Yale Economic Review, Summer/Fall 2011 by Mona Cao

Yale Economic Review

Yale Economic Review Summer/Fall 2011

a yale college student publication Summer/Fall 2011 | Volume VII, Issue 2

The end of the

euro?

Africaâ&#x20AC;&#x2122;s Unofficial Economy page 11 academic Superfast Broadband page 20 features Great Expectations page 52 interview Stephen Roach page 30 insights

Words from the Editors Dear Reader, The global economy sits at an uncertain crossroads: the present is turbulent, the future unclear. The Fed continues to pump liquidity into a languid business climate, but to no avail: the unemployment rate remains at levels unseen for over three decades. Financial markets have grown increasingly volatile in the face of concerns over the strength of the economy at home and abroad. The public, in its frustration, has occupied the major financial centers of the world in an expression of frustration against the excesses of Wall Street. Each of these trends continues to develop amidst the backdrop of an international sovereign debt crisis which threatens the solvency of European nations and, perhaps, the very livelihood of the euro. Rarely has public awareness about global economic and financial developments been as important as it has grown to become today. The continued stability of the economy rests upon the decisions made by today’s global economic leaders, all of which will have grave consequences for each of us as individuals and for the world economy as a whole. The editors, writers, and staff of the Yale Economic Review hope to have done their part to make you conscious of the trends which define the contemporary economic environment and its future course. In this issue, our writers investigate global economic developments such as the unfolding European debt crisis and the rising popularity of medical tourism. We also examine the domestic economic climate, evaluating the Federal Reserve’s recent attempt to revive the economy through ‘Operation Twist’ and questioning the value of corporate social responsibility at both the micro and macro levels. For readers with an interest in the Chinese economy, this issue takes a critical lens to China’s continued financial and fiscal growth, analyzing both the nation’s labor-producer relations and its rapidly evolving relationship with Brazil. In an exclusive interview, YER sat down with Stephen Roach, Chairman of Morgan Stanley Asia and Lecturer at Yale University, to pick apart the nation’s political and economic environment and to examine its role as an international economic leader. As always, our Academics and Insights articles provide a wealth of interesting information from amidst the landscape of economic research. The work featured in this issue is broad and diverse, exploring topics as distinct as the size of African corporations and the evolving costs of broadband technology. We are also proud to showcase the senior essays of two graduates of Yale University’s Class of 2011, both of which were nominated for titled awards by the Department of Economics. We are confident that readers will find this rigorous research, though performed in an academic setting, to be topical, accessible, and personally interesting. The staff of the YER works to deliver timely and relevant content of interest to a broad audience, ranging from academics to concerned public citizens. We would like to thank the entire YER team for its dedication to this goal, and we hope that you find this issue to be interesting, educational, and, hopefully, entertaining.

Jennifer Barrows

Adam Holzman

Yale Economic Review

a yale college student publication

Table of Contents Fronts

Hot and Cold: Exploring Economies at the Extremes

BY JONATHAN SILVERSTONE

Brazil and China: A Happy Marriage for Both?

Features

BY ERIC LEVINE

Insights

It’s the Economy, Stupid BY ERIC LEVINE

For the Love of the Coin BY ZACH RENEAU-WEDEEN

8 Euro Dilemma 8

The history of the debt crisis goes back more than decade. Now Europe finds itself at a crossroads with painful choices regarding austerity and collaboration. What will the future hold for the world’s largest monetary union? by ashutosh venkatraman

Housing Growth

9 The Economics of 34 Social Responsibility The Beautiful Game No More 10 Corporate The costs and benefits of voluntary Corporate Social Responsibility BY JAY KIM

BY ASHUTOSH VENKATRAMAN

Africa’s Unofficial Economy 11 BY AYEZAN MALIK

Academic

14 Great Expectations

Planning a Subway System 14 for Las Vegas BY ISAAC PARK

Investor Proximity

Superfast Broadband

BY IKE LEE

BY ROBERT KENNY AND CHARLES KENNY

Interview 24 Stephen S. Roach

Non-Executive Chairman of Morgan Stanley Asia and Yale Lecturer Stephen Roach gets candid about China, housing bubbles and the European debt crisis. INTERVIEW BY DAVID YIN AND VICTORIA BUHLER

programs to society, on the both microeconomic and macroeconomic levels. by ayezan malik

With few tools left at the Fed’s disposable, communications is one of the only ways left for the Fed to support the economy. by derek walker

Power in Population

The driving force of China’s economy is its human capital stock. by devi mehrotra

Yale Economic Review A Yale University Student Publication

Yale Economic Review

a yale college student publication

EDITORIAL Editors-in-Chief Jennifer Barrows Adam Holzman Managing Editors Victoria Buhler Nabeem Hashem Andrew Maleki Ashutosh Venkatraman Derek Walker

Layout & Design Mona Cao Ashutosh Venkatraman

Associate Editors James Luo Ayezan Malik Devi Mehrotra

BUSINESS President and Publisher Eesan Balakumar

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www.yaleeconomicreview.com

Vice President of Development Daniel Cheng

Vice President of Marketing And Sales Archit Sheth-Shah

Vice President of Corporate Relations Alexander Shapiro

Director of Web Development and Technology Cameron Musco

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The Yale Economic Review is produced by undergraduate, graduate and professional students from Yale University, and Yale University is not responsible for its content. The contents of this publication are copyright of the Yale Economic Review and may not be reproduced without express written consent. The opinions expressed by contributors to the Yale Economic Review do not necessarily reflect those of its staff, advisors, or sponsors. The Yale Economic Review would like to thank the Yale School of Management, Yale Economic Department, Yale Office of New Haven and State Affairs, Yale Institution for Social and Policy Studies, and Yale Center for International and Area Studies for their support of this publication.

STAFF Karthikeyan Ardhanareeswaran Evan Beck Brandon Boyer Julian Debenedetti Zenas Han Kaity Hsieh David Hu Tim Jeon Jay Kim Kevin Kory

Ike Lee Eric Levine Yuchen Liu Isaac Park Zack Reneau-Wedeen Daniel Shen Jonathan Silverstone James Ting David Yin Steven Zhu

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Fronts

Brazil and China: A Happy Marriage for Both? BY ERIC LEVINE

Hot and Cold: Exploring Economies at the Extremes BY JONATHAN SILVERSTONE

HOT: SAUDI ARABIA

As the Arab Spring raged on throughout the Middle East and Northern Africa, King Abdullah of Saudi Arabia preempted any analogous movement among his people by offering a $130 billion social spending package. The large expenditure used for wage increase, job creation, housing, and loan assistance has been effective in preventing an overthrow of the current regime. Figures suggest, however, that this fiscal action has taken significant tolls on the Saudi economy. Heightened Saudi demand for goods pushed inflation to 5.3% in September as components of the CPI basket rose almost 4%. This provides cause for concern as global economic troubles have driven the price of oil down over 30%, leaving Saudi Arabia with a gap in much needed revenue to fund the promised social programs. Subsidies for energy consumption offered as part of the social package have led to a spike in Saudi domestic demand for oil at low costs. Accordingly, significantly less oil is available on the global market. Issuance of debt or the use of Saudi oil reserves may be necessary to fund the politically driven spending, as domestic oil consumption increases and external forces undermine prices.

COLD: CANADA

The Conference Board of Canada’s Leading Indicator of Industry Profitability concluded that in September 2011, 28 of 49 Canadian industries declined – and at increasing rates. While inflation has grown to 3.1% in Canada, wages have gone up only 2.2%, according to government statistics. Other indicators, like job creation and GDP growth, suggest economic growth for the United States’ northern neighbor. However, as prices continue to rise and income remains the same, Canadian consumers have just not been spending. As spending comes to a slowdown, the Conference Board report forecasts a decrease in profits for corporations in these industries in the approaching months. Canadians will likely feel the squeeze from the price of consumer goods, and face dwindling job prospects for the unemployed. The Canadian economy is proving to be another area for concern as many analysts predict another recession in the near future.

Jonathan Silverstone is a freshman in Berkeley College. Contact him at jonathan.silverstone@yale.edu.

In 2000, the trade flows between Brazil and China valued $2.5 Billion. In 2005, trade between the two rising powers more than quadrupled to reach $12.2 Billion. And by 2010, trade between China and Brazil quadrupled again to over $56 billion, as China ended 80 years of US-dominance to become Brazil’s largest trading partner. Just in the first ten months of 2011, Sino-Brazilian trade already totaled over $64 billion, with $37 billion of Brazilian exports to China, and $27 billion of Chinese exports to Brazil. Chinese capital flows into Brazil have also exploded recently. According to the Brazil China Chamber of Commerce, Chinese investment in Brazil totaled $392 million in 2009. Just one year later, Chinese companies made nearly $20 billion in direct investments, in addition to a $10 billion loan to Petrobras to expand deep-water oil production. Specific characteristics of the two fast-developing nations make the relationship seem like a perfect match: China’s enormous demand for commodities coupled with Brazil’s wealth of natural resources, China’s strong manufacturing sector and Brazil’s consumption-hungry growing middle-class, China’s savings surplus and Brazil’s need for more capital and infrastructure investments. The relationship has provided great benefits to both countries. The Chinadriven commodity boom of the past decade has dramatically improved Brazil’s terms of trade, strengthened the country’s position in foreign exchange re-

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serves, and most importantly, it has allowed the country to raise millions into the middle class and a better life. And cheap Chinese manufactured goods allow Brazilian consumers to enjoy products that were previously unaffordable. China’s recent economic growth model has championed strong industry, high levels of fixed-investment, and reliance on manufactured exports, a resource-intensive model which depends upon more natural resources than China can supply. Just from January-September of 2011, Brazil provided China with over $13 billion of iron ore, $9.7 billion worth of soybeans, and $3.5 billion worth of crude oil. These massive influxes of raw materials have helped China maintain its high growth rate. Furthermore, to Chinese manufacturers, the growing Brazilian consumer market stands in sharp contrast to the

stagnating European and American markets. Although China’s latest 12 year plan calls for a shift away from resource-intensive manufacturing towards a more consumption-based and service-oriented economy, China’s increased importation of Brazilian commodities looks to be a long-term phenomenon that is here to stay for several reasons. Firstly, 300 million Chinese are projected to migrate from rural areas to cities over the next thirty years, which requires iron ore to make the steel needed for cities. Secondly, as middle-class Chinese want more varied diets, demand for agriculture products, such as soybean, will continue to grow. Thirdly, as billions of Chinese consumers begin driving cars, China hopes to meet a good portion of its skyrocketing demand for oil from Brazil, projected to be one of the top 5

largest global oil producers by 2020. Brazil has certainly benefitted financially from trade with China, but has reason to be wary about the direction that trade with China is taking the economy. Over 90% of Brazilian exports to China in 2010 were primary commodities, and over 80% of Chinese exports to Brazil were manufactured goods. While the Chinese yuan is undervalued because of China’s large foreign exchange reserves and high savings rate, strong demand for Brazilian commodities and high real interest rates have resulted in an appreciated Brazilian real. The discrepancy between the currency values and China’s superior infrastructure alongside overall state support for exporters make it difficult for Brazilian industry to compete with Chinese goods in the domestic market. Although the theory of compara-

Yale Economic Review Summer/Fall 2011

Fronts tive advantage tells countries to focus on what they’re best at, economies too dependent on the export of primary commodities can suffer from “Dutch Disease,” as foreign demand for commodities drives up a currency’s value, hurting all sectors that compete in the international market. Easy revenue from natural resource exploitation could increase corruption in Brazil, already high, and reduce the pressure on the government to press on with reforms. Furthermore, increased dependency on unpredictable world commodity prices could render Brazil’s economy more vulnerable to a potential global demand shock, whether instigated by crisis in the Euro Zone, a “hard landing” in China, or some unforeseeable event. The nature of the Brazil-China relationship has faced some criticism from

the Brazilian political leadership. Dilma, Brazil’s president, stated that she wants China to buy more than iron and soybeans, which alone comprise over 70% of Brazilian exports to China. Guido Mantega, Brazil’s finance minister, has raised issues over China’s devalued currency, and has favored interventions aimed at keeping the real from appreciating too much. The Brazilian manufacturing sector has already successfully lobbied for protectionist measures unrolled in 2011, and will continue to do so into the coming years. Imported cars and trucks face tax levels of 30%, after legislation passed in September. But protectionist measures are no long-term solution. China must modify the economic relationship to reduce the risk of cutting itself off from such a fast-growing

consumer market. China should allow the gradual appreciation of the yuan to prevent further protectionist backlash, while spurring domestic consumption and stemming inflation, both goals of the latest 5-year plan. China also can play a critical role in financing mutually beneficial investments in infrastructure and manufacturing. When the stronger real becomes a long-term reality as Brazil rapidly expands oil exports, the Brazilian manufacturing sector will not be able to compete without dramatic improvements in worker productivity, and China can play a role in helping Brazil. The massive exchange reserves from China’s savings surpluses are mostly invested in low-yield American and European assets, but higher returns lie in Brazil. Over the past two years, there has been a rapid increase of investment in sectors of interest to Chinese firms. The Baoji Oilfield Machinery Company (Bomco) has entered into a joint venture that has invested $130 million reais, about $75 million dollars, into a factory in Bahia that produces machines and equipment for oil exploration and production. In the past year, China has also increased investments unrelated to the oil supply-chain, and would stand to gain by continuing investments across sectors. Finally, China can help Brazil make much-needed improvements to its roads, ports, airports, and overall infrastructure, which would raise Brazilian worker productivity. As Brazil-China trade flows and investment progress rapidly, both countries must ensure that the relationship proceeds in a manner that can be sustained into the future.

