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December 17, 2006

Disappointing Results from Deregulation

The deregulation of electricity generation has been problematic:

Competitive Era Fails to Shrink Electric Bills, by David Cay Johnston, NY Times: A decade after competition was introduced in their industries, long-distance phone rates had fallen by half, air fares by more than a fourth and trucking rates by a fourth. But a decade after the federal government opened the business of generating electricity to competition, the market has produced no such decline. Instead, more rate increase requests are pending now than ever before...

The disappointing results stem in good part from the fact that a genuinely competitive market for electricity production has not developed. ... The Federal Energy Regulatory Commission and five other agencies, in the draft of the report to Congress, are unable to specify any overall savings. “It has been difficult,” the report states, “to determine whether retail prices” in the states that opened to competition “are higher or lower than they otherwise would have been” under the old system. ...

Under the old system, regulated utilities generated electricity and distributed it to customers. Under the new system, many regulated utilities only deliver power, which they buy from competing producers whose prices are not regulated. For example, Consolidated Edison, which serves the New York City area, once produced almost all the power it delivered; now it must buy virtually all its electricity from companies that bought its power plants and from other independent generators. The goal is for producers to compete to offer electricity at the lowest price, savings customers money.

Independent power producers, free-market economists and the Clinton Administration cheered in 1996 when the federal government allowed states to adopt the new system. ... But ... A truly competitive market has never developed, and, in most areas, the number of power producers is small. ...

[C]ritics say that, as in California five years ago in a scandal that enveloped Enron, the auction system can be manipulated to drive up prices, with the increases passed on to customers. What is more, companies that produce electricity can withhold it or limit production even when demand is at its highest, lifting prices. This happened in California, and the federal commission has found that it occurred in a few more instances since then. Critics say that more subtle techniques to reduce the supply of power are common ...

Richard Blumenthal, the Connecticut attorney general, said the supposedly competitive market has been “a complete failure and colossal waste of time and money.” He asked the federal commission to revoke competitive pricing in his state, but the commission dismissed the complaint last Wednesday, saying the state had not proved its case.

Advocates of moving to the new system say that, in time, the discipline of the competitive market will mean the best possible prices for customers. Alfred E. Kahn, the Cornell University economist who led the fight to deregulate airlines and who, as New York’s chief utility regulator in the 1970’s, nudged electric utilities toward the new system, said that he was not troubled by the uneven results so far.

“Change,” Professor Kahn said, “is always messy.” ...

Stubborn adherence to a policy that isn't working can be even messier. Free, unregulated markets are best when it results in an efficient outcome, but the necessary conditions for competition are not met in these markets and oversight is needed to prevent and penalize price manipulation.


As noted in email I've received and in comments, I have been negligent in not yet acknowledging this year's Nobel prize winner, Bangladeshi economist Muhammad Yunus, for his work on microcredit through the Grameen Bank. Here are some passages from a New Times article followed by a commentary by Hal Varian explaining the economics underlying microcredit arrangements (thanks anne):

Peace Prize to Pioneer of Loans to Poor No Bank Would Touch, by Celia W. Dugger, NY Times: A Bangladeshi economist, Muhammad Yunus, and the bank he founded 30 years ago won the Nobel Peace Prize yesterday for pioneering work in giving tiny loans to millions of poor people no commercial bank would touch — destitute widows and abandoned wives, landless laborers and rickshaw drivers, sweepers and beggars.

The Nobel Committee praised Mr. Yunus, 66, and the Grameen Bank for making microcredit ... a practical solution to combating rural poverty in Bangladesh and inspiring similar schemes across the developing world.

“Microcredit has proved to be an important liberating force in societies where women in particular have to struggle against repressive social and economic conditions,” the committee said in announcing the prize.

Mr. Yunus has long been an influential champion of the idea that even the most impoverished people have the drive and creativity to build small businesses with loans as small as $12, and Grameen Bank has dedicated itself to helping the poorest of the poor.

The borrowers used the money to buy milk-giving cows, or bamboo to craft stools, or yarn to weave into stoles, or incense to sell in stalls, among myriad other money-making schemes.

Reached in Dhaka, Bangladesh, by telephone yesterday, Mr. Yunus recalled the day in 1976 when he reached into his own pocket to give his first loan, $27, to 42 villagers living near Chittagong University where he said he was then teaching “elegant theories of economics.” The borrowers invested the money and repaid him in full, though they had no collateral and signed nothing.

He said he asked himself that day, “If you can make so many people so happy with such a small amount of money, why shouldn’t you do more of it?”

Still, over the years, Mr. Yunus faced skeptics and detractors, as it became clear that microcredit loans, alluring as they were, were not by themselves a panacea for poverty. ...

But in interviews yesterday, Mr. Yunus’s skeptics and fans alike credited him and Grameen with helping to fundamentally change the way the world saw the potential of poor people and to popularize the movement to provide financial services to the poor. ...

Or, as the Nobel committee put it: “Yunus’s long-term vision is to eliminate poverty in the world. That vision cannot be realized by means of microcredit alone. But Muhammad Yunus and Grameen Bank have shown that, in the continuing effort to achieve it, microcredit must play a major part.” ...

Indeed, in the decades since Mr. Yunus’s first loan, microcredit has become one of the most popular antipoverty strategies in the world. Last year, more than 100 million people received small loans from more than 3,100 institutions in 130 countries, according to Microcredit Summit, a Washington-based nonprofit advocacy group that Mr. Yunus helped found. The average loan from Grameen Bank was $130.

Over the years, the movement to provide financial services to the poor has become more capacious, stressing the need for services beyond loans — for safe places to save small amounts of money, for crop and life insurance, for inexpensive ways to transfer money earned in distant cities and foreign countries to families back home. ...

In 1974, Mr. Yunus, trained as an economist at Vanderbilt University, found himself teaching economics at Chittagong University when Bangladesh was struck by famine. “I decided I must do something,” he said. He began working in nearby villages, among them Jobra, where he made his first loan in 1976.

He said he tried to persuade commercial banks to give loans to poor people who had no assets and had always been dependent on local moneylenders. But the bankers only did so when he personally co-signed as a guarantor.

Mr. Yunus’s new model of banking for the poor had several unusual features, Professor Morduch said. Grameen lent to groups of five people, who helped ensure that each member repaid his or her share. It lent not only to farmers, but also to laborers and women who had a knack for crafts and shopkeeping. And it required borrowers to repay their loans in manageable, bite-sized weekly installments.

“He proved the impossible: that the poor were bankable,” Professor Morduch said.

