform, it would not be sufficient to allow current and future workers to enjoy the full fruits of productivity gains as long as we depend on payroll taxes to

Increased access without cost containment is a recipe for middle-class discontent and increased social conflict. cover the awesome gap between promises to deliver full Social Security pensions and Medicare benefits and system revenues under current-law projections. Adding revenue from another source – say income taxes or value-added taxes – would take the pressure off wages. But there’s no magic here: raising taxes rather than trimming benefits would affect the living standards of those in a position to pay taxes.

The Gordian knot that we have tied over the past century with the expansion of our health and retirement insurance schemes cannot be untied by political rhetoric. But since neither political party even seems prepared to begin a frank discussion about the link between workers’ future pay and the delivery of medical care and public pensions, it is likely that wage stagnation (or worse) will m remain the order of the day.

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Paying the

W

While there were high hopes that a strong, binding agreement to limit climate change would come out of the Copenhagen summit in December, no such accord was reached. And, without the global coordination that a binding agreement would have entailed, it is now even more likely that the planet will warm by more than two degrees Celsius, a level past which many bad things are likely happen to the earth’s environment.

Clearly, more must be done quickly to get the world off a trajectory that will warm it by 3-5 degrees in this century. But in addition to reducing emissions of greenhouse gases, there is also a real need to reduce the likely consequences of warming in order to protect people, places and ecosystems from the impact of rising sea levels, more-severe storms and droughts. And here, at least, there was some good news from Denmark: an 11th-hour side agreement negotiated by President Obama and his counterparts in China, India, Brazil and South Africa included a pledge

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Piper

Coping With the Consequences of Climate Change

BY JOEL B. SMITH

of $30 billion a year (ratcheting up to $100 billion a year by 2020) from rich countries to use both for reducing emissions in poor countries and to help them to adapt to the climate changes that do take place.

To be sure, this so-called Copenhagen Accord doesn’t carry the weight of an international treaty because the participants only “took note” of the deal. But having secured the cooperation of the United States, the richest nation on the globe, along with the likely cooperation of the European Union and other developed countries, it’s a start – and a good moment to get up to speed on the big questions faced by policymakers in building an adaptation strategy.

why focus on developing countries?

Most poor countries are relatively close to the Equator. And all the science suggests that the climate in the tropics will warm less than it will

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in mid and high latitudes. In spite of that, though, there is every reason to believe that less-developed countries will be more vulnerable to climate change.

First, almost all of those countries are more dependent on agriculture than advanced economies are. Agricultural output represents only 1 percent of the United States GDP, compared to 40 percent for Malawi.

Thus, when a drought hits, say, America’s Corn Belt, it is a regional economic problem.

When a drought hits Malawi, it has the potential to bring malnutrition and death.

Second, rich countries already have some of the infrastructure needed to cope with extreme weather. When a storm surge threatens the Netherlands, a complex set of barriers protects the lowlands. By contrast, each time a storm surge hits the Bay of Bengal, millions of acres of Bangladesh are flooded. And, of course, the contrast between the two countries’ risks of flooding will grow as global warming raises sea levels.

By the same token, developing countries will be at a disadvantage in adapting to climate change because they typically lack the financial resources and technology needed to make the necessary adjustments. Fifteen countries in the world have an average annual per capita income below $1,000 (measured in purchasing-power terms), while another 26 countries have incomes below $2,000. Contrast that with Norway’s $59,000 per capita income, or the United States’ $46,000 – or, for that matter, China’s $6,500. Thus, while the United States will be able to muster the resources to build irrigation systems in areas prone to drought and to construct sea walls J o e l B. Sm ith is a principal at Stratus Consulting in Colorado. He was a lead author of the Fourth Assessment Report of the Intergovernmental Panel on Climate Change.

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in areas prone to flooding, Malawi ($900 per capita) and Bangladesh ($1,600) will be hard-pressed to feed their populations, let alone protect them from more intense storms, floods and the spread of disease.

Poor countries also face subtler obstacles to adaptation – challenges linked to inadequate legal, political and market institutions needed to cope efficiently with new and changing risks. For example, reducing the vulnerability of coastal areas may require prohibiting development in areas likely to be flooded by rising sea levels, which will only be possible where governments have the authority and control to enforce such restrictions.

One should not minimize the difficulties that developed countries also face in this regard. They, too, will have to cope with the severe impact of climate change. And, to date,

previous pages: richard olsenius/national geographic stock; this page: istockphoto

climate change

associated press

they have not managed many existing climate risks well. For example, construction in flood plains has proved very difficult to regulate and vulnerable areas have not been well protected – think of New Orleans’ Ninth Ward.

But the prospects are far worse in poor countries. And, of course, small island-states, such as the Maldives, are particularly vulnerable because so much of their territory is at risk of being inundated by rising sea levels.

how much money will be needed?

Estimating the costs of adaptation is immensely complicated by uncertainties. While we know the climate will change, we don’t really know by how much or exactly where. The Intergovernmental Panel on Climate Change forecasts baseline temperature increases of between 1.5 and 6.0 degrees Celsius by 2100.

Sparing La Ceiba La Ceiba, a port with a population of 170,000 in Honduras, offers a good example of what adaptation planners are up against. The city, once a banana port for the Standard Fruit Company and now a tourist destination, is tucked between the Caribbean and the towering Nombre de Dios mountains. The Cangrejal River defines its eastern border.

La Ceiba has no storm sewer system; when it rains, streets (and basements) serve as drains. What’s more, the geography makes it especially vulnerable to precipitation. If the volume of water pouring off the mountains exceeds the capacity of the river channel, or if the water is blocked from reaching the sea by a tidal surge – a common phenomenon with hurricanes – it ends up in the city.

The first priority is to build a storm sewer system; one designed to manage a 50-year storm is expected to cost around $1.1 million. But increased rainfall intensity linked to climate change will make what is now a 50-year storm a more frequent occurrence; another $600,000 would be needed to adapt to the change.

Meanwhile, expensive infrastructure such as seawalls and higher levees on the Cangrejal would be needed to save La Ceiba from a major storm surge accompanied by torrential rains. source: the author

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Sea level rise is projected to be somewhere between one and six feet. The plausible range of uncertainty is even greater for sub-regions.

Moreover, we can’t predict how societies will choose to adapt. Suppose a country or region experiences a chronic shortfall in precipitation. Will residents pump more groundwater, build bigger reservoirs, or invest in water-conservation technologies? Or will they move somewhere else?

Estimates of adaptation costs have thus typically taken what is called a “top-down” approach, building on a framework of moreor-less plausible assumptions. For example, in one study conducted for the United Nations, the estimate of water-resource adaptation costs was based on the assumption that everyone facing reduced water supplies would adapt by building more reservoir capacity rather than, say, by investing in more-efficient delivery technologies or by eliminating some water uses entirely – even if those alternatives were less expensive.

That said, we can be pretty sure that successful adaptation won’t come cheap. Most of the studies to date estimate the annual costs of adaptation in poor countries will run in the tens of billions of dollars by 2030. The United Nations projects the bill at $30 to $70 billion by that year, while the World Bank’s estimate (adjusted to make the dates comparable) is $50 to $60 billion. Most of the estimated costs are for adding or enhancing infrastructure, providing water supplies and protecting coastal zones.

However, another recent study led by Martin Parry, a co-chairman of the 2007 report on climate-change impacts by the IPCC, asserted that the UN cost estimate on adaptation was too low – perhaps far too low. This report noted that, in addition to underestimating costs in sectors like water resources,

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the costs of ecosystem protection were not included in the UN figures (nor were they included in the World Bank estimate). They expect that adding land to nature reserves would add tens of billions of dollars more to the bottom line.

Parry and his colleagues also raised an important issue regarding what measures adaptation funds cover. There is little argument that adaptation would include initiatives like building sea walls to protect against rising seas. But developing countries already face very high risks from hurricanes, floods and droughts. If this existing “adaptation deficit” is to be addressed as well, the bill for remedial infrastructure alone might run over $100 billion a year.

Interestingly, the UN and the World Bank estimates are in the same ballpark – about $50 billion a year. And they more or less mesh

istockphoto

climate change

Warning Mozambique Early in 2000, Mozambique suffered five straight weeks of heavy rain. And with the ground saturated, Tropical Cyclone Eline slammed into Mozambique’s coast. Some 550 square miles of land were flooded, killing 800 people and 20,000 head of cattle.

In response to the catastrophe, Britain’s Department for International Development installed a system for warning residents of impending disasters and mobilizing disaster supplies before the event. In October 2007, the system signaled that flooding was likely in coming months. By December, food and medical items had been stockpiled, vulnerable residents had been evacuated to safer areas and a network of local centers set up to coordinate emergency operations. This time around, just 29 people died and the economy bounced back quickly. Climate change specialists see such warning systems as a first line of defense in minimizing the toll on people and property in a world of increasingly frequent and severe coastal flooding.

reuters/grant neuenburg

source: UK Department for International Development

with the funds promised in the Copenhagen Accord, which allocated $100 billion a year (by 2020) for a combination of adaptation and mitigation of emissions. That doesn’t mean, though, that the figures are reliable.

