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January 25, 2008

Economist's View - 6 new articles

"A Criminal Idea"

Jamie Galbraith tells the war hawks advocating the use of nuclear force to prevent the spread of weapons of mass destruction to think carefully about what they are suggesting because "as Nuremberg showed, it is not force that prevails. In the final analysis, it is law":

A Criminal Idea, James Galbraith, Commentary, Comment is Free: Five former Nato generals, including the former chairman of the US Joint Chiefs of Staff, John Shalikashvili, have written a "radical manifesto" which states that "the West must be ready to resort to a pre-emptive nuclear attack to try to halt the 'imminent' spread of nuclear and other weapons of mass destruction."

In other words, the generals argue that "the west" - meaning the nuclear powers including the United States, France and Britain - should prepare to use nuclear weapons ... to prevent the acquisition of nuclear weapons by a non-nuclear state. And not only that, they should use them to prevent the acquisition of biological or chemical weapons by such a state.

Under this doctrine, the US could have used nuclear weapons in the invasion of Iraq in 2003, to destroy that country's presumed stockpiles of chemical and biological weapons - stockpiles that did not in fact exist. Under it, the US could have used nuclear weapons against North Korea in 2006. The doctrine would also have justified a nuclear attack on Pakistan at any time prior to that country's nuclear tests in 1998. Or on India, at any time prior to 1974.

The Nuremberg principles are the bedrock of international law on war crimes. Principle VI criminalises the "planning, preparation, initiation or waging of a war of aggression ..." and states that the following are war crimes:

"Violations of the laws or customs of war which include, but are not limited to, ... murder or ill-treatment of prisoners of war or persons on the seas, killing of hostages, plunder of public or private property, wanton destruction of cities, towns, or villages, or devastation not justified by military necessity."

...Nuclear bombs inflict total devastation on the "cities, towns or villages" that they hit. They are the ultimate in "wanton destruction". Their use against a state with whom we are not actually at war cannot, by definition, be "justified by military necessity". ... To attack some new nuclear pretender ... would certainly constitute the "waging of a war of aggression ..." That's a crime. And the planning and preparation for such a war is no less a crime than the war itself. ...

The generals' doctrine would not only violate international law, it repudiates the principle of international law. For a law to be a law, it must apply equally to all. But the doctrine holds that "the west" is fundamentally a different entity from all other countries. ... Thus "the west" can stand as judge, jury and executioner over all other countries. By what right? No law works that way. And no country claiming such a right can also claim to respect the law, or ask any other country to respect it. ...

Is this proposed doctrine unprecedented? No, in fact it is not. For as Heather Purcell and I documented in 1994, US nuclear war-fighting plans in 1961 called for an unprovoked attack on the Soviet Union, as soon as sufficient nuclear forces were expected to be ready, in late 1963. President Kennedy quashed the plan. As JFK's adviser Ted Sorensen put it in a letter to the New York Times on July 1, 2002:

"A pre-emptive strike is usually sold to the president as a 'surgical' air strike; there is no such thing. So many bombings are required that widespread devastation, chaos and war unavoidably follow ... Yes, Kennedy 'thought about' a pre-emptive strike; but he forcefully rejected it, as would any thoughtful American president or citizen." ...

It's not just citizens and presidents who are obliged to think carefully about what General Shalikashvili and his British, French, German and Dutch colleagues now suggest. Military officers - as they know well - also have that obligation. Nuremberg Principle IV states:

"The fact that a person acted pursuant to order of his government or of a superior does not relieve him from responsibility under international law, provided a moral choice was in fact possible to him."

Any officer in the nuclear chain of command of the United States, Britain or France, faced with an order to use nuclear weapons against a non-nuclear state would be obliged, as a matter of law, to ponder those words with care. For ultimately, as Nuremberg showed, it is not force that prevails. In the final analysis, it is law.

"Welfare for Wall Street"

Thomas Palley says the recent emergency rate cut is "welfare, Federal Reserve-style":

Welfare for Wall Street, by Thomas I. Palley: The Federal Reserve's recent surprise decision to lower its short-term interest rate target by three-quarters of a point has received much attention. Most commentary has focused on the idea that the Fed is trying to stimulate spending in the hope of preventing a recession. Over-looked, and equally important, is the fact that lower interest rates raise asset prices, which is something Wall Street desperately needs to prevent a systemic meltdown.

The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. But let's not fool ourselves about Wall Street and free markets. The Fed is using its government granted power of fixing interest rates to bailout Wall Street. That is welfare, Federal Reserve-style.

Normally, economists focus on the effect of interest rates on business investment and consumer spending. The thinking is that lower rates cause increased spending, albeit with long and variable lags and the net impact is also highly uncertain and contingent on the state of confidence.