But Mr. Yunus’s approach went beyond giving the poor economic opportunity to seeking deeper social change, said Amartya Sen, who, like Mr. Yunus, is a Bengali, an economist and a Nobel prize winner.

Mr. Sen, a professor at Harvard, noted that Grameen’s loans had gone overwhelmingly to women, giving financial clout to women who had little power in Bangladeshi society and often lived cloistered in their homes.

In the overwhelmingly Muslim nation of Bangladesh, Mr. Yunus’s approach also offered hope and ideas to compete with the allure of fundamentalist Islamic causes.

“It’s a very secular movement,” Professor Sen said, “very egalitarian, market friendly and socially radical.” ...

Here's Hal Varian. This was written in 2001 so it was written before the prize was awarded:

In a model for lending in developing nations, a Bangladesh bank relies on peer pressure for collateral, by Hal R. Varian, Commentary, New York Times: The village moneylender in Bangladesh charges interest rates of over 150 percent a year. Citibank would love to get that kind of return on its investments -- so why isn't Citibank lending money in Bangladesh villages?

This is a serious question, in terms of both policy and profit. The painfully high interest rates charged by moneylenders in developing countries suggest that marginal investment opportunities there are much more profitable than in advanced industrial nations.

So why isn't there a rush of investment from Western banks to exploit these profitable opportunities -- and, as a byproduct, increase the pace of economic development in these countries?

There are several barriers to entry in the lending business in developing countries, many of which have to do with the information advantages that incumbent moneylenders have over potential entrants.

To begin, the local moneylender is intimately familiar with his clientele, and this gives him a huge information advantage over a bank officer in selecting reliable loan recipients. At the same time, the moneylender is in a very good position to monitor borrowers since he can check up on their activities daily.

Local moneylenders are also familiar with village customs and practices and can offer useful business advice; they are also in a good position to provide informal insurance to the loan recipients, too, since they know when a nonperforming loan is caused by outside causes, like bad weather, and when laziness is the cause.

Finally, moneylenders operate at a much smaller scale than Citibank does. Most of these loans are minuscule by Western standards, and Citibank just is not set up to handle tiny investments, even if they are potentially very profitable.

These factors -- selection costs, monitoring costs, local experience, insurance and inappropriate scale -- conspire to create a virtual monopoly for the moneylender. Even moneylenders from neighboring villages might find it hard to compete with someone who has an intimate knowledge of a particular village's inhabitants. The result is tens of thousands of tiny monopolies and many profitable projects that are never undertaken because of the high cost of borrowing.

But there is hope. About 25 years ago Muhammad Yunus, a Bangladeshi economist trained in the United States, developed a lending model that managed to overcome these kinds of barriers. His business model for microcredit has been immensely successful, spawning imitators the world over.

Most of these lenders are nonprofits, but they are self-supporting nonprofits, which do not require subsidies or loan guarantees. There are even a few for-profit enterprises experimenting with the Yunus microcredit model.

Mr. Yunus put his plan into effect through an institution he called the Grameen Bank.

The critical feature of the program is that a candidate for a loan must form a group with four other people who are not family members. Two members of the group originally receive a loan, and if they do well, the others then receive loans.

The borrowers are encouraged to assist each other, and all loan disbursements and repayments are made publicly, in front of other groups. Loans are always for one year, at a fixed interest rate of 20 percent, and they are always for modest amounts: no more than a few hundred dollars.

The borrowers use the loans to buy looms, chickens, cows and make other small capital investments. They start repaying the loan two weeks after getting it, and once they have repaid the initial loan, they are allowed to apply for new ones.

How does this business model solve the information problems described above? First, take the selection problem. The Grameen design provides strong incentive for good borrowers to join together, since they don't want to risk losing a loan because of one failure or troublemaker. The fact that they cannot join with other family members removes one sort of pressure to dilute group quality.

Second, the members of the group have an incentive to monitor one another's activities actively. They can provide advice, assistance, education and, if necessary, insurance. The group members themselves are in the best position to know whether a recipient is slacking off or has just had a run of bad luck, and they have great incentives to monitor their behavior in an honest and helpful way.

Third, all of this selection, monitoring, educating and insuring is done not by high-paid professionals, but by Bangladeshi peasants. The transactions costs of using groups are far, far lower than are the transactions costs for traditional bank loans.

There are other interesting economic angles. Over 90 percent of the borrowers are women. This isn't so much an ideological choice as a pragmatic one -- women turned out to be better credit risks. They were more tightly tied to the home and had fewer outside temptations, so they focused much more intently than did male borrowers on completing their projects.

All this seems to work. The bank says it has a repayment rate of 99 percent, and over 92 percent of the bank's shares are owned by the borrowers. Peer pressure can be an immensely strong force, and the Grameen Bank has figured out how to make it work in the cause of economic development.

Experiments elsewhere haven't been uniformly successful. In some countries, the poverty stricken do not have enough group solidarity to provide the necessary discipline. In more urban settings, it may be difficult to find appropriate small-scale investments. But there are numerous successful operations inspired by the Grameen bank.

One program, Project Enterprise, runs a Grameen-type program for minority entrepreneurs in New York.

To answer the question posed in the first paragraph: Citibank and other Western banks are well aware of the Grameen model. In 1999 the Citigroup Foundation donated $1 million to the program.

Citibank, along with others, is currently experimenting with microlending in India and other developing countries. Multinational banks may yet find ways to break the moneylenders' monopolies and finance microinvestment in poor countries.

Access to capital is critical for economic development. Grameen and its many offspring, both nonprofit and for-profit, offer an exciting model for alleviating poverty.

Professors and God

"Even at elite, doctoral universities, a majority of professors are neither atheistic nor agnostic":

Survey finds belief in God in the halls of academe, The Associated Press: Contrary to stereotype, most college professors are not atheists or agnostics, according to new research. In fact, only about one-quarter of professors deny God exists or claim it is impossible to know, according to survey results analyzed by sociologists Neil Gross of Harvard University and Solon Simmons of George Mason University. The rest say they believe in God at least part of the time, or some kind of higher power.

College professors are less religious than the general population, the authors report. For example, about 40 percent of professors frequently attend religious services, compared to 47 percent for the general population. But the authors say religious commitment levels are higher than previous surveys, which did not include professors at community colleges, who are more religious.

But even at elite, doctoral universities, a majority of professors are neither atheistic nor agnostic, and 20 percent say they have no doubt God exists.