Among other problems in estimating adaptation costs, there is sure to be some learning by doing as adaptation strategies are tried and less-costly approaches are adopted over time.

Even accounting for increased efficiency in adaptation with time, I suspect that the UN and World Bank numbers are low. However, even if adaptation costs were twice the $50 billion a year projected in the Copenhagen Accord, they should still be affordable.

Given all the sources of uncertainty in estimating adaptation costs, there will be a temptation to delay decisive action until we know more. But that would be a problematic strategy. For one thing, planning, design and con-

struction times for big infrastructure projects are likely to be very long. Remember, too, that the climate is already changing and the impact is already being felt around the world.

Delay will add to the burden of suffering.

how should the aid pie be divided – and when?

If developed countries do, indeed, deliver on their promises at Copenhagen and ante up $50 billion per year for adaptation alone by 2020, what regions, countries, organizations and sectors should get the money? One place to look to begin setting priorities is the World Bank’s estimate of the relative needs of different regions.

The bank estimates that sub-Saharan Africa, where the shortage of infrastructure is acute and the capacity to finance its own adaptation is minimal, deserves one-quarter of

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Drought-Proofing Zambia Zambia’s Monze East region, a major grain producing area, is experiencing its lowest groundwater levels in more than a decade. And to cope with what is likely to become a chronic problem in southern Africa as the climate changes, the Evangelical Fel­lowship of Zambia (EFZ) is training farmers in what is called “conservation farming.”

Conservation farming uses minimum tillage with the goal of trapping soil moisture and reducing wind erosion. This should improve yields during droughts and contribute to longterm sustainability of local agriculture. In addition, EFZ is encouraging farmers to diversify their crops from just maize and sorghum to vegetables and herbs. In a drought, farmers with a diversified “portfolio” will be subject to less variation in production and income. To the same end, EFZ is working with farmers on improving grain storage and distribution systems, as well as in diversification of livestock.

the money. That squares with the priorities of the signatories to the Copenhagen Accord, which specifically notes that Africa and the small-island states are especially needy. But there are some gaps in priorities between the World Bank and the accord signatories. The World Bank estimates that nations in the Caribbean, Central America, the Andes and South Asia will also need vast sums to cope.

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Yet these regions rated no special mention in the accord.

Then there is the question of whether the aid should be delivered in response to climate change or in anticipation of it. On the one hand, responding to catastrophes rather than preventing them means that lives will be lost and property destroyed. But anticipating such events means making spending deci-

©richard lord/the image works

source: Tearfund

sions based on predictions alone. And, in light of the degree of uncertainty about the pace and consequences of global warming, this approach would almost certainly lead to a lot of funding choices that look bad in hindsight.

istockphoto

is adaptation aid different than development aid?

There is a presumption that funding for adaptation is something different than economic development aid – the core work of agencies like the World Bank and the Asian Development Bank. And in some ways, the presumption makes sense: some of the demands of adaptation – in particular, the very tangible need for protective infrastructure like sea walls – are different. But most adaptation is not completely distinct from development; indeed, it may be quite similar.

Some 50 of the poorest countries prepared what are called National Adaptation Programs of Action under the UN’s Framework Convention on Climate Change. These programs contain lists of what each country sees as its highest priorities for adaptation investments. I reviewed about two dozen of them, and found that at least three-fifths of the requested priority funding was for projects that are ostensibly for climate change adaptation, but are in fact for basic economic development. That is, these projects would be considered worthy investments even if the climate were not changing.

If the highest priority in adaptation projects does, indeed, amount to economic development, one has to wonder why adaptation is being financed from a separate pot of money.

By the same token, one must wonder whether mainstream development aid is currently supporting projects that are at cross-purposes with adaptation – by, for example, encouraging overuse of aquifers in

drought-prone places or financing urbanization in areas vulnerable to sea-level rise. Perhaps it would make economic sense – if not always political sense – to integrate climate change into mainstream development efforts.

This line of reasoning raises some troubling questions. Whether development assistance has actually resulted in raising the standard of living in developing countries is a controversial matter. Moreover, even if adaptation projects are well designed and executed, will the most vulnerable countries have political and legal institutions adequate to the task of maintaining them over the long haul? How will donors ensure that funds are delivered to those who need them when they need them – and not siphoned off for other (perhaps less altruistic) purposes?

The Copenhagen Accord does not specify how the adaptation funds will be administered. It mentions a “Copenhagen Green Climate Fund,” but does not assign authority to a specific agency. Hopefully, whichever agency or agencies inherit the task will be up to the task of incorporating climate change into development.

The difficulties in financing and implementing adaptation in less-developed countries offer no excuse for ducking the issue.

The challenges will be formidable in the best of possible worlds. Without an aggressive effort – and a tolerance for error as adaptation projects get up to speed – those challenges could become unmanageable. There could be widespread suffering from drought, storms and inundation of coastal areas. And what happens in developing countries could indirectly affect the developed world by increasing political instability and driving mass migration. In the final analysis, there is a moral imperative for the developed world to aid the developing one in coping with climate change. m

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here to getting from

there

BY R A N DY G A R B E R A N D A M I YA S E T U

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tk

how railroads can save our highways from gridlock

A tk

merica’s highways have long been asked to do too much with too few resources, and now the chickens are coming home to roost. Growth in demand for scarce space on the roads, along with decades of deferred maintenance, have led to ever-growing traffic congestion – traffic that has become a major drag on the productivity of the intercity trucking industry as well as a major source of frustration for commuters who have no practical alternatives to using their cars.

More money in all the obvious places would help, a reality acknowledged in the Obama administration’s stimulus package, which included $29 billion for highway improvements, $8 billion for mass transit, and another $8 billion as a down payment on the construction of a handful of high-speed rail corridors. So, too, would investments in smarter roads that use a variety of information technologies to minimize bottlenecks.

But in the search for ways to increase the productivity of surface transportation, some of the lowest-hanging fruit is getting short shrift. In particular, we estimate that every $1 invested in the intermodal transportation network – the infrastructure for seamlessly shifting freight from truck to rail to ship and back – would yield $5 to $8 of benefits in terms of less congestion, reduced shipping costs and fewer traffic injuries.

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railroads and gridlock Optimizing the return on intermodal transit investment is, of course, easier wished for than done. By its very nature, it requires coordination among often bitterly competitive transportation sectors, as well as help from a host of state, local and federal agencies with widely varying priorities. But the effort, we believe, would generate a payoff measured in the hundreds of billions of dollars.

source for most of the analysis available on road use – estimates that highway congestion cost Americans an astonishing $87 billion in wasted fuel and travel time in 2007.

There is little hope, however, of solving congestion problems solely by investing in more highway capacity. According to the American Society of Civil Engineers, annual spending on highway improvements is now roughly $70 billion – a fraction of the estimated $186 billion needed to stay ahead of traffic growth.

overtaxed highways America’s Interstate Highway System was once the envy of the world. In many ways, however, it proved to be too good, encouraging dependence on cars for commuting and on trucks for long-haul freight. The Federal Highway Administration recently calculated that highway delays cost the trucking industry more than $8 billion a year. All told, the Texas Transportation Institute – the independent R a n dy Gar b e r is a San Francisco-based partner in A.T. Kearney, the management consulting firm. A m iya Se tu is a Chicago-based associate at A.T. Kearney.

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previous pages: ©crocodile images/age fotostock; this page: maksymenko 1/alamy

intermodal to the rescue?

In an era of chronic, rising congestion and high fuel costs, it’s no surprise that shippers are attracted to intermodal systems because they offer ways to bypass highways for much of the trip. Here, freight generally starts and finishes the journey on trucks, but is moved long distances by water and rail.

Actually, the appeal of intermodal transportation is hardly new.

Britain pioneered intermodal systems in the 1920s. Shipping systems using the now-familiar steel boxes, bearing the logos of shipping companies from dozens of countries, really came into their own in the late 1960s with the global standardization of containers.

Truck-train intermodal transit, the key to land-based service, took off in the United States in the decades that followed. For one thing, the deregulation of interstate truck and rail transit gave shippers far greater flexibility to choose modes and routes that minimized costs. For another, the explosive growth of global trade and the conversion of virtually all non-bulk ocean-going freight to container systems led to massive demand for intermodal options at the ports.

Markets are, of course, the primary force driving the demand for intermodal service: Truck-train combos are far cheaper on most long-haul routes than door-to-door trucking because rail uses far less fuel and manpower per ton-mile. Note, too, that the prospects for increasing carrying capacity using sophisticated information technology are greater for rail than for highways because rail systems are inherently less complex than road systems and access to rail is easier to model and to control.

But the public’s stake in freight rail transportation in general and rail-based intermodal transportation in particular goes further

are good reasons to believe that it offers the best hope of expanding future shipping capacity without pouring hundreds of billions of dollars into highways. But a variety of factors now constrain it.

Bottlenecks. Before the current recession, some key rail corridors were running at (or over) effective maximum capacity because tonnage had increased so rapidly in the previous decade. Railroads have responded by accelerating investment in double-track lines, modern signal systems and rail beds capable of supporting faster speeds. But they are still behind the demand curve.

