In a new paper, William Galston and Elaine Kamarck argue that the laws and rules that shape corporate and investor behavior today must be changed. They argue that Wall Street today is trapped in an incentive system that results in delivering quarterly profits and earnings at the expense of long-term investment.

As Galston and Kamarck see it, there’s nothing wrong with paying investors handsome returns, and a vibrant stock market is something to strive for. But when the very few can move stock prices in the short term and simultaneously reap handsome rewards for themselves, not their companies, and when this cycle becomes standard operating procedure, crowding out investments that boost productivity and wage increases that boost consumption, the long-term consequences for the economy are debilitating.

Galston and Kamarck argue that a set of incentives has evolved that favors short-term gains over long-term growth. These damaging incentives include:

• The proliferation of stock buybacks and dividends
• The increase in non-cash compensation
• The fixation on quarterly earnings
• The rise of activist Investors

These micro-incentives are so powerful that once they became pervasive in the private sector, they have broad effects, Galston and Kamarck write. Taken together, they have contributed significantly to economy-wide problems such as: (1) Rising inequality, (2) A shrinking middle class, (3) An increasing wedge between productivity & compensation, (4) Less business investment, and (5) Excessive financialization of the U.S. economy.

So what should be done? Galston and Kamarck propose reining in both share repurchases and the use of stock awards and options to compensate managers as well as refocusing corporate reporting on the long term. To this end, these scholars recommend the following policy steps:

• Repeal SEC Rule 10-B-18 and the 25% exemption
• Improve corporate disclosure practices
• Strengthen sustainability standards in 10-K reporting
• Toughen executive compensation rules
• Reform the taxation of executive compensation

Galston and Kamarck state that the American economy would work better if public corporations behaved more like private and family-held firms—if they made long-term investments, retained and trained their workers, grew organically, and offered reasonable but not excessive compensation to their top managers, based on long-term performance rather than quarterly earnings. To make these significant changes happen, the incentives that shape the decisions of CEOs and board of directors must be restructured. Reining in stock buybacks, reducing short-term equity gains from compensation packages, and shifting managers’ focus toward long-term objectives, Galston and Kamarck argue, will help address the most significant challenges facing America’s workers and corporations.  

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The Chinese currency, or renminbi (RMB), has been a contentious issue for the past several years. Most recently, members of Congress have suggested tying China currency legislation to the upcoming votes on the free trade agreements with South Korea, Colombia and Panama. While not going that far, the Senate Majority Leader, Harry Reid, and Senator Charles Schumer have promised a vote on the issue some time this year.

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Recent government data show that the bilateral trade deficit between the U.S. and China grew nearly 12 percent in the first half of 2011—fueling efforts to boost job creation domestically by authorizing import tariffs and other restrictions on countries that manipulate their currencies.

Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund (IMF), the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy as part of a broader program of “rebalancing” the Chinese economy away from its traditional reliance on exports and investment, and towards a more consumer-driven growth model. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25 percent against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the United States and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

The international conversation over the RMB remains perennially vexed because China and its trade partners have fundamentally divergent ideas on the function of exchange rates. The United States and other major developed economies, as well as the IMF, view an exchange rate simply as a price. Consistent intervention by China to keep its exchange rate substantially below the level the market would set is, in this view, a distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly.

Chinese officials take a very different view. They see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy, but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy to meet development objectives such as the creation of basic industries and infrastructure. These policies do not differ materially from those pursued by Japan, South Korea and Taiwan since World War II, or by Britain, the United States and Germany in the 19th century. Since the Chinese leaders perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China—unlike Japan in the 1970s and 1980s—is an independent geopolitical power, it is fully able to resist international pressure to change its exchange-rate policy.

A second issue raised by China’s currency and trade policies is the persistent trade surplus since 2004 which has contributed about three-quarters of the nearly US$3 trillion increase in China’s foreign exchange reserves over the past eight years. Close to two-thirds of these reserves are invested in U.S. treasury debt. Some fear that China has become the United States’ banker, and could cause a collapse in the U.S. dollar and the U.S. economy by dumping its dollar holdings. Others suggest that China’s recent moves to increase the international use of the RMB through an offshore market in Hong Kong signal China’s intent to build up the RMB as an international reserve currency to rival or eventually supplant the dollar. All of these concerns are based on serious misunderstandings of both international financial markets and China’s domestic political economy. China is not in any practical sense “America’s banker;” it is more a depositor than a lender, and its economic leverage over the United States is very modest.

And while China’s leading position in global trade makes it quite sensible to increase the use of the RMB for invoicing and settling trade, it is a huge leap from making the RMB more internationally traded to making it an attractive reserve currency. China does not now meet the basic conditions required for the issuer of a major reserve currency, and may never meet them. Most importantly, the RMB is unlikely to become more than a second-tier reserve currency so long as Chinese leaders cling to their deep reluctance to allow foreigners a significant role in China’s domestic financial markets.

China’s Currency Policies

China’s exchange-rate policy must be understood within the context of two political-economic factors: first, China’s overall development strategy which aims to build up the nation’s economic and political power with market mechanisms being tools to that end rather than ends in themselves; and second, China’s geopolitical position.

The Chinese development strategy, which emerged gradually after Deng Xiaoping began the process of “reform and opening” in 1978, is based on a careful study of how other industrial nations got rich—and in particular, the catch-up growth strategies of its east Asian neighbors Japan, South Korea and Taiwan after World War II. A key lesson of that study is that every rich nation, in the early stages of its development, used export-friendly policies to promote domestic industry and to accelerate technology acquisition. In earlier eras, when the use of the gold standard made it impossible to maintain permanently undervalued exchange rates, countries used administrative coercion and high tariffs to achieve the same effect of favoring domestic manufacturers over foreign ones. Britain’s policies of using colonies as captive markets for its manufactured exports, and prohibiting the colonies from exporting manufactures back to Britain, were important components of that nation’s rise as the world’s leading industrial power in the late 18th and 19th centuries. Resentment of those policies was one cause of the American Revolution; once independent, the United States spurred its economic development through the “American system,” which featured high tariff walls (often 40 percent or more) through the 19th and into the early 20th century. Germany used similar protective policies to foster its industries in the late 19th century. Countries did not become advocates for free trade until their firms were secure in global technological leadership and the need for protection waned for Britain, this occurred in the mid-19th century; for the United States, the mid-20th.

After World War II, undervalued exchange rates became an important tool of export promotion, partly because new global trading rules under the General Agreement on Tariffs and Trade (GATT, which morphed into the World Trade Organization in 1995) made it more difficult to maintain extremely high levels of tariff protection. The testimony of post-war economic history is quite clear. Countries that maintained undervalued exchange rates and pursued export markets enjoyed sustained high-speed economic growth and became rich. These countries include Germany, Japan, South Korea and Taiwan. Countries that used other mechanisms to block imports and encouraged their industrial firms to cater exclusively to domestic demand—so-called “import substitution industrialization,” or ISI, which usually involved an overvalued exchange rate—in some cases grew quite rapidly for 10 years or more. But this growth could not be sustained because the ISI strategy includes no mechanism for keeping pace with advances in global technology. Most ISI countries, including much of Latin America and the whole of the Communist bloc, experienced severe financial crisis and fell into long periods of stagnation.

As it tried to accelerate growth by moving from a planned to a more market-driven economy in the 1980s, China gradually depreciated the RMB by a cumulative 80 percent, from 1.8 to the dollar in 1978 to 8.7 in 1995. Since then, however, the RMB has only appreciated against the dollar, moving up to a rate of 8.3 by 1997, and holding steady at that rate until mid-2005 after which gradual appreciation resumed. Since 2006 the RMB has appreciated at an average annual rate of about 5 percent against the dollar, to its current rate of about 6.4, and it is likely that this average rate of appreciation will be sustained for the next several years. This history demonstrates that supporting export growth, while important, is not the sole determinant of China’s exchange-rate policy. During the Asian financial crisis of 1997-1998, the consensus of most economists held that the RMB was overvalued; despite this, Beijing kept the value of the RMB steady, on the grounds that devaluation would further destabilize the battered Asian regional economy. As a consequence, China endured a few years of relatively anemic growth in exports and GDP, and persistent deflation. The leadership decided that this was a price worth paying for regional economic stability.

Conversely, the appreciation since 2005 reflects Beijing’s understanding that clinging to a seriously undervalued exchange rate for too long risks sparking inflation. This occurred in many oil-rich Persian Gulf countries in 2005-2007, which held fast to unrealistically low pegged exchange rates and suffered annual inflation rates of 20 percent to 40 percent. For Chinese leaders, an inflation rate above 5 percent is considered dangerously high, and the most rapid currency appreciation in the last few years has occurred when inflationary pressure was relatively strong. A second reason for switching to a policy of gradual appreciation was the view that an ultra-cheap exchange rate disproportionately benefited manufacturers of ultra-cheap goods, whose technology content and profit margins were low. While these industries provided employment for millions, they did not contribute much to the nation’s technological upgrading. A gradual currency appreciation, economic policymakers believed, would eventually force Chinese manufacturers to move up the value chain and start producing more sophisticated and profitable goods. This strategy appears to be bearing fruit: China is rapidly gaining global market share in more advanced goods such as power generation equipment and telecoms network switches. Meanwhile, it has begun to lose market share in low-end goods like clothing and toys, to countries like Vietnam, Cambodia, Indonesia and Bangladesh.

In short, China’s exchange-rate policy is mainly driven by the aim of enhancing the nation’s export competitiveness. But other factors play a role, namely a desire to maintain domestic and regional macro-economic stability, keep inflationary pressures at bay, and force a gradual upgrading of the industrial structure. From the point of view of Chinese policy makers, all of these objectives suggest that the exchange rate should be carefully managed, rather than left to unpredictable market forces. While economists may argue that long-run economic stability is better served by a more flexible exchange rate, Chinese officials can point to the excellent track record their policies have produced: consistent GDP growth of around 10 percent a year since the late 1990s, inflation consistently at or below 5 percent, export growth of more than 20 percent a year, and a steady increase in the sophistication of Chinese exports. Until some kind of crisis convinces them that their economic policies require major adjustment, China’s economic planners are likely to stick with their current formula.

