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December 4, 2007

Economist's View - 5 new articles

"Successful Assimilation of Immigrants"

There is a belief that some groups of immigrants do not assimilate as easily as other groups, and hence, it is argued, they threaten to undermine "the very fabric of our societies." This paper uses one of the latest examples of this fear, Muslims in Britain (the particular group changes over time and across countries), to argue that this belief is not supported by the evidence:

Successful assimilation of immigrants, by Esther Duflo, Vox EU: Immigration stirs up strong enough fears to justify questionable measures of protection against it – from arrests at the doors of French schools to the border wall that separates the USA from Mexico.

Economic research suggests that the intensity of these reactions seems completely disproportionate to immigration's real economic impact on the local population. David Card has shown that even massive waves of immigration (like the arrival of Cuban boat people on the coasts of Florida) don't result in lower salaries or fewer jobs for local people in the US.[1] In a recent survey article, he concluded that the "new immigration" assimilates just as well as previous waves had, and that the wages and employment prospects of natives are not any lower in cities that received more migrants[2]. Furthermore, Patricia Cortes also showed that an increase in the number of immigrants causes a price-drop in the sectors where they're concentrated (i.e., the service and food industries, and child care); this benefits the local population.[3]

Economic reasons don't seem to provide a sufficient explanation for the persistent distrust of immigrants among the native population. It seems that in part, this distrust can be attributed to the feeling that each new wave of immigrants is unique and cannot assimilate, and that the very fabric of our societies is threatened by the presence of these strangers. Just as 19th century Italian immigrants angered the French proletariat with their outward display of religion (they were disparagingly nicknamed "the christos" by the French working class), today many predict that the new wave of Latino-American immigration is essentially unable to assimilate, because it is too distant from "traditional" American values (i.e., Anglo-Saxon and Protestant values). According to Samuel Huntington, one of the most prominent political scientists in the US, this fundamental incapacity to adapt exemplifies the "shock of civilizations": the great conflicts of the twenty first century will take place along religious lines, amongst eight great "religions" of the world.[4]

In Europe, Muslim immigration is today's prime example of this "shock of cultures". Every suburban riot and every bus burned is taken as an example that children of Muslim immigrants don't consider themselves British or French. If the French played cricket, Muslim youth would certainly fail Tebbit's "cricket test" (the British minister infamously asked which side Britain's Asian immigrants would support in a Pakistani-English match).

Even in England, where the attitude towards immigration and assimilation is more relaxed than in France, the terrorist attacks of recent years gave rise to alarming observations that children of Pakistani and Bangladeshi families weren't able to adapt to British society. This was made particularly salient by the video message of one of the July 7 London bombers (British-born but whose parents were from Pakistan), which said "your democratically elected governments continuously perpetuate atrocities against my people and your support of them makes you directly responsible, just as I am directly responsible for protecting and avenging my Muslim brothers and sisters", clearly contrasting "we" and "you".[5]

But aside from a few anecdotes and these dramatic, but isolated examples, it has never been shown that young Muslims stay foreign to the culture of their adopted country more than any other immigrants. On the contrary, a recent study from Alan Manning and Sanchari Roy, of the London School of Economics,[6] suggests that there's no real difference in the pace of assimilation between Muslim immigrants (essentially Bangladeshis, Pakistanis, Somalians and Indians) and other immigrants. Manning and Roy study the response to the question asked in an annual survey which asked about what nationality the respondent associate with. The specific question is "What do you consider your national identity to be? Please choose as many or as few as apply?" There were six possible responses: British, English, Scottish, Welsh, Irish and Other. The author grouped British, English, Scottish and Welsh together under the heading "British", and take the answer "British" to this question a sign of assimilation. Among those who were born in England, 94% of persons asked consider themselves British; whereas those in Northern Ireland are 24% less likely to identify as British (they consider themselves as Irish). Second-generation children of immigrants identify less often as British, but not to a large extent (from 2% to 5% depending on the country), and it is similar across countries – in other words, children of Pakistani immigrants identify as British at least as often as the children of Italian or Chinese immigrants.