A single intermodal freight train can displace as many as 300 intercity trucks from the highways, and reduce fuel consumption by 75 percent in the process. than lower shipping costs. Transportation is replete with what economists call “externalities” – the costs of congestion, pollution and energy insecurity that are borne by third parties rather than by the buyers and sellers of the shipping services. A single intermodal freight train can displace as many as 300 intercity trucks from the highways, and reduce fuel consumption by 75 percent in the process. One study (admittedly, commissioned by the railroad’s trade association) estimates that if 25 percent of freight volume were shifted from trucks to rail by 2026, commuters could save an average of 41 hours a year in time spent in traffic. And, of course, since railroads are far more fuel-efficient than trucks, the shift would reduce both local air pollution and greenhouse gas emissions.

the worms in the apple Domestic intermodal rail traffic has quadrupled since 1980, and, as we’ve suggested, there

In some cases, rail corridors have enough capacity to operate more intermodal trains.

But the junctions or terminals at the ends of the corridors (usually in urban areas) are highly congested and thus act as bottlenecks.

Often, the simplest way to increase corridor capacity would be to double-stack standardized containers on the rail cars. But on the older rail networks – especially those in the eastern half of the country – double-stacking will not be possible until tunnels are enlarged and bridges are raised to accommodate taller trains.

The railroad industry understands the importance of eliminating bottlenecks, and is investing with this goal in mind. But the sums involved are daunting: the American Society of Civil Engineers estimates that some $200 billion in improvements will be needed to meet demand for rail services over the next quarter-century. And in the post-financialmeltdown era of tight credit, that amount of

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railroads and gridlock money will not be easily found.

Money, moreover, isn’t the only barrier to eliminating corridor bottlenecks. Local governments must approve the expansion and modernization of truck-rail interchange infrastructure – not a small matter since the expansion of intermodal facilities will mean increased road traffic around rail and truck terminals.

Service complexity and inconsistency.

While intermodal transportation for long hauls is generally cheaper than door-to-door trucking, it requires greater coordination than single-mode transport. This extra layer of complexity – and the resulting risks of breakdowns in service – make many shippers hesitant to switch from long-haul trucking to intermodal approaches where the financial benefits aren’t beyond dispute. That’s why the industry needs to improve its track record, particularly in meeting transit-time commitments. Among other things, that will require a major investment in the information technology needed to manage incredibly complex traffic patterns.

staying on track Myriad public and private groups have stakes in expanding intermodal capacity to meet rising demand. Without more capacity, highway congestion will spread ever further from city centers. But these groups’ interests – in particular, how much should be invested, where and when – are hardly identical. Hence, the need to build effective coalitions that can identify priorities and manage reasonable compromises in dividing the financial burden.

Low-hanging fruit. One no-brainer is improving the efficiency of the interchange itself.

Interchange between carriers and modes (rail-to-rail, rail-to-truck) is too often the Achilles heel in intermodal systems, delaying 70

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shipments, raising costs and undermining the whole logic of using multiple transport modes to get from here to there. Railroads plainly have a major role to play in improving the technology at terminals that makes it possible to anticipate congestion and reroute traffic accordingly. Other stakeholders – notably governments – can support interchange efficiency by allocating land for rail connections and terminals outside of urban centers and by minimizing land-use red tape. By the same token, the elimination of remaining grade crossings in urban areas offers the prospect of quick payoffs for both shippers and the public.

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Few investments can return so much so fast in terms of improved speed, reduced fuel consumption and, of course, public safety.

The CREATE Program (Chicago Region Environmental and Transportation Efficiency) is a model of the sort of publicprivate cooperation needed. It brings together freight railroads, Amtrak and the regional commuter rail authority along with the local, state and federal governments in Chicago, where six of the seven major United States railroads converge. The partners are committed to spending more than $2.5 billion on some 78 local infrastructure projects,

with the railroads contributing a bit more than $200 million – their estimated direct benefits from the improvements.

The Alameda Corridor initiative in Southern California is another example. The rail corridor, completed in 2002, links the adjacent ports of Long Beach and Los Angeles (one of the highest volume freight hubs in the world) with the transcontinental rail yards 20 miles away in central Los Angeles. The authority running the corridor, which is governed by the two cities and the port managers in cooperation with the railroads using the ports, continues to build rail and truck-rail

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railroads and gridlock infrastructure in the area, with the goal of reducing bottlenecks and improving air quality.

Capacity expansion. Long-haul corridors are the backbone of cost-effective intermodal transportation, and in many cases their capacity could be expanded considerably without creating new rights of way. The investments needed: the aforementioned bridge and tunnel clearances for double-stack trains (along with locomotives capable of hauling

A century of straitjacket economic regulation virtually destroyed America’s private railroads, and in the process left the country dependent on trucks for far too much of its shipping needs. them), and information technology for signaling and coordination that would decrease the space between trains that is needed for safety.

One such corridor in the making is the Norfolk Southern’s $150 million Heartland Corridor. It will link the giant port at Norfolk, Va, to the Midwest, making double-stacking possible on the route as well as cutting 200 miles (and $500 per container in shipping costs) on the run to Chicago. The even more ambitious National Gateway improvements, a public-private partnership led by the CSX railroad, is investing $700 million to open three corridors (Wilmington NC, to Charlotte NC; North Carolina to Baltimore; Washington DC to northwest Ohio via Pittsburgh) to double-stack trains.

Information technology, in the form of

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positive train control (PTC), offers another opportunity to improve capacity on the intermodal network. PTC uses global positioning satellites to track trains with sufficient accuracy to safely reduce spacing between them – especially where freight shares congested corridors with passenger trains. The 2008 crash between a commuter train and freight train in suburban Los Angeles that killed 25 should be a reminder of what’s at stake here.

the bottom line Most Americans are rightly skeptical when business asks for help from the government.

Too often, it’s easier to compete in the “market” for government aid than in the market for goods and services. And transportation, we would note, has a long, unhappy relationship with government: a century of straitjacket economic regulation (which ended only in 1980) virtually destroyed America’s private railroads, and in the process left the country dependent on trucks for far too much of its shipping needs.

But the sorts of problems facing the transportation industries today aren’t likely to be solved by markets alone. Road congestion has reached crisis levels in many parts of the country and will only get worse as the economy resumes growth. Moreover, excessive use of the roads adds unnecessarily to the country’s greenhouse gas emissions and will make it that much harder to contain climate change.

The least expensive way (arguably, the only way) to increase shipping traffic without inviting highway gridlock or increasing carbon emissions is to expand intermodal transportation so that most of the traffic growth is accommodated by rail. That will take plenty of money, business flexibility and innovation from the transportation industry. But it will also take the best efforts of government to m ease the way.

b o o k e x c e r p t

Radical, Religious and Violent

E

The New Economics of Terrorism Economists aren’t shy about pontificating

by eli berman

on all manner of subjects. And while their

pronouncements sometimes seem like

they’re coming from the brain of Star Trek’s Mr. Spock, the economic way of thinking can provide breakthrough insights on issues that, on first reflection, seem to have nothing to do with the dismal science. Case in point: Eli Berman’s striking new book, Radical, Religious and Violent: The New Economics of Terrorism.* ¶ Berman, an economist at the University of California (San Diego) and research director of the UC’s Institute on Global Conflict and Cooperation, explains what makes a successful terrorist in three words: incentives, incentives, incentives. But his thesis is certainly not reductionist claptrap. At the heart of contemporary, religionbased terrorism, Berman argues, is what has come to be known to scholars as the associated press

Hamas club model. And the key to containing terrorism is weakening the ties that make these economic clubs so good at what they do.

— Peter Passell

*Reprinted with permission of the MIT Press. All rights reserved.

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In October 2005, a major earthquake shook Kashmir, the disputed region that sits uncomfortably between Pakistan and northwest India. In the earthquake’s aftermath, humanitarian needs were acute. National and international aid efforts were immediate, but often disorganized. Indeed, some of the most nimble providers of aid were reported to be bearded young radical Islamists.

Men like Maqsood were the first aid workers to arrive in the disaster zone.… They conducted systematic searches for survivors in the rubble of ruined buildings, often digging with their bare hands. Many local residents owe their lives to these aid workers.…

Today Maqsood is the acting director of the Al-Rahmat Trust Camp, a refugee camp for earthquake victims in central Muzaffarabad.

It’s an open secret that the organization is the civilian wing of a banned guerilla organization, Jaish-e Mohammed.

Koelbl goes on to describe these militants: Their politics and policies resemble those of the militant groups Hamas and Hezbollah in the Middle East, where radicals have filled the vacuum left by the state. They develop social institutions and help address the local population’s day-to-day survival needs. In the long term, this social role also helps the local population identify with the respective groups’ political goals.

While it is reassuring to realize that these terrorists are neither theologically brainwashed drones nor the psychopathic killers of B movies, it’s hardly a consolation to know that people who are effective at providing humanitarian assistance, education and health care to their own constituencies are at the same time so deadly when it comes to outsiders.

