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However, productivity growth in this sector has been sluggish, both in the US and around the world. Thus, a team of authors from the McKinsey Global Institute–Filipe Barbosa, Jonathan Woetzel, Jan Mischke, Maria Joao Ribeirinho, Mukund Sridhar, Matthew Parsons, Nick Bertram, and Stephanie Brown–has published \”Reinventing construction through a productivity revolution\” (February 2017).

As a starting point, consider this figure. Each circle represents a country, and the size of the circle shows the size of the construction industry in that country. The horizontal axis shows the annual rate of productivity growth in construction from 1995-2015 in that country. The vertical line at 0% shows that the US construction industry, along with a number of others, has experienced negative productivity growth in the last two decades. The vertical axis shows output/hour in 2015, a standard measure of productivity. It\’s expected that high income countries like the US will tend to be relatively high in productivity: after all, that\’s why they are high-income countries in the first place. The countries in yellow are the few examples of nations where labor productivity in construction exceeds labor productivity in the country as a whole.

What\’s going on here? Here are some summary paragraphs from the McKinsey team:

\”Even while other sectors from retail to manufacturing have transformed their efficiency, boosted their productivity, and embraced  the digital age, construction appears to be stuck in a time warp. In the United States since 1945, productivity  in manufacturing, retail, and agriculture has grown by as much as 1,500 percent; productivity in construction has barely increased at all. This not only represents a lost opportunity for the industry but costs the world economy. …

The [construction] industry is extensively regulated, very dependent on public-sector demand, and highly cyclical. Informality and sometimes corruption distort the market. Construction is highly fragmented. Contracts have mismatches in risk allocations and rewards, and often inexperienced owners and buyers find it hard to navigate an opaque marketplace. The result is poor project management and execution, insufficient skills, inadequate design processes, and underinvestment in skills development, R&D, and innovation. … 

\”Examples of innovative firms and regions suggest that acting in seven areas simultaneously couldboost productivity by 50 to 60 percent. They are: reshape regulation; rewire the contractual framework  to reshape industry dynamics; rethink design and engineering processes; improve procurement and supply-chain management; improve on-site execution; infuse digital technology, new materials, and advanced automation; and reskill the workforce. Parts of the industry could move toward a  system of  mass production, standardization, prefabrication, and modularization—a production system—that has  the potential to boost productivity by five to ten times …\”

\”For the past 20 years, public corporations in the United States have been disappearing. The number of U.S.-based companies listed on Nasdaq and the New York Stock Exchange has dropped by over half since 1996. The dot-com bust of 2000 and the financial crisis of 2008 account for some of this decline, yet the downward trend has continued with little let-up, even as the markets have reached record highs. The number of IPOs in the past five years is less than the number in 1996 alone. Something has gone wrong with the public corporation in the United States.\”

So writes Gerald F. Davis at the start of \”Post-corporate: The Disappearing Corporation in the New Economy,\”  written for the Third Way think tank (February 1, 2017). He continues:

\”What industries have accounted for most of the decline? In the aftermath of the dot-com boom, there was an exit of many software and online service providers. A wave of exits and mergers in telecom industries soon followed. Since 2008, there has been a large reduction in the number of commercial and investment banks. The offshoring of electronics manufacturing and assembly led to closures and mergers of many US firms in these industries. The pharmaceutical industry has seen many closures and consolidations, too.\”

Davis also points out that in the modern globalized economy, there is often less of a need to raise capital by selling stock for a large production facility. If a firm is largely based on information technology capital, it\’s possible to lease or rent a lot of what is needed. If a firm is based on producing goods, it\’s often possible to outsource production to facilities in other countries. And if you do need to raise capital for a US production facility, you can often turn to private equity firms, which now manages more than $4 trillion in assets, rather than needing to sell stock. Davis writes:

\”Thus, Flip was the best-selling portable video camera in 2009, with 100 employees in San Francisco. Vizio was the best-selling television brand in the U.S. in 2010, with a staff of 200 in Irvine. If you can send your specifications to Alibaba, you can become a major electronics firm too, without having to leave your apartment. It’s not just in technology: if you want to launch a new beer, or pet food, or tomato sauce brand, there are generic vendors happy to produce your recipe and get it to store shelves. If you want to start an airline, there are used jets in the Arizona desert waiting to be leased and consultants eager to help you complete the government paperwork. If you want to start a bank, Infosys has a `bank in a box\’ suite of software called Finacle, providing all the functionality people need through an online service.