However, another feature of lower interest rates is that they increase the price of fixed income assets. Thus, when interest rates go down, bond prices go up, and that is critical for understanding recent Federal Reserve policy moves.

The U.S. financial system is currently deeply stressed. Growing perceptions of heightened default risk on mortgages and consumer debts have caused large price declines for securities backed by these assets. That in turn has caused massive losses at banks and insurance companies, eroding their capital. This erosion has placed many firms in danger of regulatory insolvency, unable to meet capital requirements. Some are in deeper danger of bankruptcy with the value of liabilities exceeding assets.

The problem is acutely visible among bond insurers, where rising default rates have reduced asset values while simultaneously increasing potential payouts on insured securities. If the bond insurers are downgraded, this could trigger a cascade of losses that could fracture the system. This is because insured bonds would fall in value, thereby wiping out further capital.

This possibility means maintaining asset prices, and preventing further mark-to-market losses is critical. The Fed's problem is that as quickly as it has been lowering the federal funds rate, default rates on mortgage and consumer debts have been rising. Consequently, rising credit risk has offset the effect of a lower federal funds rate, so that asset prices have remained weak.

Moreover, there are pitfalls in the low interest rate policy. On one hand lower rates increase bond prices and also reduce defaults on adjustable rate mortgages. On the other hand, lower interest rates could trigger a wave of mortgage re-financing by those good risks still capable of re-financing. That would cause pre-payment losses to holders of existing mortgage backed securities, while also concentrating the proportion of remaining bad risks. The net effect is prices of mortgage-backed securities could fall further.

The fact that Wall Street needs this helping hand has important public policy implications. The existing system of regulation by capital requirements helps discipline risk-taking, but it has proven inadequate. The problem is individual firms do not take account of the impact of their risk-taking on others, so that the system takes on too much risk. This problem can only be solved by a system-wide regulator who monitors and limits total risk-taking. Yet, that is exactly what the Federal Reserve has rejected during the last twenty-five years of de-regulation.

Remedying this failing calls for deep regulatory reform that is nothing less than paradigm change. This is something the Fed will resist and Congress will have to push. But until deep regulatory reform is enacted, the "welfare for Wall Street" problem will persist.

Paul Krugman: Stimulus Gone Bad

I'm getting pretty tired of Democrats caving in on important issues rather than standing up and fighting for their core principles:

Stimulus Gone Bad, by Paul Krugman, Commentary, NY Times: House Democrats and the White House have reached an agreement on an economic stimulus plan. Unfortunately, the plan — which essentially consists of nothing but tax cuts and gives most of those tax cuts to people in fairly good financial shape — looks like a lemon.

Specifically, the Democrats appear to have buckled in the face of the Bush administration's ideological rigidity, dropping demands for provisions that would have helped those most in need. And those happen to be the same provisions that might actually have made the stimulus plan effective.

Those are harsh words, so let me explain... Aside from business tax breaks — which are an unhappy story for another column — the plan ... ensures that the bulk of the money would go to people who are doing O.K. financially — which misses the whole point.

The goal ... should be to support overall spending, so as to avert or limit the depth of a recession. If the money ... doesn't get spent — if it just gets added to people's bank accounts or used to pay off debts — the plan will have failed.

And sending checks to people in good financial shape does little or nothing to increase overall spending. ... Give such people a few hundred extra dollars, and they'll just put it in the bank. In fact, that appears to be what mainly happened to the tax rebates affluent Americans received during the last recession in 2001.

On the other hand, money delivered to people who aren't in good financial shape ... does double duty: it alleviates hardship and also pumps up consumer spending.

That's why many of the stimulus proposals we were hearing just a few days ago focused ... on expanding programs that specifically help people who have fallen on hard times, especially unemployment insurance and food stamps. ...

There was also some talk among Democrats about providing temporary aid to state and local governments, whose finances are being pummeled by the weakening economy. Like help for the unemployed, this would have done double duty, averting hardship and heading off spending cuts that could worsen the downturn.

But the Bush administration has apparently succeeded in killing all of these ideas...

Why would the administration want to do this? It has nothing to do with economic efficacy... Instead, what seems to be happening is that the Bush administration refuses to sign on to anything that it can't call a "tax cut."

Behind that refusal, in turn, lies the administration's commitment to slashing tax rates on the affluent while blocking aid for families in trouble — a commitment that requires maintaining the pretense that government spending is always bad. And the result is a plan that not only fails to deliver help where it's most needed, but is likely to fail as an economic measure...

And the worst of it is that the Democrats, who should have been in a strong position — does this administration have any credibility left on economic policy? — appear to have caved in almost completely. ...[B]asically they allowed themselves to be bullied into doing things the Bush administration's way.