Religion doesn't have any impact on the answer to this question. Moreover, this variable doesn't seem to change over time; the youngest group of immigrant children aren't less English than other, older immigrant children. Even events like September 11th, the war in Iraq or July 7th, had no effect on young Muslims' feeling of being English. Furthermore, from the third generation, the difference (in response to this question) between the offspring of immigrants and that of native British people completely disappear, for all nationalities.

These results strongly suggest that there is no erosion of British identity amongst the children of immigrants. However, they could still feel British, but have different values. To explore this question, Manning and Roy turned to a survey of "values", conducted on 15,000 people, 5000 of whom were children of immigrants. The survey focuses on the "rights and obligations" of those surveyed (example of rights are freedom of speech, freedom of thoughts, freedom of religion, right to be treated fairly and equally, right to free education etc….; examples of responsibility include "to help and protect your family; to educate children properly, to obey and respect law. Etc..". Once again, there is no difference between Muslims and others on the number of rights and responsibility that they think they should have; and this is born out by looking at specific rights individually.

Manning and Roy rightly conclude that, on the basis of available evidence, Huntington's pessimism - that Muslim immigrants will prove "indigestible" to non-Muslim societies, seems unjustified indeed. If anything, the constant reminders of "native" Europeans that there is "us" and "them", the new, scary, Muslim immigrants and their offspring may do substantially more to create a rift than any religious or cultural feeling these immigrants have brought with them and transferred to their children.


1 David Card has written extensively about immigration. The famous piece on the massive Cuban immigration to Miami can be found at: "The Impact of the Mariel Boatlift on the Miami Labor Market." Industrial and Labor Relations Review 43 (January 1990). Other 2 David Card (2005) "Is the new Immigration Really so bad" Economic Journal 115 (November 2005) 3 Patricia Cortes (2006) "The Effect of low skilled immigration on US Prices" Working paper, university of Chicago Graduate School of Business. 4 Samuel Huntington "The Clash of Civilization and the Remaking of World Order" New York: free Press (2002) 5 Cited in Manning and Roy (2007), see reference below. 6 Alan Manning and Sanchari Roy "Culture Clash or Culture Club" Working Paper, Center for Economic Performance, London School of Economics.

"Creative Destruction's Reconstruction"

Brad DeLong on Schumpeter, my comments are at the end:

Creative Destruction's Reconstruction: Joseph Schumpeter Revisited, by J. Bradford Delong, Chronicle of Higher Education: My guess is that average literate Americans know of three 20th-century economists: John Maynard Keynes, Milton Friedman, and Alan Greenspan. ... In Prophet of Innovation: Joseph Schumpeter and Creative Destruction ..., Thomas K. McCraw, an emeritus professor of business history at Harvard Business School, tries to add another name to the list - Joseph Schumpeter. ...

Over the previous two and a half centuries, three different economic worldviews, in succession, reigned. In the late 18th and early 19th centuries, Adam Smith's was the key economic perspective, focusing on domestic and international trade and growth, the division of labor, the power of the market, and the minimal security of property and tolerable administration of justice that were needed to carry a country to prosperity. You could agree or you could disagree with Smith's conclusions and judgments, but his was the proper topical agenda.

The second reign was that of David Ricardo and Karl Marx. Their preoccupations dominated the late 19th and early 20th centuries. They worried most about the distribution of income and the laws of the market that made it so unequal. They were uneasy about ... whether an ungoverned market economy could produce a distribution of income - both relative and absolute - fit for a livable world. Again, you could agree or disagree with their judgments about trade, rent, capitalism, and machinery, but they asked the right questions.

The third reign was that of John Maynard Keynes. His agenda dominated the middle and late 20th century. Keynes's theories centered on what economists call Say's Law... Say's Law supposedly guaranteed something like full employment..., if the market was allowed to work. Keynes argued that Say's Law was false in theory, but that the government could, if it acted skillfully, make it true in practice. Agree or disagree with his conclusions, Keynes was in any case right to focus on the central bank and the tax-and-spend government to supplement the market's somewhat-palsied invisible hand to achieve stable and full employment.