International pressure to accelerate the pace of RMB appreciation is unlikely to have much impact. The basic reason is that other countries have very little leverage that they can bring to bear. In the 1970s, the United States was able to pressure Germany and Japan to appreciate their currencies because those countries were militarily dependent on America. (Moreover, the United States was able unilaterally to engineer a devaluation of the dollar by going off the gold standard in 1971.) Japan’s position of dependency forced it to accede to the Plaza Accord of 1985, which resulted in a doubling of the value of the yen over the next two years. China, being, geopolitically independent, has no incentive to bow to pressure on the exchange rate from the United States, let alone Europe or other nations such as Brazil. The only plausible threat is that failure to appreciate the RMB could lead to a protectionist backlash that would shut the world’s doors to Chinese exports. Yet this threat has so far proved empty: even after three years of the worst global recession since the Great Depression, trade protectionism has failed to emerge in the United States or Europe.

Other considerations further strengthen the Chinese determination not to give in to foreign pressure on the exchange rate. One is the Japanese experience after the Plaza Accord. The generally accepted view in China is that the dramatic appreciation of the yen in the late 1980s was a crucial contributor to Japan’s dramatic asset-price bubble whose collapse after 1990 set the former world-beating economy on a two-decade course of economic stagnation. Chinese officials are adamant that they will not repeat the Japanese mistake. This resolve was strengthened by the global financial crisis of 2008, which in China thoroughly discredited the idea—already held in deep suspicion by Chinese leaders—that lightly regulated financial markets and free movements of capital and exchange rates are the best way to run a modern economy. China’s rapid recovery and strong growth after the crisis are deemed to vindicate the nation’s strategy of a managing the exchange rate, controlling capital flows, and keeping market forces on a tight leash.

The Internationalization of the RMB

Despite this generally self-confident view of the merit of its exchange-rate and other economic policies, Chinese leaders are troubled by one headache caused by the export-led growth strategy: the accumulation of a vast stockpile of foreign exchange reserves, most of which are parked in very low-yielding dollar assets, principally U.S. treasury bonds and bills. For a while, the accumulation of foreign reserves was viewed as a good thing. But after the 2008 financial crisis, the perils of holding enormous amounts of dollars became evident: a serious deterioration of the US economy leading to a sharp decline in the value of the dollar could severely reduce the worth of those holdings. Moreover, the pervasive use of the dollar to finance global trade proved to have hidden risks: when United States credit markets seized up in late 2008, trade finance evaporated and exporting nations such as China were particularly hard hit. The view that excessive reliance on the dollar posed economic risks led Chinese policy makers to undertake big efforts to internationalize the RMB, beginning in 2009, through the creation of an offshore RMB market in Hong Kong.

Before considering the significance of RMB internationalization, it is worth addressing some misconceptions about China’s large-scale reserve holdings and investments in U.S. treasury bonds. Because China’s central bank is the biggest single foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. First of all, it is by no means in China’s interest to cause chaos in the global economy by prompting a run on the dollar. As a major exporting nation, China would be among the biggest victims of such chaos. Second, if China sells U.S. treasury bonds, it must find some other safe foreign asset to buy, to replace the dollar assets it is selling. The reality is that no other such assets exist on the scale necessary for China to engineer a significant shift out of the dollar. China accumulates foreign reserves at an annual rate of about US$400 billion a year; there is simply no combination of markets in the world capable of absorbing such large amounts as the U.S. treasury market. It is true that China is trying to diversify its reserve holdings into other currencies, but at the end of 2010 it still held 65 percent of its reserves in dollars, well above the average for other countries (60 percent). From 2008 to 2010, when newspapers were filled with stories about China “dumping dollars,” China actually doubled its holdings of U.S. Treasury securities, to US$1.3 trillion.

The other crucial point is that China is not in any meaningful sense “America’s banker,” and its economic leverage is modest. China owns just 8% of the total outstanding stock of US Treasury debt; 69% of Treasury debt is owned by American individuals and institutions. Measured by Treasury debt holdings, America is America’s banker—not China. And China’s holdings of all US financial assets – equities, federal, municipal and corporate debt, and so on – is a trivial 1%. Chinese commercial banks lend almost nothing to American firms or consumers. The gross financing of American companies and consumers comes principally from U.S. banks, and secondarily from European ones. It is more apt to think of China as a depositor at the “Bank of the United States”: its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere -- no other bank in the world is big enough.

It is precisely this dependency that has prompted Beijing to start promoting the RMB as an international currency. By getting more companies to invoice and settle their imports and exports in RMB, China can gradually reduce its need to put its export earnings on deposit at the “Bank of the United States.” But again, headlines suggesting that internationalization of the RMB heralds the imminent demise of the current dollar-based international monetary system are premature.

The simplest reason is that the RMB’s starting point is so low that many years will be required before it becomes one of the world’s major traded currencies. In 2010, according to the Bank for International Settlements, the RMB figured in under 1 percent of the world’s foreign exchange transactions, less than the Polish zloty; the dollar figured in 85 percent and the euro in 40 percent. There is no question that use of the RMB will increase rapidly. Since Beijing started promoting the use of RMB in trade settlement (via Hong Kong) in 2009, RMB-denominated trade transactions have soared: around 10 percent of China’s imports are now invoiced in RMB. The figure for exports is lower, which makes sense. Outside China, people sending imports to China are happy to be paid in RMB, since they can reasonably expect that the currency will increase in value over time. But Chinese exporters wanting to get paid in RMB will have a difficult time finding buyers with enough RMB to pay for their shipments. Over time, however, foreign companies buying and selling goods from China will become increasingly accustomed to both receiving and making payments in RMB – just as they grew accustomed to receiving and making payments in Japanese yen in the 1970s and 1980s.

Since China is already the world’s leading exporter, and is likely to surpass the United States as the world’s leading importer within three or four years, it is quite natural that the RMB should become a significant currency for settling trade transactions. Yet the leap from that role to a major reserve currency is a very large one, and the prospect of the RMB becoming a reserve currency on the order of the euro—let alone replacing the dollar as the world’s dominant reserve currency—is remote. The reason for this is simple: to be a reserve currency, you need to have safe, liquid, low-risk assets for foreign investors to buy; these assets must trade on markets that are transparent, open to foreign investors and free from manipulation. Central banks holding dollars and euros can easily buy lots of U.S. treasury securities and euro-denominated sovereign bonds; foreign investors holding RMB basically have no choice but to put their cash into bank deposits. The domestic Chinese bond market is off-limits to foreigners, and the newly-created RMB bond market in Hong Kong (the so-called “Dim Sum” bond market) is tiny and consists mainly of junk-bond issuances by mainland property developers.

Again, we can reasonably expect rapid growth in the Hong Kong RMB bond market. But the growth of that market, and granting foreigners access to the domestic Chinese government bond market, remain severely constrained by political considerations. Just as Chinese officials do not trust markets to set the exchange rate for their currency, they do not trust markets to set the interest rate at which the government can borrow. Over the last decade Beijing has retired virtually all of its foreign borrowing; more than 95 percent of Chinese government debt is issued on the domestic market, where the principal buyers are state-owned banks that are essentially forced to accept whatever interest rate the government dictates. There is absolutely no reason to believe that the Chinese government will at any point in the near future surrender the privilege of setting the interest rate on its own borrowings to foreign bond traders over whom it has no control. As a result, it is likely to be many years before there is a large enough pool of internationally-available safe RMB assets to make the RMB a substantial international reserve currency.

In this connection the example of Japan provides an instructive example. In the 1970s and 1980s Japan occupied a position in the global economy similar to China’s today: it had surpassed Germany to become the world’s second biggest economy, and it was accumulating trade surpluses and foreign-exchange reserves at a dizzying rate. It seemed a foregone conclusion that Japan would become a central global financial power, and the yen a dominant currency. Yet this never occurred. The yen internationalized – nearly half of Japanese exports were denominated in yen, Japanese firms began to issue yen-denominated “Samurai bonds” on international markets, and the yen became an actively traded currency. Yet at its peak the yen never accounted for more than 9 percent of global reserve currency holdings, and the figure today is around 3 percent. The reason is that the Japanese government was never willing to allow foreigners meaningful access to Japanese financial markets, and in particular the Japanese government bond market. Even today, about 95 percent of Japanese government bonds are held by domestic investors, compared to 69 percent percent for US Treasury securities. China is not Japan, of course, and its trajectory could well be different. But the bias against allowing foreigners meaningful participation in domestic financial markets is at least as strong in China as in Japan, and so long as this remains the case it is unlikely that the RMB will become anything more than a regional reserve currency.

Implications for U.S. Policy

The above analysis suggests two broad conclusions of relevance to United States policymakers. First, China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Second, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy that generates large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency. A related observation is that an average annual appreciation of the RMB against the dollar of about 5 percent now seems to be firmly embedded in Chinese policy. An appreciation of this magnitude enables China to maintain export competitiveness while achieving two other objectives: keeping domestic consumer-price inflation under control, and gradually forcing an upgrade of China’s industrial structure.

Generally speaking, these trends are quite benign from a U.S. perspective. In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage that can be plausibly brought to bear. While the persistent undervaluation of the RMB will present increasing difficulties for American manufacturers of high-end equipment, as Chinese manufacturers gradually become more competitive in these sectors, the steady appreciation of the currency will increase the purchasing power of the average Chinese consumer and the total size of the Chinese consumer market. United States policy should therefore de-emphasize the exchange rate, where the potential for success is limited, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.

This paper is part of a series of in-depth policy papers, Shaping the Emerging Global Order, in collaboration with ForeignPolicy.com. Visit ForeignPolicy.com's Deep Dive section for discussion on this paper.