Maybe a professor is God. Perhaps there's this all-powerful, all-knowing scientist out there somewhere, and we along with beings on other planets in the universe are experiments in the equivalent of the scientist's Petri dishes. The scientist sets up a dish, seeds it with creatively designed self-replicating biological processes, then watches to see what happens over time as evolution unfolds in response to the external shocks built into the dynamic system. All day long, twenty-four hours a day every day, the scientist records everything we do in one huge data set, a data set that is bigger and more complete than we can understand (well, maybe this guy gets it). When we die, our data are reviewed at a gateway. The data from the good observations in the dish are retained (their spirits go to heaven) while the unsuccessful experimental outcomes are discarded (they go to hell and burn). Events like great floods are a sterilization of the Petri dish due to the emergence of unstable trajectories (and, before sterilizing you need to retain the best outcomes in each class in an "ark" to use to reseed the next experiment). Thus, we are the outcome of creatively designed and creatively destructed experiments on evolutionary processes.

Or maybe not.

December 12, 2006

The Harmonious Society

According to this idealized view from a Chinese columnist, the harmonious society is coming to China and it will serve as a model for the world. Resistance is futile. You will be assimilated:

Harmonious society to be a model for the world, by Qin Xiaoying, China Daily: Guided by the scientific outlook of development, the whole country, from the top authorities on down, is on board for building a harmonious society. A harmonious society, in essence, is one that respects the rights of people, sticks to the principles of human civilization and abides by the laws of nature.

With its vast territories and large population, China naturally exercises significant influence on the world politically, economically and culturally. The impact of its bid to bring about a harmonious society will also ripple across the globe...

The concept of the harmonious Chinese society is of reference value for ushering in a harmonious world. At the core of the "harmonious world" is a shift of the political ideas for handling conflicts.

Some Western scholars believe that taking extremist means to settle social contradictions and conflicts is the hallmark of religious fundamentalist groups.

However, in the opinion of this author, in the period of industrialization, countries, especially industrially advanced ones, first differentiated between friend and foe by values, bullied others with military or economic force, and wiped out "heresies" through cutthroat struggles. ... Science and technology, which made people almost invincible in all undertakings to tap the potential of nature, also made mankind believe that social problems could simply be resolved by physical strength.

As a result, the theory of biological evolution and the principles of mechanic dynamics were applied in the realm of social management. This was multiplied by the insatiable desire to maximize profits and the lust to snatch the most possible wealth. All this set the stage for law-of-the-jungle Social Darwinism, from which racism and gunboat policy later stemmed.

We can still see today the roughshod reflections of the players in the age of industrialization in the way international corporate giants and that single superpower approach international affairs, economic or political.

The fact that the Chinese Communist Party, a party in power in a big country, now names "building a harmonious society" as its basic guiding principle suggests that it has abandoned the concept of "class struggle" as the key link and is also discarding the mentality of confrontation and turning to the ideas of harmony.

Chinese believe that humanity's ultimate goal should be a harmonious world, in which international conflicts and disputes are resolved through peaceful means and the world countries share stability and prosperity together. They also believe that building a harmonious Chinese society will contribute significantly to bringing about a harmonious world.

So, striving to see the coming of a harmonious world will constitute a new pillar for Chinese diplomacy. ... Building a harmonious society has other connotations as well, covering various fields such as narrowing the gap between rich and poor, aiding disadvantaged groups, restraining monopolies, sharing the public wealth and making the distribution of wealth fairer.

It also involves taking care of the environment and ecological system for the sake of sustainable development and diverting as much public wealth as possible into the areas of social security, health care and education. Charity projects and mutual help between individuals are also encouraged.

All this could offer a model for narrowing the world's North-South gap and helping bring about a more rational world economic order, in this author's opinion.

By the way, the Chinese Government is not going in for a Utopian society that denies all differences. The Chinese recognize differences between individuals, their incomes and how they fare in society and between areas.

At the same time, however, they know well that it is dangerous when the disparities and differences become too wide to be bridged, and threaten to disrupt the social fabric.

So, it is a test for the top leadership to leave the general difference in place while reducing particular differences, especially the alarmingly gaping ones, so that the vitality of the society is maintained while its smooth operation is assured. It is also a test to protect the environment and ecological system well while meeting people's growing demand for well-being.

Some may argue that much of the content in building a harmonious Chinese society - environmental protection, social security, poverty elimination and sustainable development - could long be found in the practices of Western countries where socialist parties were in power. They may assert that "harmony," like "equality," has long embodied the aspirations of humanity.

In the opinion of this author, however, what is important is that 1.3 billion people on the earth will be moved to action by this concept of a harmonious society. Their fathers or grandfathers declared war on the earth, which meant mass campaigns that overtaxed the natural resources decades ago in order to feed themselves.

Now, the 1.3 billion Chinese have bid farewell to the out-of-date concept and have started taking care of our Mother Nature. Having 1.3 billion people move towards the goal of a harmonious Chinese society is bound to have "effects of scale" on the world at large.

The Levee

Paul Krugman explains the analysis underlying his column on Democrat's chances of retaking the House of Representatives, Will the Levee Break?:

Notes on November’s Election, by Paul Krugman, Money Talks: ...My back of the envelope calculation ran as follows. I used the 2004 data to calculate the Republican share of the combined R and D vote for each district in 2004 (counting Independent Bernie Sanders as a Dem), then ranked the districts and graphed the result, which looks like this:


In 2004, every seat to the left of the point where the curve crosses 0.5 went to the Republicans. Now suppose that what happens in this election is that a certain percentage “x” of the voters shifts from R to D in every district – a crude model of the change in the political winds, but probably as good an approach as any. This will let the Dems climb the curve: every seat for which the Republican share in 2004 was less than 50% + x will shift parties. But as you can see, the curve is very steep where it crosses 0.5, so even a sizeable x doesn’t gain the Dems many seats. To reduce the R’s to 217 seats, x has to equal about 5 percent, which would correspond to an overall Democratic lead in the vote of about 7 percent.

But here’s the thing: if the Dems climb to that point, they’re past the steep “wall” that crosses 0.5 — the levee that protects the Republicans — and even a little bit more gives them big gains. If x equals 7.5 percent, corresponding to a 12 point generic lead — Franklin’s estimate — I have the Dems gaining 30 seats.

December 11, 2006

A Professor of Biocomplexity Has Advice for Economists

A professor of biocomplexity says economists won't get anywhere unless they stop acting like physicists and start adopting the models and analytical techniques of biology:

The Evolution of Future Wealth, by Stuart A. Kaufman, Scientific American: When the world changes unpredictably over the course of centuries, no one is shocked... Yet monumental and surprising transformations occur on much shorter timescales, too. Even in the early 1980s you would have been hard-pressed to find people confidently predicting the rise of the Internet or the fall of the U.S.S.R. Unexpected change bedevils the business community endlessly, despite all best efforts to anticipate and adapt to it—witness the frequent failure of companies’ five-year plans.

