Year: 2014

When other nations send foreign aid with the intention of helping those enmeshed in a civil war, does the aid make the conflict worse? The question has been asked by some with high credibility in these matters, like the 1999 Nobel Peace Prize winner Médecins Sans Frontières. In reflecting on their attempts to help those in the conflicts in Chad and Darfur, the organization wrote:

We are unable to determine whether our aid helps or hinders one or more parties to the conflict … it is clear that the losses—particularly looted assets—constitutes a serious barrier to the efficient and effective provision of assistance, and can contribute to the war economy. This raises a serious challenge for the humanitarian community: can humanitarians be accused of fueling or prolonging the conflict in these two countries.

Nathan Nunn and Nancy Qian offer this quotation as a starting point for their investigation of the relationship between \”US Food Aid and Civil Conflict,\” which appears in the June 2014 issue of the American Economic Review (104:6, pp. 1630–1666). (The AER isn\’t freely available on-line, but many readers will have access through library or personal subscriptions.) They find that \”an increase in US food aid increases the incidence and duration of civil conflicts.\”

There is considerable anecdotal evidence that foreign aid may prolong civil conflict. Here\’s Nunn and Qian (citations and footnotes omitted):

Humanitarian aid is one of the key policy tools used by the international community to help alleviate hunger and suffering in the developing world. The main component of humanitarian aid is food aid. In recent years, the efficacy of humanitarian aid, and food aid in particular, has received increasing criticism, especially in the context of conflict-prone regions. Aid workers, human rights observers, and journalists have accused humanitarian aid of being not only ineffective, but of actually promoting conflict. These qualitative accounts point to aid stealing as one of the key ways in which humanitarian aid fuels conflict. They highlight the ease with which armed factions and opposition groups appropriate humanitarian aid, which is often physically transported over long distances through territories only weakly controlled by the recipient government. Reports indicate that up to 80 percent of aid can be stolen en route. Even if aid reaches its intended recipients, it can still be confiscated by armed groups, against whom the recipients are typically powerless. In addition, it is difficult to exclude members of local militia groups from being direct recipients if they are also malnourished and qualify to receive aid. In all these cases, aid ultimately perpetuates conflict. A large body of qualitative evidence shows that such cases are not rare, but occur in numerous contexts.

Of course, a bunch of anecdotes don\’t prove the general case that aid increases civil conflict. As social scientists like to say, \”data\” is not the plural of \”anecdote.\” But figuring out a persuasive statistical approach for investigating whether food aid causes additional conflict is tricky. After all, if civil conflict and dysfunctional political and economic institutions lead to a situation where it looks like more aid is needed, then there might be a positive correlation between conflict and aid–but the conflict is causing the need for aid, rather than the aid causing additional conflict.

In a perfect world for social science, there could be experiments with foreign aid, where aid would be randomly given for some civil conflicts but not for other equivalent civil conflicts, and over a period of a few decades researchers could then study the results. In the real world, the challenge is to find some way of looking at the existing evidence that can approximate this thought experiment of the effects of random variation. Nunn and Qian offer an approach that is a nice illustration of a method called \”two-stage least squares,\” and which I\’ll try to explain here in words.

The authors focus on two reasons why food aid for countries can vary that are not related to whether the country is currently experiencing a civil conflict. One is the size of U.S. agricultural harvests; bigger US harvests are correlated with  more food aid. The other is how likely a specific country is to receive food aid in any given year over the 36-year period of the data, from 1971-2006. These trick is first to estimate how much of the year-to-year variation in humanitarian food aid for any given country is determined by these two factors. This calculation will determine what share of the rise and fall in food aid is determined by U.S. weather, which can be viewed as an event that is increasing or decreasing food aid randomly whether there is a civil conflict or not. (This is the \”first stage\” of a two-stage least squares approach.)

Next, calculate whether these random rises and falls in food aid are correlated with civil conflict in the recipient countries. (This is the \”second stage\” of two-stage least squares.) Nunn and Qian summarize the results:

[T]he 2SLS [two-stage least squares] estimates identify a large, positive, and statistically significant effect of US food aid on the incidence of civil conflict, but show no effect on the incidence of interstate conflict. The estimates imply that increasing US food aid by 1,000 metric tons (MT) (valued at $275,000 in 2008) increases the incidence of civil conflict by 0.25 percentage points. For a country that receives the sample mean quantity of US food aid of approximately 27,610 MT ($7.6 million in 2008) and experiences the mean incidence of conflict (17.6 percentage points), our estimates imply that increasing food aid by 10 percent increases the incidence of conflict by approximately 0.70 percentage points. This increase equals approximately 4 percent of the mean incidence of conflict. 

In more detailed statistical work looking at large-scale and small-scale civil conflicts, as well as whether conflicts are starting or the length of conflicts, they find \”these findings suggest that the primary effect of food aid is to prolong the duration of smaller-scale civil conflicts.\”

Perhaps the bottom line goes without saying, but I\’ll say it anyway: These results certainly don\’t prove by themselves that food aid is overall counterproductive, or overall a bad policy idea. They do suggest that food aid, regardless of its humanitarian intentions, has a mixture of effects, and that sensible public policy will seek ways to tilt the balance toward the good and away from the bad.