Time and again, China has defied the skeptics who claimed its unique mixed model—an ever-more market-driven economy dominated by an authoritarian Communist Party and behemoth state-owned enterprises—could not possibly endure. Today, those voices are louder than ever. Michael Pettis, a professor at Peking University's Guanghua School of Management and one of the most persistent and well-regarded skeptics, predicted in March that China's economic growth rate "will average not much more than 3% annually over the rest of the decade." Barry Eichengreen, an economist at the University of California, Berkeley, warned last year that China is nearing a wall hit by many high-speed economies when growth slows or stops altogether—the so-called "middle-income trap."

No question, China has many problems. Years of one-sided investment-driven growth have created obvious excesses and overcapacity. A weaker global economy since the 2008 financial crisis and rapidly rising labor cost at home have slowed China's vaunted export machine. Meanwhile, a massive housing bubble is slowly deflating, and the latest economic data is discouraging. Real growth in GDP slowed to an annualized rate of less than 7 percent in the first quarter of 2012, and April saw a sharp slowdown in industrial output, electricity production, bank lending, and property transactions. Is China's legendary economy in serious trouble?

Not just yet. The odds are that China will navigate these shoals and continue to grow at a fairly rapid pace of around 7 percent a year for the remainder of the decade, overtaking the United States to become the world's biggest economy around 2020. That's a lot slower than the historical average of 10 percent, but still solid. Considerably less certain, however, is whether China's secretive and corrupt Communist Party can make this growth equitable, inclusive, and fair. Rather than economic collapse, it's far more likely that a decade from now China will have a strong economy but a deeply flawed and unstable society.

China's economic model, for all its odd communist trappings, closely resembles the successful strategy for "catch-up growth" pioneered by Japan, South Korea, and Taiwan after World War II. The theory behind catch-up growth is that poor countries can achieve substantial convergence with rich-country income levels by simply copying and diffusing imported technology. In the 1950s and 1960s, for instance, Japan reverse-engineered products such as cars, watches, and cameras, enabling the emergence of global firms like Toyota, Nikon, and Sony. Achieving catch-up growth requires an export-focused industrial policy, intensive investment in enabling infrastructure and basic industry, and tight control over the financial system so that it supports infrastructure, basic industries, and exporters, instead of trying to maximize its own profits.

China's catch-up phase is far from over. It has mastered the production of basic industrial materials and consumer products, but its move into sophisticated machinery and high-tech products has only just begun. In 2010, China's per capita income was only 20 percent of the U.S. level. By most measures, China's economy today is comparable to Japan's in the late 1960s and South Korea's and Taiwan's around 1980. Each of those countries subsequently experienced another decade or two of rapid growth. Given the similarity of their economic systems, there is no obvious reason China should differ.

For catch-up countries, growth is mainly about resource mobilization, not resource efficiency, which is the name of the game for lower-growth rich countries. Historically, about two-thirds of China's annual real GDP growth has come from additions of capital and labor. Mainly this means moving workers out of traditional agriculture and into the modern labor force, and increasing the amount of capital inputs (like machinery and software) per worker. Less than a third of growth in China comes from greater efficiency in resource use.

In a rich country like the United States—which already has abundant capital resources and employs all its workers in the modern sector—the reverse is true. About two-thirds of growth comes from efficiency improvements and only one-third from additions to labor or capital. Conditioned by their own experience to believe that economic growth is mainly about efficiency, analysts from rich countries come to China, see widespread waste and inefficiency, and conclude that growth must be unsustainable. They miss the larger picture: The system's immense success in mobilizing capital and labor resources overwhelms marginal efficiency problems.

All developing economies eventually reach the point where they have moved most of their workers into the modern sector and have installed roughly as much capital as they need. At that point, growth tends to slow sharply. In countries that fail to make the tricky transition from a mobilization to an efficiency focus (think Latin America), real growth in per capita GDP can virtually grind to a halt. Such countries also find themselves stuck with high levels of income inequality, which tends to rise during the resource mobilization period and fall during the efficiency phase. Some worry that China—which for the last decade has had by far the highest capital spending boom in history—is already on the edge of this precipice. But the data do not support this pessimistic view. First, much surplus agricultural labor remains. Just over one-third of China's labor force still works in agriculture; the other northeast Asian economies did not see their growth rates slow noticeably until the agricultural share of the workforce fell below 20 percent. It will take about a decade for China to reach this level.

And despite years of breakneck building, China's stock of fixed capital—the total value of infrastructure, housing, and industrial plants—is not all that large relative to either the economy or the population. Rich countries typically have a capital stock a bit more than three times their annual GDP. For China, the figure is about two and a half. And on a per capita basis, China has about as much fixed capital as Japan did in the late 1960s and less than a third of what the United States had as long ago as 1930. Further large-scale investments are still required. So China's economy can continue to grow in part based on capital spending, though a gradual transition to a consumer-led economy does need to begin soon.

One illustration of China's enduring capital deficit is housing. Scarred by the catastrophic U.S. housing bubble, many observers see an even scarier property bubble in China. Robert Z. Aliber, who literally wrote the book on financial manias, called China's housing boom "totally unsustainable" this January. And it's true: Since 2005, land and housing prices have rocketed, and the outskirts of many cities are dotted by blocks of vacant apartment buildings.

But China's housing situation differs dramatically from that of the United States. The U.S. bubble started with too much borrowing (mortgages issued at 95 percent or more of a house's supposed market value), which caused a rise in housing prices far beyond the well-established trend of the previous 40 years and sparked the construction of far more houses than there were families to buy them. In China, mortgage borrowing is modest; price appreciation was mainly a one-off growth spurt in an infant market, rather than a deviation from established trend; and there is a desperate shortage of decent housing.

Since 2000, the average house in China has been bought with around 60 percent cash down, according to research by my firm, GK Dragonomics, and the minimum legal down payment has been something in the range of 20 to 30 percent—a far cry from the subprime excesses of the United States. House prices rose rapidly, but that's partly because they were artificially low before 2000, when state-owned enterprises allocated most of the housing and there was no private market. Much of the home-price appreciation of the last decade was simply a matter of the market catching up with underlying reality. And despite articles about "ghost cities" of empty apartment blocks, the bigger truth is that urban China has a housing shortage—the opposite of what typically happens at the end of a bubble.

Nearly one-third of China's 225 million urban households live in a dwelling without its own kitchen or toilet. That's like the entire country of Indonesia living in factory dormitories, temporary shelters on construction sites, basement air-raid shelters, or shanties on city outskirts. Over the next two decades, if present trends continue, another 300 million people— equivalent to nearly the entire population of the United States—will move from the countryside to China's cities. To accommodate these new migrants, alleviate the present shortage, and replace dilapidated housing, China will need to build 10 million housing units a year every year from now to 2030. Actual average completions from 2000 to 2010 were just 7 million a year, so China still has a lot of building to do. The same goes for much basic infrastructure such as power plants, gas and water supplies, and air cargo facilities.

Yet the housing market also illustrates China's true problem: not that growth is unsustainable, but that it is deeply unfair. The overall housing shortage coexists with an oversupply of luxury housing, built to cater to a new elite. Although most Chinese have benefited from economic growth, the top tier have benefited obscenely—often simply because of their government or party connections, which enable them to profit immensely from land grabs, graft on construction projects, or insider access to lucrative stock market listings. A 2010 study by Chinese economist Wang Xiaolu found that the top 2 percent of households earned a staggering 35 percent of national urban income. A handful of giant state firms, secure in monopoly positions and flush with cheap loans from state banks, has almost unlimited access to moneymaking opportunities. The state-owned banks themselves earned a staggering $165 billion in 2011. Yet private firms, which produce almost all of China's productivity and employment gains, earn thin margins and suffer pervasive discrimination.

At the root lies a political system built on a principle of unfairness. The Communist Party ultimately controls the allocation of all resources; its officials are effectively immune to legal prosecution until they first undergo an opaque internal disciplinary process. Occasionally a high official is brought down on corruption charges, like former Chongqing party secretary Bo Xilai. But such cases reflect elite power struggles, not a determined effort to end corruption. In a few years' time, China will likely surpass the United States as the world's top economy. But until it solves its fairness problem, it will remain a second-rate society.

Event Information

In recent years, China has increasingly confronted new challenges in economic policy, including rising labor costs, low household consumption, rapid urbanization and inefficient domestic investment. While it is now widely acknowledged in Beijing that major structural adjustments are needed to address these issues, implementing serious reforms pose major challenges for the newly installed leadership.

On April 16, the John L. Thornton China Center at Brookings and China’s Caixin Media Group hosted a conference to examine the daunting challenges confronting China’s new leaders. The morning panels featured a discussion of the financial sector as well as the relationship between the domestic agenda for financial reform and China’s evolving strategy for outbound investment. The afternoon panels took a close look at the political obstacles to implementing major economic reform in areas such as tax policy, the household registration system and land transfers, as well as explore the impact of environmental and natural resource constraints on China’s economic growth.

Audio

• Part 1 - The Road Ahead for China’s Economy
• Part 2 - The Road Ahead for China’s Economy

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20130416_china_economy

Just how much economic trouble is China in? To judge by global markets, a lot. In the first few weeks of the year, stock markets around the world plummeted, largely thanks to fears about China. The panic was triggered by an 11 percent plunge on the Shanghai stock exchange and by a small devaluation in the renminbi. Global investors—already skittish following the collapse of a Chinese equity-market bubble and a surprise currency devaluation last summer—took these latest moves as confirmation that the world’s second-biggest economy was far weaker than its relatively rosy headline growth numbers suggested.

In one sense, markets overreacted. China’s economy grew by 6.9 percent in 2015; financial media headlines bewailed this as “the lowest growth rate in a quarter century,” but neglected to mention that this is still by a good margin the fastest growth of any major economy except for India. Even at its new, slower pace, China continues to grow more than twice as fast as developed economies. Some doubt the reliability of China’s economic statistics, of course, but most credible alternative estimates (based on hard-to-fake indicators of physical output) still suggest that China is growing at around 6 percent, and that if anything there was a slight pickup in activity in late 2015.