Economists have so far not been able to offer much help to firms trying to be more adaptive. Although economists have been slow to realize it, the problem is that their attempts to model economic systems focus on those in market equilibrium or moving toward it. They have drawn their inspiration predominantly from the work of physicists in this respect (often with good results, of course). For instance, the Black-Scholes model used since the 1970s to predict the volatility of stock prices was developed by trained physicists and is related to the thermodynamic equation that describes heat.

As economics attempts to model increasingly complicated phenomena, however, it would do well to shift its attention from physics to biology, because the biosphere and the living things in it represent the most complex systems known in nature. In particular, a deeper understanding of how species adapt and evolve may bring profound—even revolutionary— insights into business adaptability and the engines of economic growth.

One of the key ideas in modern evolutionary theory is that of preadaptation. The term may sound oxymoronic but its significance is perfectly logical: every feature of an organism, in addition to its obvious functional characteristics, has others that could become useful in totally novel ways under the right circumstances. The forerunners of air-breathing lungs, for example, were swim bladders with which fish maintained their equilibrium; as some fish began to move onto the margins of land, those bladders acquired a new utility as reservoirs of oxygen. Biologists say that those bladders were preadapted to become lungs. Evolution can innovate in ways that cannot be prestated and is nonalgorithmic by drafting and recombining existing entities for new purposes—shifting them from their existing function to some adjacent novel function—rather than inventing features from scratch.

A species’ suite of adaptive features defines its ecological niche through its relations to other species. In the same way, every economic good occupies a niche defined by its relations to complementary and substitute goods. As the number of economic goods increases, the number of ways in which to adaptively combine those goods takes off exponentially, forging possibilities for all-new niches. The autocatalytic creation of niches is thus a main driver of economic growth.

We do not yet know what makes some systems more adaptable than others, but research on complexity has yielded some clues. Some of my own work on physical systems called spin glasses suggests that the level of central control over subsidiary parts of a system is an important consideration. Too much control freezes the system into limited configurations; too little causes it to wander aimlessly. Only systems that hover on the border between order and chaos exhibit the needed general stability and capacity to explore the universe of possible solutions to challenges.

The path to maximum prosperity will depend on finding ways to build economic systems in which new niches will generate spontaneously and abundantly. Such an approach to economics is indeed radical. It is based on the emergent behavior of systems rather than on the reductive study of them. It defies conventional mathematical treatments because it is not prestatable and is nonalgorithmic. Not surprisingly, most economists have so far resisted these ideas. Yet there can be little doubt that learning to apply these lessons from biology to technology will usher in a remarkable era of innovation and growth.

When Stuart says "We do not yet know what makes some systems more adaptable than others" and that they are just discovering that the "level of central control" matters ( his "spin glasses") I have to wonder if maybe biocomplexologists shouldn't spend more time talking to economists - we have some pretty good ideas about how that works.

As for niches, or profit opportunities in economic terms, I think there is some value in that concept, particularly when combined with the ideas such as those from an article by Olivia Judson where the existence of niches, or the lack thereof, explains differential rates of evolutionary change (i.e. different rates of innovation). For example:

Newly erupted islands are famous for this. Over and over again, archipelagos see explosive bursts of evolutionary change and the rapid appearance of species found nowhere else. New Zealand is full (and was fuller) of an amazing array of unique flightless birds... Hawaii has an abundance of unique fruit flies, spiders, silverswords ... and birds. Madagascar has all manner of lemurs... And everyone knows about the Galápagos.

Rapid bursts of evolution can also happen in new lakes... Indeed, right now, the great lakes of tropical Africa are the backdrop for the fastest known radiation of vertebrates, the cichlid fishes. Lake Victoria, for example, ... has cichlids that eat algae, cichlids that eat other cichlids, cichlids that eat fish eggs — cichlids, in short, that have evolved to eat everything that can be eaten. Some fish live in shallow water; others prefer the deeps...

Ideas about adaptive radiation can also be tested in experiments. ...[M]any bacteria can whiz through hundreds of generations in a month. This makes it relatively easy to use bacteria to look at radiations. Here’s what you do. You create two sets of environments, one simple, and one complex. The complex environment might have several different places to live, or a variety of sources of carbon. The simple environment has just one habitat or foodstuff. Then, since bacteria reproduce asexually, you take genetically identical individuals, and release them into the two different environments. Sure enough, mutations happen, and the bacteria rapidly evolve to exploit the different niches. After a month, you will find that bacteria from the complicated environment have become genetically diverse. Those from the simple environment, in contrast, remain unevolved.

In short, empty niches are a license for evolutionary change. Once the new niches are full, natural selection acts to stop further change, and the rate of evolutionary change slows. Fossils, islands and test tubes — they all show the same dynamics. ...

But this tells us very little about how islands and lakes supplying the new niches - the opportunities for profit - are created in relation to the biological system, and it does not acknowledge the additional complexity that arises when the actors within the system can respond rationally to change. Once again, I think economists have something to say about this - more than simply beginning with the exogenous emergence of lakes, islands, etc. and then modeling how these niches are filled.

Mishkin: Globalization: A Force for Good?

The newest Fed Governor, Frederic Mishkin, gives his first speech. The topic, the globalization of financial markets, has been covered here recently in an commentary by Mishkin from the Financial Times, and an interview from Crooked Timber about his book on the same topic. Here's one small section of the speech:

Globalization: A Force for Good?, by Frederic S. Mishkin, Board of Governors: ...Can more globalization--in particular, financial globalization--be a force for good?

The globalization of trade and information over the past half century has lifted vast numbers of the world's people out of extreme poverty. Despite the doom and gloom that you often hear, world economic growth since the Second World War has been at the highest pace ever recorded. What we are seeing in countries that are export oriented, and thus able to take advantage of the present age of globalization, is a reduction in poverty and a convergence of income per capita toward industrial-country levels. In India and China, for example, globalization in recent years has lifted the incomes of more than 1 billion people above the levels of extreme poverty. ...

The benefits of globalization of trade in goods and services are not controversial among economists. Polls of economists indicate that one of few things on which they agree is that the globalization of international trade, in which markets are opened to flows of foreign goods and services, is desirable. But financial globalization, the opening up to flows of foreign capital, is highly controversial, even among economists...