Eric Levine is a junior in Timothy Dwight College. Contact him at eric.levine@yale.edu.

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Insights

It’s the Economy, Stupid BY EVAN BECK

Unemployment’s effects on presidential elections

he phrase, “It’s the economy, stupid,” entered the national lexicon during Bill Clinton’s 1992 campaign when he successfully took the White House from George H. W. Bush. Less than a year before Clinton’s victory, the senior Bush was polling well above 70% in the wake of military involvement in the Persian Gulf. Yet while American unity strengthened the President during his term, his reelection prospects were victim to the single largest closer of national elections: economic conditions. While unemployment figures and GDP data may not be the sexiest conversation topic, quantitative evidence suggests they act as one of

the largest determinants of a president’s reelection prospects. According to the Bureau of Labor Statistics, national unemployment was at 5.2% when Bush was inaugurated in the winter of 1989 and rose to 7.3% by November 1992. The last three presidents to lose election bids did so in the face of upward ticks in unemployment relative to its level in the month of their inauguration. The question is, are today’s unemployment numbers high enough to lose Barack Obama his place in the White House? For most of 2011, unemployment has hovered at or above 9.0%, levels at which no president has been reelected since

Franklin Delano Roosevelt during the Great Depression. Add to this situation the first ever downgrade of America’s AAA credit rating by Standard & Poor’s, and it becomes apparent that whispers of a second recession have replaced talks of recovery. Thus a paradox emerges: the belief that economic recovery has stalled or reversed even as real GDP has begun to grow again and unemployment is down from its peak in late 2009. The muddy mix of economic indicators makes it tough to predict a definite direction for the American economy and thus any future trend for 2012 voting. The importance of the economy in determining who will be Commander-in-Chief in a year proves how little daily tracking polls really tell us. Though the unemployment rate has been stubborn over the last year, were it to fall below 8% (a number usually considered quite high), Obama’s reelection would be virtually in the bag given the positive trend it would indicate. This sort of shift could occur just months before November 2012, and consumer confidence and related attitudes could trend in his favor just weeks before the general election. Contrarily, if a double dip were to occur, the United States could be in the depths of chronic financial turmoil during the next election cycle. With no golden bullet to fix the economy (no matter what people from either party say), it will not be the populist Tea Party or a New York Times editorial that decides who lives at 1600 Pennsylvania Avenue come 2013, but rather the product of yet-to-be realized economic forces.

Evan Beck is a sophomore in Branford College. Contact him at evan.beck@yale.edu.

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For the Love of the Coin

BY ZACK RENEAU-WEDEEN

Exploitation in college athletics

lthough college football and men’s basketball players earn billions of dollars for their universities and the NCAA, they are forbidden from receiving benefits beyond scholarships in return. The incongruity between worth and compensation defies market forces and has led to rule violations and repercussions. Among the many examples: Ohio State’s head football coach Jim Tressel resigned this summer, admitting that he knew players were selling trophies and championship rings; USC was forced to vacate its 2004 national championship after star running back Reggie Bush took “improper” benefits (money from marketers) during his team’s remarkable run. In their summer 2010 article “A Trail of Tears: the Exploitation of the College Athlete,” Robert and Amy McCormick of Michigan State University investigate the validity of college sports’ amateur status. How much truth is in the term “studentathlete”? The professors examine the relationship between athletes and their universities, especially in the case of men’s basketball and football players, asking whether the primary relationship is educational or commercial. McCormick and McCormick find that university practices often de-prioritize the educational relationship between the university and its athletes. A high school senior can answer every question on the SAT incorrectly and still be eligible to compete at an NCAA member school the following season with

a senior-year GPA of 3.55. Once in college, an athlete devotes upwards of fifty hours per week to his sport and must even schedule classes around sports-related activities. Universities have devised majors and classes with minimal rigor to allow athletes to focus on athletics. A basketball course at the University of Georgia includes the following questions in its final exam: “How many halves are in a college basketball game?” and “How many points does a 3-point field goal account for?” The Ohio State University offers a two-credit class called “Varsity Football”—limited to the football team—which players may take up to five times for ten credits. McCormick and McCormick conclude that athletes serve under the control of coaches and athletic departments, and that many universities actively work to minimize the academic rigor of athletes’ schedules. Therefore, they argue it is clear that football and men’s basketball players’ primary relationship to their universities is not educational, but economic. Moreover, especially gifted men’s basketball and football players cannot transcend the college ranks for professional sports in the U.S. until they are one and three years out of high school, respectively, leaving them in a position vaguely akin to indentured servitude. Because universities portray their relationships with athletes as educational, their sports programs gain amateur status in labor law terms, tax exemptions, and antitrust law protection, paving the way for exploitation. Essentially employees of the university, athletes are the driving force behind packed stadiums, bestselling videogames, billion dollar television contracts ($6 billion for March Madness), and considerable donations, yet they never see a cent of the proceeds and often live below the poverty line. Moreover, the exploitation has racial implications, as mostly African-Amer-

ican teams facilitate the commercial gain of mostly European-American coaches and administrators. Within the top 25 football and basketball programs in the country, around 70% of football and men’s basketball players are African American, compared to only 7% of the general student bodies. While McCormick and McCormick’s opinion may seem at first to be an overreaction to a long-heralded tradition of American entertainment and athletes who play for “the love of the game,” their argument is sound. College athletics, especially at the highest rank, is essentially a full-time job. If some coaches can be the highest paid public employees in their states, and if the NCAA and its member universities can profit so greatly, then athletes—athletes who put their bodies on the line every game, who are more commercially related to the school than educationally, and who often live below the poverty line—should receive a fair share as well, no question.

Zack Reneau-Wedeen is a sophomore in Trumbill College. Contact him at julien.reneau-wedeen@yale.edu.

Housing Growth BY JAY KIM

Congestion and the housing crisis

igh-density inner cities and suburbs have created a string of problems for the exceptionally modernized United States. In addition to economic problems, housing realities contribute to social troubles such as congestion, pollution

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and even disease. According to Niccolo Leo Caldararo of San Francisco State University in “The Housing Crisis and Homelessness: An Outline History, Functions and Future,” our cultural values partly explain the planning practices that lead to highdensity population distributions. After analyzing past studies on the correlation between urban buildings and highly Americanized values, Caldararo concludes that our society overemphasizes wealth. This drive leads to the construction of monumental buildings fitted with only first-rate resources. The notoriously American tendency to treat houses as status symbols, which is apart of the “wealth concentration” concept and the idea that “bigger is better,” triggers domestic housing crises and associated economic troubles. As soon as homeowners are faced with financial difficulty, many find it necessary to rent out rooms or move in with friends. Eventually, oversupply causes the market for houses to collapse, and a crisis ensues. Even in times of prosperity, Americans continually feed the cycle of oversupply by pulling down smaller, affordable houses to make way for increasingly larger structures. These renovations also reinforce the idea of wealth concentration. American residents increasingly demand un-

necessary, but “fashionable” amenities, such as basement home theater systems, to their houses. Low cost housing therefore becomes nearly impossible and both land and resources are inefficiently used. Some have responded to this particular housing crisis with the answer of “green housing.” However, green homes are currently infeasible, as the average American family’s income cannot support the construction of such resource and eco-friendly buildings. Single Americans own almost 27% of households and the average house is well over 2,000 square feet, rendering expensive green construction impractical. Caldararo instead proposes increased efficiency in the use of existing housing and land. He stresses that there is a need to change the American mentality of “more is better,” a common sentiment expressed by local builders and the real estate business. Small housing should not be destroyed, but instead maintained and promoted as the answer to our housing crisis. Clearly, Caldararo’s proposed solution responds directly to the assumed American issue of wanting only the best and the biggest. Although the American sentiment for the expression of wealth may be true, the belief that every American treats housing as status symbols is implausible. Perhaps it is not entirely about consumers wanting status symbols that cause housing crises, but about the market being trapped in a cycle that reinforces bigger housing. Suburban houses, since the 1950’s, have generally been mass-produced for efficiency and to promote a sense of community. Thus, since houses are required to be similar in design and size, as soon as the American housing market began building larger homes, it instantly became the norm and expectation. Naturally, this narrows down the choices that the supply side of the

housing market provides for consumers. It is also reinforced when the prices of houses are forced to go down and are bought once again, even if consumers do not wish for spacious homes or when smaller homes are destroyed to make room. The problem may not be purely cultural in nature, but rather a fundamental market issue.

Jay Kim is a sophomore in Timothy Dwight College. Contact him at jay.y.kim@yale.edu.

The Beautiful Game No More?

BY ASHUTOSH VENKATRAMAN

Of taxation and starting lineups

occer, or football as it is more often called, is the world’s most popular sport. Tales of majestic victories and players with breathtaking skill have led to football’s famous epithet, “the beautiful game.” Of late, however, footballing sagas have more commonly been played out across the negotiating table than on the field. Has the sport been reduced to who can lure the best players? Can success on the field be bought off of it? In their November 2010 paper entitled “Taxation and International Migration of Superstars: Evidence from the European Football Market,” Henrik Kleven of the London School of Economics, Emmanuel Saez of Univeristy of California-Berkeley and Camille Landais of Stanford University analyze the effects of top earnings tax rates on the international migration of top football players in Europe.

Yale Economic Review Summer/Fall 2011

Insights By comparing rigid and flexible models of labor demand, Kleven, Saez and Landais find that there is a significant correlation between tax rates and team performance in European club competitions. The European football market is the ideal setting for such a study on mobility and taxation. With the Bosman ruling of the European Court of Justice in 1995, many preexisting restrictions on the free movement of labor were lifted. Over the last two decades countries like Spain, Belgium and Denmark have introduced preferential tax schemes to foreigners, further inducing mobility within the EU. These variations in tax policy, along with free movement of labor, provided the ideal experimental setup for the study. The key question is how is the demand for players structured? On one hand, teams can only field 11 players at a time with a max-

imum of 3 substitutions per game, suggesting that the demand for labor in football is rigid. On the other hand, clubs often play more than 50 matches a season and players are prone to injuries and fluctuations in form. This suggests that adding players is beneficial for a club and that squad sizes may be flexible. In formulating these two different models of labor demand, Kleven, Saez and Landais found that each reveals a different picture. The rigid model, by fixing the equilibrium employment in a country, predicts sorting in the labor force by ability: foreign and domestic players are crowded out at low ability levels while more foreign players are drawn in at the high ability levels. In contrast, the classical flexible demand model predicts that cutting taxes on foreigners attracts immigrant players, across all ability levels, but has no cross price effects on domestic players. The intuition behind this is clear: teams with only a fixed number of open positions would rather fill them with quality players than with reserves. The data tells the same story. Estimating the flexible model, the authors found the elasticity of location with respect to net-of-tax wage to be 0.4. In addition, in estimating the sorting by ability the authors found a strongly positive elasticity at high ability levels and a negative elasticity for domestic players. These estimates, though gauged on football data, hold larger significance for labor migration. By focusing on such a highly mobile labor segment the authors have provided an upper bound on the migration response of the labor market. And indeed the migration response in European club football has been significant. So significant, in fact, that top teams like Real Madrid and Chelsea field mostly international players despite having vast youth academies.