The Food and Agriculture Organization at the United Nations suggess estimates that 870 million people are undernourished–roughly one in eight people in the world. Moreover, the world population has risen past 7 billion and is headed for about 9 billion by mid-century. Thus, it may seem contrary-minded, even for an economist, to suggest that the world may already be growing a sufficient quantity of food. But that\’s a finding of that same Food and Agriculture Organization,which together with the United Nations Environment Programme is focusing on the issue of food waste. For example, here\’s UNEP, referring to a 2013 report from the FAO:

Research shows that at least one-third, or 1.3 billion tonnes, of food produced each year is lost or wasted – an amount corresponding to over 1.4 billion hectares of cropland. Even a quarter of this lost food could feed all the world\’s hungry people. According to the FAO, almost half of all fruit and vegetables is wasted each year. About 10 per cent of developed countries\’ greenhouse gas emissions come from growing food that is never eaten, and food loss and waste amounts to roughly USD 680 billion in industrialized countries and USD 310 billion in developing countries.

This notion of food that is \”wasted\” can be an elusive one. After all, most food products can spoil, and they can do so in the field, in storage, in a processing or production facility, in a wholesale or retail establishment, or in a home. Calling something \”waste\” can involve judgments about what counts as food: for example, one of the the websites linked to this effort offers suggestions like the joys of eating fish heads. Measuring what is \”wasted\” is a tricky empirical problem. Indeed, the whole idea of \”waste\” is tricky for economists. If the food that is \”wasted\” has economic value–and could be sold to someone–then there would be strong incentives not to waste it. Thus, an economist is tempted to infer that \”waste\” really means \”not worth the costs of saving it.\”

The problem for the world food supply isn\’t a physical inability to grow enough food. Those around the world who are severely malnourished often live in a geographic areas where the supply of food is broadly adequate for the population as a whole: they just have very low incomes and find it hard to buy enough food. Thus, a substantial part of feeding the world isn\’t about raising the physical supply of food, but instead raising the buying power of those who need the food most.

In addition, while the world has the physical capacity to feed its population a healthy diet, the task becomes harder if the obesity rate keeps rising. Depending on just how you measure obesity and undernourishment, it is likely that the two problems are now about the same size from a global perspective–but undernourishment is shrinking and obesity is rising. Here\’s an illustration from a 2013 World Bank report, showing the trends in the share of world population that is obese or undernourished.

Various studies suggest that well-focused technological progress and productivity growth can create enough of a rise in food supply to cover population growth in the decades to come (for discussion, see here and here). The efficiency gains from reduced food waste at all the stages of the food production process would surely help in this task as well. But even with sufficient food being produced, the question of sufficient diets for some and appropriate diets for others will remain.

One of the biggest economic adaptations for high-income economies in a globalizing world is the recognition that the lion\’s share of economic growth in the next few decades will be happening outside their borders in \”emerging\” economies. The U.S. economy, with its enormous domestic market, has been somewhat insulated from world markets in the past, and European companies have often focused more on building ties across the internal market of the EU. Such a strategy made sense back around 1980, or perhaps even 1990. It won\’t make sense in the next few decades. A team at the McKinsey Global Institute–James Manyika, Jacques Bughin, Susan Lund, Olivia Nottebohm, David Poulter, Sebastian Jauch, and Sree Ramaswamy–sketches how the world economy is evolving in an April 2014 report, \”Global flows in a digital  age: How trade, finance, people, and data connect the world economy.\” They write (footnotes omitted): 

\”Yet the fact remains that even the world’s largest multinational companies remain underweight in emerging markets. In 2010, McKinsey research found that 100 of the world’s largest companies headquartered in developed economies derived just 17 percent of their total revenue from emerging markets—despite the fact that those markets accounted for 36 percent of global GDP and are likely to contribute more than 70 percent of global GDP growth between now and 2025. Business leaders need to not only invest more in emerging markets but also understand how the role of these countries in the world economy is undergoing a historic transformation. In the first wave of globalization, developing countries first supplied commodities and raw materials for production and then economies recently became an abundant source of cheap labor for global supply chains. In the current wave of globalization, the emerging world is increasingly becoming a source of new customers. But a third wave is coming, enabled by digital technologies. In the new era, emerging economies will increasingly be the source of new talent pools, innovations, competition, and partnerships. Companies need to look globally for the right talent, suppliers, and innovation—and much of those could be in emerging markets.\”

Large companies based in emerging economies are already changing the shape of global competition.

[L]arge companies from emerging markets are increasingly formidable global players. For instance, Bharti Airtel, the largest telecommunications company in India, has more than 260 million mobile customers around the world, more than the combined population of Germany, Japan, and Spain. Lenovo is the largest PC seller in the world. Mumbai’s Tata Sons is now the largest private-sector employer in the United Kingdom with more than 40,000 workers across Tata Steel, Jaguar Land Rover, Tata Consultancy Services, and TGB, a drinks branch that acquired British tea company Tetley. Two Mexican companies—Cemex and Bimbo—are the US market leaders for cement and bread, respectively.