For example, in his best-selling book Globalization and its Discontents, Nobel laureate Joseph Stiglitz is very critical of globalization because he sees the opening up of financial markets in emerging-market economies to foreign capital as leading to economic collapse. Even Jagdish Bhagwati, one of the leading economists defending globalization of trade (after all, his book is titled In Defense of Globalization), is highly skeptical of financial globalization, stating that "the claims of enormous benefits from free capital mobility are not persuasive." George Soros, the prominent financier, opens his book On Globalization with a chapter entitled "The Deficiencies of Global Capitalism."

One reason for the controversy is that opening up the financial system to foreign capital flows has led to some disastrous financial crises causing great pain, suffering, and even violence. These crises can arise when bad policies encourage excessive risk taking by financial institutions, policies that rich elites in the developing countries often advance for their own profit. There are those (including Stiglitz and Bhagwati) who put the primary blame for the failures of financial globalization in emerging-market economies on outsiders, specifically on the International Monetary Fund, or what they refer to as the Wall Street-Treasury complex. The evidence has brought me to the conclusion that institutions like the IMF or the U.S. Treasury are not primarily to blame, although neither are they blameless--public and private financial institutions active in the international capital markets have often aided and abetted poorly designed financial globalization, although that was not their intention. ...

We have seen that the repression of the financial system is a great obstacle to economic growth and the reduction of poverty in poorer countries. Yet, if financial development offers such tremendous benefits, why doesn't every country jump on the path to growth and prosperity by imitating the institutions of the advanced economies? Part of the answer is that good institutions need to be home-grown; institutional frameworks that have been developed in the rich countries frequently do not translate well to poorer countries. This is a lesson that many in the advanced economies of the world have yet to learn. The development of good institutions in the advanced countries took hundreds of years; as they grew, they adapted to local conditions. Poor countries must develop their own institutions, and the citizens of these nations must feel they have ownership of the institutions or the institutions will be ineffective and short lived. ...

I will conclude by saying that those who oppose any and all globalization have it completely backward: Protectionism, not globalization, is the enemy. It is true that, by itself, globalization in both finance and trade is not enough to ensure economic development and that economies must position themselves to handle foreign capital flows. But as I said, to be against globalization as such is most assuredly to be against poor people, and this is presumably not the position antiglobalizers want to take. Developing countries cannot get rich unless they globalize in both trade and finance. Making financial flows truly worldwide and creating robust, efficient financial markets in developing countries is not optional: It needs to be the focus of the next great globalization. In sum, I want to challenge those who oppose globalization to rethink their objections. As Kofi Annan, the Secretary General of the United Nations, has put it, "The main losers in today's very unequal world are not those who are too much exposed to globalization. They are those who have been left out." Rather than opposing or limiting globalization, we in the rich countries and those in the developing countries must, as a moral imperative, work together to make globalization work for the general good of people all over the world.

"Inflation Persistence in an Era of Well-Anchored Inflation Expectations"

John Williams from the San Francisco Fed asks whether there has been a fundamental shift in the behavior of inflation:

Inflation Persistence in an Era of Well-Anchored Inflation Expectations, by John Williams, SF Fed: Inflation expectations and core inflation in the United States have been remarkably stable during the past 10 years, a dramatic break from the pattern seen in the prior two decades, as seen in Figure 1. Indeed, long-run inflation expectations, as measured by the median response of the Survey of Professional Forecasters have barely budged since 1998. Economic theory suggests that the observed behavior of inflation may be different in a regime of stable inflation and inflation expectations compared to regimes in which inflation is allowed to drift for a considerable period of time and expectations are poorly anchored. Such a change in the behavior of inflation, if it has occurred, potentially has important implications both for forecasting inflation and for the appropriate monetary policy response to a change in the inflation rate. This Economic Letter examines whether the recent stability of inflation and inflation expectations represents a fundamental shift in the observed behavior of inflation and explores some possible reasons why inflation dynamics may have changed.

Has the persistence of inflation changed? A large research literature has examined the determination of inflation in the United States. Much of this research focuses on the issue of how persistent inflation is, that is, how slowly it returns to its average value following a disturbance of some kind. During much of the postwar period, inflation appears to have been extremely persistent. Indeed, Atkeson and Ohanian (2001) find that inflation behaves like the so-called random walk model, where the best forecast of inflation next year is simply the most recent observed inflation rate and the inflation rate does not predictably tend to an average value ever.

Recent research has found evidence that inflation persistence in the United States may have declined starting in the early 1980s or early 1990s, when inflation became relatively low and stable. Researchers use different methods to measure persistence and to gauge whether the persistence has changed. Cogley and Sargent (2005) study a model where the inflation process changes over time and find that inflation persistence declined in the 1980s and 1990s. Stock and Watson (2006) examine a model where inflation is affected by both transitory and permanent shocks. They find a large reduction in the magnitude of permanent shocks to inflation during the 1980s and 1990s, implying that inflation has become much less persistent on average. And Levin and Piger (2002) find that after adjusting for a shift down in the average inflation rate that occurred in the early 1990s, inflation has tended to return to its average value reasonably quickly since the early 1980s.

The decline in inflation persistence can also be examined in the context of a Phillips curve model of inflation that has been popular for forecasting and policy analysis. In this model, the inflation rate in the current quarter depends on the inflation rates observed in the recent past, the unemployment rate in the previous quarter, and a constant. I adjust the unemployment rate for changes in the labor market using the Congressional Budget Office's estimates of the natural rate of unemployment. In implementing this model using quarterly data, I include four lags of inflation. The sum of the coefficients on the four inflation lags provides a rough measure of the degree of intrinsic inflation persistence, after controlling for the effects of labor market slack on inflation as measured by the unemployment rate. For example, if the sum of the coefficients on past inflation is near one, then inflation over the past four quarters has an important influence on the inflation rate in the current quarter, while if the sum of the coefficients is small, the influence of past inflation is correspondingly smaller.

In order to see whether the intrinsic persistence in inflation has changed over the past few decades, I estimated this Phillips curve model over and over for different data samples. In each case, the sample ending point is held fixed at the most recent observation of the second quarter of 2006. The sample start date ranges from the first quarter of 1980 to the fourth quarter of 1999. Because many of these data samples are quite short, I estimate this model using Rudebusch's (1992) median-unbiased estimator that corrects for the bias in standard least squares estimation that can occur with small samples. I look at two popular measures of "core" inflation based on: (1) the price index of personal consumption expenditures (PCE), and (2) the Consumer Price Index (CPI). In both cases, the "core" price index excludes prices of food and energy components. For the CPI, I use the Bureau of Labor Statistics' methodologically consistent series that corrects for changes in methodology over the past few decades.