It’s true that construction and heavy industry, which drove China’s growth from 2000 to 2013, are now nearing recession levels. But services—which now account for over half of China’s economy—and consumer spending remain strong, underpinned by solid employment and wage gains. The latest Nielsen survey of consumer confidence ranked China eighth of 61 countries in consumer optimism, and confidence actually increased in the last quarter of 2015. All in all, another year of 6 percent-plus growth should be achievable in 2016.

Markets also exaggerate the risk of financial crisis, with their breathless talk of capital fleeing the country. Most of this so-called “capital flight” is simply a matter of companies prudently paying down foreign-currency debts, or hedging against the possibility of a weaker renminbi by shifting their bank deposits into dollars. In the main, these deposits remain in the mainland branches of Chinese banks. Domestic bank deposits grew by a healthy 19 percent in 2015 and now stand at $21 trillion—double the country’s GDP and seven times the level of foreign exchange reserves. The continued fast rise in credit is an issue that policymakers will need to address eventually. But they have time, because lending to households and companies is backed one-for-one by bank deposits. By contrast, the United States on the eve of its crisis in 2008 had nearly four dollars of loans for every dollar of bank deposits. As long as China’s financial system stays so securely funded, the chance of a crisis is low.

Yet while we should not worry about an imminent economic “hard landing” or financial crisis, there are reasons to be seriously concerned about the country’s economic direction. The core issue is whether China can successfully execute its difficult transition from an industry- and investment-intensive economy to one focused on services and consumption, and how much disruption it causes to the rest of the world along the way. History teaches us that such transitions are never smooth. And indeed, China’s transition so far has been much rougher than the gradual slowdown in its headline GDP numbers suggests.

Remember that when China reports its GDP growth, this tells you how much its spending grew in inflation-adjusted renminbi terms. But to measure China’s impact on the rest of the world in a given year, it is better to look at its nominal growth—that is, not adjusted for inflation—in terms of the international currency: the U.S. dollar. This is because nominal U.S.-dollar figures better show how much demand China is pumping into the global economy, both in volume terms (buying more stuff) and in price terms (pushing up the prices of the stuff it buys).

When we look at things this way, China’s slowdown has been precipitous and scary. At its post-crisis peak in mid-2011, China’s nominal U.S.-dollar GDP grew at an astonishing 25 percent annual rate. During the four-year period from 2010 to 2013, the average growth rate was around 15 percent. By the last quarter of 2015, though, it had slowed to a tortoise-like 2 percent (see chart). In short, while investors are wrong to complain that China distorts its GDP data, they are right to observe that, for the rest of the world, China’s slowdown feels far worse than official GDP numbers imply.

This dramatic fall in the growth of China’s effective international demand has already hit the global economy hard, through commodity prices. In the past 18 months, the prices of iron ore, coal and oil, and other commodities have all fallen by about two-thirds, thanks in part to the slowdown in Chinese demand and in part to the glut of supply built up by mining companies that hoped China’s hunger for raw materials would keep growing forever. This has badly hurt emerging economies that depend on resource exports: Brazil, for instance, is now mired in its worst downturn since the Great Depression. The slowdown also hurts manufacturers in rich countries like the United States and Japan, which rely on sales of equipment to the mining and construction industries.

This helps explain why markets react so fearfully at every hint the renminbi might fall further in value: A weaker currency reduces the dollar value of the goods China can buy on international markets, creating more risk of a further slowdown in an already languid world economy.

There is a silver lining: The flattening of its commodity demand shows China has turned its back on an unsustainable growth model based on ever-rising investment. The question now is whether it can succeed in building a new growth model based mainly on services and consumer spending. As we noted above, growth in services and consumer spending is solid. But it is still not strong enough to carry the whole burden of driving the economy. For that to happen, much more reform is needed. And the pace of those reforms has been disappointing.

The crucial reforms all relate to increasing the role of markets, and decreasing the role of the state in economic activity. China has an unusually large state sector: OECD researchers have estimated that the value of state-owned enterprise assets is around 145 percent of GDP, more than double the figure for the next most state-dominated economy, India.[1] This large state sector functioned well for most of the last two decades, since the main tasks were to mobilize as many resources as possible and build the infrastructure of a modern economy—tasks for which state firms, which are not bound by short-term profit constraints, are well suited.

Now, however, the infrastructure is mostly built and the main task is to make the most efficient use of resources, maximize productivity, and satisfy ever-shifting consumer demand. For this job, markets must take a leading role, and the government must wean itself off the habit of using state-owned firms to achieve its economic ends. And the big worry is that, despite the promises in the November 2013 Third Plenum reform agenda, Beijing does not seem all that willing to let markets have their way.

The concerns stem from the government’s recent interventions in the equity and currency markets. Last June, when a short-lived stock market bubble popped, the authorities forced various state-controlled firms and agencies to buy up shares to stop the rout. This stabilized the market for a while, but left people wondering what would happen when these agencies started selling down the shares they had been forced to buy. To enable these holdings to be sold without disrupting the market, the authorities instituted a “circuit breaker” which automatically suspended stock-exchange trading when prices fell by 5 percent in one day. Instead of calming the market, this induced panic selling, as traders rushed to dump their shares before the circuit breaker shut off trading. The government canceled the circuit breaker, and the market remains haunted by the risk of state-controlled shareholders dumping their shares en masse.

Similarly, Beijing got into trouble in August when it announced a new exchange-rate mechanism that would make the value of the renminbi more market determined. But because it paired this move with a small, unexpected devaluation, many traders assumed the real goal was to devalue the renminbi, and started pushing the currency down. So the People’s Bank of China (PBOC) intervened massively in the foreign exchange markets, spending down its foreign-currency reserves to prop up the value of the renminbi. This stabilized the currency, but brought into question the government’s commitment to a truly market-driven exchange rate. 

Then, in December, PBOC made another change, by starting to manage the renminbi against a trade-weighted basket of 13 currencies, rather than against the dollar as in the past. Because the dollar has been strong lately, this in effect meant that PBOC was letting the renminbi devalue against the dollar. Again, PBOC argued that its intention was not to devalue, but simply to establish a more flexible exchange rate. And again, it undermined the credibility of this intention by intervening to prevent the currency from falling against the dollar.

One could argue that these episodes were merely potholes on the road to a greater reliance on markets. This may be so, but investors both inside and outside China are not convinced. The heavy-handed management of the equity and currency markets gives the impression that Beijing is not willing to tolerate market outcomes that conflict with the government’s idea of what prices should be. This runs against the government’s stated commitment in the Third Plenum decision to let market forces “play a decisive role in resource allocation.”

Another source of unease is the slow progress on state enterprise reform.  Momentum seemed strong in 2014, when provinces were encouraged to publish “mixed ownership” plans to diversify the shareholding of their firms. This raised hopes that private investors would be brought in to improve the management of inefficient state companies. Yet to date only a handful of mixed-ownership deals have been completed, and many of them involve the transfer of shares to state-owned investment companies, with no private-sector participation. Plans to subject the big centrally controlled state enterprises to greater financial discipline by putting them under holding companies modeled on Singapore’s Temasek have been incessantly discussed, but not put into action. Meanwhile the number of state firms continues to grow, rising from a low of 110,000 in 2008 to around 160,000 in 2014.

So long as Beijing continues to intervene in markets to guide prices, and fails to deliver on the key structural reforms needed to create a sustainable consumer-led economy, markets both inside and outside China will continue to be nervous about the sustainability of growth, and we will see more “China scares” like the one we endured in January. A clearer sense of direction is required, as is better communication.

For three decades, China sustained fast economic growth by steadily increasing the scope of markets, even as it preserved a large role for the state. Because investors were confident in the general trend towards more markets and more space for private firms, they were happy to invest in growth. Today neither private entrepreneurs in China, nor traders on global financial markets, are confident in such a trend. By the end of 2015 growth in investment by non-state firms had slowed to only about two-thirds the rate posted by state-owned firms, ending nearly two decades of private-sector outperformance.

Doubts are amplified by the government’s failure to communicate its intentions. During the last several months of confusion on foreign exchange markets, no senior official came forth to explain the goals of the new currency policy. No other country would have executed such a fundamental shift in a key economic policy without clear and detailed statements by a top policymaker. As China prepares for its presidency of the G-20, the government owes it both to its own people and to the global community of which it is now such an important member to more clearly articulate its commitment to market-oriented reforms and sustainable growth.

[1] P. Kowalski et al., “State-owned Enterprises: Trade Effects and Policy Implications,” OECD Trade Policy Papers No. 147 (2013). http://dx.doi.org/10.1787/5k4869ckqk7l-en

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Northeast Asia has seen significant leadership changes in recent months, with the election of Park Geun-hye as president of South Korea, Xi Jinping as leader of China’s ruling Communist Party, and Shinzo Abe as prime minister of Japan. As leaders of world-leading economies, these key players will no doubt bring about dynamic change in the region’s politics and economy, while balancing relations with the United States and its own newly re-elected president.

On November 28, 2012, the Center for Northeast Asian Studies (CNAPS) at Brookings, the Japan Center for Economic Research, and Nikkei held a one-day conference on “Managing Transitions in Northeast Asia, the Global Economy, and Japan-U.S. Relations.” Three panels, featuring Brookings scholars as well leading experts from across Asia, provided their views on issues of profound importance to the Northeast Asian region including leadership transitions, global economy and trade, global governance, and U.S.-Japan relations in the 21st Century.

Audio

• Part 1: Managing Transitions in Northeast Asia, the Global Economy, and Japan-U.S. Relations
• Part 2: Managing Transitions in Northeast Asia, the Global Economy, and Japan-U.S. Relations

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On February 2 and 3, 2010, the Brookings Institution Metropolitan Policy Program and Lazard convened leaders from the public sector, energy, infrastructure, finance and venture capital communities for an in-depth conversation focused on innovative policy and business practices that will help build the next American economy.