And that could turn out to be a very bad thing.

We don't know for sure how deep the coming slump will be... But there's a real chance not just that it will be a major downturn, but that the usual response to recession — interest rate cuts by the Federal Reserve — won't be sufficient to turn the economy around...

And if that happens, we'll deeply regret the fact that the Bush administration insisted on, and Democrats accepted, a so-called stimulus plan that just won't do the job.

When Iceland was Ghana

Thorvaldur Gylfason "assesses African development prospects using Iceland's economic ascent over the last century as a benchmark":

When Iceland was Ghana, by Thorvaldur Gylfason, Vox EU: Believe it or not: in 1901, Iceland's per capita national output was about the same as that of Ghana today. Today, Iceland occupies first place in the United Nations' ranking of material success according to the Human Development Index that reflects longevity, adult literacy, and schooling as well as the purchasing power of peoples' incomes. Can Iceland's rags-to-riches story be replicated in Africa and elsewhere in the developing world? If so, what would it take?

Grandmother-verifiable statistics

In 1901, my grandmother was twenty-four. She had six children, as was common in Iceland at the time, even if the average number of births per woman had decreased from almost six in the early 1850s to four around 1900, like in today's Ghana. In fact, the number of births per woman in Iceland was four in 1960, so Iceland and Ghana are separated in this respect by a half-century or less. It took Ghana less than fifty years, from 1960 to date, to reduce the number of births per woman by three, from almost seven to four. It took Iceland a century and a half, from the late 1850s to date, to reduce the number of births per woman by three, from five to two (or 2.1 to be precise, the critical number that keeps the population unchanged in the absence of net immigration).

True, Ghana has made more rapid progress on the population front than many other African nations. The average number of births per woman in Sub-Saharan Africa has decreased from 6.7 in 1960, as in Ghana, to 5.3 in 2005. These averages, however, mask a wide dispersion in fertility across countries. Mauritius is down to two births per woman compared with almost six in 1960. Botswana is down to three, from seven in 1960. The women of Kenya, Tanzania, and Uganda now have five, six, and seven children each on average compared with eight, seven, and seven in 1960.[1]

Goodbye to short lives in large families

The point of this comparison of demographic statistics is that social indicators often provide a clearer view than economic indicators of important aspects of economic development. Moreover, several social indicators of health and education – fertility, life expectancy, literacy, and such – are readily available for most countries and in some cases reach farther back in time than many economic statistics. Fertility matters because most families with many children cannot afford to send them all to school and empower them to make the most of their lives. Families with fewer children – say, two or three – have a better shot at being able to offer a good education to every child, thus opening doors and windows that otherwise might remain shut. Reducing family size, therefore, is one of the keys to more and better education and higher standards of life. As Hans Rosling has pointed out very vividly, short lives in large families are no longer a common denominator in developing countries.[2]

Around the globe, including in many parts of Africa, there is a clear trend toward smaller families and longer lives. In Ghana, for example, life expectancy at birth has increased by more than three months per year since 1960, from 46 years in 1960 to 58 years in 2005. In Sub-Saharan Africa on average, all 48 countries included, life expectancy increased less rapidly, from 41 years in 1960 to 47 years in 2005. Average life expectancy is now on the rise again in Africa, having reached a peak of 50 years in the late 1980s and then decreased mostly on account of the HIV/AIDS epidemic.

Iceland's economic history through African eyes

Let us now return to Iceland and briefly trace its economic history since 1901 through African eyes, as it were. In 1901, Iceland's Gross Domestic Product (GDP) per capita was about the same as that of Ghana today, measured in international dollars at purchasing power parity. This observation, illustrated in Figure 1, follows from two simple facts:

  1. Iceland's per capita GDP has increased by a factor of fifteen since 1901, a mechanical consequence of an average rate of per capita output growth of 2.6% per year from 1901 to 2006;
  2. In 2006, at USD 2,640 at purchasing power parity, Ghana's per capita GDP was about one-fourteenth of Iceland's per capita GDP of USD 36,560.
Figure 1. Through African Eyes: Iceland's per capita output, 1901-2006 (2000 = 100) Iceland

With the passage of time, Iceland's economy grew. The uneven trajectory in the figure traces the ups and downs of Iceland's actual per capita GDP, whereas the smooth one shows Iceland's potential per capita output, conventionally estimated by a simple regression of actual per capita GDP on time, thus abstracting from business cycles. By 1920, Iceland's per capita GDP had reached the level of today's Lesotho. By 1945, Iceland had become Namibia and by 1960, Botswana. By 2006, Botswana's per capita GDP had climbed to USD 12,250, one third of Iceland's. Put differently, Iceland's per capita GDP in 1960 was one third of what it is today, and its annual growth rate of 2.6% per year tripled the level of per capita GDP from 1960 to 2006. By 1985, leaving Africa behind, Iceland had become South Korea.