For a deeper sense of these changes, contemplate how quickly economic growth is moving in some of the converging economies. This figure shows the amount of time that it took various economies to double their per capita GDP from about $1300 to $2600. In the UK, this process took 150 years from about 1700 to the mid-1800s. In the U.S. and Germany, it happened in a little more than half-century in the middle of the 1800s. It took Japan 33 years in the early 1900s. Not only has that process been much faster in China and India, but look at the size of the populations involved. When the US started its process of doubling per capita GDP between these two levels in about 1820, the U.S. population was about 10 million. When China and India started the same step, their populations were close to 1 billion people each. Buying power is shifting to the emerging markets of the world.

The greater involvement of emerging markets in most aspects of the international flow of goods, services, finance is already underway. Here are the changes in the share of emerging markets in the last decade or so. For example, emerging markets were 22% of global GDP in 2002, and 39% of GDP in 2012, just a decade later.

Sometimes it\’s the more specific facts that help drive home some of the changes around us. For example, the McKinsey team reports that \”China is already a larger market for BMW than the
United States.\” Computer-to-computer Skype calls barely existed a decade ago; now, they are almost 40% of the volume of traditional international phone calls. \”Netflix, which provides movies and television shows online, has become an increasingly international business. By 2013, nearly one-quarter of its streaming customers lived outside the United States, a testament to the speed at which companies can establish a global footprint courtesy of digital technologies. Some 40 percent of
Amazon’s revenue in 2013 came from sales outside of North America.\”

The United States and other high-income countries are competing for what roles they will play in the globalizing economy, and thus how they can experience domestic economic benefits from the rapid growth of emerging economies around the world. But except for what sounds mostly like 20th-century talk about trade agreements and big-company export sales, the discussion of how to reorient high-income economies around these global realities seems to me barely underway.

The Council of Economic Advisers is organizationally part of the White House. My usual suggestion when reading its reports, under administrations of both parties, is that you can take or leave the politic elements of the report as you please, while still picking up a lot of useful facts and analysis from the figures and discussion. In that spirit, here are some points that struck me from the May 2014 CEA report, \”The All-Of-The-Above Energy Strategy as a Path to Sustainable Economic Growth.\”

As a starting point, here\’s an overview of U.S. energy consumption over the country\’s history. You can see the dominance of wood as a fuel source in the late 18th and into the 19th century, followed by the rise of coal in the late 19th century, and then the arrivals of petroleum, natural gas, and nuclear. A close look at the right-hand side of the figure shows some changes in the last decade or so. Petroleum and coal are down, while natural gas and renewables are up.

The CEA report discusses various economic consequences of cheaper natural gas: gains in direct jobs from production of natural gas, spin-off jobs, cheaper energy for U.S. firms than for their global competitors (which should give a boost to U.S. manufacturing), and an overall reduction in trade deficit. Given that crude oil prices are set in a global market and petroleum is still the single biggest energy source for the U.S. economy, the U.S. economy cannot be fully insulated from movements in world energy prices. But it can be less affected by global energy market fluctuations than in the past.

Here\’s one snapshot of how the U.S. economy evolved in the last 15 years: an identical number of total hours worked in 1998 and 2013, even though the population rose by over 40 million people, but a 42% gain in output. Shawn Sprague explains in \”What can labor productivity tell us about the U.S. economy?\” published as the Beyond the Numbers newsletter from the U.S. Bureau of Labor Statistics for May 2014. Sprague writes:

\”[W]workers in the U.S. business sector worked virtually the same number of hours in 2013 as they had in 1998—approximately 194 billion labor hours. What this means is that there was ultimately no growth at all in the number of hours worked over this 15-year period, despite the fact  that the U.S population gained over 40 million people during that  time, and despite the fact that there were thousands of new businesses established during that time. And given this lack of growth in labor hours, it is perhaps even more striking that American businesses still managed to produce 42 percent—or $3.5 trillion—more output in 2013 than they had in 1998, even after adjusting for inflation. . . .One thing can be said for certain: the entirety of this additional output growth must have come from productive sources other than the number of labor hours. For example, businesses may increase output growth by investing in faster equipment, hiring more high-skilled and experienced workers, and reducing material waste or equipment downtime. In these and other cases, output may be increased without increasing the number of labor hours used. Gains in output such as these are indicative of growth in  labor productivity over a period.\”

A lot can be said about this basic fact pattern. Of course, the comparison years are a bit unfair, because 1998 was near the top of the unsustainably rapid dot-com economic boom, with an unemployment rate around 4.5%, while 2013 is the sluggish aftermath of the Great Recession. The proportion of U.S. adults who either have jobs or are looking for jobs–the \”labor force participation rate\”–has been declining for a number of reasons: for example, the aging of the population so that more adults are entering retirement, a larger share of young adults pursuing additional education and not working while they do so,  a rise in the share of workers receiving disability payments, and the dearth of decent-paying jobs for low-skilled labor.