California Governor Arnold Schwarzenegger and Pennsylvania Governor Edward G. Rendell provided the keynote remarks. Both stressed the need for strategic investments in innovative infrastructure and energy practices going forward.

Framing the conference was the notion that the next American economy must be export-oriented, low carbon, innovation-fueled and opportunity rich—an idea which has been proposed by leading economists such as Director of the National Economic Council Larry Summers. It is with this mindset that Brookings and Lazard put together high-level, dynamic panels that centered around the private sector needs for building out the next American economy—and the policy implications. Specifically, they focused on how the traditional industry leaders (e.g., utility companies), the new industry leaders (e.g., venture capital investors), and public sector leaders can work together to move our country forward, especially within the metro areas where the resources and networks that drive innovation are rooted.

Video

• The Keys to American Competitiveness

Audio

• The Next American Economy: Transforming Energy and Infrastructure Investment

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• Transcript (.pdf)
• Bruce Katz's delivered remarks (.pdf)

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• 0203_transcript
• 0203_nextecon_katz
• 0203_overview
• 0203_agenda
• 0203_nextecon_pres

Even the most well-intentioned public policy can have unintended consequences. President Obama’s promise of doubling exports offers one thread of a broader strategy for getting our economy back on track.

Increasing our output of goods to ship and sell abroad implies that if all goes well, a growing number of goods will be transported to one of our 400 ports. Yet, as Rob Puentes has determined, our top 15 ports already move over 73 percent of the value of international freight. Increasing our exported goods means one of two possibilities: additional goods will be funneled to just a handful of ports or other ports will need to move international cargo.

And here is where the pain starts. Increasing port activities has real and often severe consequences for the cities, towns, and neighborhoods located nearby. The most immediate ramification is the increased volume in truck traffic on local roads and arterials. Back in 2005, the U.S. Department of Transportation surveyed 23 ports and found that 58 percent found local access to be below average conditions or, in other words, choked with congestion.

With more trucks carrying additional loads, some ports will likely find they have little choice but to push for port expansion to handle the supply. The process of local authorities approving port expansions is wrenching and emotional for the entire community--a controversy perhaps only superseded by the siting of jails.

If these costs seem reasonable to get our country back on track, try to argue this point to neighborhoods already burdened with these impacts. Accomplishing this national goal at the local level will not be so easy.

Yet, an easy answer for the feds is that they don’t have authority over local land use. This is also the case in Germany, where local land use decisions are determined by state and local governments. Yet on the issue of ports, Germany’s federal government has taken a keen interest in how local municipalities are supporting port activity. Their interest grew out of a desire to increase the volume of exports. In German cities and regions that contain “ports of national importance”, local municipalities will now be encouraged by the feds to change the hierarchy of land uses and activities within their zoning processes.

Specifically, local governments will be asked to consider how new uses, such as housing, will not hurt the competitiveness of the port. So instead of port noise needing to be mitigated by the port, homebuilders, and ultimately homeowners, could be responsible for mitigating the noise. One noise mitigation strategy is that homebuilders install heavy, noise-proof glass.

If the Germans should be lauded for at least trying to reconcile national economic objectives with local priorities, I wonder if more can be done than create neighborhoods of glass.

Productivity, which is the output produced by each hour of work in the non-farm business sector, grew at a paltry 1.2 percent a year in the 10 years through the third quarter of this year. In the prior decade, the growth rate was more than double, at around 3 percent a year. The question is what it means.

High-wage workers have done better than the average Joe; and profits have grown faster than wages, but productivity growth is even more important — it is the rising tide that lifts most boats. Average wages grew at more than 2 percent a year during the years of strong productivity growth and are growing at under 1 percent a year now.

The pace of the productivity increase is also vital to the nation’s finances. The last balanced federal budgets came after the fast-growth 1990s, which drove up incomes, profits and tax revenues. Today there are scary forecasts of the size of future budget deficits, and those forecasts are set to become much scarier unless productivity improves.

Slow productivity growth does not have the drama of Janet Yellen arguing with angry senators. It is a problem like termites in the attic where you don’t realize it exists until the roof collapses. And, even worse, it is a problem where there is no generally recognized explanation, nor are there obvious solutions.

One possible explanation, put forward by leading economist Robert Gordon, is that all the best innovations have been used up. He looks at the broad sweep of history, describing the age of steam, the age of electricity, and so on. The last wave, he argues, is the one fueled by the technology bubble, and it ran its course 10 years ago.

Gordon’s diagnosis is hard to swallow, however, as technology is changing all around us. A June 2015 survey of the Fortune 500 companies asked CEOs to list the biggest challenges they face, and their number-one answer by far was the challenge of rapid technological change. Any visitor to Silicon Valley or Cambridge, Massachusetts, is impressed by the pace of change.

There seems to be a major gap occurring between the cup and the lip. Technology changes apace, but the changes are apparently not translating into more efficient factories and offices.

One reason for this could be a lack of investment in business and human capital —the skills of the workforce. The Great Recession certainly put a damper on all forms of investment and the recovery has been sluggish. Regardless of what caused the slowdown, a boost to investment would help productivity.

Another possibility is that economic data are not capturing the fruits of innovations. Improved surgical procedures, new drugs and better treatment protocols allow hospitals to become more productive, but this large sector of the economy shows almost no measured productivity growth. Silicon Valley is turning out new apps to make our lives easier, but very little of this activity shows up in our productivity statistics.

Another clue to the productivity problem is that, for some reason, the dynamism of the U.S. economy seems to have faded. The number of startups is down, especially the so-called gazelles that grow fast and become much more productive.

Traditionally, a source of productivity growth has been the expansion of the most productive firms and the contraction of the less productive, and this dynamic has also slowed, perhaps due to diminished access to funding, or maybe regulation has become more burdensome.

While the cause of the problem and the nature of the solution remain uncertain, there is a lot of exciting research going on to understand productivity better and formulate policies to enhance it. If misery loves company, the United States should feel better because weak productivity is a problem for all advanced economies.

Moreover, understanding slow growth is not just a challenge for “experts.” Many of the latest best ideas are coming from the global community. Perhaps a new explanation for and solution to the productivity problem will bubble up from the new interconnected world.

Editor's Note: this piece first appeared in Inside Sources. 

A major oil spill will result in cleanup spending that boosts GDP, but no one thinks oil spills are good. Oil spills and other forms of pollution are examples of negative externalities — harm caused to others by the economic activity of a firm or industry. These externalities represent a failure of the market, and unless there is corrective action, their presence means that there is too much production of something that causes negative spillovers.

That criticism can be applied to the financial services industry. Many say that it grew too large, triggered a financial crisis and damaged the rest of the economy. Is that still the case, and is financialization spoiling the economy? Despite the alarmist rhetoric around today’s finance sector, the answer is generally “no” because of changes made to financial regulation.

First, a check on the facts: How large is the industry and how much has it grown? The broad definition of the financial sector includes finance, insurance and real estate, known by the acronym “FIRE.” It was 17.5 percent of gross domestic product in 1990 and rose to 20.0 percent in 2014, but that figure is misleading as it includes office and apartment rents and leases — stuff that has little to do with Wall Street.

Finance and insurance separately peaked well before the financial crisis at 7.7 percent of GDP, which was up from 5.8 percent in 1990. In 2014, it was 7.0 percent of GDP. Employment in finance and insurance has been on a downtrend since 2003 and is currently 4.25 percent of total nonfarm payrolls. Most of those jobs are in offices and bank branches around the country. (The output data given here are drawn from the Bureau of Economic Analysis, GDP by Industry data. The employment data are from the Bureau of Labor Statistics, Payroll Employment data. Author’s calculations.)

Still, salaries and bonuses at the top are extremely attractive, so perhaps the externality plays out by drawing the best and brightest away from other more productive activities. The Harvard Crimson reported that in 2007, 23 percent of graduating Harvard seniors said they planned to enter finance. That is an impressive number, but things turned around sharply, with the 23 percent figure falling to 11.5 percent in 2009 after the financial crisis. At this point, the financial industry really isn’t large enough to crowd out other parts of the economy.

Meanwhile, the insurance industry serves an important social purpose providing life, property, and casualty insurance. AIG got into trouble in the crisis because it strayed into providing very risky financial services, not because of its main insurance business. Likewise, the core value of banks is financial intermediation between savers and investors, giving savers relatively secure and liquid assets while also funding investment.

There are critics of how well our banking industry serves this core purpose, a quality that is hard to determine. My judgment is that it does the job pretty well compared to most other countries. As the IMF reported in September 2015, the non-performing loan problem among European banks remains severe, whereas most U.S. banks now have strong balance sheets. Good financial intermediation means that most of the savings dollars are transferred to investors and are not lost through inefficient bank operations. A 2002 study that I participated in found bank productivity higher in the United States than in France or Germany.

The parts of the financial sector that give rise to the most concern are market-making, deal-making and the creation and trading of derivatives on Wall Street. The volume of market trading has increased exponentially because of the increased speed of computers and communications. Up to a certain point, the increased volume is helpful because it adds to the liquidity of markets, but the advent of high-frequency trading has taken us over the top. As Michael Lewis describes in his book Flash Boys, the high speed traders are finding ways to shave milliseconds off the time needed to make trades. That is thoroughly wasteful. As for deal-making, it has been going on for a long time — indeed the go-go years for deals were in the 1980s — so it is hard to blame the recent slowing of economic growth on this activity.

Still, the explosion of derivatives and other overly-complex instruments was problematic, and it is crystal clear that the mortgage market became too opaque and removed accountability from the system. The layering of complex derivatives on top of lousy mortgages (and other shaky assets) distorted the economy, resulted in the overbuilding of houses, and caused the financial crisis. There are plenty of people at fault besides the bankers, but the smart people on Wall Street were driving the process, and they should have known better. The excessive financialization obscured the reality of loans that depended upon ever-rising home prices and thus were never going to be paid back. There was an externality because the private calculations of potential profit ignored the risks being imposed on society.