Craig Doidge. G. Andrew Karolyi, and René M. Stulz have an article forthcoming in the Journal of Financial Economics on \”The U.S. Listing Gap.\” (An earlier version is available as National Bureau of Economic Research Working Paper #21181, published May 2015).  They look at data from a number of different countries, and examine how the number of listed companies is typically correlated with various economic and institutional factors. They find that back in 1999, the number of listed firms in the US was roughly what one would expect, using international comparisons based on these factors, but since then the number of US publicly listed firms has fallen, so that now the number is less than half what one would predict based on international comparisons. They write in the abstract:

This “U.S. listing gap” is consistent with a decrease in the net benefit of a listing for U.S. firms. Since the listing peak in 1996, the propensity to be listed is lower for all firm size categories and industries, the new list rate is low, and the delist rate is high. The high delist rate accounts for 46% of the listing gap and the low new list rate for 54%. The high delist rate is explained by an unusually high rate of acquisitions of publicly listed firms.

Davis makes a similar argument, pointing out that the rate initial public offerings leading to new publicly listed companies has been low, while the number of delistings–often due to mergers between public companies–has been high.

People all over the world economy are in \”vulnerable\” jobs, which the International Labor Organization defines as \”own-account work and contributing family employment\”–that is, you\’re working for yourself or for your family, rather than for an employer. Not surprisingly, the desire to emigrate is high in many parts of the world, and seems to be on the rise. Here are two figures from the World Employment and Social Outlook: Trends 2017, published in January 2017 by the International Labour Organization.

For starters, here\’s a figure showing some employment patterns across the world. The first panel shows that the official unemployment rate doesn\’t look all that dramatically different across developed, emerging, and developing economies. The  big difference is the \”vulnerable\” employment rate, which is about 10% in developed economies, nearly half the workforce in emerging markets, and more than three-quarters of the workforce in developing countries. As ILO notes, \”these workers have less access to social dialogue and are less likely to exhibit job security, regular incomes and access to social protection than their wage and salaried counterparts.\”

The bottom panel shows the share of workers living in extreme or moderate poverty, which is defines as iving on less than US$3.10 per day. In emerging countries, this is nearly one-quarter of all workers; in developing countries, it\’s about two-thirds of all workers.

It\’s no surprise that many people who are staring these economic prospects in the face would be willing to relocate to another country. The bars and dots show the share of people in each region who answer that they would like to move to another country, in answer to the question: “Ideally, if you had the opportunity, would you like to move permanently to another country, or would you prefer to continue living in this country?” The bars are for the year 2009; the dots are for 2016. Thus, for regions of the world other than North America, Southern Asia, and Southeastern Asia, share of people who would be willing to move if they had a chance is typically more than 15-20%.

One of the most striking and troubling patterns in the US economy in recent decades is the \”declining labor share: that is, the pattern that the share of the value of output (in the nonfarm business sector) that goes to workers in the form of compensation, which includes benefits as well as wage and salary compensation, has been dropping. The labor share was typically in the range of 63-65% from the 1950s into the early 1970s. By the 1980s and 1990s, it was more often falling in the range of 61-63%. In the early 2000s, it fell below 60%, and since the end of the Great Recession in 2009 it has typically been between 56-58%.

This falling labor share is not some statistic recently created and promoted by partisan sources. It\’s calculated by the US Bureau of Labor Statistics, using a methodology that has remained more-or-less standard over the years. Two economists at the BLS, Michael D. Giandrea and Shawn A. Sprague, explain \”Estimating the Labor Share\” along with an overview of research findings on the issue in the February 2017 issue of the Monthly Labor Review.

As a starting point, here\’s their figure showing labor\’s share:

There seems to be a slow decline in the labor share from the 1960s though the 1990s, which is briefly interrupted by a dot-com bounce at the 1990s, and then turns into a faster decline in the early 2000s. This pattern is part of what lies behind some other much-discussed changes in the US economy. For example, average wage increases have not matched up average productivity gains in recent decades, which is because the share going to labor is declining. A smaller labor share also has implications for the distribution of overall income, because it implies that those who receive a greater share of their income from non-labor sources, like returns on investment, are going to do relatively well.

Giandrea and Sprague offer a nice concise overview of the main hypotheses for explaining the declining labor share. The theories include:

Cheaper investment goods, like computers, are leading firms to use more capital and less labor, which reduced the labor share. 

For example, the authors write: \”Karabarbounis and Neiman examined data from more than 50 countries and argue that the decline in the relative price of investment goods—in particular, computerized capital—has led firms to employ more capital and relatively less labor. They find that this shift has been responsible for approximately one-half of the observed decline in the labor share.\”

A related version of this theory is that while some new technologies should be viewed as substituting for labor, many other should be viewed as augmenting the productive power of labor. As the authors describe it: \”Lawrence writes that increases in labor-augmenting technical changes essentially increase the amount of labor provided by a given number of workers, thereby decreasing labor’s share of output.\”

The underlying assumptions about \”proprietor income\” are biasing the labor share calculations. 