Here\’s a figure showing the patterns of hours worked, output, and productivity in the aftermath of the Great Recession. Sprague explains: \”[A]s the recession began, productivity flattened out as output and hours both fell approximately in concert with one another. Output and hours continued to fall together until the latter part of the recession, when the fall in output ceased but hours continued to decline. During this period there was substantial productivity growth: from the fourth quarter of 2008 through the fourth quarter of 2009, productivity grew 5.6 percent. In fact, this was the highest four-quarter rate of productivity growth recorded in more than 35 years.\”

Here\’s a figure showing productivity growth rates in the post-World War II era. Notice that annual rates of productivity growth were relatively rapid from about 1947-1973 at 3.2% per year. Then there is a dramatic slowdown of productivity growth in the 1970s, and while higher rates follow in the 1990s and more recently, the U.S. economy has failed to return to the more rapid productivity growth of the 1950s and 1960s. As I\’ve noted from time to time in previous posts (for example, here and here), there is no more important question for the long-run health of the U.S. economy than whether a fairly robust rate of productivity growth can be sustained.

The more immediate question is what to make of an economy that is growing in size, but not in hours worked, and that is self-evidently having a hard time generating jobs and bringing down the unemployment rates as quickly as desired. I\’m still struggling with my own thoughts on this phenomenon. But I keep coming back to the tautology that there will be more good jobs when more potential employers see it as in their best economic interest to start firms, expand firms, and hire employees here in the United States.

I  have written an essay for the June 2014 issue of Finance and Development on the subject of \”Economics and Morality\” (51: 2, pp. 34-38). Here are the opening paragraphs, the closing paragraphs, and a couple of snippets in between. Of course, I encourage you to read the whole thing.

\”Economists prefer to sidestep moral issues. They like to say they study trade-offs and incentives and interactions, leaving value judgments to the political process and society. But moral judgments aren’t willing to sidestep economics. Critiques of the relationship between economics and moral virtue can be grouped under three main headings: To what extent does ordinary economic life hold a capacity for virtue? Is economic analysis overstepping its bounds into zones of behavior that should be preserved from economics? Does the study of economics itself discourage moral behavior? …\”

\”Rather than focusing on philosophical abstractions about the moral content of work, consider a prototypical family: parents working, raising some children, friendly with coworkers and neighbors, interacting with extended family, involved with personal interests and their community. It seems haughty and elitist, or perhaps betraying unworldly detachment, to assert that people who work are condemned to live without virtue—unless they can squeeze in a bit of virtuous activity in their spare time. On the other hand, it seems bizarrely and unrealistically high minded to assert that daily work surrounds people every day with transformational opportunities for virtue. A middle ground might be to accept that while moments of grace and opportunities for virtue can occur in all aspects of life, including economic life, the range and variety of opportunities for virtue may vary depending on the characteristics of one’s economic life. …\”

\”A standard complaint about studying economics is that the subject is “all about getting money and being rich.” … Economists can feel unfairly singled out by this complaint. After all, many academic subjects study unsavory aspects of human behavior. Political science, history, psychology, sociology, and literature are often concerned with aggression, obsessiveness, selfishness, and cruelty, not to mention lust, sloth, greed, envy, pride, wrath, and gluttony. But no one seems to fear that students in these other disciplines are on the fast track to becoming sociopaths. Why is economics supposed to be so uniquely corrupting? After all, professional economists run the ideological gamut from far left to far right, which suggests that training in economics is not an ideological straitjacket.\”

\”I have become wary over the years of questions framed in a way that seeks to pit economics against moral virtue in a winner-takes-all brawl. No economist would recommend consulting an economics textbook as a practical source of transcendent moral wisdom. As the recent global economic crisis reminded anyone who needed reminding, economics doesn’t have answers for all of the world’s economic problems. But to be fair, moral philosophers don’t have answers for all the world’s spiritual and ethical problems. In his famous 1890 Principles of Economics textbook, the
great economist Alfred Marshall wrote that “economics is the study of people in the everyday business of life.” Economists cannot banish the importance of moral issues in their field of study and should not seek to do so. But when moral philosophers consider topics that touch on the ordinary business of life, they cannot wish away or banish the importance of economics either.\” 

It\’s common to talk about economic development \”in Africa,\” and I\’ve done so on this blog a few times (for some examples, here, here, here and here). But \”Africa\” includes 54 countries and 1.1 billion people, so does referring to it as a single unit make any economic sense? In my reading, one of the themes of the African Economic Outlook 2014, recently published by the African Development Bank Group, OECD, and the UN Development Programme, is that thinking about Africa as a whole does make some economic sense.

The reason is that in the modern global economy, there are no examples of small stand-alone economies that have achieved a high standard of living. Instead, the high-income countries either have an enormous internal market (the US and Japan, for example) or have close economic ties to a number of other national economies (like the countries of the European Union), or both. If the national economies of Africa are going to build on their real if modest economic progress of the last decade or so, one of the big reasons will probably be that they bolster trade relationships within the countries of Africa, as well as tap into international flows of goods, services, people, and finance. To some extent, this change is already underway.

As far as trade within Africa, one subsection of the report is headlined: \”Africa is the world’s fastest growing but least globally integrated continent. … There is only low level connectivity between African economies – although this is gradually improving . . .. This is largely due to an incomplete
legal architecture for regional integration, poor physical infrastructure and one-way trading relationships. Leading African exporters such as Angola, Algeria, Egypt, Libya, Morocco, Nigeria and South Africa have stronger economic links to the rest of the world than with regional neighbours.\” As one example of the issues, the 54 nations of Africa are divided into eight somewhat overlapping regional economic groups, all proceeding with various steps of economic integration at different speeds.