Piling up capital (and books)

How did Iceland do it? To make a long story short, upon achieving Home Rule in 1904, Iceland accumulated capital at a fairly rapid pace, all kinds of capital, for this is what capitalism in a mixed market economy is all about, plus hard work: physical capital through saving and investment, human capital through education and training, foreign capital through trade, financial capital through banking, and social capital by means of democracy, institution building, and equality. Natural capital also played a role, first rich fishing grounds offshore and later hydro power and geothermal energy, but the key to the successful harnessing of the country's natural capital was its earlier accumulation of human capital. And human capital is probably the single most important key to Iceland´s growth performance, due to smaller families and steadily longer lives.

When Home Rule was achieved in 1904, most of Iceland's impoverished population was already literate because literacy had been near universal since the end of the 18th century. Thus, Icelanders were well prepared for the modern age into which they were catapulted at the beginning of the 20th century. Not only is the general level of education made possible by near-universal literacy good for growth, but the social conditions – law abidance, for example – that make near-universal literacy possible are almost surely also good for growth. Exact measures of literacy in Iceland in 1900 are unavailable, but statistical information on the number of books published is available. In 1906, the number of books in Icelandic published per one thousand inhabitants was 1.6, which is more than in today's Norway and Sweden. By 1966, the number of books published in Icelandic per one thousand inhabitants had climbed to 2.7, the current level in Denmark and Finland. By 2000, the figure for Iceland had risen to seven books published per one thousand inhabitants. It is possible that, with small editions of each book, small countries such as Iceland (population 300,000) have room for more titles. Nonetheless, these are impressive figures, and reading is good for growth.[3]

Closing the gap

At the beginning of the 21st century, African societies face a twofold challenge. First, they must achieve near-universal literacy because education is the key to the accumulation of human capital as well as other types of capital and the key to growth-friendly management of natural capital. In 1970, 28% of adults in Sub-Saharan Africa knew how to read and write. By 1990, Africa's literacy rate had increased to 51% and by 2006, to 61%. Youth literacy – that is, literacy among those between the ages of 15 and 24 – had risen to 73% in 2006. The literacy gap must be closed as quickly as possible, with no child left behind. With near-universal literacy, Ghana should be able increase its per capita GDP by a factor of fifteen – why not? – in three generations, or less, as Iceland did by practicing democracy and piling up capital of all kinds through education, trade, and investment. Other African countries should as well, though most have further to go than Ghana, whose per capita GDP in 2006 was twice that of Kenya and almost four times that of Malawi.

By now, fourteen out of 48 Sub-Saharan African countries have managed to reduce the number of births per woman below 4.3, Iceland's 1960 figure. Some distances are shorter than they might seem.


1 All figures on output, fertility, and literacy cited in the text are taken from the World Bank's World Development Indicators 2007 except the historical figures on Iceland that are obtained from Statistics Iceland.

2 See the opening minutes of Rosling's 2007 TED presentation, available at

3 Canoy, Marcel F. M., Jan C. van Ours, and Frederick van der Ploeg, "The Economics of Books," Chapter 21 in V. Ginsburgh and D. Throsby (eds.), Handbook of the Economics of Art and Culture, 2006, North-Holland, Amsterdam. Also available as CEPR Discussion Paper No. 4892, February 2005.

links for 2008-01-25

I See What You Mean, It Is Broken

Lately, I've been hearing a lot about how recent events in financial markets show that capitalism is broken.

When regular old workers are thrown out of work and their lives are thrown into turmoil, we're told that's capitalism functioning as it should, creative destruction, dynamism, able to respond quickly to changes in conditions and all of that. It's a big shock to the workers who lose their jobs and their source of steady income, even more so for the large number who don't qualify for unemployment compensation that allows the unemployed to replace about half their lost income, at least for a time, but a necessary shock according to the creative destructionists.

However, when executives face the same dynamism and their income falls (so that they also face a reduction in their income, say from a million to half a million), global capitalism is broken and needs to be fixed (e.g. "Market Bloodbath Highlights Cracks in Capitalism," one of many along these lines).

So, when only workers are affected, it's capitalism doing what it does best. But when it's executives who are facing the turmoil, capitalism needs fixing. I actually agree that we could do more in terms of both preventative policy (better regulation of the financial sector for example) and stabilization policy (see the less than optimal current fiscal stimulus package) to help capitalism function better, it's just interesting how much louder the calls are to fix the system when it's the executive ox that's getting gored.

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