So is football the beautiful game no more? The supporters of the Catalan club Barcelona might argue otherwise, but the fact remains that today, football has devolved into a strategy of who can offer the highest salary.

Ashutosh Venkatraman is a junior in Berkeley College. Contact him at ashutosh.venkatraman@yale.edu.

Africa’s Unofficial Economy BY AYEZAN MALIK

Informal firms in Africa

et’s ask ourselves this: does the decision of a roadside vendor in sub-Saharan Africa to register his business with official authorities really matter? You might be tempted to think not; indeed production, what’s really important, will be taking place regardless. Economics professors Rafael La Porta and Andrei Shleifer, of Dartmouth College and Harvard University respectively, would disagree. In their recent paper “The Unofficial Economy in Africa,” they describe the distinguishing characteristics of informal firms, explain the trade-offs they face in registering, and, in a classic case of addressing a macroeconomic issue through microeconomic analysis, show how substantial economic growth comes only from formal firms. La Porta and Schleifer characterize informal firms as firms that withhold their entire business from government authorities, not just output. Such firms differ from registered enterprises on many counts. Their access

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to resources is poor; for one, they lack financial capital to hire highly skilled managers. Technologically, they are less likely to be connected to the electrical grid, make use of computers in their operations, or have any web presence whatsoever. As a result, their goods are of inferior quality and sales volume is significantly lower. Further, informal firms’ clientele consists mostly of local, small-scale customers: only 1.8% of the informal firms make the largest fraction of their sales to large firms, in comparison to 13.9% of registered firms, which export goods abroad as well. Unusually though, the proportion of total production capacity that both formal and informal firms utilize is comparable, supporting the view that quality segments the market into different niches (Linder effect) with little to no crossover activity. Registering poses obvious costs for the firm, both financial and administrative, such as tax payments, registration fees and regulation. Not so ob-

vious are the benefits, which include access to public finance, electricity, and formal (more lucrative) markets, since only registered firms can issue invoices and advertise to the public. From this, we can predict that registered firms would be more productive, which is indeed proven by the data: value added per employee is between 80% and 240% higher for registered firms than for unregistered ones. This difference in productivity has far-reaching economic consequences in Africa, where informal firms constitute more than half of all economic activity. The authors use the Theory of Duality to explain that informal firms, while sufficient to provide subsistence to owners and employees, are not productive enough to generate significant economic growth or substantially increase living standards. Furthermore, unregistered firms have lower employment growth than registered ones (7.4% vs. 8.9%), debunking previous conceptions that

informal firms are a “reservoir of entrepreneurial talent,” (14) or “dynamic engines of employment creation” (12) that complement formal firms in economic growth. Lastly, informal firms do not “grow into” formal firms with time either, as data shows that 81% of formal firms were registered from the beginning. Therefore, informal firms are not a forerunner for formal, more productive firms either. The overall effect? Economic growth slows down to a bare minimum. African economies are dominated today by informal firms, which are only as useful as the subsistence they provide, saving households from abject poverty, but these firms are clearly not the road to significant economic development. The paper’s findings, therefore, call for a revision of development strategies, especially in developing countries. Governments need to recognize the economic power of formal firms and subsequently encourage their growth, for instance by providing incentives in taxation and ensuring easy access to electricity, public finance, and human capital for them. For long-term economic development, La Porta and Schleifer conclude, formal firms, and formal firms alone, are key.

Ayezan Malik is a sophomore in Trumbull College. Contact him at ayezan.malik@yale.edu.

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Yale Economic Review Summer/Fall 2011

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Planning a Subway System for Las Vegas: Economic Efficiency and Dynamic Demand Modeling

BY ISAAC PARK

Subway network modeling

ESS THAN TEN MILES apart, the bustling suburbs of Silver Spring and Rockville are connected by the Red Line of the Washington Metro. But the Red Line—the busiest subway line on the second-busiest subway system in the country—traces a broad, U-shaped curve through downtown Washington, DC, resulting in a travel time of almost one hour from one locale to the other. Both were quiet suburbs when the system was first designed, but the ensuing demographic change after its construction rendered the old route map staggeringly inefficient. This inefficiency illustrates a unique challenge that countless cities

around the country experiencing demographic changes now face—that of planning subway route networks. This challenge has recently been tackled by Aneesh Raghunandan, Yale ‘11, as part of his senior thesis on modeling public transit networks. The underlying questions that Raghunandan seeks to answer are clearly demonstrated by the inefficiencies of the DC Metro: How can we ensure that subway networks are adequately planned? Moreover, how can we optimally route the system, given that its very construction will inevitably affect commuting and residential patterns? He focuses his inquiry on Las

Vegas, NV, the fastest-growing city in the United States. Las Vegas is far from oversaturated, with plenty of room for relocation and growth. This is key to his approach, which is the first to include dynamic demand in its modeling framework. Previous approaches assume that where people live and where they want to go are unaffected by the construction of a subway system; Raghunandan similarly assumes that people’s destinations are fixed but introduces the ability for people to react to the construction of a subway by changing their residence. This is a crucial consideration in the planning of a subway network: unlike bus systems

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and airlines, subway systems require enormous initial capital investment, and once a line has been built, underuse of the line is extremely inefficient. An accurate model should therefore consider endogenous demand change—that is, demand change caused by the construction of the line itself. As it turns out, the predicted optimal route varies significantly depending on whether the underlying model incorporates static or dynamic demand. The most notable difference is the number of lines in each subway map: the static system includes more subway lines that are relatively short, while the dynamic map uses fewer lines that are significantly longer. Unlike the static model, the dynamic model predicts

residential clustering around subway stops, which leads to greater income segregation. Public transit systems are, in effect, a transfer of tax dollars from rich to poor, and this process is most efficient when the poor are best situated to use the public transit system. Thus, the predictions of a static demand model—the same predictions that guided the construction of the DC Metro—are economically inefficient, decreasing consumerside and provider-side welfare by millions of dollars.

MATHEMATICALLY MODELING A SUBWAY SYSTEM Because of the sheer complexity involved in a general equilibrium model of people’s locations, transit

choices, land prices, and unobservable tract-specific variables, Raghunandan’s model involves several assumptions and simplifications. It divides up the city of Las Vegas into census tracts, approximating neighborhoods of less than 10,000 people, where each tract is represented by a single node. It assumes that people’s choice of residence is influenced not by overall neighborhood affluence, but by an inherent, estimated “niceness” value for each neighborhood and an unobservable, idiosyncratic preference statistically assigned from a distribution. Finally, it assumes that the addition of a subway system to a neighborhood increases property values by 10%, as most empirical studies suggest a value between 6% and 13%.

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Under those assumptions, the dynamic model requires a set of rules that govern whether people move or keep their old residence. The model assumes that an individual’s utility derived from their residence depends on consumption level, amount of property, and two variables representing the tract-specific “niceness” value and the utility derived from using a car or subway. This is subject to a budget constraint where people’s property, consumption levels, and commuting costs are limited to their income. Based on this framework, people will move to a new census tract if the move allows them to consume more, own more property, live in a nicer neighborhood, or use a

preferred method of transportation. As previously stated, the dynamic model predicts that subway riders will move closer to subway lines and non-subway riders will move away from them. Even given the higher property values (which implies decreased consumption), riders are willing to move closer because the convenience of living near a subway line more than compensates for the necessary decrease in their consumption. Similarly, non-riders are willing to move away because increased property values allow them to achieve a higher consumption level if they sell their land and move. This is a fairly intuitive result. After the above approach yields

before-and-after snapshots of residential patterns and tract-by-tract demand for public transit, Raghunandan applies a routing algorithm developed by Mauttone and Urquhart (2008) to determine optimal routes. For the static model, the algorithm is fairly straightforward: essentially, (1) choose the unconnected pair of census tracts with the highest between-tract traffic, (2) connect them in the most efficient way possible, and (3) repeat the previous two steps until all tracts have been connected or the cost constraint has been met. For the dynamic model, the algorithm is slightly more complicated: (1) choose the unconnected pair of tracts with the highest

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Academic between-tracts traffic, (2) connect them in the most efficient way possible, (3) allow people to move as desired (carry out a “geographical update”), and (4) repeat the previous three steps until the network is fully connected. These algorithms generate two different network maps for Las Vegas. The static map has many more

18 experienced a decrease in median income roughly proportional to their increase in population. This effect is especially pronounced in census tracts with heavy out-demand for public transportation, and the introduction of a subway system appears to encourage the development of a concentrated zone of low-income residents. This “clustering” effect

presence of a subway line. But even using a relatively uncomplicated algorithm and many simplifying assumptions, the results of his analysis change dramatically based on whether he incorporates a static or dynamic model—on the order of millions of dollars in lost efficiency. His analysis also sheds some light on the socioeconomic effects of

Raghunandan has provided city planners with a portentous reminder of the importance of dynamic demand subway lines—most under ten stops—which dramatically affects the cost of the system: adding new stops onto a preexisting track is fairly inexpensive, while constructing a new subway line is much more capitalintensive. In contrast, the dynamic map has fewer subway lines that are much longer, reflecting a “clustering” effect around stops by subway riders. Using the above approach, the probability that a rider will move closer to a subway line in any given iteration of the algorithm is about 1.4%. Applied over 847 iterations of the algorithm, this tendency of riders to move fundamentally changes the residential composition of Las Vegas. This has troubling implications for the accuracy of the static model’s predictions. Also, because the construction of a subway system generally attracts lower-income riders, the aforementioned clustering effect directly affects the median income of these census tracts. Of 22 subway tracts,

of the dynamic model therefore increases the economic efficiency of a mass transit system. In fact, Raghunandan attempts to estimate the fare revenue that the city of Las Vegas would lose if they planned their subway system using only a static demand model: $15.1 million per year, conservatively.

FURTHER WORK AND FINAL CONCLUSIONS

Raghunandan is sure to emphasize that his simplifying assumptions could, if relaxed, easily change the numerical conclusions of his approach. The purpose of his analysis, then, is not to determine the “correct” system map for Las Vegas, but to demonstrate a crucial difference between static and dynamic demand modeling. In fact, his conclusions are likely to be understated, as his approach fails to include immigration of new residents into the city, who would be significantly more likely to choose their residence based on the

the construction of a subway system, effects that are linked to, but less often discussed than, considerations of economic efficiency. Raghunandan has thus provided city planners with a portentous reminder of the importance of dynamic demand—and all the while, the inefficient Red Line of the DC Metro lingers as a powerful testament to the crucial difference between static and dynamic modeling.

Isaac Park is a junior in Calhoun College. Contact him at isaac.park@yale.edu.