But there ought to have been a fourth reign, for there was a set of themes not sufficiently explored. That missing reign was Schumpeter's, for he had insights into the nature of markets and growth that escaped other observers. It is in that sense that the late 20th and early 21st centuries in economics ought to have been his: He asked the right questions for our era.

He asked those questions in ... the Theory of Economic Development. Previous first-rank economists (with the partial exception of Marx) had concentrated on situations of equilibrium. ... Schumpeter pointed out that that wasn't how market economies really worked. The essence of capitalist economies was, ... the entrepreneur and the innovator: the risk taker who sets in motion new and more-efficient ways of making old or new products, and so produces an economy in constant change. ... Schumpeter saw ... that market capitalism destroys its own earlier generations. There is, he wrote, a constant "process ... that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism..."

In a later book, Capitalism, Socialism, and Democracy, Schumpeter wrote that the traditional view of competition must be abandoned. "Economists," he said, "are at long last emerging from the stage in which price competition was all they saw. ... [I]n capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization - competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives." ...

The innovator shows that a product, a process, or a mode of organization can be efficient and profitable, and that elevates the entire economy. But it also destroys those organizations and people who suddenly find their technologies and routines outmoded and unprofitable. There is, Schumpeter was certain, no way of avoiding this: Capitalism cannot progress without creating short-term losers alongside its short- and long-term winners: ...

Schumpeter's ideas lay waste to economists' smooth graphs of long-run growth trends and economic evolution. Growth produces progress and wealth, but in unforeseeable ways and in discrete lumps that create many small winners (for example, the people who can now buy their shirts at Wal-Mart for $8.99 as opposed to $12.99 at its less-efficient competitors), a few huge winners (for example, the Walton family of Bentonville, Ark.), and notable substantial losers (the Main Street merchants of the Mississippi Valley, the Great Plains, and the Sun Belt).

Schumpeter ... feared for the long-term survival of capitalism. ... The challenge for the government ... becomes ... the tremendously difficult job of managing the creative destruction so that capitalism does not undermine and destroy itself for essentially political reasons. Schumpeter did not think the beast could be managed...

Capitalism ... inevitably generates ... mammoth inequalities through creative destruction. The combinations of market economies and political democracies that we see today in the richest countries in the world were, Schumpeter thought, unlikely to be stable. ... He did not think governments could maintain enough social insurance to counter the destructive part of capitalism without strangling the sources of rapid growth. ...

Schumpeter's influence was limited. He died half a decade later than Keynes, but Keynes's reputation put Schumpeter's in near-total eclipse for more than a generation. ...

McCraw is ... too devoted to his subject to see one essential strand of Schumpeter's story: the academic undervaluation that resulted from his political delusions. ... Back in 1970, the economist Harry G. Johnson pointed out that all successful founders of schools not only are geniuses with profound insights but also provide a road map that tells their followers and successors what to do to make a successful academic career within the school. Schumpeter did not do that second part.

Perhaps this next century will give Schumpeter's work its proper place as the power of innovation to transform, create, enrich, and destroy makes itself manifest globally. And while we marvel at how much he got right, we can hope Schumpeter was wrong in his political analysis. One great test of our era will be whether creative destruction can flourish alongside public order and political liberty. If not, we're in big trouble. But if so - and I'm an optimist on the point - the results could be a marvel.

I cut quite a bit out, in particular Brad's description of "how Schumpeter tripped himself up over a political understanding as clumsy as his economic understanding was brilliant," but I want to focus on something else. Many people use Schumpeter's idea of creative destruction to argue that business cycles are good. Not good in the sense of having no losers - Brad has described the winners and losers above - but good in the sense of advancing economies to higher and higher levels of growth and productivity.

Are business cycles necessary for innovation? I don't think they are - there's always an incentive to improve upon existing products or production processes, cycles are not needed for this incentive to exist. Think about a single industry. Let this industry be dynamic - due to new innovation that arrives at a constant rate, suppose that each and every year 20% of the firms fail and are replaced by new upstarts with better products or better production processes. This industry is very dynamic, undergoes rapid change, yet if the 20% replacement rate stays constant there is no cycle in this industry at all. There will, of course, be structural unemployment due to the displacement of 20% of the workforce each year, and hopefully social insurance is available to them, but the amount of structural unemployment will be constant from year to year, it won't cycle.