Is that still the situation today? No. Things have changed. Banks and other financial institutions that create risks for the whole economy are now required to hold sufficient capital to cover losses even in periods of economic and financial stress, plus a liquidity buffer (they must pass “stress tests” administered by the Federal Reserve). The screws have been turned pretty tight, and the owners of large financial institutions will bear the costs of future failures — not taxpayers. This brings private incentives in line with the public interest, getting rid of the externality that gave us too much financialization in the first place. But to keep the future safe, we’ll have to make sure no one forgets what happened in the last crisis, and ensure that new risks are not created in other, less-regulated parts of the industry.

Editor's note: This piece originally appeared in the Washington Post.

Australia's economic performance has been the standout among advanced economies for several decades. With economic growth at nearly twice the pace of US or Germany over the past decade, a remarkable 25 years without a recession and a large, highly competitive mining sector despite the end of the resources boom, Australia remains a strong economic participant in a region of the world where future global growth is likely to be generated.

But with drivers of growth over the past 25 years unlikely to be the engines of growth in coming decades, now is not a time for complacency. And if there's one lesson from Britain's decision to leave the EU, it's that that disruptive forces are sweeping through the global economy. Australia, with its cohesive politics and economic success, has been able to avoid the worst of these problems, but the dangers are present if the economic challenges are not met.

To start with, the impacts of the reforms of the 1980s and 1990s are fading. The investment boom in mining is over, and the prices for mining and agricultural exports will probably remain subdued with slower growth in China. While Australia's incomes were boosted by the improved terms of trade, this has partially reversed. The housing boom will inevitably eventually slow.

As evidenced by the results of the Brexit referendum, there is a distrust of the political and economic elites that have led the world's biggest economies. Disruptive, rapid changes in technology have not led to broad-based productivity growth. Workers in many countries have been left with stagnant incomes and governments with rising public debt.

Industry policy has a bad name among American economists who see it as a manifestation of "capture" where special interests are able to obtain subsidies from taxpayers or special protections that are not in the national interest. The modern theory of industry policy, however, recognises that a well-designed policy can actually help markets work better, therefore helping an economy like Australia's make the transition to a new growth path when faced with changing economic conditions. Productivity is the key to high growth and rising incomes – and well-designed industry policy can help.

Structure of trade competitiveness

Take, for example, Australia's manufacturing sector. Mostly because of comparative advantage, it is the smallest among all advanced economies relative to the size of its economy. In 2010, Germany had 21.2 per cent of its workforce in manufacturing while Australia's was 8.9 per cent. While it's not surprising that Australia's structure of trade competitiveness differs from Germany's because of its enormous export strength of mining and agriculture, it will benefit by taking advantage of its highly skilled workforce and the potential to develop industries based on this human capital – including advanced manufacturing industries.

One of the traditional strengths of the American economy is the close link that exists between leading universities and businesses – an area Australian policymakers are seeking to improve upon. At MIT and Stanford, professors of engineering, biology, finance or economics finish their lectures and head off to the companies they run or advise. They often enlist graduate or undergraduate students to help them with their commercial projects and these collaborations often result in jobs as well as experience. There is a danger in this model if pure research loses out to business interests, but the interaction between academia and the practical needs of companies can largely improve both research and business profitability. It's worth recalling that even the giants of science in the 18th century were motivated by the need to improve navigation or build new machines or design buildings. Funding for research should support greater industry-university cooperation as highlighted by the Watt Review.

Another important element in Australia's continued economic success is the growth of its service industries. With most jobs in these industries, the performance and productivity of services will be the largest determinant of Australia's living standards. Productivity comparisons between Australia and the United States show that Australian productivity lagged behind the US as recently as the mid-1990s, but there has since been substantial catch-up taking place. Smart regulation that promotes competition and rewards innovation are necessary to bring up the laggards. While there is a continuing debate about the possible end of productivity growth in advanced economies, Australia can still do much to catch up to global best practice.

The winners of this weekend's election will be charged with answering an important question: what is the role of government in a modern economy? How they answer that will determine future prosperity for all Australians.

Martin Baily is a senior fellow at the Brookings Institution in Washington and a former chair of the US President's Council of Economic Advisers. He has been invited by the Australian Ministry of Industry Innovation and Science to report on lessons from the US for policies to enhance economic growth, innovation and competitiveness.

Warwick McKibbin AO, is the director of the Centre for Applied Macroeconomic Analysis in the ANU Crawford School of Public Policy and is a non-resident senior fellow at the Brookings Institution.

Editor's note: this opinion first appeared in Australian Financial Review.

I have been writing for years about the Armenian Genocide. The issue is of great emotional as much as ethical and historical significance to me. But for reasons I will explain for the first time, 1915 is also a very personal matter for me. No, not because I suddenly discovered I am of Armenian descent, but mainly because 1915 is the main reason my career took a turn toward academia rather than diplomacy.

I did not join the Foreign Service because I was detained almost 20 years ago, when I was a 25-year-old tour guide. The reason? I dared to answer a couple of questions about 1915 from a group of American tourists visiting the Museum of Anatolian Civilizations in Ankara. That day changed my life. I'm not naïve; I knew answering their question in public would be risky. And I would have probably refrained from doing so had they not asked me first whether there is freedom of speech in Turkey. Trying to make light of it, I quipped: "Yes, there is freedom of speech, but freedom after speech can get tricky." I did not know my joke would turn into self-fulfilling prophecy.

Shortly after explaining to my group why the term “genocide” is problematic for Turkish officialdom, I was arrested by guards in the museum, taken to a police station and interrogated for five hours. This unexpected encounter with Turkish law enforcement convinced me about a couple of things. First, I realized how difficult life in Turkey would be if I were of Armenian descent. "Are you Armenian?" was the first question I was asked in the police station. When I said "No," the police officer laughed and said I was not the first Turkish traitor they had interrogated. To this day, I wonder how life in Turkey would be if my name was Onik instead of Ömer.

Second, I was also convinced that I no longer wanted to become a diplomat. As a diplomat, I knew you turn into a defense attorney for your country. I also knew that in the larger scheme of things, what happened to me that day was not tragic or even very consequential. But the idea of defending a country that arrests a tour guide for speaking about what happened 100 years ago turned me off intellectually and emotionally. All of a sudden, Turkey's predicament had gained a disturbingly personal dimension in my eyes and thoughts. I remember having a conversation the night I was arrested with my father, a Turkish diplomat himself and in disbelief about my lack of situational awareness. "Do you think you think you live in Sweden?" he asked me with sarcasm and some anger. Anyway, the case was closed for me. I now had a police detention record. And this was enough to disqualify me from the Foreign Ministry exam.

Since the Turkish Foreign Service had now lost a brilliant (!) future diplomat, I turned my gaze to academia and decided to continue my seditious activities in the United States by writing a dissertation on Turkey's identity problem. My focus was on the interplay between Kemalism, the official ideology of the republic and the Kurdish question and political Islam. Ever since I started working in academia and think-tanks, I made an involuntary reputation for myself as a public intellectual with pro-Kurdish, pro-Islamic, pro-Armenian tendencies. I guess that's a small price to pay for trying to be a liberal in today's Turkey. The alternative would have been a life in Turkish diplomacy talking about the "so-called Armenian Genocide,” the separatist-terrorist organization called the Kurdistan Workers' Party (PKK) and various "coup" attempts against the sacred Turkish state during the Gezi protests and the corruption investigations.

At the end of day, my arrest 20 years ago was a blessing in disguise. I'm happy my Armenian journey took me where I am.

This article was originally published in Today's Zaman.

If you're an upstanding U.S. citizen, you'll stand up and be counted this Election Day, right? Well, maybe not. Just because Americans can vote doesn't mean they do. But who shows up is what decides the tight races, which makes turnout one of the most closely watched aspects of every election -- and one that has fostered a number of myths. Here are five, debunked:

1. Thanks to increasing voter apathy, turnout keeps dwindling.

This is the mother of all turnout myths. There may be plenty of apathetic voters out there, but the idea that ever fewer Americans are showing up at the polls should be put to rest. What's really happening is that the number of people not eligible to vote is rising -- making it seem as though turnout is dropping.

Those who bemoan a decline in American civic society point to the drop in turnout from 55.2 percent in 1972, when 18-year-olds were granted the right to vote, to the low point of 48.9 percent in 1996. But that's looking at the total voting-age population, which includes lots of people who aren't eligible to vote -- namely, noncitizens and convicted felons. These ineligible populations have increased dramatically over the past three decades, from about 2 percent of the voting-age population in 1972 to 10 percent today.

When you take them out of the equation, the post-1972 "decline" vanishes. Turnout rates among those eligible to vote have averaged 55.3 percent in presidential elections and 39.4 percent in midterm elections for the past three decades. There has been variation, of course, with turnout as low as 51.7 percent in 1996 and rebounding to 60.3 percent by 2004. Turnout in the most recent election, in fact, is on a par with the low-60 percent turnout rates of the 1950s and '60s.

2. Other countries' higher turnout indicates more vibrant democracies.

You can't compare apples and oranges. Voting rules differ from nation to nation, producing different turnout rates. Some countries have mandatory voting. If Americans were fined $100 for playing voter hooky on Election Day, U.S. participation might increase dramatically. But in fact, many people with a ballot pointed at their head simply cast a blank one or a nonsense vote for Mickey Mouse.

Moreover, most countries have national elections maybe once every five years; the United States has presidential or congressional elections every two years. Frequent elections may lead to voter fatigue. New European Union elections, for instance, seem to be depressing turnout in member countries. After decades of trailing turnout in the United Kingdom, U.S. turnout in 2004 was on a par with recent British elections, in which turnout was 59.4 percent in 2001 and 61.4 percent in 2005.