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Investor Proximity BY IKE LEE

“Location, Location, Location”

“I

T’S ALL ABOUT location, location, and location,” people say. Nearly every fledgling entrepreneur is given the same piece of advice: choose the location of your business carefully. If you don’t, your company could struggle not because it is poorly run but simply because of where you chose to build your store. On its face, this advice seems quaint. Of course location matters. After all, Google is headquartered in Silicon Valley—home to hundreds of venture capitalists—not Poughkeepsie. But is this an outdated adage or savvy business guidance? New research by Nick Huang, Yale ‘11, finds that entrepreneurs would do well to heed this suggestion. Location does indeed matter. Past research has shown that American investors are more likely to have shares of firms that are geographically closer to them. For example, speculators in New York are much more inclined to trade stocks based on the nearby Wall Street than stocks on the distant Kazakhstan Stock Exchange. This makes intuitive sense: traders can easily obtain information about these companies

through local information sources, such as the media, word of mouth, or perhaps even from employees of the firm themselves. Studies have also shown that local media coverage gets investors to trade in the firm’s stock, implying that investors do operate on local knowledge, even in our globalized economy. But Huang’s results take this a step further, showing that investors are not just more likely to invest in companies located near them but are also willing to pay higher premiums and accept lower returns as well. Using raw stock market data spanning from 1990 to 2009, Huang finds that stocks that are located closer to their investors enjoy higher valuations. Using one measure of proximity, Huang finds that a 1% increase in proximity to investors results in a 0.120%–0.127%

increase in valuation ratios, such as the Price to Earnings ratio, the price of the stock relative to the company’s earnings. There exists significant theoretical support for these results. For instance, Robert Merton, a Nobel Prize winner for his work on stock options, has argued that a large component of a security’s value is a function of how many investors were familiar with, or recognized, it. In Merton’s theory, which has come to be known as the Investor Recognition Hypothesis, investors are informed of only a small universe of stocks and ignore others that they know little about. As a result, some investors end up with less diversified portfolios and have large positions in the few stocks they know well. In order to take on the addition-

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Academic al risk that results from having such a concentrated portfolio, those who invest in these lesser-known securities demand higher returns. Conversely, the better known a stock, the higher its valuation and the lower its returns. Huang’s analysis confirms that Merton may have been on to something. Huang’s results demonstrate that this relationship between proximity and stock valuations is significant and has continued into the modern era. There are, of course, complications to Huang’s analysis. As he explains, “A firm might enjoy higher valuations not because it is located close to potential investors, but because certain geographical factors that encourage economic and population growth also provide the firm with operational or strategic advantages...” In other words, companies located in New York City may not enjoy higher premiums because their investors are close by but because New York City provides regulations and geography that are conducive to both population growth and running a business. But Huang takes this into ac-

count by using the years since a state joined the Union to control for the possibility that unobserved factors may affect both proximity and a company’s stock characteristics. The years since a state joined the Union is unlikely to affect a company’s valuations except indirectly, by affecting investor proximity. Since an area would ﬁrst have to be settled by enough households to gain sufﬁcient economic and political clout to become a state, the years since a state joined the Union is also likely a good indicator for an area’s proximity to investors. As a result, Huang’s analysis shows that a company’s returns are not simply correlated with investor proximity, but are directly affected by proximity. Of course, Huang’s results do not say that every firm in populated areas will always enjoy such benefits. But on average, they do. These conclusions could have important implications. In particular, aspiring capitalists may want to think twice before opening an investment bank to rival Goldman Sachs in the sparsely populated Tuscaloosa. Since Morgan Stanley and JP Mor-

gan, to name a few, are headquartered strategically in New York City with hoards of investors to strike deals with, their stock may enjoy higher premiums. To be clear, this won’t bring in extra revenues, but in exchange for given level of ownership in the company, the firm will be able to raise more cash. This may make it harder for other firms in rural areas to compete. Yet, there is good news for the entrepreneurs of Boise: Huang finds that the Internet has attenuated the effects of location. Today, though companies that are stationed in closer proximity to their investors enjoy higher valuations, the effects are significantly less pronounced than they were before the Internet took hold. In practice, since the web lowers the cost of sharing and duplicating information, investors can now know more about firms farther from them than before. That being said, however, the Internet is no panacea, as reputations online are not built overnight; it can still take a firm a considerable amount of time and energy to “get the word out” to those living in more populated areas. Nevertheless, these results are, in some sense, rather comforting. As communications and technology drive forward, companies located far away from major investor bases may be at less of a disadvantage. Perhaps in a few years, the next Google may even be in Chattanooga.

Ike Lee is a freshman in Ezra Stiles College. Contact him at ike.lee@yale.edu.

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Superfast Broadband BY ROBERT KENNY AND CHARLES KENNY

Is it really worth a subsidy?

NUMBER OF countries are investing in fiber optic cable rollout to deliver universal or near-universal high-speed broadband access. In 2008 and 2009 alone, ten countries committed over $16 billion toward the development of “next generation” networks. Many governments argue that their countries will be unable to stay globally competitive without such networks, of which fiber-to-the-home (FTTH) offers the fastest connections. Although faster networks are certainly desirable, all else equal, FTTH seems to fall into the category of maglev trains, passenger hovercraft, and supersonic airliners—products where demand is not high enough to justify cost. In this article, we begin by looking at past information and communication technologies (ICT) revolutions to examine their impact.

We examine potential applications of FTTH, on the basis of which supporters believe it to be worthy of a subsidy, and whether or not those applications can be achieved with current networks. We conclude that the costs of fiber are exceedingly high, that almost all of its potential applications can be achieved using already-existing networks, and that much of the support for fiber is results from considering benefit against no Internet as opposed to the relevant factor, incremental benefit over current networks. In short, while the impacts of past ICT revolutions have been exaggerated, the gap between expectations and likely impact is even larger in the case of superfast broadband. PAST ICT REVOLUTIONS In assessing the potential impact

of FTTH, it is worth examining past revolutions of ICT. No one would question the importance of the Internet to the global economy. Nonetheless, its economic impact has been less than optimists predicted a decade ago, with the same fervor that marks supporters of fiber today. Alan Greenspan argued that the Internet had “altered the structure of the way the American economy works.” The G8 proclaimed IT to be “a vital engine of growth for the world economy.” In fact, US GDP growth in the past decade has been the lowest since 1960. And according to Kevin Stiroh of the New York Federal Reserve, the impact of IT on overall productivity has been falling. Around the world, IT-producing industries have grown considerably in the past twenty years. However, it appears that investment in IT has

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Proponents of fiber exaggerate its worth by ignoring alternative possibilities

COSTS OF FTTH Whether or not fiber will be different - providing above average economic returns to investment and positive externalities - it is clear that its implementation will carry with it a hefty price tag. An upgrade to fiber would be the third upgrade of the telecoms network for the purpose of Internet connectivity. The first upgrade was to dial-up, around 1997. At the time, a 56 Kbps modem cost $100, and the per-line share of the Internet Service Provider’s (ISP) modem bank was an additional $90. For less than $200 per household, society got email, e-commerce (Amazon), User-Generated Content (Geocities), online news, and social networking (SixDegrees). Certainly the benefits outweighed the cost of switching to dial-up. However, dial-up is too slow to run applications like Skype, YouTube, Flickr, and Hulu. They require the speeds offered by technologies such as Digital Subscriber Line (DSL). But again, the cost of this upgrade was relatively low—$100 for a DSL modem and $50 per port for equipment, totaling $150. Considering the developments DSL upgrades have allowed for, they too have certainly been worth the cost. Unlike dial-up and DSL, however, implementing fiber requires a completely new network, not just tweaks to the ends of an existing network. For this reason, Verizon estimates that rolling out fiber-to-thehome would cost about $2,750 per

household—eighteen times more expensive than the DSL upgrade. Moreover, rebuilding the network is not the only cost associated with providing universal superfast connectivity. If consumers are actually to realize the superfast promise of FTTH, capacity across the network will need to be upgraded, not just the last mile. (It is for this reason that the average download rate for U.S. FTTH customers is 16.6 Mbps, even though their access links could theoretically achieve 100 Mbps.) Such additional network costs, which are not taken into account in some analyses, are part of the full cost-benefit calculus of rolling out fiber-to-the-home. Because the overall incremental cost of upgrading to fiber is so high, so too must be the incremental benefit it provides over current technology, if an investment is justified. Looking at the touted benefits, that appears a hard justification to make. POTENTIAL BENEFITS OF FTTH Fiber enhances download speeds, greatly improves upload speeds, and ensures more consistently available access. However, to conclude that government support for fiber rollout is worthwhile, one must show that society will greatly benefit from applications that depend on fiber—applications that existing infrastructure such as basic broadband (already available to the great majority of population in

OECD countries) is unable to support. Most problematic in many proponents’ arguments for fiber is that their claimed benefits of FTTH can already be achieved with basic broadband. Indeed, there are few services—virtually none that would have the type of positive effect on the economy that supporters predict— which can only be provided over fiber-based broadband. For example, fiber has been heralded by some as vital to the creation of “smart grids”—electricity networks which monitor and optimize use to reduce peak demand and so, in turn, the need for additional power plants. But smart grids do not require upload speeds faster than basic broadband. In fact, in Italy, the Telegestore project has helped install 30 million smart meters between 2001 and 2005, which require a bandwidth of only 2.4 Kbps –considerably less than the bandwidth used for a traditional telephone call. Telegestore has reduced peak electricity demand and CO2 output all without the use of fiber connectivity. In assessing benefits to education, advocates of FTTH have made the same mistake of crediting superfast with the benefits of earlier Internet technologies. The UK Government’s publication “Britain’s Superfast Broadband Future” claims that in Australia, “higher speed broadband has led to the creation of virtual classrooms which help to deliver a better quality of service

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and enables teachers to engage with students as a group through video conferencing.” The trial to which the publication refers was conducted in 2002, and compared lower speed satellite broadband to two-way radio – clearly nothing to do with the incremental benefits of fiber broadband. Even if high speed broadband were shown to be necessary in schools, that would not require fiber to every home. Instead, a fiber rollout could be more targeted, like the fiber-to-the-school (FTTS) program that Korea has completed, or the NZ$200 million that New Zealand has earmarked to improve Internet access in schools. And as far as education in the home is concerned, university lectures and other educational videos can be downloaded with the current copper network. For instance YouTube offers 65,000 videos and 350 full courses from universities including Yale, Cambridge, Stanford, MIT, and UChicago, all delivered over the existing network.

Again, proponents of FTTH say that it will allow more people to telework—to work from home over the Internet—and therefore alleviate traffic congestion while benefiting the environment. In 2008, the FTTH Council of Europe claimed that a fiber rollout supporting 3 days of teleworking per week by 10% of the working population could result in a 330 kg eq. CO2 reduction per user. But teleworking has been on the rise around the world even without FTTH. In 2000, some Nordic countries already had 17% of the population teleworking. Between 2000 and 2005, the teleworking population in the EU15 grew from 5.3% of the total to 8.4%. In the UK, the percentage of employers offering teleworking more than quadrupled between 2004 and 2008 from 11% to 46%. And in the U.S., 34 million people telecommunicated at least one day per month in 2008, double the amount in 2001. One exception to the trend is Korea, which has had a fiber network for some time. Their

current telecommuting rate remains below 1%.It seems unfounded, then, to suggest that fiber would be necessary to bring Europe as a whole to a 10% telework share. In fact, surveys suggest the key barriers to teleworking are issues such as security concerns, supervision difficulties, and doubts about return on investment. Bandwidth is not usually a critical concern. FTTH supporters also tout its benefits for television, since it allows applications like streaming HD video. However, existing technologies including cable access, widespread throughout the developed world, can already deliver streaming HD. The incremental advantage of fiber is to allow for exceptionally high concurrent usage. Motorola’s case for superfast broadband, for example depicts a household simultaneously using two HD TV streams, two standard definition streams, and a picture-inpicture stream, while its inhabitants also upload a large number of photos. And even this remarkably busy

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Academic scenario does not necessitate FTTH; far-cheaper fiber-to-the-cabinet (FTTC) could support the required 30 Mbps load just fine. Cool to be able to watch five channels at once? Perhaps. Worthy of a government subsidy? Doubtful. This survey of existing potential uses of superfast leaves out one common argument in favor of FTTH: that it is “future-proof,” or capable of meeting bandwidth demand for services and applications yet to be developed. But that argument is problematic for three reasons. Firstly, it assumes that no technology that can deliver FTTH speeds (or faster) at lower cost will be developed before some future application makes superfast more attractive. Indeed, cable modem coverage is already over 90% in the United States, and operators are starting to offer speeds over 100 Mbps over cable for the price of around $100 per home. Secondly, it assumes such applications will be developed. We have no convincing evidence that they will be. Thirdly, even if fiber may eventually be the right answer, that does not make it the right answer today. Other options such as FTTC can provide the infrastructure necessary to fulfill society’s current needs, until FTTH becomes cheaper to implement or applications develop that necessitates its bandwidth. FTTC could be implemented for about one-fifth the cost of FTTH. The “future-proof” argument might be one to further strengthen an already strong case in favor of FTTH, but it certainly cannot stand alone. A strong sign that FTTH may not carry immense benefits to consumers is consumer willingness to pay for faster connections. Surveys conducted for the Federal Communica-

tions Commission have estimated that the average household would be willing to pay around $45 per month to upgrade from “slow” to “fast” Internet speeds, but only $3 per month to move from “fast” to “very fast” speeds. Again, in six out of nine European countries with FTTH available, fiber broadband prices were the same or less than those of ‘basic broadband’ ADSL2+ services. This suggests that connectivity providers believe consumers are unwilling to

rankings are prone to fluctuation— among OECD countries Austria has gone from 9th to 18th in the last seven years, while Luxembourg has skyrocketed to 8th from a position of 22nd. Being slightly late to the party in this case does not mean it will start without you. In sum, the high costs of rolling out fiber-to-the-home appear to outweigh the benefits. In electricity, healthcare, education, and transportation, proponents of FTTH exag-

Many of the claimed benefits of FTTH can already be achieved with basic broaband pay for the incremental improvement of FTTH. Politicians frequently cite global economic competition as a reason to favor FTTH subsidies. In announcing Australia’s fiber subsidies, the Prime Minister of the day (Kevin Rudd) cited the fact that the country ranked in the bottom half of OECD countries (16 out of 30) in broadband take up to argue that “slow broadband is holding our national economy back.” But there is no evidence for the argument that relatively slow take-up of FTTH is putting some countries at an economic disadvantage. And until there is a powerful economic case for FTTH rollout, there is little logic in investing simply for the sake of being able to claim a place at the top of the league table. That is especially true given how much broadband

gerate its worth by ignoring alternative possibilities and attributing many of the benefits of basic broadband to FTTH. Further, supporters overplay the significance of an ICT “revolution,” based on superfast access, comparing it to less expensive predecessors whose potential applications were better known. Considering current potential applications, alternatives, and costs—both of waiting and rolling out—it appears as though government subsidies for fiber rollout to the home are unlikely to be a smart economic move, and certainly not right now.

