British politics is starting to resemble a bowling alley. One after another, political figures are tumbling–including the leading lights of the Brexit campaign. They sowed the wind and now are reaping the whirlwind.

First to topple was the prime minister. After the referendum, David Cameron announced that he would step down. Last week fellow Conservative Boris Johnson, the leading light of the Brexit campaign, said he would not run to succeed Mr. Cameron after his ally Michael Gove, the justice secretary, concluded, in quintessentially British style, that Mr. Johnson lacked “the team captaincy” required. Then Nigel Farage stepped down as leader of the UK Independence Party, saying “I want my life back.” Labour Party leader Jeremy Corbyn has lost the support of his parliamentary colleagues and may be next to fall.

The exit of the leading Brexiteers is a relief. The skills required to run a populist, fact-averse campaign are not the same skills needed to lead a nation. For all his mercurial talents, on full display during his colorful stint as mayor of London, Boris Johnson would have been a disastrous prime minister. The alternatives–especially Mr. Gove and Home Secretary Theresa May–are steadier souls. Both are also better positioned to unite Conservative members of Parliament and hold on until the next scheduled general election, in 2020.

Mr. Corbyn is likely to go; the question really is when. It he doesn’t, the Labour Party will break apart. In his case the departure will be only slightly about the vote to remain in or leave the European Union. Broadly, his fellow Labour MPs didn’t want him as their leader in the first place; it was the votes of more left-wing party members that propelled him to the leadership, and many see him as an electoral liability. (He is.)

There is no direct connection between Brexit and Donald Trump. But a few things can still be deduced on this side of the pond. First, Mr. Trump may succeed in making the connection tighter. His immediate announcement that the vote was about “declaring independence” reflected his sharpening political instincts. The day after the vote, Mr. Trump said: “The people of the United Kingdom have exercised the sacred right of all free peoples. They have declared their independence from the European Union. … Come November, the American people will have the chance to re-declare their independence. Americans will have a chance to vote for trade, immigration and foreign policies that put our citizens first.”

Independence is a powerful populist theme, one Mr. Trump is likely to exploit it to its fullest.

Brexit and the economic and political chaos it has already sparked are proof that no matter how crazy or far-fetched an electoral outcome appears, it can happen. Right up to the last minute, many believed that even if the vote were close, it would be to remain in the EU. At some level we just couldn’t imagine the alternative. Maybe Mr. Cameron and Mr. Corybn felt the same, which is why they were so complacent. Not so, the other side.

All this suggests the wisdom of treating every poll with a fistful of salt. Electorates are becoming more volatile and more visceral. Pollsters are getting it wrong as often as they get it right. The last general election in the U.K. is another case in point. Populist sentiment wrecks standard political models. When people are angry, they don’t weigh the costs and benefits of their actions in the usual way; that’s true in life and it’s true in voting.

It’s also why it’s risky to allow populist campaigners near the levers of power. I’ve written in this space before about the dangers of injecting direct democracy in a parliamentary political system. Think of referendums as akin to Ming vases: something rare, to be handled with great care. The British Parliament is now acting as a firebreak. The leading populists will not get the keys to 10 Downing Street.

But the United States holds direct elections for president. If Donald Trump wins in November, he will assume the most powerful office in the world. There is no firebreak, no buffer, no second chance.

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Editor's note: This piece originally appeared on the Wall Street Journal's Washington Wire blog.

       

As a rhetorical ideal, greater opportunity is hard to beat. Just about all candidates for high elected office declare their commitments to promoting opportunity – who, after all, could be against it? But opportunity is, to borrow a term from the philosopher and political theorist Isaiah Berlin, a "protean" word, with different meanings for different people at different times.

Typically, opportunity is closely entwined with an idea of upward mobility, especially between generations. The American Dream is couched in terms of a daughter or son of bartenders or farm workers becoming a lawyer, or perhaps even a U.S. senator. But even here, there are competing definitions of upward mobility.

It might mean being better off than your parents were at a similar age. This is what researchers call "absolute mobility," and largely relies on economic growth – the proverbial rising tide that raises most boats.

Or it could mean moving to a higher rung of the ladder within society, and so ending up in a better relative position than one's parents.

Scholars label this movement "relative mobility." And while there are many ways to think about status or standard of living – education, wealth, health, occupation – the most common yardstick is household income at or near middle age (which, somewhat depressingly, tends to be defined as 40).

As a basic principle, we ought to care about both kinds of mobility as proxies for opportunity. We want children to have the chance to do absolutely and relatively well in comparison to their parents.

On the One Hand…

So how are we doing? The good news is that economic standards of living have improved over time. Most children are therefore better off than their parents. Among children born in the 1970s and 1980s, 84 percent had higher incomes (even after adjusting for inflation) than their parents did at a similar age, according to a Pew study. Absolute upward income mobility, then, has been strong, and has helped children from every income class, especially those nearer the bottom of the ladder. More than 9 in 10 of those born into families in the bottom fifth of the income distribution have been upwardly mobile in this absolute sense.

There's a catch, though. Strong absolute mobility goes hand in hand with strong economic growth. So it is quite likely that these rates of generational progress will slow, since the potential growth rate of the economy has probably diminished. This risk is heightened by an increasingly unequal division of the proceeds of growth in recent years. Today's parents are certainly worried. Surveys show that they are far less certain than earlier cohorts that their children will be better off than they are.