The calculation of labor share involve adding compensation received by employees to \”proprietor income,\” which is the labor income received by those who run their own business. However, proprietor income is conceptually tough to measure, because someone who owns their own business can receive both \”labor income,\” as if the person was an employee of their own business, and \”capital income,\” as the owner of the business. In the real world, these two types of payments are jumbled together. To address this issue, the Bureau of Labor Statistics has assumed that the hourly labor compensation of proprietors is the same as that of employees. However, if the labor income of proprietors is actually rising over time, then this assumption means that the labor share is understated. One study finds that about one-third of the observed decline in labor share is due to this assumption that the hourly labor compensation of proprietors is the same as that of employees, rather than using an alternative method that tries to estimate the capital income of proprietors directly.

Increased imports of labor-intensive goods. 

A rise in imports of more labor-intensive goods means that production in the US economy will tend to be focused on less labor-intensive goods, which should tend to drive down the labor share. Teh authors cite work by  Elsby, Hobijn, and Şahin concerning \”an increased reliance on imported inputs used in domestic production, especially inputs that have labor-intensive production processes. These `offshored\’ inputs are typically produced in countries with lower labor costs, resulting in an overall reduction in the price of domestically produced final goods.\”

Different industries have different labor shares, so shifts in which industries are larger or smaller can affect labor share.

The authors write: \”Declines in durable goods manufacturing and nondurable goods manufacturing were responsible for 2.8 percentage points and 1.6 percentage points, respectively, of the decline in the overall labor share. Over the same period, several industries showed gains in their labor share—led by professional and business services, which contributed 2.5 percentage points, partially offsetting the decline in the overall labor share.

These explanations all have some plausibility, but it isn\’t clear to me that, taken together, they adequately explain the fall of more than four percentage points in labor share in the decade or so from the early 2000s (roughly 61%) to the years right after the Great Recession (just above 56%). The labor share does show some sign of rebounding in the last couple of year, and it will be interesting to see whether that turns out to be true bounce-back or a damp squib.

There is reason to be dubious, at least in theory, about  how kidnap insurance can work. After all, buying kidnap insurance only makes sense if you believe that, in the case of being kidnapped, it will increase your chance of being released. After all, if kidnappers know (or can figure out) that certain people have kidnap insurance, won\’t they tend to target such people? Also, if a kidnap victim has insurance  has insurance, won\’t the kidnappers demand the monetary equivalent of the earth, moon, and stars as a ransom? In these ways, might the presence of kidnap insurance increase the amount of kidnapping? On the other side, insurance companies have a profit motive to take actions that would reduce the number of kidnappings and the size of ransom payments. But if kidnappers make extraordinarily high demands and the insurance company pushes back, then it seems likely that negotiations over ransom will tend to break down–in which case the rationale for buying kidnap insurance in the first place would disappear. And how can kidnap insurance companies figure out a way to deal with the situation of kidnap victims who don\’t have insurance: if the representatives of those victims (who may in some cases be national governments) pay high ransoms, then it will be harder for the companies that sell kidnap insurance to keep other ransom demands down.

 Anja Shortland explores \”Governing kidnap for ransom: Lloyd\’s as a `private regime,\” in an article forthcoming in Governance magazine (the publisher, Wiley, has laudably made an \”Early View\” preprint version of the article available here). The short answer to the concerns over how kidnap insurance markets are likely to break down is that if all the companies providing that interact with each other, swap information, and follow common protocols, then kidnap insurance can function. For kidnap insurance, Lloyd\’s serves as a place where that interaction happens. Shortland writes (citations omitted):

Kidnapping is a major (if largely hidden) criminal market, with an estimated total turnover of up to US$1.5 billion a year. Transnational kidnaps, where the victims are foreign tourists, high-net-worth local residents insured by multinational insurers, and the employees of foreign enterprises, are scary one-off events for almost all families and most firms. Ransoming hostages is beset with trust and enforcement problems. Kidnappers seek to maximize ransoms and can employ extreme violence to pressurize stakeholders to reveal their assets. Law enforcement may prepare rescue operations while families (pretend to) negotiate a ransom. Any sequential payment process is potentially problematic, but ransom drops can fail even if both parties act in good faith. Kidnappers need not release (live) hostages after payment and may demand multiple ransoms. Yet, despite these considerable difficulties—and contrary to general perceptions based on newspaper headlines—the vast majority of transnational kidnap victims survive and most cases conclude relatively quickly.  …