Here\’s a figure comparing intra-Africa trade with other trading partners. A common pattern–say, if one looks at the EU or at North America–is that trade volumes are larger with those who are geographically close. But intra-African trade (the black dashed line) is similar trade between African nations and the US, and lags behind Africa\’s trade with China or especially the EU.

Basic steps to encourage intra-African trade are still lacking. It\’s costly for people to move between countries: \”Africans need visas to get into at least two thirds of other African countries.\” It\’s hard for goods and services to move, because of missing infrastructure: \”While there has been progress in developing regional transport corridors, there are still missing links – which are investment opportunities for African and foreign investors. From the Ethiopia-Djibouti corridor, to Lagos-Abidjan, major road corridor upgrades are needed to link key cities to ports and airports. …  Increasing attention is being given to obstacles such as regulatory bottlenecks, the opaque legal environment and institutional inefficiencies holding up new infrastructure.\”

The economies of Africa are becoming more closely tied to the buying power in the rest of the world economy in various ways. One of the most visible signs is the type and size of financial flows to Africa. The graph shows four kinds of financial flows: remittances sent back to Africa from emigrants working abroad; official development assistance; portfolio investment, which consists of cross-national financial investments that don\’t involve a management interest and thus can be liquidated very quickly; and foreign direct investment, which consists of cross-national financial investments that do have a management interest.

Notice that remittances are now the single biggest category of financial flows into Africa–bigger than foreign aid. Notice also that foreign direct investment, which often involves transfers of management expertise, business connections, and technology as well as financial capital–outstrips portfolio investment.

A common question is whether the foreign direct investment into Africa is all about outsiders developing oil and minerals. That\’s clearly a big part of the picture, but not all of it. Here\’s a breakdown of foreign direct investment into African countries that are resource-rich, and those that are not. The absolute amounts of FDI into the resource-rich countries is larger, but the flow to the non-resource-rich is catching up–and is already larger as a share of GDP.

The overall effect of these foreign capital inflows is that Africa is able to finance more investment than if it had to depend solely on national saving. Here\’s a figure showing that Africa\’s investment/GDP ratio and its rate of economic growth have outstripped Latin America in recent years, although not reaching the levels of high-growth Asian economies.

One of the intriguing possibilities for Africa\’s economic future is for its economies to become more integrated into \”global value chains,\” in which intermediate inputs to production are produced in a number of different countries. The report devotes a special section and several chapters to this possibility.

\”In the past, for a country to industrialise it had to develop the domestic capacity to perform all major steps in the value chains of complex  manufactured products. Today, through linking into an international production network, countries can establish a specific section of a product’s value chain without having all the upstream capabilities in place. These remain elsewhere and are linked through shipments of intermediate products and communication of the know-how necessary for the specific step in the value chain present in the country. . . . Through participation in a value chain, countries and firms can acquire new capabilities that make it possible to upgrade, i.e. to capture a higher share of the value added in a global value chain. The development experiences of several Asian countries show how industrialisation depends on linkages and on innovations arising from knowledge spillovers. For instance, China integrated into global value chains by specialising in the activities of final product assembly and was capable of upgrading its participation by building a competitive supply base of intermediate goods (developing linkages) and by enhancing the quality of its exports. At the firm level, economic upgrading is defined as “moving up” the value chain into higher-value activities, which theoretically enables firms to capture a higher share of value in the global value chain and enhances competitiveness . . .

Many of the factors that hinder economic integration across Africa, or affect economic growth in Africa more broadly, also affect the prospects for Africa\’s participation in global value chains. Still, there are a few initial promising signs. Some African countries are making a push to be involved in the business outsourcing market: \”The global business processing outsourcing market was forecast to grow 5.1% in 2013 and reach USD 304 billion. The race is on among countries such as Egypt, Kenya, Ghana, Mauritius, South Africa, Tunisia and Uganda to become the new “India” in Africa using incentives and special economic zones to develop their outsourcing sectors.\”

Perhaps the biggest problem is that global value chains as they currently exist are regionally concentrated: around east Asia, the European Union, and North America. Geographic areas like Africa or Latin America are thus trying to break into these existing networks:

\”Despite their name, global value chains exhibit high regional concentration, which is shrinking slowly. Africa does not play a significant role yet. When measuring the linkages between major supply-chain traders, the strongest relationships can be found within the regional blocks of East Asia, Europe and North America. About 85% of global value chain (GVC) trade in value added takes place in and around these three hubs. While other regions remain marginal, their share has increased from only 10% in 1995 to 15% in 2011. Africa’s share in GVC participation increased from 1.4% to 2.2% during the same time.\”

So-called \”shadow banks\” were at nexus of the financial market meltdown that brought on the Great Recession. But what\’s a \”shadow bank\” and why does it cause problems?  Daniel Sanches offers an overview in \”Shadow Banking and the Crisis of 2007-08,\” in the Business Review of the Federal Reserve Bank of Philadelphia (2014, Q2, pp. 7-14).

As a starting point, think about how a plain vanilla ordinary bank functions in the economy, acting as a financial intermediary between savers and borrowers. Here\’s a schematic taken from Chapter 29 of my Principles of Economics textbook (and of course, I encourage those teaching intro econ next year to check it out.) Savers deposit money in banks. Banks lend those funds to borrowers. Borrowers repay the loans with interest, and the original savers are paid some of that interest, along with having the ability to withdraw their money as desired.