Americans are asked to vote more often -- in national, state, local and primary contests -- than the citizens of any other country. They can be forgiven for missing one or two elections, can't they? Even then, over the course of several elections, Americans have more chances to participate and their turnout may be higher than that in countries where people vote only once every five years.

3. Negative ads turn off voters and reduce turnout.

Don't be so sure. The case on this one is still open. Negative TV advertising increased in the mid-1980s, but turnout hasn't gone down correspondingly. The negative Swift boat campaign against Sen. John F. Kerry (D-Mass.) apparently did little to depress turnout in the 2004 presidential race.

Some academic studies have found that negative advertising increases turnout. And that's not so surprising: A particularly nasty ad grabs people's attention and gets them talking. People participate when they're interested. A recent GOP attack ad on Rep. Harold E. Ford Jr. (D-Tenn.), a Senate candidate, has changed the dynamic of the race, probably not because it changed minds or dissuaded Democrats, but because it energized listless Republicans.

We'll have to wait to see whether the attack on Ford backfires because voters perceive it as unfair. That's the danger of going negative. So campaigns tend to stick to "contrast ads," in which candidates contrast their records with those of their opponents. When people see stark differences between candidates, they're more likely to vote.

4. The Republican "72-hour campaign" will win the election.

Not necessarily. You can lead citizens to the ballot, but you can't make them vote.

Republicans supposedly have a super-sophisticated last-minute get-out-the-vote effort that identifies voters who'll be pivotal in electing their candidates. Studies of a campaign's personal contact with voters through phone calls, door-to-door solicitation and the like find that it does have some positive effect on turnout. But people vote for many reasons other than meeting a campaign worker, such as the issues, the closeness of the election and the candidates' likeability. Further, these studies focus on get-out-the-vote drives in low-turnout elections, when contacts from other campaigns and outside groups are minimal. We don't know what the effects of mobilization drives are in highly competitive races in which people are bombarded by media stories, television ads and direct mail.

Republican get-out-the-vote efforts could make a difference in close elections if Democrats simply sat on the sidelines. But this year Democrats have vowed to match the GOP mobilization voter for voter. So it'll take more than just knowing whether a prospective voter owns a Volvo or a BMW for Republicans to eke out victory in a competitive race.

5. Making voter registration easier would dramatically increase turnout.

Well, yes and no.

In 1993, the Democratic government in Washington enacted "Motor Voter," a program that allowed people to register to vote when they received their driver's license or visited a welfare office. Democrats thought that if everyone were registered, turnout rates would increase -- by as much as 7 percentage points.

But while many people registered to vote, turnout didn't go up much. Subsequent studies found only small increases in turnout attributable to Motor Voter, perhaps 2 percentage points.

Sizable increases in turnout can be seen in states with Election Day registration, which allows people to register when they vote. This may be related to the fact that lots of people don't make up their minds to vote until Election Day, rather than months in advance when they get a license.

Leaders will head to the G-20 Summit in Los Cabos, Mexico, among renewed serious concern about the world economy. The turmoil that started with the U.S. subprime mortgage crisis has resulted in now almost five years of ongoing instability. The emerging market economies fared much better than the advanced economies and pulled out of the crisis already in 2009, but the slowdown we are now facing in 2012 is again global, demonstrating the interdependence in the world economy. The emerging market economies have stronger underlying trend growth rates, but they remain vulnerable to a downturn in the advanced economies. The center of concern is now squarely on Europe, with a recession threatening most European countries, even those that had reasonably good performances so far. After an encouraging start in 2012, the U.S. economy, while not close to a recession, is also showing signs of a slowdown rather than the hoped for steady acceleration of growth. And the slowdown is spreading across the globe.

At a time like this it would be desirable and necessary that the G-20 show real initiative and cohesion. The essays in this collection look at the challenge from various angles. There is concern that the G-20 is losing its sense of purpose, that cohesion is decreasing rather than increasing, and that policy initiatives are reactive to events rather than proactive. Let us hope that at this moment of great difficulty, the G-20 will succeed in giving the world economy a new sense of direction and confidence. It is much needed.

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On May 16, I got into a Twitter argument with Campbell Brown of The 74, an education website.  She released a video on Slate giving advice to the next president.  The video begins: “Without question, to me, the issue is education. Two out of three eighth graders in this country cannot read or do math at grade level.”  I study student achievement and was curious.  I know of no valid evidence to make the claim that two out of three eighth graders are below grade level in reading and math.  No evidence was cited in the video.  I asked Brown for the evidentiary basis of the assertion.  She cited the National Assessment of Educational Progress (NAEP).

NAEP does not report the percentage of students performing at grade level.  NAEP reports the percentage of students reaching a “proficient” level of performance.  Here’s the problem. That’s not grade level. 

In this post, I hope to convince readers of two things:

1.  Proficient on NAEP does not mean grade level performance.  It’s significantly above that.
2.  Using NAEP’s proficient level as a basis for education policy is a bad idea.

Before going any further, let’s look at some history.

NAEP history 

NAEP was launched nearly five decades ago.  The first NAEP test was given in science in 1969, followed by a reading test in 1971 and math in 1973.  For the first time, Americans were able to track the academic progress of the nation’s students.  That set of assessments, which periodically tests students 9, 13, and 17 years old and was last given in 2012, is now known as the Long Term Trend (LTT) NAEP. 

It was joined by another set of NAEP tests in the 1990s.  The Main NAEP assesses students by grade level (fourth, eighth, and twelfth) and, unlike the LTT, produces not only national but also state scores.  The two tests, LTT and main, continue on parallel tracks today, and they are often confounded by casual NAEP observers.  The main NAEP, which was last administered in 2015, is the test relevant to this post and will be the only one discussed hereafter.  The NAEP governing board was concerned that the conventional metric for reporting results (scale scores) was meaningless to the public, so achievement standards (also known as performance standards) were introduced.  The percentage of students scoring at advanced, proficient, basic, and below basic levels are reported each time the main NAEP is given.

Does NAEP proficient mean grade level? 

The National Center for Education Statistics (NCES) states emphatically, “Proficient is not synonymous with grade level performance.” The National Assessment Governing Board has a brochure with information on NAEP, including a section devoted to myths and facts.  There, you will find this:

Myth: The NAEP Proficient level is like being on grade level.

Fact: Proficient on NAEP means competency over challenging subject matter.  This is not the same thing as being “on grade level,” which refers to performance on local curriculum and standards. NAEP is a general assessment of knowledge and skills in a particular subject.

Equating NAEP proficiency with grade level is bogus.  Indeed, the validity of the achievement levels themselves is questionable.  They immediately came under fire in reviews by the U.S. Government Accountability Office, the National Academy of Sciences, and the National Academy of Education.[1]  The National Academy of Sciences report was particularly scathing, labeling NAEP’s achievement levels as “fundamentally flawed.”

Despite warnings of NAEP authorities and critical reviews from scholars, some commentators, typically from advocacy groups, continue to confound NAEP proficient with grade level.  Organizations that support school reform, such as Achieve Inc. and Students First, prominently misuse the term on their websites.  Achieve presses states to adopt cut points aligned with NAEP proficient as part of new Common Core-based accountability systems.  Achieve argues that this will inform parents whether children “can do grade level work.” No, it will not.  That claim is misleading.

How unrealistic is NAEP proficient? 

Shortly after NCLB was signed into law, Robert Linn, one of the most prominent psychometricians of the past several decades, called ”the target of 100% proficient or above according to the NAEP standards more like wishful thinking than a realistic possibility.”  History is on the side of that argument.  When the first main NAEP in mathematics was given in 1990, only 13 % of eighth graders scored proficient and 2 % scored advanced.  Imagine using “proficient” as synonymous with grade level—85 % scored below grade level! 

The 1990 national average in eighth grade scale scores was 263 (see Table 1).  In 2015, the average was 282, a gain of 19 scale score points.

Table 1.  Main NAEP Eighth Grade Math Score, by achievement levels, 1990-2015

That’s an impressive gain.  Analysts who study NAEP often use 10 points on the NAEP scale as a back of the envelope estimate of one year’s worth of learning.  Eighth graders have gained almost two years.  The percentage of students scoring below basic has dropped from 48%  in 1990 to 29% in 2015.  The percentage of students scoring proficient or above has more than doubled, from 15% to 33%.  That’s not bad news; it’s good news.

But the cut point for NAEP proficient is 299.  By that standard, two-thirds of eighth graders are still falling short.  Even students in private schools, despite hailing from more socioeconomically advantaged homes and in some cases being selectively admitted by schools, fail miserably at attaining NAEP proficiency.  More than half (53 percent) are below proficient. 

Today’s eighth graders have made it about half-way to NAEP proficient in 25 years, but they still need to gain almost two more years of math learning (17 points) to reach that level.  And, don’t forget, that’s just the national average, so even when that lofty goal is achieved, half of the nation’s students will still fall short of proficient.  Advocates of the NAEP proficient standard want it to be for all students.  That is ridiculous.  Another way to think about it: proficient for today’s eighth graders reflects approximately what the average twelfth grader knew in mathematics in 1990.   Someday the average eighth grader may be able to do that level of mathematics.  But it won’t be soon, and it won’t be every student.

In the 2007 Brown Center Report on American Education, I questioned whether NAEP proficient is a reasonable achievement standard.[2]  That year, a study by Gary Phillips of American Institutes for Research was published that projected the 2007 TIMSS scores on the NAEP scale.  Phillips posed the question: based on TIMSS, how many students in other countries would score proficient or better on NAEP?  The study’s methodology only produces approximations, but they are eye-popping.