Figure 2: Some evidence of less inflation persistence since the early 1990s

The estimated sum of coefficients on lagged inflation falls well below one for samples that begin in the early 1990s or later, indicating that inflation has become much less persistent in the past 15 years. Figure 2 shows the resulting estimated sum of the coefficients on lagged inflation, where the date on the horizontal axis indicates the starting date of the sample used for estimation. The decline in the estimated degree of inflation persistence is evident in both measures of core inflation.

Although the decline in the point estimates of the sum of the coefficients for more recent samples shown in the figure is clear to the eye, standard statistical tests do not confirm this. This inability to find clear evidence of a break reflects the imprecision of the coefficient estimates and is consistent with the findings of Pivetta and Reis (2006) and indicates that, from a purely statistical point of view, the low degree of inflation persistence observed in recent years may well be due to random variation in the data rather than a true shift in the observed behavior of inflation.

Interpreting the change in the observed behavior of inflation One interpretation of the contemporaneous attainment of stable inflation and inflation expectations and low inflation persistence is that we have experienced a run of good luck. This is the view of those who think inflation persistence has always been high and the recent evidence is not compelling enough to convince them that anything has changed. Alternatively, we may have been "lucky" in that the magnitude of "permanent inflation shocks" has fallen, as in the analysis of Stock and Watson (2006).

A different interpretation is that the change in the observed behavior of inflation reflects the effects of a past fundamental shift in monetary policy whereby the Federal Reserve now systematically acts to stabilize core inflation around a constant long-run "target" and has gained credibility with the public that it will continue to do so in the future. The observed high degree of inflation persistence in the past puzzled many macroeconomists, as discussed in Fuhrer and Moore (1995). Textbook theories of price dynamics with forward-looking expectations typically predict that inflation will display relatively low persistence, meaning that the inflation rate will tend to move close to its average value within, say, a year or two. Thus, the recent behavior of inflation appears to be more consistent with standard theories than its past behavior was.

The change in the observed persistence of inflation may reflect the effects of a shift from poorly anchored inflation expectations in the past to well-anchored expectations today. Erceg and Levin (2003) show that inflation will appear to be highly persistent if the central bank changes its inflation objective but the public is uncertain of the change, even in a model where inflation displays very little persistence if the long-run inflation objective is constant. In this view, the very high observed degree of inflation persistence seen in the past reflects the conduct of monetary policy during this period, which led to the sustained rise in inflation in the 1970s and the disinflations of the early 1980s and early 1990s. Similarly, in the model of Orphanides and Williams (2005), if long-run inflation expectations are well anchored, then inflation will be less persistent than if the public is uncertain about the long-run inflation objective.

An extreme but nonetheless illuminating example of how changes in monetary policy regimes affect the behavior of inflation is found by comparing inflation dynamics in two very different monetary policy regimes. Ball (2000) shows that variations of the random walk model describe inflation reasonably well over 1960-1999, but these models perform very poorly in the period of 1879-1914 when the monetary regime was very different and inflation displayed little persistence. In the pre-World War I period, a reasonable model is one where inflation returns to a sample mean with only a modest degree of persistence.

Conclusion Recent research finds evidence suggesting that the observed degree of inflation persistence may have become far lower in the past decade than it was in the prior two decades. This finding is consistent with the prediction of theoretical models when monetary policy systematically acts to stabilize inflation around a constant long-run target and has credibility with the public. If true, then one should expect inflation to display low persistence in years to come as long as policy continues to act in the pattern of the past decade and inflation expectations remain well anchored. This conclusion is admittedly quite tentative. Because I am looking at a relatively short period of time, it is simply not possible to determine unequivocally whether the observed shift in the observed persistence in inflation represents a sustained change in the observed behavior of inflation or instead is due to random causes.

Importantly, even taken at face value, this evidence regarding possible shifts in the persistence of inflation may only reflect changes in the correlations in the data, possibly induced by changes in the behavior of monetary policy, and not correspond to any change in the true structure of the economy. Therefore, the recent low level of inflation persistence cannot be taken as a given in designing monetary policy: if policy acts in ways to create a high degree of inflation persistence, then the public's expectations would eventually shift to reflect that reality.

John C. Williams Senior Vice President and Advisor

References [URLs accessed October 2006.]

Atkeson, Andrew, and Lee E. Ohanian. 2001. "Are Phillips Curves Useful for Forecasting Inflation?" FRB Minneapolis Quarterly Review 25(1), pp. 2-11.

Ball, Laurence. 2000. "Near-Rationality and Inflation in Two Monetary Regimes." NBER Working Paper 7988.

Cogley, Timothy, and Thomas J. Sargent. 2005. "Drifts and Volatilities: Monetary Policies and Outcomes in the Post WWII U.S." Review of Economic Dynamics 8, pp. 262-302.

Erceg, Christopher J., and Andrew T. Levin. 2003. "Imperfect Credibility and Inflation Persistence." Journal of Monetary Economics 15, pp. 915-944.

Fuhrer, Jeff, and George Moore. 1995. "Inflation Persistence." The Quarterly Journal of Economics, pp. 127-159.

Levin, Andrew T., and Jeremy M. Piger. 2002. "Is Inflation Persistence Intrinsic in Industrialized Economies?" FRB St. Louis Working Paper 2002-023E.

Orphanides, Athanasios, and John C. Williams. 2005. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy." In The Inflation-Targeting Debate, eds. Ben S. Bernanke and Michael Woodford. Chicago: University of Chicago Press, pp. 201-234.

Pivetta, Frederic, and Ricardo Reis. 2006. "The Persistence of Inflation in the United States." Journal of Economic Dynamics & Control, forthcoming.

Rudebusch, Glenn D. 1992. "Trends and Random Walks in Macroeconomic Time Series: A Re-examination." International Economic Review 33 (August), pp. 661-680.

Stock, James H., and Mark W. Watson. 2006. "Why Has Inflation Become Harder to Forecast?" NBER Working Paper 12324 (June).

Paul Krugman: Will the Levee Break?

Paul Krugman analyzes the odds of Democrats taking control of the House of Representatives:

Will the Levee Break?, by Paul Krugman, Storm Surge, Commentary, NY Times: The conventional wisdom says that the Democrats will take control of the House of Representatives next month, but only by a small margin. I’ve been looking at the numbers, however, and I believe this conventional wisdom is almost all wrong.

Here’s what’s happening: a huge Democratic storm surge is heading toward a high Republican levee. It’s still possible that the surge won’t overtop the levee — that is, the Democrats could fail by a small margin... But if the surge does go over the top, the ... Democrats [will]... probably win big. ...