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Compared to older terrorist organizations, the current cohort of radical religious terrorists all started out relatively short on training and experience. Yet Hamas, Hezbollah and the Taliban nonetheless quickly developed into the most destructive rebel organizations in their respective conflicts. I think the central question about modern terrorism is this: if religious radicals are neither blinded by theology nor psychopathic killers, then why, when they turn to violence, are they so effective at it? The first step is to see violent religious radicals as their constituencies do – as economic clubs.

origins of the model Social service provision dates back to the very beginnings of modern political Islam. Hasan al-Banna, the first political Islamist of the 20th century, was a gifted schoolteacher in the Egyptian city of Ismailia. A charismatic preacher, al-Banna would lecture in the mosques and even in the coffeehouses in the evenings. Together with six laborers, he founded the Society of Muslim Brotherhood at age 22 in 1928. Like other religious thinkers at the time, al-Banna opposed European and secular influences. He advocated a return to traditional Muslim values, the strengthening of families, and an Islamic approach to social and political issues. Unlike other organizations, the Brotherhood took practical action

associated press

Der Spiegel reporter Susanne Koelbl describes 25-year-old Mohammed Maqsood, a “militant” in Kashmir who would not shake her hand or even make eye contact with a female:

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under his leadership. Al-Banna and his followers raised money and built a mosque, and then two schools (one for boys and one for girls) as well as a social club.

The Brotherhood organized youth groups, charities, trade unions and night schools for workers. Eventually they even owned factories.

Al-Banna’s organization expanded to 15 branches by 1932, when he relocated the headquarters to Cairo; and to 300 by 1938, with a membership estimated at between 50,000 and

strike in Palestine, a rebellion of Arabs against both the British – who governed Palestine under a mandate from the League of Nations – and Jewish settlement. The rebellion gave the Brotherhood a chance to show solidarity with an anti-imperialist movement without actually endangering themselves by challenging British control in Egypt.

The second was the terribly unpopular collaboration of the Wafd Party with the British. The Wafd Party had previously gained

The Brotherhood filled a demand for educational, cultural, social and medical services.

150,000. By 1949 the Brotherhood’s 2,000 branches throughout Egypt included between 300,000 and 600,000 members.

The Brotherhood filled a demand for educational, cultural, social and medical services.

Yet a club is not a government – to motivate members, it must be prepared to expel them for shirking in their work and exclude nonmembers from access to services.

The Brotherhood established a tiered membership structure by 1935. Lower-tier members paid dues, held a membership card and had access to the social service network and mosques.

At higher tiers, the Brotherhood required more commitment, including an oath of allegiance, Koranic studies and physical training. This structure allowed the organization to select suitable candidates among the large pool of lower-tier members who sought services, then train and indoctrinate them. Once selected and prepared, higher-tier members could be entrusted with more sensitive jobs.

For the first decade, the Brotherhood remained apolitical. That changed when two political currents merged into a perfect wave of opportunity. The first was the 1936 general

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widespread support by waving the banner of Egyptian nationalism, so its implicit acceptance of British rule was considered a betrayal.

In 1941, the Brotherhood seized the opportunity, running candidates in elections and calling for both social reform and British withdrawal. The British responded by banning the party and arresting its leaders.

Yet by this time the Brotherhood was difficult to suppress. Its broad membership base made it resilient to the loss of leaders. The organization easily weathered the storm. The British soon went back to concentrating on the war effort and released the Brotherhood leaders.

That organizational base would prove critical in surviving the next, more severe, round of repression. Sometime around 1939 the Brotherhood leadership had reluctantly established a militia, the “Secret Apparatus,” in response to internal pressure from more militant leaders. After the end of World War II, the Apparatus began attacking British and government targets. Egypt responded by legally dissolving the Brotherhood in December 1948. The Apparatus took revenge later in the

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same month, assassinating Prime Minister Mahmud Fahmi al-Nuqrashi.

Al-Banna condemned the assassination, but was shot in the street by government agents in February 1949. Despite losing its charismatic founding leader and suffering fierce repression – which included the arrest of four thousand members – the Brotherhood again proved resilient, managing to retain the loyalty of members and of its constituency.

The Free Officers coup of 1952 led to an even more serious challenge.

The new president, Gamal Abdel Nasser, and the coup leadership had allied themselves with the Brotherhood to gain power. The Brotherhood demanded power sharing and was incensed, among other things, over the British-trained officers’ refusal to ban alcohol. In October 1954, a Muslim brother attempted to assassinate Nasser. Or perhaps he was framed. Either way, Nasser emerged a hero and exploited the opportunity. He legally dissolved the Brotherhood, had six members hanged, imprisoned thousands, and launched a protracted campaign of arrest and torture that would last for a decade.

Nasser took an additional, critical step that the British and the previous Egyptian government had not. He nationalized the Brotherhood’s social service provision network and operated it as part of the Egyptian government. That counterinsurgency strategy was singularly effective: without its schools and clinics the vast organization withered. To this day it has not recovered its political strength or organizational ability.

One of the jailed and tortured leaders was Sayyid Qutb, who had edited the Brotherhood newspaper. In prison, Qutb developed the extreme principles that became the basis

of current jihadist theology. He argued that the Western values of individualism, colonialism, capitalism and Marxism had not only failed, they were a symptom of jahiliyya – the chaos that engulfed the world before the time of the prophet Mohammed. This reversion to pre-Islamic chaos had been brought on not

by foreign rule, but by secularism – a denial of the will of the Almighty.

Qutb’s solution was clear: prepare for a jihad to overthrow the usurpers in Egypt and abroad, and to establish Islamic states in their place. Qutb preached that, under the circumstances, violent revolt was a religious duty, even against Muslim nationalists. He called on his followers to segregate Islamist communities from the secular culture until that revolt was feasible.

The Egyptian Brotherhood and the Egyptian clerical establishment largely rejected Qutb’s theories, as do most Muslims. Muslims generally interpret Islam as tolerant of other cultures, permitting violence only in self-defense and never in religious matters.

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Nasser hanged Sayyid Qutb for treason in 1966. But his brother, Mohammed Qutb, survived to publicize his works, and would eventually personally influence Al Qaeda leaders Ayman al-Zawahiri and Osama bin Laden.

While it is easy to lump al-Banna and Qutb together, understanding the broad influence of the Muslim Brotherhood requires carefully distinguishing al-Banna’s organizational

the Egyptian Islamic Jihad, an outgrowth of the Muslim Brotherhood that espoused a jihadist theology influenced by Qutb.

President Hosni Mubarak, Sadat’s successor, has taken a middle course, allowing the Muslim Brotherhood to compete unofficially in tightly controlled elections while brutally suppressing the Egyptian Islamic Jihad. In the Egyptian parliamentary elections of 2005,

Al-Banna’s model of Islamist charities combined with politically active Islam has spread successfully and widely. model from Qutb’s theology. Al-Banna’s major innovation was not theological, but organizational. He invented what is now called the Hamas model – an Islamic social service provision organization that can quickly evolve to exploit political opportunities as they arise, all with the goal of enabling personal piety and eventually establishing an Islamic state. This model generated the exponential growth and popularity of the Muslim Brotherhood long before massive oil revenues were available to subsidize present-day Islamist charities. Al-Banna’s model of Islamist charities combined with politically active Islam has spread successfully and widely, with Brotherhood chapters now established throughout the Muslim world.

President Anwar El-Sadat, who succeeded Nasser in 1970, freed members from jail and co-opted the Brotherhood in an effort to present himself as a more Muslim leader as he consolidated power. Sadat would not survive his experiment: in October 1981, as he reviewed a military parade, a truck full of troops halted in front of the review stand and opened fire on the presidential party, killing Sadat and 11 others. The troops were loyal to

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Muslim Brotherhood candidates ran as independents. Despite strict government control of both the media and the election process, they won one-fifth of the total seats and formed the largest opposition bloc.

hamas With the history of the Muslim Brotherhood as background, the birth of Hamas appears familiar. Palestinian-born Sheikh Ahmed Yassin returned to Gaza in the early 1970s from Egypt, where he had joined the Muslim Brotherhood as a university student. He vitalized local branches of the Brotherhood by following al-Banna’s standard procedure: build an organizational base of social service provision and wait patiently for political opportunities. The Israeli occupational government and foreign aid sources left him lots of service provision opportunities. Gaza had a tremendous unfilled demand for schools, clinics, youth groups and the like.

The Brotherhood managed to supplement local charitable giving by soliciting funding from Muslims abroad, especially after the oil crises of the 1970s initiated a flood of oil revenue into the Persian Gulf. The organization

also found a way to gain revenue and political power with the help of an unlikely ally. With the tacit approval of the Israelis, to whom the Brotherhood looked like a placid counterbalance to Yasir Arafat’s Fatah, they gained control over important mosques and the substantial waqf (Muslim charitable trust) property attached to them.

Yassin’s initial reluctance to get involved in the nationalist, territorial struggle with Israel would have been sensible, considering the odds against expelling the Israelis and the Brotherhood’s dismal history with its Secret Apparatus in Egypt. But internal pressure from younger members combined with the threat of being left out of a popular uprising – the first Intifada – eventually prompted him to authorize a militia, Hamas, in late 1987.

The new name would have been an attempt to distance the militia from the social service institutions, which might be vulnerable to repression, as the Muslim Brotherhood’s network of institutions in Egypt had been.