Here are just a few countries:

Table 2.  Projected Percent NAEP Proficient, Eighth Grade Math

Singapore was the top scoring nation on TIMSS that year, but even there, more than a quarter of students fail to reach NAEP proficient.  Japan is not usually considered a slouch on international math assessments, but 43% of its eighth graders fall short.  The U.S. looks weak, with only 26% of students proficient.  But England, Israel, and Italy are even weaker.  Norway, a wealthy nation with per capita GDP almost twice that of the U.S., can only get 9 out of 100 eighth graders to NAEP proficient.

Finland isn’t shown in the table because it didn’t participate in the 2007 TIMSS.  But it did in 2011, with Finland and the U.S. scoring about the same in eighth grade math.  Had Finland’s eighth graders taken NAEP in 2011, it’s a good bet that the proportion scoring below NAEP proficient would have been similar to that in the U.S.  And yet articles such as “Why Finland Has the Best Schools,” appear regularly in the U.S. press.[3]

Why it matters

The National Center for Education Statistics warns that federal law requires that NAEP achievement levels be used on a trial basis until the Commissioner of Education Statistics determines that the achievement levels are “reasonable, valid, and informative to the public.”  As the NCES website states, “So far, no Commissioner has made such a determination, and the achievement levels remain in a trial status.  The achievement levels should continue to be interpreted and used with caution.”

Confounding NAEP proficient with grade-level is uninformed.  Designating NAEP proficient as the achievement benchmark for accountability systems is certainly not cautious use.  If high school students are required to meet NAEP proficient to graduate from high school, large numbers will fail. If middle and elementary school students are forced to repeat grades because they fall short of a standard anchored to NAEP proficient, vast numbers will repeat grades.    

On NAEP, students are asked the highest level math course they’ve taken.  On the 2015 twelfth grade NAEP, 19% of students said they either were taking or had taken calculus.   These are the nation’s best and the brightest, the crème-de la crème of math students.  Only one in five students work their way that high up the hierarchy of American math courses.  If you are over 45 years old and reading this, the proportion who took calculus in high school is less than one out of ten.  In the graduating class of 1990, for instance, only 7% of students had taken calculus.[4] 

Unsurprisingly, calculus students are also typically taught by the nation’s most knowledgeable math teachers.  The nation’s elite math students paired with the nation’s elite math teachers: if any group can prove NAEP proficient a reasonable goal and succeed in getting all students over the NAEP proficiency bar, this is the group. 

But they don’t.  A whopping 30% score below proficient on NAEP.  For black and Hispanic calculus students, the figures are staggering.  Two-thirds of black calculus students score below NAEP proficient.  For Hispanics, the figure is 52%.  The nation’s pre-calculus students also fair poorly (69% below proficient). Then the success rate falls off a cliff.  In the class of 2015, more than nine out of ten students whose highest math course was Trigonometry or Algebra II fail to meet the NAEP proficient standard.

Table 3.  2015 NAEP Twelfth Grade Math, Proficient by Highest Math Course Taken

Source: NAEP Data Explorer

These data defy reason; they also refute common sense.  For years, educators have urged students to take the toughest courses they can possibly take.  Taken at face value, the data in Table 3 rip the heart out of that advice.  These are the toughest courses, and yet huge numbers of the nation’s star students, by any standard aligned with NAEP proficient, would be told that they have failed.  Some parents, misled by the confounding of proficient with grade level, might even mistakenly believe that their kids don’t know grade level math.

Conclusion 

NAEP proficient is not synonymous with grade level.  NAEP officials urge that proficient not be interpreted as reflecting grade level work.  It is a standard set much higher than that.  Scholarly panels have reviewed the NAEP achievement standards and found them flawed.  The highest scoring nations of the world would appear to be mediocre or poor performers if judged by the NAEP proficient standard.  Even large numbers of U.S. calculus students fall short.

As states consider building benchmarks for student performance into accountability systems, they should not use NAEP proficient—or any standard aligned with NAEP proficient—as a benchmark.  It is an unreasonable expectation, one that ill serves America’s students, parents, and teachers--and the effort to improve America’s schools.

Medicare Hospital Insurance and Social Security would not add to deficits because they can’t spend money they don’t have.

The dog days of August have given way to something much worse. Congress returned to session this week, and the rest of the year promises to be nightmarish. The House and Senate passed budget resolutions earlier this year calling for nearly $5 trillion in spending cuts by 2025. More than two-thirds of those cuts would come from programs that help people with low-and moderate-incomes. Health care spending would be halved. If such cuts are enacted, the president will likely veto them. At best, another partisan budget war will ensue after which the veto is sustained. At worst, the cuts become law.

The putative justification for these cuts is that the nation faces insupportable increases in public debt because of expanding budget deficits. Even if the projections were valid, it would be prudent to enact some tax increases in order to preserve needed public spending. But the projections of explosively growing debt are not valid. They are fantasy.

Wait! you say. The Congressional Budget Office has been telling us for years about the prospect of rising deficit and exploding debt. They repeated those warnings just two months ago. Private organizations of both the left and right agree with the CBO’s projections, in general if not in detail. How can any sane person deny that the nation faces a serious long-term budget deficit problem?

The answer is simple: The CBO and private organizations use a convention in preparing their projections that is at odds with established policy and law. If, instead, projections are based on actual current law, as they claim to be, the specter of an increasing debt burden vanishes. What is that convention? Why is it wrong? Why did CBO adopt it, and why have others kept it?

CBO’s budget projections cover the next 75 years. Its baseline projections claim to be based on current law and policy. (CBO also presents an ‘alternative scenario’ based on assumed changes in law and policy). Within that period, Social Security (OASDI) and Medicare Hospital Insurance (HI) expenditures are certain to exceed revenues earmarked to pay for them. Both are financed through trust funds. Both funds have sizeable reserves — government securities — that can be used to cover short falls for a while. But when those reserves are exhausted, expenditures cannot exceed current revenues. Trust fund financing means that neither Social Security nor Medicare Hospital Insurance can run deficits. Nor can they add to the public debt.

Nonetheless, CBO and other organizations assume that Social Security and Medicare Hospital Insurance can and will spend money they don’t have and that current law bars them from spending.

One of the reasons why trust fund financing was used, first for Social Security and then for Medicare Hospital Insurance, was to create a framework that disciplined Congress earmarked to earmark sufficient revenues to pay for benefits it might award. Successive presidents and Congresses, both Republican and Democratic, have repeatedly acted to prevent either program’s cumulative spending from exceeding cumulative revenues. In 1983, for example, faced with an impending trust fund shortfall, Congress cut benefits and raised taxes enough to turn prospective cash flow trust fund deficits into cash flow surpluses. And President Reagan signed the bill. In so doing, they have reaffirmed the discipline imposed by trust fund financing.

Trust fund accounting explains why people now are worrying about the adequacy of funding for Social Security and Medicare. They recognize that the trust funds will be depleted in a couple of decades. They understand that between now and then Congress must either raise earmarked taxes or fashion benefit cuts. If it doesn’t raise taxes, benefits will be cut across the board. Either way, the deficits that CBO and other organizations have built into their budget projections will not materialize.

The implications for projected debt of CBO’s inclusion in its projections of deficits that current law and established policy do not allow are enormous, as the graph below shows.

If one excludes deficits in Social Security and Medicare Hospital Insurance that cannot occur under current law and established policy, the ratio of national debt to gross domestic product will fall, not rise, as CBO budget projections indicate. In other words, the claim that drastic cuts in government spending are necessary to avoid calamitous budget deficits is bogus.

It might seem puzzling that CBO, an agency known for is professionalism and scrupulous avoidance of political bias, would adopt a convention so at odds with law and policy. The answer is straightforward—Congress makes them do it. Section 257 of the Balanced Budget and Emergency Deficit Control Act of 1985 requires CBO to assume that the trust funds can spend money although legislation governing trust fund operations bars such expenditures. CBO is obeying the law.

No similar explanation exonerates the statement of the Committee for a Responsible Federal Budget, which on August 25, 2015 cited, with approval, the conclusion that ‘debt continues to grow unsustainably,’ or that of the Bipartisan Policy Center, which wrote on the same day that ‘America’s debt continues to grow on an unsustainable path.’ Both statements are wrong.

To be sure, the dire budget future anticipated in the CBO projections could materialize. Large deficits could result from an economic calamity or war. Congress could abandon the principle that Social Security and Medicare Hospital Insurance should be financed within trust funds. It could enact other fiscally rash policies. But such deficits do not flow from current law or reflect the trust fund discipline endorsed by both parties over the last 80 years. And it is current law and policy that are supposed to underlie budget projections. Slashing spending because a thirty-year old law requires CBO to assume that Congress will do something it has shown no sign of doing—overturn decades of bipartisan prudence requiring that the major social insurance programs spend only money specifically earmarked for them, and not a penny more—would impose enormous hardship on vulnerable populations in the name of a fiscal fantasy.

Editor's Note: This post originally appeared in Fortune Magazine.

Event Information

For Cubans, “D17”—December 17, 2014—changed everything. On that day, the United States and Cuba announced that the two countries would renew diplomatic relations nearly 60 years after Fidel Castro came to power. For both countries, a new transformation has begun—but this time, it is the promise of Cuba’s insertion in the globalized economy and the crumbling U.S. embargo that is catalyzing change on the island.

On May 31, the Brookings Book Club hosted Nonresident Senior Fellow Richard E. Feinberg and NPR Correspondent Tom Gjelten for a discussion of Feinberg’s new book, “Open for Business: Building the New Cuban Economy” (Brookings Institution Press, 2016). The discussion focused on the factors that guided this monumental decision: international diplomacy; changes already underway in Cuba; successful Cuban entrepreneurs and foreign investments; and scenarios for Cuba’s future development path.

Three young Cuban leaders, including two whose vignettes appear in the book, “Open for Business,” joined the discussion and shared their personal experiences with the economic realities in Cuba today, as well as the opportunities created by the shift in Cuban-American relations.

Video

• Open for business: Building the new Cuban economy

Audio

• Open for business: Building the new Cuban economy

Transcript

• Transcript (.pdf)

Event Materials

• 20160531_cuba_economy_transcript