Unless the Bush administration is keeping Osama bin Laden in a freezer somewhere, a majority of Americans will vote Democratic this year. If Congressional seats were allocated in proportion to popular votes, a Democratic House would be a done deal. But they aren’t...

The key point is that African-Americans, who overwhelmingly vote Democratic, are highly concentrated in a few districts. This means that in close elections many Democratic votes ... simply add to huge majorities in a small number of districts...

My back-of-the-envelope calculations suggest that because of this “geographic gerrymander,” ... the Democrats need as much as a seven-point lead in the overall vote to take control.

No wonder, then, that until a few months ago many political analysts argued that the Republicans would control the House for the foreseeable future, because only a perfect political storm could overcome the G.O.P. structural advantage.

But what’s that howling sound? Every poll taken this month shows the Democrats with a double-digit lead in the generic ballot question... The median Democratic lead is 14 points.

And here’s the thing: because there are many districts that the G.O.P. carried by only moderately large margins in recent elections, a large Democratic surge — one only a bit bigger than that needed to take the House at all — would sweep away many Republicans holding seats normally considered safe. If the actual vote is anything like what the polls now suggest, we’re talking about the Democrats holding a larger majority in the House than the Republicans have held at any point since their 1994 takeover.

So if the Democrats win, they’ll probably have a substantial majority. Whether they’ll be able to keep that majority is another question. But be prepared to wake up less than four weeks from now and learn that everything you’ve been told about American politics — liberalism is dead, whoever controls the South controls Washington, only Republicans know “the way to win” — is wrong. (Are we seeing the birth of a new New Deal coalition, in which the solid Northeast takes the place of the solid South?)

The storm may yet weaken. ... If that happens, will it mean that Republican control is permanent after all?

No. Bear in mind that the G.O.P. isn’t in trouble because of a string of bad luck. The problems that have caused Americans to turn on the party, from the disaster in Iraq to the botched response to Katrina, from the failed attempt to privatize Social Security to the sudden realization by many voters that the self-proclaimed champions of moral values are hypocrites, are deeply rooted in the whole nature of Republican governance. So even if this surge doesn’t overtop the levee, there will be another surge soon.

But the best guess is that the permanent Republican majority will end in a little over three weeks.

_________________________ Previous (10/9) column: Paul Krugman: The Paranoid Style Next (10/16) column: Paul Krugman: One Letter Politics

For Sale: Supportive Think Tank "Analysis"

The pieces of the Republican propaganda machine are slowly being revealed. Next time you see a piece from a group such as Americans for Tax Reform, Citizens Against Government Waste, or the National Center for Public Policy Research, be very, very skeptical - you may be hearing what someone is paid to say - essentially a commercial disguised as independent, professional analysis:

Report Says Nonprofits Sold Influence to Abramoff, by James V. Grimaldi and Susan Schmidt, Washington Post: Five conservative nonprofit organizations, including one run by prominent Republican Grover Norquist, "appear to have perpetrated a fraud" on taxpayers by selling their clout to lobbyist Jack Abramoff, Senate investigators said in a report issued yesterday.

The report includes previously unreleased e-mails between the now-disgraced lobbyist and officers of the nonprofit groups, showing that Abramoff funneled money from his clients to the groups. In exchange, the groups, among other things, produced ostensibly independent newspaper op-ed columns or news releases that favored the clients' positions.

Officers of the groups "were generally available to carry out Mr. Abramoff's requests for help with his clients in exchange for cash payments," said the report...

The Senate report released yesterday states that the nonprofit groups probably violated their tax-exempt status "by laundering payments and then disbursing funds at Mr. Abramoff's direction; taking payments in exchange for writing newspaper columns or press releases that put Mr. Abramoff's clients in a favorable light; introducing Mr. Abramoff's clients to government officials in exchange for payment; and agreeing to act as a front organization for congressional trips paid for by Mr. Abramoff's clients." ...

The groups named in the report are Norquist's Americans for Tax Reform; the Council of Republicans for Environmental Advocacy, which was co-founded by Norquist and Gale Norton before she became secretary of the interior; Citizens Against Government Waste; the National Center for Public Policy Research, a spinoff of the Heritage Foundation; and Toward Tradition, a Seattle-based religious group founded by Rabbi Daniel Lapin. ...

The Abramoff scandal has bruised the image of Norquist... Abramoff traded on Norquist's cachet, at one point referring to him in an e-mail as a "hard-won asset" of his lobbying empire. In exchange for Norquist's opposition to taxes on Brown-Forman products, Norquist recommended a $50,000 donation to Americans for Tax Reform, according to an Abramoff e-mail.

"What is most important, however, is that this matter is kept discreet," Abramoff wrote to a colleague at the Preston, Gates & Ellis law firm. "We do not want the opponents to think that we are trying to buy the taxpayer movement."

The e-mails show that Abramoff and Norquist explicitly discussed client donations to Norquist's group in exchange for Norquist's support. The group's advocacy "appears indistinguishable from lobbying undertaken by for-profit, taxable firms," the report said...

Norquist wrote an op-ed piece, published in the Washington Times, as part of an extensive Abramoff campaign for Channel One, which broadcasts educational programming and advertising into public school classrooms. An Abramoff e-mail to Norquist offered him $1,500 for an op-ed, and another e-mail exchange suggested up to $3,000 to buy an "economic analysis."...

Update: See also The Abramoff Gift That Keeps on Giving by Andrew Leonard at Salon.

December 10, 2006

Standards Wars

The battle between the Blu-ray and HD DVD standards:

Standard Bearers, by James Surowiecki, New Yorker: ...Technological standards—like the compact disk, or the protocols that make the Internet function—are essential to the smooth running of a global economy. Yet standards themselves are determined in unstandardized ways. Sometimes they are the product of government mandate. ... Sometimes a quasi-governmental organization or a technological consortium steps in, and sometimes deals are cut between companies. But sometimes companies that have spent billions developing new technologies decide to slug it out in the marketplace, just as Edison and Westinghouse did. Such fights are called standards wars—a familiar example is Betamax’s defeat by V.H.S.—and the biggest standards war today is the one between Blu-ray and HD DVD.

Standards wars ... generally involve just two big players, and end in a winner-take-all situation... Thus the rules that govern these wars are different from those of simple free markets.