Commercially, kidnap insurance is only viable under three (related) conditions. First, kidnaps should be nonviolent and detentions short—otherwise, individuals and firms withdraw from high-risk areas. Second, insurance premia must be affordable. Although insurance is only demanded if people are concerned about kidnapping, actual kidnaps must be rare, and ransoms affordable. Insurers struggle in kidnapping hotspots: High premia deter potential customers. … Third, ransoms and kidnap volumes must be predictable and premium income must cover (expected) losses. If kidnapping generates supernormal profits, more criminals enter the kidnap business. Premium ransoms quickly generate kidnapping booms. Insurers, therefore, have a common interest in ordering transactions and preventing ransom inflation. …

[K]idnap insurance is indeed controlled by a single enterprise: Lloyd\’s of London. Yet within Lloyd\’s there are around 20 international syndicates underwriting kidnap for ransom insurance. The syndicates compete for business according to clear protocols regarding how insurance contracts are structured, how information is (discreetly) exchanged, and how ransom negotiations are conducted. …

All kidnap insurance is underwritten or reinsured at Lloyd\’s. By setting clear parameters for commercial resolution, Lloyd\’s enables “fair” competition between different providers and avoids kidnap insurance being sold monopolistically. There is a protocol for insuring and resolving kidnaps, which emerged from the members themselves. Its use is mandatory and it (largely) prevents individual insurers from conferring externalities to the rest of the sector. The insurance market works smoothly because Lloyd\’s enables relevant case information to flow easily between insurers without compromising client confidentiality. Underwriters constantly interact with each other and individuals who do not pass (truthful) information to the Lloyd\’s insurance community or spread it beyond its confines can be ostracized.

 Shortland has compiled an array of evidence on kidnaps and ransoms from nations in Africa, Latin America, the Middle East, and elsewhere. But she also includes some specific anecdotes that tell the story of how these dynamics often work out:

The owner-manager of a Mexican company is abducted at gunpoint. A ransom of US$1 million is demanded with a threat of mutilating the hostage. His kidnap for ransom insurance is activated. A crisis response consultant coordinates a crisis management team with the hostage\’s brother as the only point of contact with the kidnappers. The consultant advises that previous cases in this area have settled for around US$100,000 and that “we have yet to actually receive an ear….” The brother makes an initial cash offer of US$40,000 citing liquidity problems at the firm. This is progressively raised, but in decreasing increments. After 16 days the wife tearfully pawns her engagement and wedding rings to bring the total offer to US$99,814. The kidnappers accept, the crisis responder manages the ransom drop, and the hostage is safely released.

An aid worker is kidnapped in Yemen. Unbeknownst to the family, the NGO\’s strategic risk management plan includes kidnap for ransom insurance. Within 24 hr, a crisis response specialist convenes a crisis management team of senior staff to conduct the negotiation with the kidnappers. He personally assures the family that “… everything will be done to ensure the timely and safe return of the hostage.” The NGO is advised to negotiate, but to stall and reject the ransom demand of US$500,000. A former SAS officer bases himself in war-torn Aden to open indirect negotiations with tribal elders. After 36 days, the local sheik indicates that the hostage could be released in exchange for a new generator for his village. The NGO agrees, the unharmed hostage is released, and the NGO operates undisturbed afterward.

If you  are teaching about insurance markets and need to spruce up your classroom with a fresh and vivid example of adverse selection, moral hazard, and potential spillovers, this topic and very readable article could be a useful resource.

The high costs of health care are not just an issue for the United States, but for countries all over the world. The OECD addresses the issue of How to Tackle Wasteful Health Care Spending in a January 2017 (which can be ordered or read online for free here). Here\’s a taste of the findings from the \”Foreword\”:

Across OECD countries, a significant share of health care system spending and activities are wasteful at best, and harm our health at worst. One in ten patients in OECD countries is unnecessarily harmed at the point of care. More than 10% of hospital expenditure is spent on correcting preventable medical mistakes or infections that people catch in hospitals. One in three babies is delivered by caesarean section, whereas medical indications suggest that C-section rates should be 15% at most. Meanwhile, the market penetration of generic pharmaceuticals – drugs with effects equivalent to those of branded products but typically sold at lower prices – ranges between 10-80% across OECD countries. And a third of OECD citizens consider the health sector to be corrupt or even extremely corrupt. At a time when public budgets are under pressure worldwide, it is alarming that around one-fifth of health expenditure makes no or minimal contribution to good health outcomes. … Actions to tackle waste are needed in the delivery of care, in the management of health services, and in the governance of health care systems. 

There\’s no magic bullet for reducing wasteful spending: instead, the strategy of the report is to pile up studies and examples until the sheer weight and number of opportunities to reduce health care spending is overwhelming. The report divides the evidence into three main categories: wasteful clinical care (care that either provides very low value or can even be counterproductive to health); operational waste (like paying excessively high prices or overusing expensive inputs like brand-name drugs); and governance-related waste (like ineffective or unnecessary administrative expenses). Here are a few words on each.