But here\’s the potential problem. Once the money is loaned out, the borrowers are on a schedule to repay gradually over time. However, the original savers want the ability to withdraw their money any time they please. The assets of the bank (the loans it has made) are long-term, while the liabilities of the bank (the money it owes to savers) are potentially very short-term. In the textbook, I call this the \”asset-liability time mismatch.\” Before the enactment of deposit insurance, if the original savers heard that their bank had made a lot of loans that might not pay off, they have an incentive to \”run\” on the bank, quickly withdrawing their deposits and bringing the bank to its knees. When the government started requiring deposit insurance, it knew that savers no longer had an incentive to monitor whether their bank was behaving prudently, and so the government also installed a system of bank regulation.

Sanches says it this way:

\”This description of a typical banking crisis clearly reveals why banks are fragile: They fund illiquid assets with deposits that can be withdrawn at will. Economists usually refer to this practice as maturity transformation. It is important to mention that this role played by banks has a value for society. People have a preference for holding highly liquid assets — assets that are easy to sell without taking a loss — but the most profitable investments take a long time to pay off. Banks offer demand deposit contracts that give people ready access to their funds and a higher rate of return than they would get by holding liquid assets directly. Banks are able to offer a higher rate of return to depositors because they pool resources in such a way that permits them to invest a significant fraction of their assets in higher-yielding, long-term projects such as mortgages and other types of long-term loans. Normally, funding illiquid assets with short-term liabilities works fine. But
when depositors begin to worry about losses, a bank run may ensue.\”

The combination of deposit insurance and bank regulation worked to keep the U.S. financial system fairly stable for about 70 years from the late 1930s up to the start of the Great Recession. But during the last few decades, a new type of financial structure arose. Here\’s a schematic from Sanches showing how a shadow bank works:

As he writes, step 1 is for the bank to make loans. However, in this case the bank does not wish to continue holding or servicing the loans, and so it sets up an SPV, or special purpose vehicle, which purchases the loans from the bank. Next, the special purpose vehicle issues asset-backed securities (ABS), which are just financial securities where the return is determined by the loans that the SPV purchased from the bank. Outside investors can buy these asset-backed securities.

There is nothing necessarily wrong with any of this. By selling off the loans to a special purpose vehicle, the bank insulates itself from the risk that loans might go bad. As a result, the bank regulators are pleased. The loans that are sold to the SPV might be home mortgages, or car loans, or money owed to credit card companies, or they might be loans to businesses, like the short-term loans called \”commercial paper.\” Instead, the outside investors in the SPV bear that risk. Imagine, for example, that the outside investor is a large pension fund or insurance company, with long time horizons. The pension fund isn\’t set up like a bank to make business loans. But by purchasing a portfolio of such loans made through an SPV, the pension fund or insurance company can be well-positioned to bear the risk that some loans won\’t pay off, as long as on average it receives a solid return over time.

But several issues can arise in the new financial structure, as well. One risk is that that when banks know that they are not going to be holding the loans themselves, but rather selling the loans along to an SPV, they are likely to put less time and attention into evaluating the risk of the loans. The loans in an SPV may end up being riskier than expected, and if investors recognize that these risks are high, they will be less willing to invest in certain kinds of SPVs. In turn, if banks face a situation where it\’s hard for them to re-sell their loans to an SPV, and the banks have decided that they no longer wish to hold loans themselves, then the banks will cut back sharply on making loans in the first place.

Part of the credit crunch during the Great Recession was because investors became aware that at least some of the SPVs that included home mortgages were quite risky–but they didn\’t know which ones. As a result, they became unwilling to invest in any SPVs based on home mortgages for a time.

Another issue arises if those investing in the SPV are not an entity like a pension fund, with long-term time horizons and an ability to ride out the bumps in the market, but instead have very short-term time horizons. Imagine that you are running a corporation or a big financial organization like a pension fund, and you need to keep a certain amount of your money in cash, so that you can use it to pay bills and payroll. However, as Sanches points out: \”Until 2011, large commercial depositors could not receive interest on their short-term deposits, another motivation for them to seek an alternative place to park their funds.\” When interest rates were very low, pension funds were searching for options to hold cash that paid a higher interest rate, too.

As a place to invest their liquid assets and still earn some return, these institutions turned to what\’s called the \”repo\” market, where repo is short for \”repurchase.\” The market works this way. On one side you have parties who hold some financial assets, which could be Treasury bonds or mortgage-backed securities or car-loan-backed securities or something else. These institutions may often be investment banks or broker dealers. These institutions want to borrow some funds, and they offer the securities they hold as collateral. On the other side of the market, you have the big corporations and financial funds that are looking for a place to park their short-term cash and get some interest.