Zack Reneau-Wedeen is a sophomore

in Trumbill College. Contact him at julien. reneau-wedeen@yale.edu.

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Stephen S. Roach Stephen Roach is a highly influential authority on the global financial system. Roach has been at Morgan Stanley since 1982, most recently as the Hong Kong-based Chairman of Morgan Stanley Asia and previously as chief and senior economist. He is a senior fellow at the Jackson Institute. Yale Economic Review: China’s 12th Five-Year Plan aims to increase its domestic consumption as a share of its economy through job creation in services, massive urbanization, and the broadening of its social safety net. To what extent do you think this objective will be fulfilled? Stephen Roach: I think the plan is ambitious and complex but China will deliver. If there’s one thing that’s constant about China over the past 60 years, it is that it has a strategy and a commitment to its strategy that is deeply seared in periodic episodes of social instability over its long history. It also has the tools to deliver the policies or reforms. I do not underestimate the complexity of shifting the macro-model of any economy from being a producer society to a consumer society. But the balance will shift significantly over the next five years and I wouldn’t be surprised to see the consumption share of the Chinese economy rise from extremely low levels of below 35% towards 40%. That would still leave China with a consumer segment that is very small compared to all major economies in the world today. The main reason China is going to do this is to generate better-balanced and more sustainable economic growth. The current model is an export-led growth - the export share went from 5% of China’s GDP in 1979 to 36% in 2007- and the key to export-led growth is to have competitive export industries and vigorous external markets. China still has the former but not the latter. The crises in America and Europe have killed the prospect for vigorous growth and external demand. So China, being pragmatic, needs to keep growing rapidly to absorb surplus labor and has to turn to a new source of growth, which is its internal consumer market.

price of properties. By conventional metrics like price-torent and price-to-income ratios, China is experiencing a property bubble. Do you think this bubble will burst and what are the effects on China’s economy? SR: There has definitely been a massive price appreciation for top-tier properties in a dozen of first-tier costal cities. The government has taken a lot of administrative action by boosting loan-to-value ratios for multiple purchases of residential properties by speculators. They did that in April 2010 and it has sharply curtailed multiple unit purchase. But your basic point is right in that the price of housing is too high. I think that reflects a chronic supply-demand imbalance that is driven by two factors. First, massive rural-urban migration is running 15-20 million people a year and projected to run another 15 million a year through 2030 by OECD. This puts enormous strain on what is a rapidly increasing, but still inadequate, supply of shelter for Chinese people. Second, in a country like China where the range of assets that can be invested for individuals is relatively low and limited, property has become an asset class of preference for many Chinese people. The Chinese government has very aggressive programs aimed at low-end “social housing”, building 15-20 million units a year in the foreseeable future. But this does not boost supply immediately, so the affordability of housing is a very basic issue for Chinese people. YER: Is the Chinese model of government more effective at solving capitalism’s persistent bubbles?

SR: They have a different approach. The approach in China is fixated on one word – stability – whether it is YER: A key issue in China today is the unsustainable economic, political or social stability. So when the gov-

ernment senses that there is something that is brewing and is destabilizing, it moves and asks questions later. Examples include taking actions in the Asian Financial Crisis in the late 1990s and the sub-prime crisis a decade later. These were huge disturbances right in China’s backyard for the Asian Financial Crisis, and in the case of the sub-prime crisis, China’s major export markets in the developed world. Stability and taking pre-emptive actions to deal with the economic and social fallout of instability is very much ingrained in the psyche of senior Chinese policy-makers. We just do it differently in the West. We believe in the inherent wisdom of the market. We see bubbles come and go. We think we can never prevent them and always go back to tools to clean up after the bursting of bubbles. I think there is good reason to draw these assumptions into serious question. Look at the post-bubble mess we are in right now. Is this the kind of thing we want to happen over and over again and say we have the tools to clean up after bubbles? We have an economy in the US that is in a post-bubble liquidity trap and unresponsive to policy actions. I think it draws a lot of doubt about our reactive approach to instability, as opposed to China’s proactive approach. These are very dif-

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ly “unstable, unbalanced, uncoordinated, and ultimately, unsustainable”. That put a really important stamp on the philosophy of macro-management in China and that was to ensure that the government is focused on a strategy to deal with these inherent risks of instability and unbalance. If your value preposition rests on the premise of doing everything within your power to maintain stability, you are operating with a different mindset compared to someone who sees stability as an afterthought. YER: China today bears many resemblances to Japan in the 1980s: high growth rates, an export and investmentdependent growth model, an undervalued currency (according to the US), exuberant optimism and perhaps a growing bubble economy. How similar are these two situations and what can China learn from the Japanese experience? SR: I would add one more similarity that you did not mention. Like Japan, where much of the resource allocation during the high growth decades of the 1970s and 1980s were driven by an elite bureaucracy, the Ministry of International Trade and Industry (MITI), China has

No one is infallible. At the end of the day, policy makers are humans whether they are operating individually or through consensus. ferent approaches and I think there are lessons we can the very powerful National Development and Reform learn from the Chinese. Commission (NDRC) that also plays a very active role in resource allocation. China studied the Japanese case very, YER: At the same time, we in the West associate many very carefully. While they do share some similarities, of the bubbles with policy actions. And China is very in- their differences go back to strategy, commitment, and volved in directing its economy and initiating economic the wherewithal to deliver, which Japan did not have. policies. If we as humans do not have foresight to see The Chinese see how the Japanese got into trouble by how economic forces will unfold, does China risk creat- staying with an unbalanced, mercantilist growth policy ing more bubbles with its five-year plans? and by listening to the West on the currency issue, with a huge one-off revaluation to the yen. The Bank of Japan SR: No one is infallible. At the end of the day, policy also made massive mistake on monetary policy, which makers are humans whether they are operating individu- lead to massive economy-wide bubbles in properties and ally or through consensus. The Premier of China, Wen equities, and took a lasting toll on the Japanese economy Jiabao, said it best in March 2007, before the sub-prime even to this day. crisis, that while China looked strong on the surface, he was worried about a Chinese economy that is increasing- YER: Moving onto the Euro-zone issues. Do you see a

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strategy behind George Papandreouâ&#x20AC;&#x2122;s call for referen- litical union. Germany, France, and Italy were the first dum, besides angling for a better deal? violators of the growth of stability pattern and have done a terrible job in leading by example. Ultimately, Europe SR: It is hard to wrap these political gyrations around a knows that there is no way out of this crisis without a fisstrategy. The only thing that seems coherent from that cal union. Do they have the political will to abrogate their point of view is that he was able to achieve some conces- sovereign responsibilities as leaders of their respective sion on the referendum from the opposition party. That nation-states? That is the biggest issue right now and I might not have happened had he not gone out on a limb think there has been disappointingly small progress in to articulate the need for referendum, which he subse- that regard. quently backed off on before stepping down as Prime Minister. YER: Some people argue that greater integration will not be enough. There has to be a complete re-ordering of YER: What steps do you think Italy needs to take right the European way of life, such as changes to the working now to reassure the markets? hours, in view of competition from rising Asian powers. Do you agree with this? SR: Italy needs a credible program of fiscal restraint. Berlusconi showed up at the G-20 meeting last week SR: What you find in European economies and societwith a vague, unspecified letter on dealing with priva- ies is a gradual realization of competitive issues that force tization of government assets, but very little specificity incremental changes, as opposed to radical changes. One in expenditure controls. The markets -in terms of Ital- would hope that in an increasingly global environment, ian bond yields- have continued to put more pressure on Europe, and countries like Italy and Spain in particular, the Berlusconi government to deliver more credible fiscal would wake up to its lack of competitiveness. Producmeasures. tivity growth in Italy and Spain has not been good for a long time and these countries have lost much of their YER: Even if we see specific proposals, will they still be competitive edge to Asia, but also to other European and credible if the market does not believe the European pub- developed economies around the world. It is rather ironic lic will put up with these proposals for austerity? that of all the countries in the Eurozone, the one that has been most aggressive in implementing reforms is GerSR: There is a big political issue overhanging Italy right many. Germany has benefited a lot from structured labor now. Berlusconi has assured us that he is not resigning reforms, as well as from using a currency that is a much but most politicians who are on the brink of resigning cheaper than what the Deutschmark would otherwise be. always do that till the end. He has been a survivor, he is very powerful, and he has great control over the po- YER: Finally, do you see a role for China in the Eurozone litical apparatus in Italy. But he is certainly closer to the crisis? end of his political career than the beginning for some obvious reasons. The markets are definitely looking for SR: Not unless Europe really gets its act together. There much more specificity than what Berlusconi or any lead- are many rumors that the Chinese government is coning Italian politicians have been able to offer. The person sidering a contribution to the European Financial Stabilrumored to come in to lead a caretaker government, Ma- ity Facility (EFSF). In view of the political gyrations that rio Monti, is very seasoned and much more conversant in were evident in Europe in the past few weeks, there is market-type solutions than Berlusconi. much uncertainty about the future of Europe. The last thing the Chinese want to do is to be accused of sending YER: Do you think that a successful future for the Eu- â&#x20AC;&#x153;dumb moneyâ&#x20AC;? to bail out nations that are in trouble. rozone requires further political integration, or it can be achieved through market reforms that keep the current David Yin is a freshman in Berkeley College. Contact him at structure of the currency union? david.yin@yale.edu.

SR: This crisis is all about the fact that the biggest short- Victoria Buhler is a junior in Jonathan Edwards College. coming of the currency union is the lack of fiscal or po-

Contact her at victoria.buhler@yale.edu.