Hamas did not need Qutb’s global jihadist ideology to turn to terrorism. The possibility of Fatah gaining a Palestinian state simply created opposing political agendas and a political opportunity that could be captured through violence. At first, violent resistance against Israel was designed to position Hamas as a nationalist organization like Fatah. Later it was designed to undermine Fatah by crippling peace efforts.

The Oslo process stalled in the mid-1990s; then economic conditions on the West Bank and in Gaza worsened. These unhappy developments allowed Hamas to brand Fatah as corrupt collaborators. Hamas, its reputation enhanced by both a thriving social service provision organization and lethal acts of terrorism, could present itself as an honest and brave alternative.

In this sense, Hamas is not a terrorist orga-

nization using social service provision as a front to disguise its other activities. It is better understood as a radical religious, socialservice-providing organization in the mold of al-Banna’s Muslim Brotherhood, which adopted terrorism in order to achieve its political goals.

the taliban, hezbollah and the mahdi army The Taliban traces its origins to refugee camps run for Afghans in Pakistan by the Jamiat-e Ulama-I Islam (JUI), a small Pakistani Islamist political party. The JUI are fundamentalists, following the Deobandi Islamic movement’s educational tradition. The Deobandi movement began in India in the 19th century as a reaction to British rule – in particular, a rejection of instruction in English, the language of the colonial power. Deobandi schools have a strong antisecular bias, teaching mostly religious subjects. They are supported by charity and waqf with additional donations coming from Saudi Arabia since the 1970s. Deobandi schools expanded rapidly in the 1980s in Pakistan, partially because of supportive government influence over waqf assets.

During the Afghan campaign against Soviet occupation, JUI madrassas adopted a militant jihadist stance with the approval of the Pakistani Inter-Services Intelligence organization (ISI), the CIA and Saudi Arabia – all of which supported the rebels as a means of expelling the Soviets from Afghanistan. After the Soviet retreat in 1989, the CIA lost interest. But the JUI madrassas and relief network on the Pakistani side of the border remained, eventually giving birth to the Taliban in 1994.

The Taliban’s own version emphasizes provision of a critical service, protection from marauding Mujahedeen bands that made life miserable in rural areas of Afghanistan.

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For its part, Hezbollah’s early leaders were active in Lebanese Shiite charities. With Iranian funding, Hezbollah quickly expanded its social service network, triggering an accompanying expansion in visible religiosity.

Social service provision also played an important role in the history of the Mahdi Army, Muqtada al-Sadr’s militia in Iraq. Al-Sadr’s father, Mohammad Sadeq al-Sadr, built an extensive charity network in the 1990s to serve Shiite Muslims in Baghdad and southern Iraq when the sanctions-depleted government of Saddam Hussein cut back services to Shiites.

Those two organizations, Hezbollah and the Mahdi Army, have a close theological af-

that matter, impoverished. Furthermore, many of the most lethal suicide attackers of the 1980s came from an atheist ethnic organization – the Tamil Tigers.

Why, then, are some radical religious organizations so very deadly? Surprisingly, the explanation has much to do with their charitable activities.

The charitable activities of Hamas, the Taliban, Hezbollah and al-Sadr’s militia are confusing to most observers, considering that we first heard these names in the context of violence and terrorism. However, there is an organizational logic that links the benign and the violent activity.

There is an organizational logic that links the benign and the violent activity. finity. Both are built by students who studied in the Shiite holy cities of Iran and Iraq. And both are quite distinct theologically from the Sunni Taliban, Hamas and Muslim Brotherhood. What all these groups share, though, is the Hamas model.

why religious radicals are such lethal terrorists One of the most alluring yet misleading myths about radical religious terrorists is that their ability to inflict damage stems from their belief in reward in heaven, a Jihadist theology, an ideology of hate or a religionlinked psychosis. These arguments make for terrific screenplays, but don’t bear up to the light of objective analysis. We know from careful interviews conducted by Israeli psychologist Ariel Merari that failed suicide attackers do not list virgins in heaven, theological considerations or hate as their primary motivations. Nor are they deranged – or for

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Consider a hypothetical example of two young Taliban men manning a dusty checkpoint in southwestern Afghanistan. A convoy is coming into view as it rounds a corner and the men are considering their options: defect, steal the convoy and start a new life in Turkey, or remain loyal and accept their (much smaller) share of the toll. They would wave a low-value ($10,000) convoy safely through, since defection wouldn’t be worth it. But if they were offered a high-value ($100,000) convoy, they would steal it.

The young men illustrate the “defection constraint” – here, the largest-value convoy that can be sent down the road without operatives appropriating it for themselves. And it suggests two general points about loyalty.

First, loyalty is critical in lawless places, since there is no legal system to enforce contracts.

Second, only an organization that can convince clients of the loyalty of its subordinates will be able to credibly commit to securing its

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clients’ goods along a trade route.

The background of those two Taliban members as religious radicals allows us to understand why they are unlikely to defect. All those years reciting the holy texts in a madrassa in their refugee camp did very little to

organization. The head of a $40,000 convoy need not worry about being held up, since he knows that the Taliban guards at the checkpoint are not tempted by treasure and economic emancipation in a foreign land. By the same token, smugglers in Quetta across the

prepare them for a new life elsewhere – say running a grocery store as refugees in Turkey.

They lack the social skills to get by in a foreign culture, not to mention the ability to run a small business. Without a secular education, Taliban guards at the checkpoint have very limited outside options, both in a cultural and in an economic sense.

The poor outside options of Taliban foot soldiers have wonderful implications for the

Pakistani border from Kandahar as well as the Pakistani intelligence service in Pakistan could be sure that the Taliban was a disciplined organization that could control its troops and thus keep its promises. Once the route was conquered, the Taliban could protect it and open it to trade. Toll revenue allowed the Taliban to grow, financing the conquest of more and more provinces.

Who, then, decided to destroy the Taliban

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fighters’ outside options by sending them to inferior schools? It wasn’t the Taliban, though it benefited, since most fighters were already well through madrassa when the Taliban got organized in 1994. It may have been the JUI, which organized traditional Deobandi schools in the refugee camps. But even if there had been secular schooling options for Afghan children in Pakistan, their parents may still have chosen to send them to madrassas if that was the cost of admission to the JUI mutual aid network in the refugee camps.

attack. He considers recruiting operative 2, carefully thinking over operative 2’s level of commitment. What about operative 2’s outside options? How does he know that operative 2, once recruited to the plot, will not call the Israeli Security Agency [Shin Bet]? The Israelis can afford to pay much more for information than Hamas can pay their operatives.

Operative 1 thinks through how much the Israelis will pay for the information that would save this particular target – the value of the target to the victim. Then he considers

It is service provision rather than theology that confers destructive organizational capacity.

Thus, no one necessarily forced future Taliban fighters to receive an inferior education that limited their outside options. It could have been a wise choice, made with the understanding that even if religious education would not open the door to a good job, it would open doors to membership in a service-providing club.

Consider, too, the complementary logic of sacrifice. By limiting outside options one incurs a cost, which signals to a community that you can be trusted. That signal, in turn, makes you an attractive member of some sort of collective production cooperative. Usually that cooperative production activity is benign: mutual aid. But if a need or opportunity arises, religious radicals sometimes press the advantage that their loyal networks provide to be effective at coordinated violence.

terrorist clubs A similar argument invoking loyalty can explain the effectiveness of radical religious groups at terrorism. Operative 1 of Hamas needs a few more compatriots to carry out an 82

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operative 2’s defection constraint, taking into account the services Hamas provides to operative 2’s family and factoring in the outside options operative 2 might have in an Israeli witness protection program.

Operative 1 probably knows operative 2 fairly well. They might have attended the same madrassa and probably spent time together in some kind of social service operation. In the case of Hamas, they could well have bonded in prison, after being arrested for some type of rebellious offense such as throwing stones at an Israeli patrol. Those stones didn’t shorten the occupation or even hurt the Israeli soldiers. However, they did take months and often years away from studying, gaining work experience or raising a family – an expensive sacrifice by any account.

The social service provision network is therefore important to loyalty for a number of reasons. First, demonstrations of commitment to a mutual aid club, or some other form of collective activity show that an individual cares less about the material gains that would come from defecting and more about loyalty

to the club. Second, the sacrifice directly reduces outside options, in the form of years of investment in schooling forfeited while in a madrassa or in jail, for example. Third, an operative and his friends and family may depend on the network for security, education, health care and other services. If he defects they could be excluded or shunned in subtler ways.

Social service provision also makes terrorism more effective through harvesting: the more individuals the social service provision network comes into contact with, the more opportunities it has to find an individual predisposed to high commitment as an operative or attacker.

Finally, there’s the willingness of nonmembers to share incriminating information with the authorities. An Iraqi living along a main road may hear some unusual activity in the middle of the night, as a Sadr operative sets a roadside bomb. He could report the incident and perhaps collect a reward anonymously. But he is less likely to inform if Sadr’s social service network is a better provider of essential services than whoever might take over if Sadr’s local organization were replaced.

The club approach’s strong implication – that social service provision makes for more effective terrorists – can be tested. If terrorist organizations with a social service provision base can really take on higher-value targets without risking defection, then we should observe that they are more effective than other terrorists. An awful, but appropriate, measure of effectiveness is lethality: the number of fatalities per attack.