For example, Ian Forde and Carol Nader contribute a chapter on \”Producing the right health care:
Reducing low-value care and adverse events.\” They write (citations omitted):

Health care systems still struggle to quantify the true extent of low-value care, partly because of the lack of consensus on how to define it. …  A rare exception to the lack of consensus on defining low value concerns births by caesarean section. The internationally accepted consensus is that the ideal rate for caesarean sections is between 10% and 15% of all births. No OECD countries fall within this band … 

The tricky part of interpreting this figure is that administrative costs play a bigger role in private sector health insurance, and the the US has much more of its health insurance in the private sector than other countries. So if you put these together, it turns out that the US administrative expenses related to health insurance are substantially larger than in other countries.

It would of course be foolish to argue that all administrative costs are wasteful, and the report is far too sharp to make such a claim. But it is fair to say that one of the costs in the way that the US has chosen to organize its health care sector is higher administrative costs. And of course, the answer to high administrative costs often seems to be hiring another set of administrators to oversee utilization, promulgate rules for provision of care, double-check payments, and so on.

In  many cases, decisions about what medical care to receive and how to deliver that care fall into a gray area. It\’s often not 100% clear whether a certain procedure was needed, or not needed; not 100% clear that an error was made, or whether a reasonable judgment call was made; or whether a certain administrative act is wasteful, or whether it is reasonable oversight that reduces the risk of poor care and holds down costs. But the report makes a persuasive case that a substantial share of health care spending, not just in the US but in all advanced economies, is not doing much to improve health.

Agriculture in countries across sub-Saharan Africa is a large share of GDP, but a much larger share of jobs for many of the poorest people, in an economic context of widespread malnutrition. The OECD‑FAO Agricultural Outlook 2016‑2025 devotes a chapter to \”Agriculture in Sub-Saharan Africa: Prospects and challenges for the next decade.\” Here are some basic facts:

\”The Sub-Saharan Africa (SSA) region accounts for more than 950 million people, approximately 13% of the global population. By 2050, this share is projected to increase to almost 22% or 2.1 billion. Undernourishment has been a long-standing challenge, with uneven progress across the region. Despite being reduced from 33% in 1990-92 to 23% in 2014-16, the percentage of undernourishment remains the highest among developing regions. Owing to rapid population growth of 2.7% p.a. over the same period, the absolute number of undernourished people has increased by 44 million to reach 218 million. … 

\”The high contribution of the agricultural sector to GDP also underlines the limited diversification of most African economies. On average, agriculture contributes 15% of total GDP, however it ranges from below 3% in Botswana and South Africa to more than 50% in Chad … Agriculture employs more than half of the total labour force and within the rural population, provides a livelihood for multitudes of small-scale producers. Smallholder farms constitute approximately 80% of all farms in SSA and employ about 175 million people directly. … [R]ecent surveys suggest that agriculture is also the primary source of livelihood for 10% to 25% of urban households.\”

Economic development typically involves a process of rising productivity in agriculture, along with a shift to producing not just commodity products, but products with higher value-added. How might that process be encouraged and facilitated across sub-Saharan Africa? The report has lots of detail on specifics of cereals, pulses, fruits, livestock, dairy, fish, and so on. Here are some of the broader insights:

Output of agriculture in sub-Saharan Africa has more than doubled in the last 25 years.

However, \”[p]roduction growth in SSA has failed to keep pace with demand deriving from population and income growth, resulting in rising imports for food commodities such as wheat, rice and poultry. In many instances, import tariffs have been employed to support domestic producers, particularly relative to other producers outside the region.\”

In the past, output growth in African agriculture has tended to be driven by more land and more intense cropping, not by improvements in productivity or mechanisation.

\”The African model of agricultural growth differed significantly from that of Asia or South America. In Asia, growth was driven largely by intensification, whereas in South America, it was the result of significant improvement in labour productivity arising from mechanisation. By contrast, strong growth in SSA agricultural output has accrued predominantly from area expansion and intensification of cropping systems, as opposed to large-scale improvement in productivity. ,,, [P]roductivity per agricultural worker has improved by a factor of only 1.6 in Africa over the past 30 years, compared to 2.5 in Asia.\”

However, future major expansions in agricultural land seem unlikely. \”Much of the underutilised land is concentrated in relatively few countries and between one half and two thirds of surplus land is currently under forest cover. Conversion of such forest land to agriculture would come at considerable environmental cost.\” Thus, the projections for the next decade show only  modest rise in agricultural land. More intensive cropping on that land has natural limits, too.

What are some of the main priorities that could help African agriculture to evolve in the direction of higher productivity and higher value-added?