Yale Economic Review Summer/Fall 2011

Dilemmas of the

Euro Age BY ASHUTOSH VENKATRAMAN

UROPE FINDS ITSELF in a bit of a pickle today. Investor confidence may not be eroding at a daily rate and public anger may not be flaring like it once did but Europeâ&#x20AC;&#x2122;s leaders still face a quandary: what to do with the euro. Not so long ago, Europe was

basking in the success of the newly formed currency union, with trade reaching unprecedented levels and the Eurozone economies booming. Inflation was consistently stable and countries could borrow money freely. Yet today Europe is in deep crisis and the single currency it worked so

hard to establish is proving to be a bigger and bigger impediment to the resolution of its woes. How did that happen? THE BOOM It all began at the stroke of midnight on the first of January

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1999. Europeans awoke to a new a buying spree. In Greece it was So when house prices fell, these currency in their bank accounts mainly the government, helped countries were hit just as badly as that would be uniform across the along the way by the financial leg- the US. The crisis was all the more painful in Europe as construction accounted for almost a sixth of employment in countries like Spain and Ireland – more than twice as much as in the US. But that was only the tip of the iceberg. Starting in late 2009, as much of the world began to recover, the European crisis entered a new chapter. Greece, Spain, Ireland and Portugal all suffered dramatic losses in investor confidence and hence interest rates shot up once again. Why? For one the fiscal effect of the Eurozone. The euro quickly be- erdemain of Wall Street, that bor- crisis on these countries was twocame a major international re- rowed huge sums from German fold. The loss in tax receipts, couserve currency with a substantial banks in order to fuel economic pled with the increase in payments bond market and worldwide cir- growth. But elsewhere, private for unemployment benefits – unculation. The creation of the euro borrowers lead the binge, most employment in Ireland and Spain also engendered a new confidence notably in the real estate market, rose to over 14 percent – virtually in those European countries that leading to the housing bubble. In wiped out government revenues. had historically been considered Spain and Ireland housing prices In Ireland the government also investment risks. Only now is it nearly tripled from 1998, just be- guaranteed all bank debts, in the becoming apparent that this new fore the euro was introduced, to process bringing its own solvencredence paved the way for a much 2007. Even traditionally strong cy into question. As a result both larger pitfall. economies like Germany reaped Spain and Ireland went from budThroughout the 1990s coun- the benefits of the new system ex- get surpluses in 2007 to deficits in tries like Greece faced high bor- periencing an upswing in exports. 2009. rowing costs because their fiscal And in the midst of all this growth In Greece the situation was problems were reflected in their the euro was pronounced a great muchworse. Even before the crisis bond yields. Investors would buy success. the government had been borrowbonds issued by these countries That was until the bubble ing large sums of money without only if they paid much higher in- burst. revealing the true level of debt. terest. With the introduction of Rampant tax evasion, to the tune the euro, however, risk premi- THE BUST of over $20 billion a year further ums melted away and by the mid saddled the government with in2000s, Greek, Irish, Spanish and The economic crisis of 2008 creasing deficits so that by 2010 Portuguese bonds were all traded is largely seen as something made Greek public debt was over 140% as if they were as safe as German in the USA; but Europe deserves of GDP. It’s no wonder then that bonds. its fair share of credit too. The in the midst of mounting arrears, As interest rates fell across real estate bubbles in the newly with the European economy withEurope these formerly high-risk moneyed economies masked their ering, investors lost confidence countries, predictably, went on underlying untenable borrowing. in these countries’ ability to pay

Without sufficient fiscal integration the single currency leads to a loss of economic flexibility.

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them back. And over the past two of years these countries have devolved into a vicious cycle: as lenders lose confidence interest rates rise, damaging future prospects, leading to a further loss of confidence and even higher interest rates. The EU’s leaders have averted an immediate meltdown by providing Greece and Ireland with emergency funds through the European Financial Stability Mechanism, but a more permanent solution needs to be found. THE DEEPER PROBLEM Greece and other European countries may have large debts, but there are still other nations – in particular the US and Britain

– that have comparable debts, as a percentage of GDP, and yet have not lost investor confidence. This inconsistency points to a deeper issue, one specific to the euro-crisis countries. The problem in a recession is that while the resulting economic contraction and deflation causes incomes and asset prices to fall, debt remains unaffected. Debtors thus have to meet their commitments with reduced incomes. To do this they have to reduce spending, depressing the economy even further and causing a vicious cycle. As Irving Fisher’s debt-deflation theory points out, central banks can prevent such a situation by implementing monetary expansion and raising inflation

by devaluing the currency. And in the US and the UK this is exactly what the Federal Reserve and the Bank of England are doing. But Greece, Ireland, Spain and Portugal don’t have that option because they don’t control their currency or their monetary policy. This is the underlying problem caused by the introduction of a common currency and the very reason that threatens the existence of the euro. Without sufficient fiscal integration a single currency leads to a loss of economic flexibility. Countries like Greece with drastic debt-deflation problems are unable to devalue their currency because they are shackled to the euro. Indeed, Germany would not take kindly to raising prices espe-

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cially because its economy relies so heavily on exports. The result of all this is that the debt-ridden countries have had to institute harsher and harsher

the next four years. A slew of new nancially solvent countries like the wealth and sales taxes have also UK experiencing riots. been levied in order to further reduce the public debt. Naturally, THE END OF THE EURO? the Greek people have not taken The euro debt crisis requires a comprehensive solution: one that does not merely include austerity measures. To ensure that investor confidence is restored the EU will have to undertake some form of debt restructuring and devalue the euro or face the brunt of a Greek default Ă la Argentina in 2003. The urgency of the situation is further heightened by the threat of a spread of the crisis. Endangered but still-solvent countries like Belgium, Spain and Italy are already showing signs of losing investor too kindly to their benefits be- confidence given their rising ining cancelled and thousands have terest rates. taken to the streets in protest. A The writing on the wall, so far, similar pattern has emerged across is clear: solely cutting spending Europe, with even traditionally fi- and raising taxes is not enough to

The writing on the wall, so far, is clear: solely cutting spending and raising taxes is not enough to solve Europeâ&#x20AC;&#x2122;s woes. austerity programs. Greece has reduced public sector wages by 15%, raised the retirement age and plans to reduce welfare benefits by more than â&#x201A;Ź6 billion over

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Feature solve Europe’s woes. Interest rates have continued to rise and public anger is close to the boiling point. But a parochial outlook and intransigence on the part of Europe’s stronger economies threatens to break up the Eurozone and resign the debt-ridden nations to years of painful contraction. Angela Merkel will have to convince domestic voices that a collapse of the Eurozone will be far worse than a domestic rise in prices, for both Germany and the world. And the European Central Bank needs to realize that, sometimes, opposing one’s mandate and allowing inflation to rise might just be the best thing to do. If the EU can summon the same collaborative spirit that led to the creation of the euro in the first place, and cooperative on a comprehensive solution then it might just be able to undo the wrongs of the past and avert the end of the euro.

Ashutosh Venkatraman is a junior in Berkeley College. Contact him at ashutosh.venkatraman@yale.edu.

BONDS: WHAT THEY ARE & HOW THEY WORK BY YUCHEN LIU In a similar vein to stocks, bonds are a way for institutions to raise money quickly. By selling bonds for money, an institution agrees to repay the buyer interest and principal (“face value”) in regular installments for a predetermined time period. In this way, bonds are comparable to loans – they allow organizations to borrow money from the public just as an individual can borrow from a bank. There are two major types of bonds: fixed rate bonds and floating rate notes. The interest rate on fixed rate bonds remains constant throughout the bond’s lifetime, making them generally secure investments during times of great interest rate fluctuation. However, they can quickly become devalued if inflation is high. On the other hand, floating rate notes are bonds with variable interest rates, which are most often linked to benchmark interest rates such as the Federal Funds Rate. This makes floating rate notes immune to inflation, but also susceptible to interest rate fluctuations. Bonds are traded in two markets. The “primary market” is where the government sells bonds when it first issues them; after each bond’s face value is determined, it is sold through competitive auction for an “is-

sue fee.” The issue fee varies with factors such as a government’s credit rating, or the state of a nation’s economy, and can therefore be different from the bond’s face value. The “secondary market” is where previously issued bonds are traded. Bondholders can resell a bond to the public at any time for a particular price, thereby transferring the rights to all future repayments on the bond to the buyer. A bond yield is the biannual return that a bondholder receives, as a percentage of the bond’s market price. Since most government bonds, being fixed rate, have constant biannual returns, their yield is inversely proportional to the price. Events affecting a government bond’s price, such as a downgrade in the government’s credit rating, can therefore change the yield. Consequently, to keep all future bonds it issues competitive, the government must sell them at a yield comparable to the higher rate. For a given price, this translates into higher interest rates for the government, pushing up its cost of borrowing money. Bonds are widely used by governments and firms today to raise money. However, as the Euro crisis shows, they must do so with care.

The Economics of Corporate Social

y t i l i b i s on

p s e R

BY AYEZAN MALIK

Yale Economic Review Summer/Fall 2011

NTIL A FEW YEARS ago, the words “corporate” and “social responsibility” would have hardly ever appeared in the same phrase. The firm, when the notion was first conceived, had no more than one role in the society – to partake in economic activity for profit, and, as Adam Smith put it, only with “regard to [its] own interest.” As long as a business brought goods to the consumers, wages to its workers and profit to its owners, it was fulfilling its social responsibility. In short, the firm was an economic agent, and an economic agent alone. But that has changed. Public opinion today requires firms to fill in bigger shoes before we pat them on the back for being socially responsible. Among other things, they are expected to help in regional development, plant trees, build schools, control pollution and generate local employment – and the more they do it, the better. In fact, today, corporations that stick with their original role in society of solely profit-oriented production are deemed socially irresponsible. This change in public opinion has contributed to corporate social responsibility (CSR) in a way laws and regulation in the past never could – firms have now begun to take an interest in CSR themselves. As a result, corporations today have started to take initiatives voluntarily and are going beyond what the law requires of them. For instance, Chevron alone is involved in a number of projects ranging from promoting education in Richmond, California, to preventing HIV/ AIDS in Nigeria. And if anything, such actions are welcomed by the

Feature public with open arms. While there is no question about what firms must do to meet government regulations, anything beyond that must be analyzed in terms of its economics, on both micro- and macro- levels, before being granted unequivocal public support. MICRO – WITHIN THE ECONOMY The major players in an economy that are affected by CSR are the firm (and by extension its shareholders), the consumers, and “stakeholders,’”who are members of the society outside the market that are externally affected by a firm’s actions. The most prominent effect of CSR in an economy is on the people who directly benefit from the social responsibility programs – the stakeholders. This includes, for instance, the children in Richmond whose schools are funded by Chevron, the Haiti earthquake victims who received bottled water in humanitarian aid from PepsiCo, and the ecosystems of Brownfield sites that were cleaned up and redeveloped by General Motors. This effect of CSR is indeed one of benefit to the society, particularly to the people or organizations the programs are directed at. But while this may be the one effect that is most publicized through media and advertising, it is not the only way voluntary CSR affects society at the microeconomic scale. So far, CSR seems to be a “free lunch” for the society, considering the benefits it brings to stakeholders. The effects on shareholders and consumers too, however, must be considered. Firms must finance their CSR ventures somehow, and

one way they can do so is by bearing the full expense of the projects, and accepting lower profits, which then translates into lower dividends for the shareholders. But as Harvard Professors Forest L. Reinhardt, Robert N. Stavins and Richard H. K. Vietor write in a 2008 paper, doing so alone won’t be economically feasible for firms to do so. Reduced profitability means that a firm loses its competitive edge in the market, causing its stocks to devalue. In the long run, such a firm would exit the market in face of market forces and competition. But they don’t. Firms such as Chevron or PepsiCo have been engaged in CSR for years without any signs of reduced profitability or competitiveness, showing that the full ‘cost’ of CSR programs does not necessarily fall on them. Here is how. The change in public opinion over the past few years has led to ‘ethical consumerism’: there is today greater awareness among consumers about social responsibility, and they are more conscious about the CSR practices of the firms they buy from. Recognizing their power as being the demand that drives any firm’s business, consumers today can influence corporate actions through their buying patterns. In such a social climate, where consumers are essentially ‘ethical,’ firms can use CSR as a strategic tool to gain support of the public, and thus win over consumers from their competitors. This represents an increase in demand for the firm, which means that consumers are willing to buy more of its products and pay more for them than before. Indeed, research has shown that “consumers care more about get-

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ting ‘fair and honest’ prices than about getting the lowest price … [and] expressed willingness to pay more for products made ethically,” as quoted in a 2005 article in the Journal of Consumer Affairs. This gives firms the ability to transfer some or all of the cost of CSR programs to the consumers in the form of higher prices, and thus prevent their profit margins from taking a hit. What is more is that the increased demand also represents an increase in the firm’s market share, giving the firm more strategic power in the market. The firm therefore is able to get away with engaging in CSR without having to bear the full cost of the programs, and at the same time getting key strategic gains out of it. So CSR is not really a “free lunch” after all, since it represents an implied cost for consumers in the form of higher prices. But even if CSR programs come at a price, do they represent an overall benefit to society? As Reinhardt, Stavins and Vietor point out, CSR projects must “generate the greatest net social benefits” in order to be socially optimal, which basically means they should be aimed at those stakeholders who would gain the most utility from each dollar spent on them, in comparison to anyone else in the society. This can only hold if firms keep nothing but social interests in mind when deciding on their CSR initiatives, which is probably a bit too naïve to say. Once firms realize that they can potentially benefit from CSR, they seek to maximize these gains, making CSR, and the choice of who to spend it on, no different from any other business decision. As such, corporations start focus-

ing more on the business objectives they seek to fulfill from their CSR programs, such as increased consumer support for instance, than the fundamental goal of maximizing social welfare. This is perhaps why firms match their CSR programs, which are strategically located and timed, with extensive advertising. For instance, C h e v r o n chose to fund schools in Richmond, CA, where it operates a refinery, as opposed to anywhere else. Public support there clearly has the most strategic value for the business – but was it also the choice that maximizes net social welfare? That, probably, is not so clear. F r o m this angle, corporations engaging in CSR essentially become no different from NGOs and charities, receiving contributions from their consumers in the form of higher prices and, less significantly, from shareholders in the form of lower dividends, in return for humanitarian services. So the