Eight major terrorist organizations were, in fact, active in Lebanon and Israel/Palestine between 1968 and 2006. The Syrian Social Nationalist Party (SSNP) averaged 8.3 fatalities per attack, but hardly counts because it carried out only three attacks. Hamas killed 432 victims in 86 attacks, for an average of 5.0

fatalities per attack, while Hezbollah amassed a death toll of 829 in 174 attacks, for an average of 4.8 people killed per attack.

The other major terrorist organizations in the region have been less lethal, both in victims per attack and in total number of people killed. They include Fatah (24 attacks, 2.7 fatalities per attack), the Palestinian Islamic Jihad (57 attacks, 2.4 fatalities per attack), the Popular Front for the Liberation of Palestine (82 attacks, 2.0 fatalities per attack), the Democratic Front for the Liberation of Palestine (23 attacks, 1.2 fatalities per attack), and finally the Al-Aqsa Martyrs Brigade (6 attacks and 0.5 fatalities per attack).

Thus, the two social-service providers, Hamas and Hezbollah, proved to be more lethal than the other terrorist groups (if we put aside the three attacks by the SSNP), and that difference is statistically significant. Note that the Palestinian Islamic Jihad, which has the same Sunni jihadist theology as Hamas but lacks a social-service provision network, is no more lethal than its secular rivals, illustrating the empirical conclusion that it is service provision rather than theology that confers destructive organizational capacity.

clubs and violence without religion What’s surprising about this explanation for the lethality of radical religious terrorists is that it has nothing to do with the spiritual or theological content of religion. It emphasizes mundane aspects of radical religious communities, trust between members and socialservice provision. Then why don’t other violent organizations enhance their effectiveness by using sacrifices, prohibitions and the provision of social services to increase the commitment of members? They do.

The Yakuza, members of Japanese crime syndicates, have elaborate tattoos, effectively

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needy. Street gangs in the United States often constrain petty crime, sponsor street festivals and occasionally rough up landlords at the request of tenants. The Yakuza of Kobe provided disaster relief after the earthquake of 1995.

gratuitous cruelty One might think that a religious group aspiring to govern would try to make itself popular with local residents. Yet radical religious organizations often go out of their way to make life worse for the populations they aim to govern.

Hamas imposes general strikes on Palestinians, shutting down businesses that are barely surviving as is and restricting access to shopping for hungry households. Muqtada alSadr’s Mahdi Army in Basra is infamous for harassing women who don’t wear veils. The Taliban massacred civilians and executed homosexuals by dropping a wall on them. Women

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barring them from outside options – imagine the look on a prospective employer’s face if a former Yakuza member were to appear for a job interview with a tattoo visible on his arm – not to mention the look on prospective inlaws’ faces if a former Yakuza wanted to marry their child. The Russian Mafia and American street gangs use tattoos in similar ways to signal commitment.

The Hell’s Angels provide a different example of up-front sacrifice. As a rite of entry, veteran members pour buckets of urine and excrement on a new member, who then rides for weeks wearing the soiled clothes. The stench must effectively exclude social and economic opportunities outside the gang.

Note, too, that criminal organizations often find it to be in their interest to provide social services to communities. The Mafia has provided scholarships and made loans to the

If the troops establish a reputation for cruelty to the local population, the option of fraternizing and

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possibly defecting is severely undermined. were beaten publicly for the slightest offense.

Eventually the women of Kabul were secluded in their homes, with windows covered to keep them out of sight. Humanitarian aid workers objected to a ban on women in hospitals, threatening to leave – a withdrawal that would cripple hospital care in Kabul, including care for children. The Taliban’s response was to tell them to go.

The need to control defection provides a possible explanation for this savagery. When asked why the Taliban were willing to go to such lengths to seclude women in Kabul, one commander implied that the strictest possible prohibitions on women allowed him to control his troops. The commander did not explain how this worked, but our defectionconstraint argument can.

If the troops establish a reputation for cruelty to the local population, the option of fraternizing and possibly defecting is severely undermined. The more the local population hates the soldiers, the less of a discipline problem commanders would have in the cities, especially in the relatively cosmopolitan city of Kabul.

This explanation has a parallel in the approach the Taliban apparently implemented for controlling its local governors. It was not uncommon among Afghan mujahideen for factions and subfactions to defect in return for some payment, often by foreigners. The Taliban apparently rotated local governors to the battlefront or back to headquarters in Kandahar if they showed signs of creating a local power base, which would have allowed them the strength to

switch their allegiance. Conversely, governors who were particularly despised by the local population could remain longer.

objections Mohammed Atta, the lead hijacker on 9/11, was a former college student from a well-off family. Osama bin Laden is a multimillionaire. [And Umar Abdulmutallab, the Nigerian who attempted to bomb Northwest flight 253, was the scion of a rich banker.] Isn’t this evidence against the club approach, which implies that poor operatives are more likely to be loyal than rich operatives, since the poor one have worse outside options?

Finding individual terrorists with good market alternatives does not refute what we know about the rank and file of the organizations they belong to. And those individuals tend to be in need of the material services that clubs provide.

Another objection to my analysis is that organizations such as Hamas and Hezbollah provide services to non-members as well as members. But those services are provided in a highly discriminatory way, with core members receiving more support than ordinary members, who in turn receive more than non-members – a tiered structure resembling

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that established earlier by the Muslim Brotherhood in Egypt.

Al Qaeda does not fit the club mold: it does not provide social services to members.

How has Al Qaeda protected itself sufficiently from defection to carry out attacks on highvalue targets?

One possibility is that it recruits operatives among clubs, drawing on a network of club members who can vouch for potential operatives. Another possibility is that Al Qaeda extends that club network by recruiting within

Clubs can be weakened by taking the opposite tactic — by improving outside options. affiliated kinship networks, as appears to have been the case for bin Laden’s driver. Yet another method, apparently in use in Iraq, is to send foreign recruits who have not signaled commitment on suicide attacks; that way they have little time to be exposed to information that would make them defection risks.

constructive counterterrorism In 1973, PLO Chairman Yasir Arafat had a terrorism problem. The campaign of hijacking and hostage-taking, and the spectacular attack on athletes at the Munich Olympics, had exposed his cause brilliantly to the world.

These bloody acts had also made recruitment and political extortion much easier. Now, having achieved international standing, further violence threatened to undermine the new image Arafat sought to project. The PLO was being vilified as a bloodthirsty terrorist organization just when he wanted to become the foremost statesman for the Palestinian cause.

It was now critical to somehow keep his cadres of accomplished terrorists under control.

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Arafat and his deputy, Abu Iyad, offered the hundred or so Black September operatives a generous outside option: an apartment in Beirut, $3,000, a gas stove, a refrigerator and a television. Best of all, they recruited a hundred lovely young Palestinian women to the cause. If an operative married and had a child within a year, he qualified for a $5,000 bonus.

These incentives worked marvelously. The Black September organization was retired and has not been heard from since.

In a nutshell, clubs can be weakened by taking the opposite tactic – by improving outside options. Even men with a history of horrible violence respond to domestic incentives, however mundane these may seem.

fighting back The benign activities of religious clubs strengthen their violent capabilities, but that also has a wonderful implication: government can limit the lethality of terrorist clubs by countering the tactics that clubs use to insulate themselves from defection.

First, enhance outside options for rebels and potential rebels. That is to say, provide

the basic prerequisites for good jobs in the legitimate economy: thriving markets and quality educational opportunities. Anything that enhances the labor-market opportunities of potential defectors tightens the defection constraint that rebels face on terrorist activities, making it easier for the government to bribe conspirators into defection.

Second, compete directly with the rebels in social service provision. The southern suburbs

of Beirut are bomb-scarred and riddled with bullet holes marking three decades of civil war and invasion. These are also bursting with a majority Shiite population, having absorbed refugees and migrants from the Shiite villages of South Lebanon in much the same way that Sadr City in Baghdad absorbed eco-

kate brooks/polaris

nomic refugees from rural Iraq.

There is no public hospital. Hezbollah operates two of the three private hospitals and collects the garbage. It provides water and manages an electricity grid. It runs schools – both madrassas and mixed schools, which teach a combination of the governmentapproved curriculum and religious studies. It provides vocational training. Many Hezbollah schools and hospitals began by providing services only to the families of Hezbollah fighters, but later expanded to provide for others – though their militants pay lower fees and presumably still get priority treatment.

Shutting down those charities as a counterinsurgency measure would be a cruel and shortsighted response.

A wiser approach is for government to compete, providing the services that residents in developed countries have come to expect from government. Truly competing means providing services in a non-discriminatory way. Non-discrimination sends a strong message: it communicates to members of all ethnic or religious groups, minority or majority, that they have an outside option to sectarian or ethnic rebel organizations.

Third, protect service providers. Rebel clubs recognize how dependent they are on their nonviolent social services to provide an organizational base, and therefore see competing providers as a threat – be they government employees or volunteers from nongovernmental organizations (NGOs). Service providers thus need protection, which requires plenty of trained security personnel.

In Afghanistan under the Taliban, international aid organizations were completely vulnerable as they struggled to provide food, ed-

ucation, and health and welfare services to a suffering population. The Taliban did its best to capture those services, forcing organizations to discriminate according to stringent Taliban prohibitions – for example, by not allowing women to enter hospitals. The NGOs left, depriving communities of health care.