\”[A]n important uncertainty that will have a far ranging impact on production practices and productivity growth is the extent of concentration of agricultural land, which in turn will also be influenced by land tenure policies. Increasing concentration and commercialisation of medium-scale farmers could accelerate the rate of technology adoption, which has been fairly slow to date. Efficiency gains by a growing number of small, medium and large-scale farms linked into vertically integrated value chain with greater opportunity for access to credit, technology, extension services and off-take agreements, could have a meaningful impact on output levels in the coming decade. Commensurate development of upstream and downstream food sectors could increase the opportunities for non-farm income, which may in turn provide relatively productive small-scale producers with the capital to break through the barriers of subsistence agriculture into more commercialised medium-scale stature. … 

\”Arguably the greatest challenge facing the agricultural sector in SSA is weak infrastructure including transportation networks, access to energy, irrigation systems and stockholding facilities. Poor transportation networks limit access to markets, often exacerbate high levels of post-harvest losses and also inhibit efficient distribution of inputs such as seed and fertiliser. At the same time, it is an underlying factor in high food prices, as it raises the cost of both inputs and imported food products. Substantial differences in price levels between surplus and deficit regions suggest that investments able to reduce the cost of transportation would hold significant benefits to producers and consumers alike.\”

This chapter mentions issues like investing in agricultural research and development as well, but the main priorities emphasized are these issues of infrastructure, property rights, and production chains.

The enormous population boom coming in sub-Saharan Africa in the next several decades is one of those unseen demographic earthquakes that is going to shake up the world economy in all kinds of ways. For example, there will be enormous economic pressures for migration to the relatively nearby countries of the European Union.  The evolution of Africa\’s agriculture sector will play a major role in shaping the characteristics and consequences of its population boom.

The economics of exchange rates can be tough sledding. Every now and then, I post on the bulletin board beside my office a quotation from Kenneth Kasa back in 1995: \”If you asked a random sample of economists to name the three most difficult questions confronting mankind, the answers would probably be: (1) What is the meaning of life? (2) What is the relationship between quantum mechanics and general relativity? and (3) What\’s going on in the foreign exchange market. (Not necessarily in that order).\”

But even after duly acknowledging that exchange rates can be a tough subject, the political discussion of how exchange rates are manipulated and unfair to the US economy is a dog\’s breakfast of confusions about facts, institutions, and economics. For one of many possible examples, see the op-ed published in the Wall Street Journal last week by Judy Shelton, an economist identified as an adviser to the Trump transition team, titled \”Currency Manipulation is a Real Problem.\” The obvious conclusion to draw from that essay, and from a number of other writing on manipulated exchange rates, is that all exchange rates are bad.

Sometimes other countries have policies that the value of their currency is lower relative to that of the US dollar. This is bad, because it benefits exporters from those countries and helps them to sell against US companies in world markets.

But other times, countries are manipulating the value of the exchange rate so that the value of their currency is higher relative to the US dollar, like China. This is also bad, as Shelton write in the WSJ: \”Whether China is propping up exchange rates or holding them down, manipulation is manipulation and should not be overlooked. … A country that props up the value of its currency against the dollar may have strategic goals for investing in U.S. assets.\”

Exchanges rates that move are bad, too. Shelton writes that \”free trade should be based on stable exchange rates so that goods and capital flow in accordance with free-market principles.\”
But stable exchange rates are also bad.  After all, China is apparently stabilizing its exchange rate at the \”wrong\” level, and the argument that exchange rate manipulation is a problem clearly implies that many major exchange rates around the world should be reshuffled to different levels.

The bottom line is clear as mud. Exchange rates are bad if they are higher, or lower, or moving, or stable. The goal is that exchange rates should be manipulated to arrive at some perfect level, and then should just stick at that level without any further manipulation, which would be forbidden. This perspective on exchange rates is so confused as to be incoherent. With the perils of explaining exchange rates in mind, let me lay out some alternative facts and perspectives.

Currencies are traded in international markets; indeed, about $5 trillion per day is traded on foreign exchange markets. This amount is vastly more than what is needed for international trade of goods and services (about $24 trillion per year) or for foreign direct investment (which is about $1.0-1.5 trillion per year). Thus, exchange rate markets are driven by investors trying to figure out where higher rates of return will be available in the future, while simultanously trying to reduce and diversify the risks they face if exchange rates shift in a way they didn\’t expect. Because of these dynamics, exchange rate markets are notoriously volatile. For example, they often react quickly and sharply when new information arises about the possibilities of changes in national-level interest rates, inflation rates, and growth rates.