Yale Economic Review Summer/Fall 2011

Feature question of voluntary CSR comes down to this – are corporations the best charities for us to fund? This is what we must ask ourselves before we endorse, and end up paying higher prices to, corporations engaged in voluntary CSR on their own terms. For now, let’s go beyond individual members of the society and assess the effect of CSR on the overall economy. MACRO – THE ECONOMY Resources are scarce. This is probably the first lesson we all learned in economics, and a fact without which the entire discipline might have never existed. For an economy to do its best, it is pertinent that its resources be put to their best use, a principle commonly referred to as the division of labor. For instance, we never see agricultural farmlands housing industrial estates, or doctors working on Wall Street, because that is not the pur-

pose each of them is best suited for. Firms, similarly, are specialized institutions, focusing on and mastering the art of production of goods and services. Simply put, they use society’s scarce resources (land, labor, capital and entrepreneurship) to produce goods more efficiently than any other institution in the society. As such, division of labor requires them to do just that. Voluntary CSR represents a competing use of the firm’s resources and expertise. Every time a firm chooses to invest in building a hospital or a school, it is diverting precious time, money and other resources that are best suited for production. As Reinhardt, Stavins and Vietor point out, this can end up being socially inefficient on a number of counts. First of all, firms may not be efficient at doing charity work because they have little experience evaluating the full social benefit of particular projects. While governments and charities are seasoned in carrying out costbenefit analyses for the provision of public goods, firms are not, and therefore may not make the best decisions when choosing between different CSR initiatives. Furthermore, if we think that something is still better than nothing, we must understand that in engaging in CSR, firms “‘crowd out’ donations to more efficient charities,” which would have probably put the money to better social use. This occurs because the higher prices for consumers and lower rents for shareholders translate into lower incomes, and therefore lower savings, thus reducing their ability for people to donate directly to charities. Lastly, while it is the most

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profitable firms that are most able to engage in CSR, they are also the ones for which it is most inefficient to do so, since they are clearly the most efficient at the production of goods and services. Diverting the resources of these firms away from production can lead to the greatest social inefficiency. In a blunt comparison, this would be similar to a doctor working on Wall Street.

it doesn’t promote a firm’s products – it only promotes the firm. To understand this, imagine that you are a desktop computer user, meaning that you are currently outside the market of laptop computers. Now if you see a commercial promoting the Apple Macbook, you might be attracted into buying one. In doing so, you would enter the laptop market, and add to the market demand

the aggregate demand of an economy. This means that where advertising can potentially cause the output of an economy to either rise or fall, CSR would strictly reduce the output of an economy, thereby threatening its GDP growth. So is voluntary CSR best for society? While firms don’t have a choice about CSR required by law and regulation, voluntary CSR does pose a choice for them, which becomes a strategic choice in today’s world of ‘ethical consumerism.’ At the microeconomic scale, we see that firms compete with other charities in pursuing voluntary CSR, while at the macroeconomic scale, they compete with their own, original objective of goods’ production in doing so. Does this translate into an overall benefit for the society? It’s probably too early to answer in yes or no for sure, but it’s definitely time to start thinking whether the in addition to Apple’s individual de- shoes we ask firms to fill in today mand. On the other hand, if you see are too big for them. a news piece about a recent school Apple built for underprivileged children, it might encourage you to buy at Apple next time if you’re Ayezan Malik is a sophomore in Trumbull College. Contact him at a current laptop user, but what are ayezan.malik@yale.edu. the chances it would convince you, a desktop user, to buy a laptop, such as the Macbook? Definitely lower, because the Macbook was never even pitched to you. So while Apple’s own consumer demand may rise because of CSR, market demand would remain unchanged. This difference has an overall effect on the economy. While both advertising and CSR raise the cost of production for firms, causing the short-term aggregate supply to fall, only advertising has the potential to raise market demand, and therefore

Every time a firm chooses to invest in building a hospital or a school, it is diverting precious time, money and other resources that are best suited for production It can be argued that spending on voluntary CSR can’t be worse than spending on advertising, which too doesn’t play a direct role in the production of goods. And while we condone advertising in modern day economics, why not CSR? CSR is indeed similar to advertising in its effect of increasing a firm’s consumer base, and therefore demand, for reasons given earlier. However, there is a subtle difference when we look at it from a macroeconomic perspective. Advertising promotes a firm’s products, and indeed does increase consumer demand for that product of the firm. Furthermore, it does so both by diverting consumers from competing firms, and by attracting new consumers from outside the market. CSR fails to do the latter, since

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Yale Economic Review Summer/Fall 2011

Great Expectations: The Fed, Communication, and the Importance of Public Perceptions BY DEREK WALKER

EN BERNANKE, the Chairman of the Federal Reserve, is not one to raise his voice. He is, after all, an academic at heart—a professor who seems better suited for advising doctoral dissertations than for negotiating the hostilities of Washington. But, perhaps out of necessity, Bernanke has learned how to make his and the Fed’s voices heard over the clamor of politicians and pundits. For instance, in the wake of Lehman Brothers’ demise in Sep-

tember 2008, Bernanke believed that a forceful, coordinated response from all branches of government, including Congress, was needed to keep the economy from deteriorating further. But Henry Paulson, the Treasury Secretary at the time, had misgivings, which he voiced on a call with Bernanke and other officials—he felt convincing Congressional leaders would be a harder task than Bernanke realized. According to Paulson, the Fed and Treasury would do better to make

do with their own tools than risk a rebuff from legislators. Ever the professor, Bernanke disagreed, responding with an overwhelming 15-minute exposition on the history of financial crises and the need for a decisive, united response. His explanation swept across continents and time, detailing the outcomes of financial crises both domestic and abroad throughout the last century. Once Bernanke yielded, Paulson quickly ended the call. But the Fed Chair

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was not done, repeating his lecture on a call with Paulson the next day. Before Chairman Bernanke got far into his tour of historic crises, Paulson relented and admitted that perhaps something could be gained by going to Congress. The unassuming professor had found his voice. But that was 2008. The additional tools from Congress came. They weren’t enough. And now, three years later, the economy is little improved and the Fed is facing increasing hostility from the public. This leaves the Fed in a precarious position: more stimulus is needed, but any additional easing will likely be met with criticism. Yet, curiously, the Fed has been relatively silent. Bernanke and Fed officials have described their policies on the fed funds rate, indicating that conditions will likely war-

rant low rates until 2013. But they have kept quiet on how conditions would need to change for the Fed to change its policy course. This is concerning. Though it may not agree with Bernanke’s self-effacing nature, the Fed needs to continue to raise its voice and better explain to the public how its policies will change and evolve as the economy improves or deteriorates. Bernanke need not relish the spotlight as his predecessor, Alan Greenspan, did, but clearer, transparent guidance on future policy would help the economy avoid the tumult it experienced in the recent past. To be fair, the notion that the Fed ought to be transparent and clearly articulate its policies is somewhat counterintuitive. After all, Greenspan was notorious for keep-

ing the public guessing—investors spent weeks poring over his statements for a hint of where “the maestro” would take the economy next. But, with the fed funds rate nearing zero percent, the Fed has largely exhausted its traditional toolset. By expanding its communications and, thus, shaping the public’s expectations of what the Fed’s policies will be in the future, the Fed can have material effects on the state of the economy today. For instance, in the early 2000s, in an effort to fight deflation, the Bank of Japan (BOJ) used quantitative easing to provide stimulus to the market. This involved purchasing government securities by issuing reserves, flooding the market with additional yen. By expanding the supply of money, the BOJ’s securities purchases should have

Yale Economic Review Summer/Fall 2011

Feature raised the expected rate of inflation. Real interest rates should have declined as a result (so long as it did not create worries over the value of the yen), stimulating the economy. But this didn’t happen or, at least, not to the extent the BOJ hoped. Rates may have declined to an extent, but, by most accounts, the effect was small and deflation continued. Arguably, the BOJ’s failure to inflate the yen was a result of its inability to affect public expectations. If investors believed that the BOJ would undo the stimulus by withdrawing the reserves used to pay for the purchase of government securities, there is little reason to believe that the policy would work. Indeed, investors may have had good cause to worry; in 2006, the BOJ quickly removed the money from the system once the economy showed signs of recovery. As a result, the policies themselves are not all that matters: a central bank must be concerned with how the public perceives policies now and in the future. Economists, including Chairman Bernanke, have provided further support for this viewpoint. In 2003, Michael Woodford, an economist at Columbia University and a former colleague of Bernanke’s at Princeton, and Gauti Eggertson, then an economist at the International Monetary Fund, argued that shaping expectations is essentially the only tool at the disposal of a central bank when short-term interest rates hover near zero percent, as they do today. The best and surest way for the Fed to do this is to manage its policy according to an explicit tar-

get. According to its mandate, the Fed is to maintain full employment and price stability; targeting either inflation or a specific level of nominal of GDP would be consistent with this directive. By expressing its policy target publicly, the central bank can paint a much more vivid and credible picture of what its policy will look like in the future. Bernanke himself has long been in favor of explicitly targeting inflation or the price level, and, though it certainly has some opposition, a wide swath of economists, including Woodford, favor it. Yet, inflation targeting faces long-standing, staunch opposition from politicians such as Barney Frank, who fear that targeting inflation would push the Fed to ignore the second part of its mandate, maximizing employment. As a result, a formal target of any sort is unlikely to be adopted anytime soon. However, the Fed could take other steps to better communicate its policies. To begin with, it could work to make sure that it sends a consistent, coherent message to the public. Bernanke, ever the professor, has tolerated an impressive amount of dissent from other Fed officials, much more so than did Greenspan. For instance, in August of 2010, Thomas Hoenig, the President of the Federal Reserve Bank of Kansas City at the time, called the Fed’s decision to keep short-term interest rates near zero percent “a dangerous gamble” that was setting the country up to repeat “the cycle of severe recession and unemployment in a few short years.” Allowing this dissent is, in many ways, admirable. It is vital to have different viewpoints when mak-

ing policy, and economists such as Hoenig certainly provide a valuable counterbalance to other members of the Fed who focus less on inflation. But public disagreement between Fed officials also inevitably encourages questions about the credibility of Fed decisions. Bernanke needn’t quash every utterance that differs from official Fed policy—in fact, he shouldn’t—but it is worthwhile to make sure that the Fed’s official viewpoint is heard clearly, leaving no doubts as to the central bank’s commitment to its policies. Additionally, there is perhaps even room for clarification in the Fed’s formal public statements. In September, the Federal Open Market Committee (FOMC)—the group of Fed officials who determine the Fed’s interest rate policy—informed the public in their quarterly statement that current conditions are “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” This is clearly an attempt to shape the public expectations. But the difficulty with such a description is that conditions could improve. If they do, no one would expect the Fed to continue to keep rates low. Admittedly, given the current state of European economies, this would seem unlikely—the economy appears more likely to deteriorate further than improve by 2013. However, the Fed could explicitly state the conditions under which it would raise short-term interest rates. If the FOMC explained that it would only begin to tighten policy once inflation reached a particular above-normal level, investors would likely raise their inflation

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expectations. Real interest rates would decline and the economy would benefit. But even this may not be so easy. Bernanke has learned to raise

known. Though the Fed operates independently of Congress, that doesn’t mean politicians aren’t free to criticize. But, in doing so, they diminish the Fed’s ability to cred-