An aid organization has no good way to resolve this dilemma.

Yet what is a dilemma for an aid group should be a simple choice for a government with the military capability of controlling territory and interested in countering terrorism.

Fourth, reduce rebel revenues. If rebels finance their activities through smuggling and drug running, as the Taliban does, suppression has multiple benefits. Yet other cases are not as clear. What if rebels collect charitable donations and use them to pay exclusively for benign activities like health care? The population is of course better off. But the establishment of services increases the potency of the rebel threat, should the charitable organization turn to violence.

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Indirect methods of reducing rebel revenue can also help weaken clubs. A reduction in heroin prices in Europe, for example, would have directly reduced the earnings of the Taliban as it rose to power in the mid1990s. Legalizing or decriminalizing drug use has other social costs. Yet it might be worth considering as a way to stabilize Afghanistan, Colombia and perhaps western Pakistan, where the government is outgunned and outbribed by wealthy narcotics traders.

Returning to the dilemma of social-service provision, is there a way to weaken religious rebels without cutting social services to communities in need? One argument foreign donors often make for contributing to the Islamists is that governments are corrupt, while the Islamic charities are effective providers. In this sense, improving the capacity of allied governments to provide services in an honest and effective way is a critical component of counterterrorism efforts.

Fifth, remember that civil society matters.

Many developing countries effectively grant religious politicians a monopoly on political representation by default when they thoroughly suppress political activity outside places of worship. Breaking the religious monopoly on opposition politics weakens radical religious clubs by providing an alternative form of political expression (an outside option) to members. Of course, providing that alternative requires protecting competing elements of civil society from being intimidated by either government or religious radicals, who have an advantage at organized violence and therefore at intimidation.

what’s wrong with the old-fashioned methods?

This is not an argument for planting roses in rifle barrels to quell terrorism. Competing in social service provision, economic develop-

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ment and political development, and cutting off insurgents’ revenue streams, all require a muscular commitment to security and enforcement. But “capture and kill” by itself is not sustainable. During the two years following the collapse of the Taliban – the lost years of Afghan reconstruction – the United States and its allies tragically underspent on improving social services and governance in Afghanistan. The Taliban, retrenched and rehydrated with smuggling revenue, again constitute an existential threat to the Afghan government.

Compare that to the constructive counterterrorism work of the U.S. Special Operations forces against the Abu Sayyaf Group on the southern Philippine island of Basilan. Though only 5 percent of Philippine residents are Muslims, the southern islands have a Muslim majority. Abu Sayyaf is an Islamic terrorist organization responsible for attacks, kidnappings and extortion in the Philippines and Malaysia, including the bombing of a ferry in Manila that killed 114 people in February 2004. The southern Philippines have hosted training camps for Indonesian Jamaiya Islamia terrorists under the protection of the Philippine Moro Islamic Liberation Front.

The Abu Sayyaf Group is small, and as far as I know provides no social services. It used Basilan as a safe haven and base of operations.

American involvement began in January 2002. While the Philippine armed forces provided security, U.S. Special Forces conducted surveys indicating that local priorities were water, security, medical care, education and roads. The Special Forces helped the Philippine government respond to these needs.

When the local population increased its support for the Philippine military presence, they provided information that led to the capture of Abu Sayyaf operatives. This success, incidentally, influenced the subsequent revision of the U.S. Army field manual on counterin-

surgency, which Gen. David Petraeus coauthored with Lt. Gen. James Amos of the Marine Corps in December 2006, a few months before returning to command forces in Iraq.

The new approach to Afghanistan and Pakistan that President Obama announced in March 2009 suggests that counterinsurgency thinking has come long way since the invasions of Iraq and Afghanistan. The U.S. military is already increasing its role in development efforts. It now directs 22 percent of U.S. development assistance, as opposed to 3.5

how much security control is necessary before service provision is effective as a constructive counterinsurgency approach? Second, even if that strategy is effective and the counterinsurgency campaign is won, will the local government have the strength and legitimacy to retain power, or will it collapse anyway in the absence of permanent foreign support, as did the government of South Vietnam in an earlier era?

The global threat of terrorism will be with us long after the last U.S. soldiers have left Iraq

Breaking the religious monopoly on opposition politics weakens radical religious clubs by providing an alternative form of political expression to members. percent a decade ago. The allies need a sort of armed Peace Corps, which can keep the peace in troubled countries and can operate with multinational partners. At the same time, it must also direct reconstruction efforts in dangerous places, while protecting NGOs and civilians engaged in reconstruction.

It is taking years for the U.S. military to build a social-service provision organization onto a war-fighting institution. Radical Islamists regularly carry out these transformations, quickly fielding forces who speak the language, know how to augment existing social service provision networks to provide basic services, and can protect themselves. Hez-­ bollah demonstrated all those abilities in the reconstruction of South Lebanon after its war with Israel in the summer of 2006. Muqtada al-Sadr’s forces showed the same flexibility in Iraq within months of the occupation.

Returning to the conflicts in Iraq and Afghanistan, and the related insurgency in Pakistan, two important questions remain. First,

and Afghanistan. Lessons learned now will be valuable in future conflicts. Capture, kill and deter is an easy first step. Yet social-service provision creates the institutional base for most of the dangerous radical religious rebels.

This implies that long-term reconstruction is a necessary part of any global effort to truly contain international terrorist threats emanating from countries exporting terrorism.

Will that be terribly expensive? Yes; that is the nature of improving governance. The question should not be how expensive nation-building is, but whether it is more costeffective in protecting our troops and allies than the traditional approach. The United States and other Western countries spend hundreds of billions annually protecting domestic targets from the terrorist fallout of rebellions abroad. While highly visible protection for domestic targets reassures the public, it is probably a much more expensive approach to protecting the homeland than is m undermining terrorism abroad.

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institute view by tong li and perry wong

The year 2009 was the year for health care reform – well, in China, anyway. And while the government has been slow to flesh out the details, the issues raised by what amounts to the second major revamping in China’s health care system in three decades offers insights into how far the country has come – and how far it has to go. For while real income per capita is roughly 10 times greater today than in it was the late 1970s, the failure to create an effective social safety net now presents a clear and present danger to the prosperity and stability of the nation. the envy of the developing world One of the few unchallengeable successes of the Maoist era was the creation of health care cooperatives that provided affordable (if ru­ dimentary) services to nearly one billion peo­ ple. This success, however, was fragile because it depended on a mix of central planning and suppression of individual choice to function properly.

For one thing, the Rural Cooperative Med­ ical Scheme (RCMS) and its urban counter­ part, the Labor Protection Medicare System (LPMS), were tied to the hukou system, the household registration system that effectively controlled internal migration in China and for decades prevented wretchedly poor peasants from trying their luck in cities. For another, it depended on “barefoot doctors” (some 1.5 mil­ lion rural residents with minimal training) to provide most of the services. This ill-paid army of public health and medical personnel was highly motivated by a mix of political be­ To n g L i is a research economist, and Per ry Wong is director of regional studies, at the Milken Institute.

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lief, nationalism (and sometimes fear of pun­ ishment for lack of zeal) – and could thus have only have existed in a country subject to the will of the central authority.

Proof of the RCMS’s success is in the num­ bers. Between 1949 and 1978 average life ex­ pectancy in China increased from 35 years to 68 years, while infant mortality decreased from 200 deaths per thousand births to just 35. Yet, expenditures on health care – at least those acknowledged in government budgets – amounted to a mere 3 percent of government outlays.

Once China loosened restrictions on the accumulation of private wealth and put the goal of economic efficiency ahead of social equity, though, the health care system lost its moorings. Indeed, once the communes disap­ peared (1983), the RCMS collapsed. By 2000, 80 percent of the rural population lacked any medical coverage.

Changes were less dramatic in state-owned manufacturing enterprises in urban areas.

However, the care provided by the LPMS also declined sharply, as state enterprises were

closed, consolidated or privatized in the 1980s and 1990s.

lynn johnson/national geographic stock

when the market was the yardstick As early as 1979, the minister of health de­ clared that “the medical system should be managed with ‘economic means,’” a euphe­ mism for rationing by price. But the process didn’t really gain steam until 1985. Medical institutions were transformed into indepen­ dently funded, self-governing entities, and re­ sponsibility for their supervision transferred to local governments. Clinics and hospitals still received subsidies: typically, expenditures were part of local government budgets. But as economic change swept China, health care

had to compete for resources with myriad other interests. Hence the quality of local care varied widely, with outlays more or less track­ ing the economic success of localities.

From 1985 to 2000, the government’s share of health care expenditures declined from 39 percent to 16 percent. Hospitals and clinics were largely left to cover their own costs, which they managed by charging higher fees to everybody and providing premium care for premium prices. Drug sales become a key revenue stream. Indeed, by year 2000, only a handful of essential drugs remained under the control of government agencies.

Medical care improved – but only for those who could afford to pay for it.