In this context, deciding whether exchange rates have bubbled too high or too low is a tricky business. But William R. Cline regularly puts out a set of estimates. For example, he writes in \”Estimates of Fundamental Equilibrium Exchange Rates, November 2016\” (Peterson Institute for International Economics, Policy Brief 16-22):

\”As of mid-November, the US dollar has become overvalued by about 11 percent. The prospect of fiscal stimulus and associated interest rate increases under the new US administration risks still further increases in the dollar.  The new estimates, all based on October exchange rates, again find a modest undervaluation of the yen (by 3 percent) but no misalignment of the euro and Chinese renminbi. The Korean won is undervalued by 6 percent. Cases of significant overvaluation besides that of the United States include Argentina (by about 7 percent), Turkey (by about 9 percent), Australia (by about 6 percent), and New Zealand (by about 4 percent). A familiar list of smaller economies with significantly undervalued currencies once again shows undervaluation in Singapore and Taiwan (by 26 to 27 percent), and Sweden and Switzerland (by 5 to 7 percent).\”

Several points are worth emphasizing here. The exchange rates of the euro, China\’s renminbi, and Japan\’s yen don\’t appear much overvalued. The US dollar does seem overvalued, but the underlying economic reasons aren\’t mainly about manipulation by other countries. Instead, it\’s because investor in the turbulent foreign exchange markets are looking ahead at promises from the Trump administration that would lead to large fiscal stimulus and predictions from the Federal Reserve of higher exchange rates, and demanding more US dollars as a result.

Countries around the world have sought different ways to grapple with risks of exchange rate fluctuations. Small- and medium-sized economies around the world are vulnerable to a nasty cycle in which they first become a popular destination for investors around the world, who hasten to buy their currency (thus driving up its value), as well as investing in their national stock and real estate markets (driving up their prices), and also lending money. But when the news shifts and some other destination becomes the flavor-of-the-month as an investment destination, then as investors sell off the currency and their investments in the country, the exchange rate, stock market, and real estate can all crash. This situation can become even worse if the country has done a lot of borrowing in US dollars, because when the exchange rate falls, it becomes impossible to repay those US-dollar loans. The combination of falling stock market and real estate prices, together with a wave of bad loans, can lead to severe distress in the country\’s financial sector and steep recession. For details, check with Argentina, Mexico, Thailand, Indonesia, Russia, and a number of others.

The International Monetary Fund puts out regular reports describing exchange rate arrangements, like the Annual Report on Exchange Arrangements and Exchange Restrictions 2014. That report points out that about one-third of the countries in the world have floating exchange rates–that is, rates that are mostly or entirely determined by those $5 trillion per day exchange rate markets. About one-eighth of the countries in the world have \”hard peg\” exchange rate, in which the country either doesn\’t have its own separate currency (like the countries sharing the euro) or else the countries technically have a separate currency but manage it so that the exchange rate is always identical (a \”currency board\” arrangement).

The rest of the economies in the world have some form of \”soft peg\” or \”managed\” exchange rate policy. These countries don\’t dare to leave themselves open to the full force and fluctuations of the international exchange rate markets. But on the other hand, they also don\’t dare lock in a stable exchange rate in a way that can\’t change, no matter the cross-national patterns of interest rates, inflation rates, and growth rates. Many of these countries are quite aware that the ultra-stable exchange rate known as the euro has not, to put it mildly, been an unmixed blessing for the countries of Europe.

The fundamental issue is that an exchange rate is a price, the price of one currency in terms of another currency. A weaker currency tends to favor exporters, because their production costs in the domestic currency are lower compared to the revenue they gain when selling in a foreign currency.
A stronger currency tends to favor importers, because they can afford to buy more goods in the supermarket that is the world economy.

Of course, the reality is that the US economy has all kinds of different players, some of whom would benefit from a stronger exchange rate and some of whom would benefit from a weaker exchange rate. Think about the difference between a firm that imports inputs, uses them in production, and re-exports much of the output, as opposed to a form that imports goods that are sold directly to US consumers. Think about the difference between a worker in a firm that does almost no exporting, but benefits as a consumer from stronger exchange rates, and a worker in a firm that does most of its production in the US and then exports heavily, where the employer would benefit from a weaker exchange rate. Think about a firm which has invested heavily in foreign assets: a weaker US dollar makes those foreign assets worth relatively more in US dollar terms, thus rewarding the firm for its foresight in investing abroad.

Here\’s one useful way to cut through the confusions about what a higher or lower exchange rate means, which is from work done by economists Gita Gopinath,  Emmanuel Farhi, Oleg Itskhoki, who point out that the economic effects of changes in exchange rates are fundamentally the same as a  policy that combines changes in value-added and payroll taxes. Specifically, a weaker currency has the same effect as a policy of a policy of raising value-added taxes and cutting payroll taxes by an equivalent amount. This should make some intuitive sense, because a weaker currency makes it harder for buyers (like a higher value-added tax) but reduces the relative costs of domestic production (like a lower payroll tax).