Bernanke needn’t quash every utterance that differs from official Fed policy—in fact, he shouldn’t—but it is worthwhile to make sure that the Fed’s official viewpoint is heard clearly, leaving no doubts as to the central bank’s commitment to its policies. his voice and make his views known when it counts. Henry Paulson can certainly attest to this. But the level of criticism the Fed is currently facing from all sides will make it extremely difficult for him to rise above the rancor and credibly commit to a course for future policy. For instance, in August, Governor Rick Perry of Texas suggested that, if the Fed opted to print more money to provide additional stimulus, it would amount to treason and result in Bernanke being “treated pretty ugly” if he ever ventured to Texas. Though this is certainly the most jarring example, it is certainly not the only one. Ahead of the September meeting of the Federal Open Market Committee (FOMC), top Republican lawmakers, including Senator McConnell and Representative Boehner, penned an open letter to Chairman Bernanke, urging him and other members of the FOMC to refrain from providing additional monetary stimulus. Perry, Boehner, and McConnell have every right to make their views

gest that Operation Twist will lower long-term interest rates by 10 to 20 hundredths of a percentage point. This is better than nothing, but it won’t make much difference for the economy. To be fair, the Fed is certainly aware that Operation Twist will likely have little effect. As conditions have worsened, Fed officials have hinted that they may resort to more radical policies, such as purchasing additional mortgage backed securities. But the members of the Fed also know that their uncommunicativeness needs to change. In an October 18 speech, Bernanke suggested that, going forward, the Fed will likely provide more guidance on the future path of interest rates than it has in the past. We can only hope that the Fed follows through with this promise to enlighten the public. With interest rates barely above the zero bound, clearer communication is crucially important. Indeed, it is one of the last tools the Fed has left. As a result, the Fed needs to do all it can to make its views known, no matter how vigorously politicians attempt to silence it or how loud the clamor of market volatility becomes. Chairman Bernanke may be a professor, prone to letting others voices be heard over his own. But professors are, of course, in the profession of education—the Fed would do well to teach the public how it thinks about the economy and its policies.

ibly commit to a policy path. With Perry threatening to rough up Bernanke if he prints any more money, it won’t be easy to convince the public that the stimulus provided by quantitative easing will not be hastily removed. The Fed’s attempts to navigate these competing demands has been to implement a half-measure: resurrecting Operation Twist, a policy first enacted under the Kennedy Administration that involved selling short-term Treasuries and purchasing an equal amount of longterm Treasuries, thereby putting upward pressure on short-term rates and lowering long-term rates. The policy does not require the Fed to add to the supply of reserves and, as a result, is more palatable to inflation hawks than earlier initiatives, such as QE2. But it is also likely to be less effective. Writing in 2004 on its original implementation in the 1960s, Bernanke himself wrote that Operation Twist Derek Walker is a junior in Jonathan Edwards College. Contact him at is “widely viewed today as having derek.walker@yale.edu. been a failure.” Most estimates sug-

Yale Economic Review Summer/Fall 2011

Feature THE FAILURE OF THE BANK OF JAPAN AND WHAT WE CAN LEARN FROM IT BY TIM JEON

History often repeats itself. Following the downturn of the late 1980’s, Japan has made several attempts to restore its economy back to its boom year levels. Japan, having already gone through the selfsame attempts to revitalize its deteriorating economy, offers American critical lessons on what to do in a liquidity trap. One of the first policy tools that Japan resorted to was quantitative easing, using traditional monetary policy tools to manipulate short-term interest rates. According to classical macroeconomic theory, decreased interest rates motivate firms and companies to borrow and invest. In Japan’s case, however, just as in America, decreased interest rates have not stimulated new investments and loans, because of the lack of investor confidence in Japan’s market situation. Why has quantitative easing failed to stimulate the economy? Rather than taking advantage of the lower interest rate and plunging into the new investment opportunities, investors held onto their cash, believing that cash is a safer asset than stocks or bonds. Because peo-

ple decreased consumption and investment, the real economic growth slowed even more, just to add to the already atrophied confidence in the market. This in turn led to the deflation of the Japanese currency, which gave the Japanese an even bigger incentive to hold onto the cash reserves at their homes. Interest rates, the cornerstone of modern monetary policy, fell short of boosting investment and clearing the cloudy uncertainties of the worldwide economy. In other words, expansionary monetary policy is like “pushing on a string”: contractionary monetary policy is effective, but not vice versa, when the central bank wants to expand and accelerate economic growth. Because firms start investing in the future when the orders come in and balance sheets look much more optimistic, real economic improvements serve as the prerequisite in full recovery of credit market and investment. If there is no significant, visible improvement in the real economy, interest rates do not serve as a strong enough incentive for the firms to invest, especially dur-

ing this global recession when firms have become very much risk-averse. This was exactly why even though the Bank of Japan eventually brought interest rates all the way down to zero, economic growth never recovered. The Bank of Japan purchased government bonds and flooded the credit market with excess liquidity so that banks would not run out of cash, but nothing much has occurred to date. Japan has, therefore, declared that quantitative easing is not effective and has, by and large, discontinued the use of monetary policy. Notwithstanding all the fiscal and monetary tools utilized, Japan is still suffering from the same suffocating stagnancy: the unending cycle of economic recession. Are government policies still effective in controlling the economy? Will America be able to walk on a different – and hopefully more invigorating – path than the one Japan is painfully trudging on?

Yale Economic Review Summer/Fall 2011

POWER IN POPULATION Human Capital’s Impact on China’s Economy BY DEVI MEHROTA

Yale Economic Review Summer/Fall 2011

HINA—the home of The Great Wall, The Temple of the Sun, and The Forbidden City. Backed by all its years of history, culture, and tradition, China is now one of the fastest growing economies in the world and is widely regarded as an emerging international leader. China’s economy is ever-growing and is thus

ever-growing in its importance. For example, without its success, it may not have been able to support the US debt and the $1.5 trillion budget deficit would have already forced the US into default. So, how is it that China’s economy is so strong? As they say, there is safety in numbers—power in population. Literature suggests that one of the main contributing factors to China’s economic growth has been their human capital. Human capi-

tal not only refers to the number of people in the labor force, but also all investments which have developed their ability to produce goods and are counted as part of a nation’s wealth. Thus, education, work experience, training, and consequently, factors such as gender and location (rural vs. urban) play a role in the value of the total human capital stock of any nation. Until 2009, there was never before an attempt to systematically valuate the total

Yale Economic Review Summer/Fall 2011

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human capital stock of China. Haizheng Li (Georgia Institute of Technology), Barbra M. Fraumeni (University of Southern Maine), Zhiqiang Liu (SUNY at Buffalo), and Xiaojun Wang (University of Hawaii at Manoa) in their paper “Human Capital in China” set out to quantify China’s human capital stock systematically, isolating the effects of rural-urban localities, education, and gender. Generally speaking, a value for human capital stock aids in understanding the dynamics of demographic changes and quantifying the impact of government policies. In the case of China, it is particularly interesting to see how labor growth may be correlated to GDP growth in recent years. In order to estimate the human capital stock in total, the authors used the lifetime income approach which computes the income generated from both market and non-market activities. First, the authors estimated the total population by the age, sex, and education data available and modified them according to assumptions about birth rate, mortality rates, etc. Then, they estimated the future potential earnings for all the individuals and used data from the Urban Household Survey to derive an equation for the earnings of males and females annually. These earnings were discounted to present value by making assumptions about the discount rate, the growth rate of real earnings, and the age and gender-probability of surviving. The Jorgensen-Fraumeni lifetime income based approach was then used to calculate numerical values for human capital. The results showed that Chi-

na’s human capital is about 10-20 times as much as its physical capital, but more importantly, that in the period in which China’s human capital stock grew at a rate of 6.74%, China’s GDP grew at a rate of 9.33%. Additionally, from 1985 to 2007, per capita (not including retired persons) human capital increased by 2.80-fold as per capita real GDP increased by 6.68-fold. Note that China’s increase in human capital is not a nonunique occurrence amongst other countries: during the same time period, per capita human capital stayed approximately constant in the US and Canada. . The increase in human capital can therefore be correlated with the dramatic economic

growth that China faced, which facilitated increased education as well as rural-urban migrations (total human capital in urban areas increased by 8.95% annually from 1985-2007 while the analogous growth rate was only 4.19% in rural areas). These statistics suggest that in the future, the Chinese government can fuel high rates of GDP growth by investing more in human capital, especially in rural areas. After valuating the total human capital stock in China from 1985 to 2007, the authors went on to make projections about the values of total human capital stock in China until 2020. Using the same parameter values in their model

Yale Economic Review Summer/Fall 2011

Feature as they did for the year 2007, the authors predict that the annual growth rate of human capital will slow down significantly to 0.61%. Reasons for this include that in the fitting model, the return on education is assumed to be the same as it is in 2007 (from which it will likely be higher), but may also include China’s stagnant population growth and the possibility that the Chinese economy may be approaching a steady-state in which its growth slows. Thus, the Chinese government may consider further investment opportunities in human capital in order to continue the boom in GDP. Let’s take a closer look at the composition of the human capital stock in China and its contribution towards GDP, as do Wei and Zhang in their February 2011 Working Paper. Partially in response to the family planning measures which China has instated, sex ratios (male:female) have been increasing in recent years. For example, in 1980, the sex ratio was 1.07 and in 2007 it was reported to be 1.22. Mathematically, then, 1 out of 9 men won’t be able to marry a female, and thus it is assumed that a man’s wealth (and family wealth) acts as a sorting factor among the eligible bachelors. Thus, the increase in sex ratio has three effects on Chinese GDP: it would increase the likelihood that young men become entrepreneurs and open private firms; increase the likelihood that parents with a son become entrepreneurs (in regions where there is a skewed sex ratio); and increase the likelihood that members of a household with a son are more willing to accept

riskier or more unwanted jobs. Empirically, it was found that an increase in the sex ratio by one

imbalance of the sex ratio. From this, we conclude that the increasing human capital in China,

The Chinese government may consider further investment opportunities in human capital in order to continue the boom in GDP. standard deviation can account for about half of the growth rate of new firms across regions. This is particularly important because from 1995-2004, China’s industrial value added increased by 266%, 71.9% percent of which was due to the growth of the private sector. Of the private sector growth, 68.5% was due to the appearance of new firms. Cumulatively, the increase in the sex ratio from 1995 to 2004 in China may have caused 47% of the increase in the number of private firms that China witnessed during that period. These values explain the effect of the skewed sex ratios on the probability for young men and their parents (in areas where skewed ratios exist) to become entrepreneurs and open private firms. The effects of the skewed sex ratio on Chinese GDP are compounded by the fact that an increase in the sex ratio by 4.3 basis points increases the probability for members of a family with a son to accept dangerous or unwanted jobs by 4.1 percentage points. Finally, the authors estimate that 20% of the growth in GDP per capita in recent years is due to the

particularly the cohort of men in the pre-marital age group and their families has profound effects on its GDP,But how valuable is this recent boom in China’s GDP? To answer this question, we can look to an investigation by Hseih and Ossa in their February 2011 Working Paper. Intuitively, a country’s welfare is correlated with its real labor income. From 1992 to 2007, China experienced an over nine-fold increase in welfare. More interestingly, though, is the effect of China’s productivity growth on international welfare. In the model, if China has an export-oriented industry then other countries benefit from China’s productivity growth. In 1992, manufacturing imports from China accounted for 2.4% of total manufacturing imports (on average); but in 2007 this number rose to 11.9%. Thus, the importance of China’s productivity on world markets is continually increasing. Another quantitative measure depicts the effect of Chinese productivity growth on the average world welfare growth, which increased from 0.61% to 2.03% from 1992

Yale Economic Review Summer/Fall 2011

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to 2007. The effects of Chinese productivity on the two countries alone are significant: it has caused

also increase. This change would decrease the observed relative increase in Chinese wages relative to

China’s contribution to world GDP has been higher than that of any other nation since 2002 a 0.33% increase in US welfare and a 0.87% increase in Japanese welfare, showing the importance of the growing Chinese economy on the international markets. It is important to note that in Hseih and Ossa’s study, the labor supply in China was assumed to be fixed. However, it may be argued that if productivity growth in China was increasing, the labor supply would

the rest of the world and therefore cause further increase in gains to the rest of the world. The International Monetary Fund reported in 2009 that China’s contribution to world GDP has been higher than that of any other nation since 2002. China’s emergence as an international power has been mainly through its expanding economy, and we now

understand just a few of the factors that have led to this expansion. China’s government can continue to foster high GDP growth by stimulating investment in human capital and monitoring its social planning policies. At some point in the future, China’s economy will likely reach steady-state, but it can definitely seize on the opportunities today to continue to influence the world economy over the next few decades.

Devi Mehrotra is a sophomore in Saybrook College. Contact her at devi.mehrotra@yale.edu.

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