The most important rule is that, as the economist Hal Varian says, “the product that people expect to win will win.” Consumers know that if they back the loser in a standards war they’ll be stuck with an obsolete product, so convincing them that your product is a winner is essential. Some economists argue that this means that quality is irrelevant in a standards war, but the historical record suggests that survival of the weakest is a rare occurrence. Betamax fans still extoll its superior picture quality, but for most consumers V.H.S. was the better product; Betamax tapes could fit only an hour’s recording time... Ultimately, the best way to make people believe your product will win is to have a better product.

That isn’t enough, though. It’s essential to develop as many partnerships as possible with companies that make ... “complementary goods.” Sony’s Playstation, for instance, became a huge success in part because there were simply so many more games available for it than for its competitors. Companies also need to get their products to market quickly, because, once a standard is established, it’s difficult to dislodge. ... But, while much has been written about the so-called “first mover advantage,” the historical evidence for it is shaky. Alternating current was developed after direct current, V.H.S. followed Betamax, and RCA’s color-TV technology (which eventually became the industry standard) was developed after CBS’s. So you need to be fast but not necessarily first.

Both Sony and Toshiba appear to have taken these lessons, ambiguous as they are, to heart. Toshiba was first to market... But Sony made sure that Blu-ray machines appeared soon afterward. Sony has done a better job of making partners: it has signed exclusive deals with Disney and Fox, and almost every Hollywood studio is releasing Blu-ray disks. But Toshiba is the exclusive distributor of films for Universal, and has so far released more movies... Blu-ray’s technology, which allows you to pack fifty gigabytes of data on a disk, is theoretically superior to that of HD DVD, which manages thirty. But for most users the differences in quality will probably seem negligible ... and Toshiba is offering its products at cheaper prices.

Curiously, though, a standards war in which both companies are avoiding obvious errors may not be in anyone’s best interest. An extended standoff will likely make customers hesitate to buy either product, resulting in hundreds of millions of dollars in lost sales. ... The obvious solution to this impasse is negotiation... Sony and Toshiba did talk last year, but there’s no sign that any kind of deal is in the works. Cutting a deal would require Sony and Toshiba to admit that they might lose the war, and right now neither company can afford to be seen to doubt its position. So they may end up staring at each other for a long time...

CBPP: "Sadly, Today's Claims of Budgetary Success are Orwellian"

There seems to be a difference of opinion about the news on the budget deficit. Here's president Bush:

Federal Deficit Now Lowest in 4 Years, by Deb Riechmann, AP: The federal deficit fell to a four-year low in the budget year that just ended, a result President Bush pointed to Wednesday in claiming Republicans are better stewards of the economy than are Democrats. ... "These budget numbers are proof that pro-growth economic policies work," Bush said...

Robert Greenstein of the Center on Budget and Policy Priorities:

Statement of Robert Greenstein, Executive Director, CBPP, In Response To Today's Announcement Of The 2006 Deficit Figure: "Today's announcement seems like good news, but it's more of a temporary blip than real progress. The improvement in the deficit may not extend even beyond this year, and the long-term outlook remains bleak. Despite Administration assertions, the evidence indicates this temporary improvement has little to do with a tax-cut driven surge in revenues or the economy. Revenues always grow and deficits always decline in economic recoveries. What stands out is that both revenue growth and the economy have performed markedly worse in the current recovery than in average recoveries of modern times. In addition, the tax cuts of recent years are a key factor behind our long-term deficit problems, which now appear worse than they did a few years ago. Sadly, today's claims of budgetary success are Orwellian."

Analysis from CBPP.

China's Public Offering of the Industrial and Commercial Bank

Has China's Industrial and Commercial Bank of China reformed or is it all cosmetic?:

In the New China, Banks Still Cling to Old Ways, by Austan Goolsbee, Economic Scene, NY Times: Perhaps nothing seems to represent new China more than the gleaming, ultramodern headquarters of the Industrial and Commercial Bank of China...

The announcement this week of details of the planned initial public offering of the bank — potentially the largest offering in financial history, topping $21 billion — has foreign investors in a frenzied clamor to get a toehold in the booming Chinese financial market....

But according to the work of the economists Anil Kashyap at the University of Chicago Graduate School of Business and Wendy Dobson at the University of Toronto, banks in the new China may look modern on the outside, but they are not so far from their traditional roots. Their behavior seems closer to the 1990’s crony capitalism of neighbors like Indonesia and Thailand, which engendered financial panics, than to that of international financial centers like London and New York.

The study ... titled “The Contradiction in China’s Gradualist Banking Reforms,” raises some troubling issues about the four big government-owned Chinese banks...

The basic problem, they say, is that the Chinese government owns the banks and will continue to control them after the public offerings. The government has always exercised ultimate authority over the banks’ lending decisions and, historically, has forced them to lend to corrupt and inefficient state-owned enterprises. That leaves the banks with a large share of loans that, effectively, default...

Because the government now badly wants to modernize its financial sector and bring it up to Western standards, it has made a clear attempt to clean up the balance sheets of the big banks in preparation for their public offerings. The Industrial and Commercial Bank received a direct infusion of something like $30 billion from the Ministry of Finance and the Chinese central bank. The government also reduced Industrial and Commercial’s ratio of “nonperforming loans” to less than 5 percent from 34 percent in 2000 by taking $35 billion in failed loans off its books...

At the same time, however, the government desperately wants to prevent a breakdown of regional stability and an overwhelming mass migration of workers out of rural areas... One major way it does that is by using bank loans to keep afloat the major employers in those remote areas: state-owned enterprises. Those are the same employers that failed to pay back the previous loans. Lending them money another time will, of course, mean that a large fraction of the bank’s loans will again go sour. By that point, though, the bank’s initial public offering will be long completed.

As Professor Kashyap put it in an interview: “...The government owns them. If someone from the party calls up and says, ‘Give money to State Store No. 6,’ are they going to say no? If not, then the bad loans will pile up again.”

He cites the case of a detailed examination by the consulting firm McKinsey & Company of the loans by one Chinese bank to companies in a particular region. For some 60 percent of the loans, the bank had no record of what collateral the borrower had given, what industry the borrower was in or even which bank official had made the decision to lend the money. ... Some of the highest lending rates are to remote regions like those bordering on Tibet, where the government wants people to stay.

The authors do admit that so long as China maintains the torrid growth rates of the last 10 years, the problems of the banking system will largely go unnoticed. Only with a slowdown may these flaws ignite a crisis.

But they are wary about China’s ability to sustain its growth rates. They point out that astounding rates of industrial investment — on the order of 43 percent of gross domestic product — have largely driven the current boom and that these investments have been artificially stimulated by cheap government loans. ...

According to Professor Kashyap: “If there is a slowdown, there will be a day of reckoning. It might be in a long, long time or it might be the day after the Olympics.”...