This is called the \”repo\” market because the financial transaction works this way: The investment bank or whoever owns the financial assets sell those assets to the corporation or financial fund, but part of the sale is an agreement to repurchase the asset at a slightly higher price the next day. The slightly higher price acts like an interest rate paid for borrowing. Now imagine that this transaction is repeated every day. The result is that the borrower has some amount that is continually being borrowed–that is, it is continually selling assets every day and buying them the next day. On the other side, the lender is receiving a steady stream of payments for their cash–that is, it is continually buying asset every day and reselling them, according to the repurchase contract, the following day. every day. It\’s a lot like a very strange bank, where every day all the depositors come and deposit their money, it is loaned out for one day, and at the end of the day all the depositors come and with draw their money–and this pattern is repeated every day. Sanches explains like this:

As should be clear by now, the “banker” in the repo transaction is the repo borrower, which typically is an investment bank or the broker-dealer arm of a large bank holding company. These institutions use the funds they borrow in the repo market to finance a wide range of activities, some of them quite risky. …  The growth of the repo market prior to the financial crisis of 2007-08 was extraordinary. The volume of repo transactions reported by primary dealers (those who trade directly with the Federal Reserve System) had grown from roughly $2 trillion in 1997 to $7 trillion in 2008. This estimate, of course, leaves out unreported transactions. … [T]he overall size of the repo market just before the financial crisis was roughly the same as the size of the
traditional banking sector as measured by total assets. …

The repo market may sound a little peculiar, but it works just fine–as long as the financial assets that are being bought and sold are extremely safe and secure, like U.S. Treasury borrowing. But in the years leading up to the financial crisis in 2007-2008, repo contracts began to be based more and more on other financial instruments, like mortgage-backed securities. In addition, financial funds like money market mutual funds, which are required by law to invest in short-term assets as a way of holding down their risks, began to put a portion of their funds into the very short-term repo markets.

As it became clear that mortgage-backed securities were not safe, those who had been putting the $7 trillion into the repo market backed away. Those who had grown to depend on being able to borrow that money–by rolling over the repo loans every day–found themselves rather suddenly without access to capital. Sanches explains this way:

\”A depositor with serious doubts about the underlying value of the collateral can do two things: either ask for more collateral or simply not renew the repo. Both actions can be interpreted as a decision to withdraw funds from the shadow banking system, much like the decision bank depositors make to withdraw funds from their bank when they believe they might not be able to get all their money out. Repo lenders initially asked for more collateral, but ultimately they simply refused to renew their loans. In other words, the repo market froze Because investors could not tell safe MBS [mortgage-backed securities] from risky MBS in most cases, they withdrew their funds even from shadow banks that probably had safe MBS to secure repos. This problem was severe enough to turn the initial panic into a systemic event — a banking crisis. Thus, the financial crisis was not very different from the banking crises of old. Investors in the repo market behaved pretty much like bank depositors did during U.S. banking crises before 1933. And the outcome was certainly very similar. The initial banking crisis spread to other financial markets, and several financial firms either failed or had to be rescued by the federal government to prevent further failures.\”

In broad terms, one way to think about these issues is that the old model of the plain-vanilla bank, making and holding loans, has been breaking down for some years now. Instead, there is a more complex web of investors in special purpose vehicles, often tied to banks if technically separate from them, who structure their financial transactions to have the overall effect of making deposits, lending, borrowing, and investing, but without having those actions happen in the organizational structure of a conventional bank. The task of creating a new structure of financial regulation to address the new realities is quite incomplete. The implementation of the Dodd-Frank financial reform legislation passed back in 2010 is only about half-completed, and for all the new requirements it seeks to impose, it does essentially nothing to address repo markets or issues of lending and borrowing financial securities.

Earlier this month, I noted that Gary Becker viewed time as the fundamental constraint that inevitably leads people to live in a world of scarcity–and therefore a world in which economic choices must be made. A reader sent me a  reminder about some speculation on what a situation without scarcity would look like. Scott Gordon offered a brief speculation on \”The Economics of the Afterlife\” in the February 1980 issue of the Journal of Political Economy  (88:1, pp. 213-214). Gordon wrote:

\”I start with one postulate: that in Heaven there is no scarcity. As David Hume recognized, all conflict springs from scarcity, so it is not necessary to describe Heaven as characterized by justice, peacefulness, mutual love, etc., since these are derivatives from the no-scarcity postulate. One might wonder how economic analysis could be applied to a regime of no scarcity, but this is exactly the point: we can use the analysis, not to describe how to allocate resources efficiently, but to discover the characteristics Heaven must have if no such allocation is necessary.\”

However, as Gordon points out, even if time is infinite in Heaven, scarcity in terms of time would still exist, because people would not be able to do everything at once, and thus would need to decide what to do sooner and what to do later. Gorgon draws the logical inference:

For Heaven to be characterized by no scarcity, it is necessary that Heaven time be different from World time. Tentatively, let us assume that Heaven time, in addition to being infinite in length, is also infinite in width. Instead of being represented by a Euclidian line which has length but no width, a Heaven time line would have both length and width and would be infinite in both dimensions. In such a regime, there would be no time constraint upon actions or experiences. This would be a condition of no scarcity, since at every instant there is an infinite amount of time.

But if the infinite range of all possible experiences could occur within an instant of time, additional instants of time would be superfluous. Heaven would thus be simultaneously rapturous and brief. Gordon sums up:

I conclude from this that, if the basic postulate of Heaven is the absence of scarcity, then the afterlife will be exquisitely intense in experience but fleetingly brief. Perhaps the reason why most people display great reluctance to experience the bliss of Heaven is due to the fact that, being accustomed to thinking in terms of World time, where duration is of the essence, they find the brevity of Heaven time unappealing. Of course, in making this suggestion, I am assuming that most people have all along known intuitively what economics only just now has proven logically.