Thus, this industry would be very dynamic and innovative, it could even be growing as new innovations are put into place when new firms enter, but there is no business cycle here, and none is needed for the industry to grow and progress.

So, are cycles needed? I can see how they might exist in this industry, there's no reason why the rate of innovation would necessarily be constant from year to year, and the rate of innovation could have some degree of persistence over time after it moves away from its long-run trend value, but much of this variation would average out when we aggregate across industries, so the existence of industry cycles does not necessarily mean there will be cycles in aggregate activity (and the converse is also true, a stable aggregate economy does not imply there are no industry cycles). Still, there could be technological changes that are sufficiently important and widespread that they function as aggregate shocks, so technologically driven aggregate cycles are certainly a theoretical possibility.

But for the question we are asking, this has causality backwards. Yes, variations in technological innovation can produce cycles, but the question is whether cycles are needed for innovation. Hopefully the industry example above makes clear that if the rate of innovation is constant, then innovation can occur even if there are no cycles at all. So cycles are not a necessary condition for innovation - if you look at an industry and its output is growing at a constant rate over time you cannot conclude that no innovation has occurred. It's possible for old firms to be cleaned out and replaced by new ones at a fairly constant rate leading to a similarly stable rate of industry growth.

Ah, you say, but you've missed the point. We need periods of higher than average growth and periods of lower than average growth, as you get with cycles, to weed out the inefficient firms and then replace them with more efficient firms in a survival of the fittest type of process. By putting the industry under stress you are able to clear out the weaker market participants, then during the upswing when profits are high the failed firms will be replaced by new and better firms. Furthermore, and this is the important part, the rate of innovation can actually be higher with cycles than without, and you might list some journal articles making this very point.

True, cycles might provide some enhancement to innovation, but I would argue this is a second-order effect (if it exists at all) relative to the amount of innovation we would get under the constant growth scenario, and that it is not at all clear that the extra innovation and growth you get with cycles is sufficiently large to compensate for the turmoil and costs that cycles bring to with them. Until someone can prove to me that innovation under a stable economy would be substantially depressed, an hypothesis contradicted by the high degree of innovation we have seen in the last twenty years despite the Great Moderation, I will continue to believe that we should pursue stabilization policy vigorously, i.e. that we do not need business cycles to attain high levels of employment, growth, and innovation.

Paul Krugman: Innovating Our Way to Financial Crisis

When you to believe in things that you don't understand, and ideology causes you to ignore signs that your beliefs are wrong, bad things can happen:

Innovating Our Way to Financial Crisis, by Paul Krugman, Commentary, NY Times: The financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance. ... I've never seen financial insiders this spooked — not even during the Asian crisis of 1997-98... This time, market players seem truly horrified — because they've suddenly realized that they don't understand the complex financial system they created.

Before I get to that, however, let's talk about what's happening right now. ... The ability to raise cash on short notice, ... "liquidity," is an essential lubricant for the ... economy... But liquidity has been drying up. Some credit markets have effectively closed up shop. ...

The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.

Behind the disappearance of liquidity lies a collapse of trust: market players don't want to lend to each other, because they're not sure they'll be repaid.

In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble — I mean, there wasn't even a glamorous new technology to justify claims that old rules no longer applied — but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk. ...

But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn't supposed to have tens of billions of dollars in subprime exposure; it did. Florida's Local Government Investment Pool, which acts as a bank for the state's school districts, was supposed to be risk-free; it wasn't (and now schools don't have the money to pay teachers).

How did things get so opaque? The answer is "financial innovation" — two words that should, from now on, strike fear into investors' hearts. O.K., to be fair, some kinds of financial innovation are good. ... But the innovations of recent years — the alphabet soup of C.D.O.'s and S.I.V.'s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk... What they did instead — aside from making their creators a lot of money, which they didn't have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, a member of the Federal Reserve Board, about a potential subprime crisis.