The timing, from the perspective of social

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institute view justice, could hardly have been worse. The prosperity of modern China’s urban elite has always come at the expense of rural peasants, who shared little of the gains associated with rising productivity in manufacturing and ser­ vices. As a result, the difference between rural and urban living standards has always been

The unchecked spread of SARS in 2003 humiliated the Chinese government by revealing just how hollow the health care system had become. large – and is still widening today. And, of course, the collapse of the medical coopera­ tives only added to the sense that rural areas had been left behind.

Don’t misunderstand: many urbanites also lost ground in the process of liberalization.

Before the economic reforms, urban workers weren’t paid much, but they got a lot of ser­ vices (including medical care) as part of their compensation. Once state-owned enterprises were subject to market pressures and had to compete with private companies, all bets were off.

The unchecked spread of SARS in 2003 hu­ miliated the Chinese government by revealing just how hollow the health care system had be­ come. And in 2005, Beijing officially acknowl­ edged that the system was beyond repair.

Health care was once again declared a funda­ mental responsibility of the state, and the cen­ tral government embarked on the grand proj­ ect of restoring universal access – now for a population of 1.3 billion.

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Actually, efforts to build the New Rural Cooperative Medical Scheme (NRCMS) had started in 2002, with local governments again put in charge. But this time around, local ad­ ministrators knew that health care was a cen­ tral government priority. In 2003, only 9.5 percent rural residents were covered by NRCMS. Five years later, the figure had reached 91 percent.

The NRCMS initially provided insurance coverage for catastrophic illness and expanded gradually from there, with households, local governments and Beijing sharing the cost.

Primary Medical Insurance, the equivalent of the NRCMS for urban residents, was re­ launched in pilot programs in 2007.

the long march (cont’d) While the principle of government-sponsored universal health care is now back in place, the operational structure has yet to be worked out. For example, it is unclear how insurees will make premium payments or receive reim­ bursement for outlays: China lacks the infra­ structure – a well-functioning tax system, an electronic payment system with wide cover­ age, or even a reliable postal system – to make this simple.

By the same token, the government’s com­ mitment to delivering services to the poor, es­ pecially those in remote areas, has yet to be tested. In the 1970s, when China was a wretch­ edly poor nation, even minimal services went a long way toward improving the quality of life. Today, China faces the subtler problems of deciding the breadth of services and level of subsidies that should be offered to those who can’t afford to pay.

For the moment, Beijing seems set on shaping the system to deliver equality of ac­ cess to health care – a far more conservative principle than say, equality of health out­ comes or equality of expenditures. Even so,

minimum number of hours to service in pub­ lic hospitals at very modest salaries.

There is some precedent for this. Private clinics have sprung up to meet unmet de­ mand for medical care in rural areas, and have apparently delivered services fairly effi­ ciently. The question now is whether the gov­ ernment can adequately serve the vast major­ ity of rural and urban dwellers who can’t afford private medicine.

To manage that, the government will have to invest hundreds of billions of dollars in fa­ cilities and equipment, and it will have to coax medical workers to move from the cities.

In Mao’s day, doctors could be lured to the communes by ideology or simply ordered to move by the government. Now they have to be paid well for their trouble. Indeed, the long

reuters/kin cheung

the challenges will be formidable.

In modern China, doctors have never been paid adequately in comparison to other pro­ fessionals (for example, engineers). Thus, it should not be surprising that once the central government shed its responsibility for health care in the 1980s, hospitals and physicians ad­ justed by charging whatever the market would bear. The problem now is how to change what amounts to an anything-goes souk into a disciplined system that can guar­ antee decent care for the indigent.

One option is to create a two-tier system, letting private clinics provide premium care for the affluent while maintaining stateowned hospitals for others. Doctors could be encouraged to open their own clinics, but as a condition could be required to devote a

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institute view years of neglect of the health care system seem to have entrenched a culture of greed and corruption in the medical establishment that will be very hard to change.

ure of the social safety net may well deter­ mine whether it makes a smooth transition to affluence and stability.

One thing is certain: getting there will be very expensive. The trillions spent on gleam­ ing skyscrapers, bullet trains and high-tech factories will have to be matched by trillions more for housing, education, a cleaner envi­ ronment – and, of course, health care facili­ ties. But the timing could prove serendipitous.

Today, China is far too dependent on ex­ port-led growth. To maintain growth mo­ mentum and provide jobs for the burgeoning labor force, the government has felt com­ pelled to keep the exchange rate of the cur­ rency low, forcing the central bank to amass trillions of dollars worth of foreign assets and exposing the country to criticism from around the world.

Investing heavily in social infrastructure would thus accomplish a multitude of goals.

It would help to decouple China’s economic

The way China now faces up to inequality and

Beijing is planning to build or upgrade some 50,000 clinics by 2011, most of which are in less-prosperous regions of China. But the government has been less than forthright in explaining how it intends to staff those fa­ cilities adequately.

the silver lining China’s retreat from central planning and embrace of markets has, of course, done far more good than harm. But it exacerbated vast inequalities in Chinese society. The way China now faces up to inequality and the fail­ 94

The Milken Institute Review

growth from foreign demand for its manufac­ tures. And it would lessen the need for Chi­ nese households to save for illness and old age, allowing them to shift part of their (clearly excessive) savings into consumption. Last but hardly least, it would ease the festering strains between rich and poor that threaten the long term stability and prosperity of the world’s largest nation.

The time for economic development at any price is over. The time to consider how China can mobilize the machinery of growth to meet the needs of all its people has just begun. m

lynn johnson/national geographic stock

the failure of the social safety net may well determine whether it makes a smooth transition to affluence and stability.

institute news

jobs, jobs, jobs

That’s what everybody is talking about. But what’s the best way to create those jobs? The Milken Institute looked at both the policy and investment sides of the problem in a new report, “Jobs for America: Investments and Policies for Economic Growth and Competi­ tiveness.” To track what policy changes could do in the medium- to long-term, we esti­ mated the impact of reducing corporate tax rates, increasing the R&D tax credit (and making it permanent), and modernizing ex­ port controls on strategically sensitive prod­ ucts. For more immediate job growth, we looked to additional infrastructure invest­ ments (some $426 billion worth of them), in­ cluding hot-topic initiatives in nuclear energy, smart grid expansion, highway and transit systems, and oil and natural gas drilling.

We found that tax incentives plus changes in regulation could add 2.9 million jobs by 2019, while more immediate relief in the form of 3.5 million jobs over three years

could be forthcoming from a major push in infrastructure. The report and an interactive data summary, including a calendar where you can try your own hand at infrastructure investment design, can be found at www. milkeninstitute.org/jobsforamerica.

sharing the load

W e never overlook the opportunity to create a buzz, so we pulled together a high-powered group of economists, energy policy specialists, private and public electric utility operators, investment bankers, real estate developers and regulators to analyze what needs to be done to renovate the U.S. electricity grid. Spe­ cifically, this latest in a series of Milken Insti­ tute Financial Innovations Labs tackled the question of upgrading the patchwork system on which the nation’s commerce, security and health depend. The group concluded that suc­ cess was within reach – but only if policy goals were aligned with financial incentives. The lab’s analysis and recommendations have been published in “Innovations for Infra­ structure Finance: The Grid, Renewables and Beyond,” available at www.milkeninstitute.org.

conference redux

What? You didn’t sign up to attend the Milken Institute’s annual Global Conference (April 26-28 in Los Angeles)? You did, but can never get enough of the dazzling array of panels on everything from retirement security to the fu­ ture of the auto industry? Once the confer­ ence is over, check out the more than 100 ses­ sions available free in our Global Conference video library at www.milkeninstitute.org/ m gc2010.

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lists

E

Busy Signals Economic development used to be a decent predictor of access to modern telecommunications (measured in the form of telephone lines) – and vice versa. But mobile phones have changed that. Bulgaria, with one-third the living standard of Germany, has greater cell penetration; by the same measure, Jamaica tops Japan. Meanwhile, Nepal, among the poorest countries on earth, has almost as many cell phones per capita as middle-income Mexico.

By contrast, Internet use correlates pretty well with income – computer literacy, or maybe the cost of the hardware seem to be significant barriers in poor countries. But the laggards among middle- and upper-income countries on this list – Germany, Saudi Arabia, Botswana, South Africa – suggest that culture plays an independent role.

GDP Per Person (Purchasing Power in $1,000)

Norway United States Germany Japan South Korea

59 46 34 33 28

44 57 66 43 50

109 77 104 79 84

82 69 47 68 73

Saudi Arabia Russia Mexico Botswana Bulgaria Brazil South Africa Jamaica China

20 15 13 12 12 10 10 8 7

16 31 18 8 31 21 10 13 28

78 105 53 56 108 53 83 94 35

19 18 19 5 22 23 11 29 10

Guatemala India Nepal

5 3 1

11 4 2

56 15 42

10 11 1

sources: UN Statistical Yearbook 2008

96

Telephone Landlines mobile Phone Subscribers Internet Users (Per 100 residents) (Per 100 residents) (Per 100 residents)

The Milken Institute Review

david r. frazier photolibrary, inc./alamy

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But the high-caliber innovation and research showcased at this event continue all year round at the Milken Institute.

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The Milken Institute Review • Second Quarter 2010 • volume 12, number 2

PEOPLE. IDEAS. SUCCESS.

Second Quarter 2010

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