Longer life expectancy is a profound blessing associated with economic development. But it raises questions for the lifetime balance between work years of earning income and retirement years of spending it. James M. Poterba explores the issues in \”Retirement Security in an Aging Population,\” which was delivered as the Richard T. Ely Lecture in January, and has now been published in the May 2014 issue of the American Economic Review: Papers & Proceedings (104:5, pp. 1–30). The AER is not freely available on-line, but many readers will have access through library subscriptions.

As a starting point, contemplate the rise in life expectancy for Americans during the 20th century. In 1900, for example, men had a life expectancy of 51.5 years, and less than a 50% chance of reaching age 65. If they reached 65, they had an additional life expectancy of 13.5 years. By 2000, men had a life expectancy at birth of 80 years, and 86.1% of men would reach age 65, when they would have an additional life expectancy of 20.4 years.

In the study of economics, no good news goes unpunished. The typical pattern across a lifetime is that children and young adults consume more than they earn, adults from age 25-65 earn more than they consume, and then adults over age 65 again consume more than they earn. Here\’s a table from Poterba showing the averages:

The difficulty arises, of course, because many people have life profiles of income and consumption that don\’t match this average. When average retirement is longer, and especially when a portion of that retirement is more likely to be spent in the above-85 age group that is more prone to physical and cognitive limitations, saving for retirement needs to be on average correspondingly larger, too.

For a sense of the differing results of working and saving over a lifetime, consider this table showing the sources of income for those over age 65. The columns show figures by income \”quartile,\” that is, by dividing the population of elderly by income into quarters. The top panel shows the percentage of people in that income quartile receiving income from a certain source, while the bottom panel shows the amount of income received from that source.

One way to think about these patterns is to divide the elderly population into three groups. First consider the lowest income quartile. About three-quarters  of this group receives Social Security, and about one-quarter receives some income from other assets. But for this group, 85% of annual income comes from Social Security. Of course, this calculation is based on income, so it doesn\’t count the value of in-kind benefits like Medicare, Medicaid (which covers nursing care for the low-income elderly) or Food Stamps. Also, at least some of the elderly in this group probably own their home outright, and for that group their out-of-pocket housing expenses may be relatively low. But the hard reality from this data is that something like one-quarter of the elderly will have no financial assets and perhaps no housing assets either at retirement. They will be reliant on Social Security and various public assistance programs.

Now consider the upper quartile. Although about three-quarters of this group also receives Social Security, it is not the primary source of income. Some of those in this over-65 group have not yet started receiving Social Security income, because half of this top quarter is still earning income, which accounts for 43% of the average income of this group (although this average includes both those who are working and those who are retired). More than half of this group have pension income, and three-quarters have income from other assets. This part of the population is also eligible for Medicare, and a fairly large share probably own their homes outright as well. Together with average income of $78,000, this top quarter of the over-65 population is in essentially good shape for retirement, even a retirement that lasts a few years longer than expected.

The third group is those in the middle. Some of this group, especially those in the third quartile rather than the second, are continuing to work and earn income, and a substantial share have some pension income. Still, Social Security accounts for 83% of the income of the second quartile (almost as high as for the first quarter) and well over half of average income in the third quartile. Average annual income for these groups is $15,400 for those in the second quartile and $26,600 for those in the third quartile, which with some mixture of Medicare, public assistance programs, family support, and maybe owning a house can be enough to scrape by. This is a group where public policy that provides incentives for additional saving in a retirement account while working, or working a few more years before retirement, might make a considerable difference.

The options for addressing the retirement financing challenge posed by longer lives is straightforward enough. For the lowest-income groups, we will need additional public support. For the middle-income groups, we need incentives for greater saving during working life, and incentives for working a few more years before retirement. The high-income group is already largely looking after itself, often by working a few more years before retirement.

How much should you be saving for retirement? Poterba offers some eye-opening illustrative calculations. He looks at a typical path of income over time, and then asks, if at age 65 you want to buy an annuity that will provide amount equal to half of your age-65 income for the rest of your life, what share of income should you be saving? He does the calculations separately for men and women, in parat because different life expectancies. He considers several different \”real\” rates of return (that is, the rate of return above inflation). He looks at whether you save for 40 year, 30 years, or 20 years. And he looks at whether you want an annuity that will pay a fixed nominal amount, or one that will increase its payments by 3% per year, to offset any increases in the cost of living.

As one example of the bottom line, say that you are a man who will save for 30 years and get a 3% real return.You want to buy the annuity that starts off at half your age 65 income, and then increases 3% per year. Then over those 30 years, you need to be saving 23.9% of your income each year. The average personal saving rate for Americans–that is, saving divided by after-tax income–has been about 5% in recent years. In short, many Americans are not saving nearly enough, including many who have the income level that if it was a priority, they could manage to put more aside. Some Americans already know that they aren\’t going to have much income in retirement, but I suspect that in the next decade or so, many more Americans are going to reach retirement and feel surprise and disgruntlement over the low level of income they are facing.