And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, "I don't think we'd want it the other way around." Is that your final answer, Mr. Secretary?

Now, Mr. Paulson's new proposal to help borrowers ... avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won't make more than a small dent in the subprime problem.

The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.

Fed Watch: Ignore the Hawks

Tim Duy says if you hear hawks screeching, pay them no mind:

Ignore the Hawks, by Tim Duy: Ignoring hawkish Fedspeak has been the winning strategy in recent weeks as increased market turmoil pointed to another rate cut this month despite repeated warnings from Fed officials. Clear statements that economic weakness is expected in the near term are dust in the wind compared to widening credit spreads. The debate is shifting towards a 50bp cut – a cut that cannot be ruled out given growing risk aversion in financial markets.

As recently as early last week Philadelphia Fed Charles Plosser reminded investors to ignore weak data:

In my view, if the FOMC members already expected some bad economic numbers and had already taken those into account in their outlooks when they set the fed funds rate target, then you should only see policymakers take action when the outlook changes significantly – not when a few pieces of bad economic news are released.

I doubt that Plosser was happy with the October rate cut, and I suspect he was less than thrilled when Fed Governor Donald Kohn came to the podium and gave the all clear for a rate cut in two weeks:

However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.

Kohn is quite clear – ignore Plosser. While recent data may be as expected, the downside risks are once again on the rise and threaten to disrupt our benign forecast. This point was reiterated the next day by Fed Chairman Ben Bernanke, cementing the importance of recent credit market tightening in the upcoming FOMC decision.

Amazingly, Plosser did not take the hint, saying the following day that:

''I'll reserve my judgment until I get more information'' on whether risks have shifted, Plosser told reporters in Philadelphia today. The Fed will ''watch and see and react as appropriate.''

And more amazingly:

Plosser said of Bernanke: ''You may be sure of what he thinks. I'm less sure of what he thinks.''

Plosser will be a voting member in 2008 – it should get interesting if he doesn't spend a little more time thinking about what Bernanke thinks. Plosser also floated the idea of cutting the discount rate, possibly to shift expectations away from a target rate cut:

Plosser noted that the Fed ''could'' further reduce the gap between the main rate and the charge on direct loans to banks. Officials in August lowered the discount rate by half a point, bringing the gap to 0.5 percentage point. The discount rate is now 5 percent, and the federal funds rate target is 4.5 percent.

''It certainly would be something that one could entertain,'' Plosser said about further reducing the spread between the rates.

To give Plosser the benefit of the doubt, these quotes may have been taken out of context, but one has to wonder if Plosser is reading any speeches other than his own given that Kohn already threw cold water on this approach:

In that regard, I think we had some success, at least for a time. But the usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions. This "stigma" problem is not peculiar to the United States, and central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress.

No Charles, the discount rate is simply a side show at the next meeting – market participants have wisely shifted the discussion toward a bigger fish, a 50bp cut. Deterioration in credit spreads is approaching the level that prompted a 50bp cut in September. And in some ways may be even worse. As noted by Jim Hamilton, risk aversion is spreading beyond commercial paper to Baa rated corporate bonds.

Still, I suspect the Fed will be hesitant to come to the table with a 50bp cut. Even the doves think they have already frontloaded policy. And the hawks will be foaming at the mouth as they likely believed that the balanced statement of risks implied a pause in December, and actually want to see hard data that changes their outlook before cutting again. I think that it would have been easier to justify a 50bp cut in December if they had passed on Halloween, but that ship has sailed.

Also, there are likely some lingering inflation fears on the FOMC. Note the three month trend in core-PCE:

Duyinf Three-Month Annualized Percentage Change in Core PCE

While the year over year trends are comforting, the recent behavior of inflation is less so. Of course, given Bernanke's focus on the credit situation, a recent uptick in inflation (a lagging indicator) is not going to forestall a rate cut, but it may give some pause before a 50bp cut, especially given the recent jump in headline inflation.

Bottom Line: The rate cutting continues, the Fed's benign medium term outlook notwithstanding.

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