In short, every time the US exchange rate moves, for whatever reason, there will be a mixed bag of those who benefit and those who are harmed. A weaker currency is the economic equivalent of combining a higher tax that hinders consumption, like the higher value-added (or sales) tax, with an offsetting cut in a tax that lowers costs of domestic production, like the lower payroll tax. If the policy goal is to help US exporters, but not to impose costs on US importers and consumers, then seeking a lower US dollar exchange rate is the wrong policy tool. It is a mirage (and a fundamental confusion) to argue that some change in the dollar exchange rate will be all benefits and no costs for the US economy.

Just to be clear, I\’m certainly not arguing that exchange rates are never \”too high\” or \”too low\”; it\’s clear that exchange rates are volatile and can have bubbles and valleys.

Nor am I arguing that countries never try to manipulate their exchange rates; indeed, I would argue that every country manipulates its exchange rates in one way or another.   If countries allow their exchange rates to float, then when the central bank adjusts interest rates or allows a chance in inflation or stimulates an economy, the exchange rate is going to shift, which is clearly a way in which exchange rates are manipulated by policy.  If countries don\’t let their exchange rates move, that\’s clearly a form of manipulation. And if countries allow their exchange rates to move, but act to limit big swings in those movements, that is also manipulation.

What I am arguing is that given even a basic notion how exchange rate markets work and the economic forces that affect exchange rates, it is opaque how \”non-manipulation\” would work. Are exchange rates going to be held stable across countries, even in the face of cross-national economic changes in interest rates, inflation, and  growth? A wide variety of experience, including the breakdown of the Bretton Woods agreement in the early 1970s and the current problems with euro, suggest that holding exchange rates stable is impractical over time and can have some very bad consequences. But if exchange rates are going to be allowed to move, then the question arises of who decides when and how much. Most national governments, especially after having watched the euro in action, will want to keep some power over exchange rates. There are serious people who discuss what kind of international agreements and cooperation it would take to have greater exchange rate stability, but it\’s a hard task, and squawking about how all exchange rates are bad–stronger, weaker, moving, stable–is not a serious answer.

In any given year, a sizable chunk of investment goes to replacing what wore out or became obsolete in the previous year. Thus, the Bureau of Economic Analysis calculates both gross investment, which is the total invested, and net investment, which is what is actually added to the capital stock after accounting for investment that only offset the depreciation of the older capital. Both gross and net investment by private business have been declining in the US economy–but net investment is declining faster. Consider some a couple of figures.

This blue line on the graph shows gross investment by private domestic firms, while the red line shows net investment by private firms, both divided by GDP. You can see that from the 1970s and up into the 1990s, high levels of gross investment exceeded 14% of GDP. But since 2000, high levels of gross investment don\’t reach 14% of GDP. Interestingly, the drop-off in investment seems more visible in the red line showing net investment.

In the next figure, net domestic investment by private domestic firms is divided by gross investment: in effect, this calculation shows what percentage of total investment is actually adding to the capital stock, rather than just replacing earlier investments that have depreciated. The striking pattern is that from the 1960s up to the early 1980s, it was common for about 40% or more of total investment to be \”net\” or  new investment. But since about 2000, it\’s been common for about 20% of total investment to be \”net\” or new investment, while the other 80% is replacing older capital stock.

The decline in net investment also shows up in government infrastructure investment, especially in the years since the Great Recession. Here\’s a figure from \”If You Build It: A Guide to the Economicsof Infrastructure Investment,\” a useful overview of issues related to infrastructure spending by Diane Whitmore Schanzenbach, Ryan Nunn, and Greg Nantz (Hamilton Project, February 2017).

I haven\’t done a deep enough dive into the underlying methodologies here to see why the net/gross ratio for private investment is falling so sharply, or if some of these reasons may help to to explain the fall in net infrastructure investment. I have seen some discussion that part of the reason is that capital investment is more likely to be in the form of computers and software, which become outdated more quickly (given technological progress in this area) than, say, large machine purchased for industrial production in old-style plants. But there are other possible explanations. (If someone out there has dug down into the growing gap between gross and net investment and how it manifests itself in the Bureau of Economic Analysis statistics, please send me the paper or a link. I\’d be happy to learn more.)

The decline in investment is bothersome in a number of ways. Investment in physical capital is one of the factors that over time raises productivity and wages. It\’s a little troublesome that 80% of gross investment is going to replace old capital, rather than add to the capital stock. And low investment is at the root of concerns about the possibility of \”secular stagnation,\” which is a worry that the economy is headed for a slow-growth future because investment spending is likely to remain low.