If the story on absolute mobility may be about to turn for the worse, the picture for relative mobility is already pretty bad. The basic message here: pick your parents carefully. If you are born to parents in the poorest fifth of the income distribution, your chance of remaining stuck in that income group is around 35 to 40 percent. If you manage to be born into a higher-income family, the chances are similarly good that you will remain there in adulthood.

It would be wrong, however, to say that class positions are fixed. There is still a fair amount of fluidity or social mobility in America – just not as much as most people seem to believe or want. Relative mobility is especially sticky in the tails at the high and low end of the distribution. Mobility is also considerably lower for blacks than for whites, with blacks much less likely to escape from the bottom rungs of the ladder. Equally ominously, they are much more likely to fall down from the middle quintile.

Relative mobility rates in the United States are lower than the rhetoric about equal opportunity might suggest and lower than people believe. But are they getting worse? Current evidence suggests not. In fact, the trend line for relative mobility has been quite flat for the past few decades, according to work by Raj Chetty of Stanford and his co-researchers. It is simply not the case that the amount of intergenerational relative mobility has declined over time.

Whether this will remain the case as the generations of children exposed to growing income inequality mature is not yet clear, though. As one of us (Sawhill) has noted, when the rungs on the ladder of opportunity grow further apart, it becomes more difficult to climb the ladder. To the same point, in his latest book, Our Kids – The American Dream in Crisis, Robert Putnam of Harvard argues that the growing gaps not just in income but also in neighborhood conditions, family structure, parenting styles and educational opportunities will almost inevitably lead to less social mobility in the future. Indeed, these multiple disadvantages or advantages are increasingly clustered, making it harder for children growing up in disadvantaged circumstances to achieve the dream of becoming middle class.

The Geography of Opportunity

Another way to assess the amount of mobility in the United States is to compare it to that found in other high-income nations. Mobility rates are highest in Scandinavia and lowest in the United States, Britain and Italy, with Australia, Western Europe and Canada lying somewhere in between, according to analyses by Jo Blanden, of the University of Surrey and Miles Corak of the University of Ottawa. Interestingly, the most recent research suggests that the United States stands out most for its lack of downward mobility from the top. Or, to paraphrase Billie Holiday, God blesses the child that's got his own.

Any differences among countries, while notable, are more than matched by differences within Pioneering work (again by Raj Chetty and his colleagues) shows that some cities have much higher rates of upward mobility than others. From a mobility perspective, it is better to grow up in San Francisco, Seattle or Boston than in Atlanta, Baltimore or Detroit. Families that move to these high-mobility communities when their children are still relatively young enhance the chances that the children will have more education and higher incomes in early adulthood. Greater mobility can be found in places with better schools, fewer single parents, greater social capital, lower income inequality and less residential segregation. However, the extent to which these factors are causes rather than simply correlates of higher or lower mobility is not yet known. Scholarly efforts to establish why it is that some children move up the ladder and others don't are still in their infancy.

Models of Mobility

What is it about their families, their communities and their own characteristics that determine why they do or do not achieve some measure of success later in life?

To help get at this vital question, the Brookings Institution has created a life-cycle model of children's trajectories, using data from the National Longitudinal Survey of Youth on about 5,000 children from birth to age 40. (The resulting Social Genome Model is now a partnership among three institutions: Brookings, the Urban Institute and Child Trends). Our model tracks children's progress through multiple life stages with a corresponding set of success measures at the end of each. For example, children are considered successful at the end of elementary school if they have mastered basic reading and math skills and have acquired the behavioral or non-cognitive competencies that have been shown to predict later success. At the end of adolescence, success is measured by whether the young person has completed high school with a GPA average of 2.5 or better and has not been convicted of a crime or had a baby as a teenager.

These metrics capture common-sense intuition about what drives success. But they are also aligned with the empirical evidence on life trajectories. Educational achievement, for example, has a strong effect on later earnings and income, and this well-known linkage is reflected in the model. We have worked hard to adjust for confounding variables but cannot be sure that all such effects are truly causal. We do know that the model does a good job of predicting or projecting later outcomes.

Three findings from the model stand out. First, it's clear that success is a cumulative process. According to our measures, a child who is ready for school at age 5 is almost twice as likely to be successful at the end of elementary school as one who is not.

This doesn't mean that a life course is set in stone this early, however.

Children who get off track at an early age frequently get back on track at a later age; it's just that their chances are not nearly as good. So this is a powerful argument for intervening early in life. But it is not an argument for giving up on older youth.

Second, the chances of clearing our last hurdle – being middle class by middle age (specifically, having an income of around $68,000 for a family of four by age 40) – vary quite significantly. A little over half of all children born in the 1980s and 1990s achieved this goal. But those who are black or born into low-income families were very much less likely than others to achieve this benchmark.

Third, the effect of a child's circumstances at birth is strong. We use a multidimensional measure here, including not just the family's income but also the mother's education, the marital status of the parents and the birth weight of the child. Together, these factors have substantial effects on a child's subsequent success. Maternal education seems especially important.

The Social Genome Model, then, is a useful tool for looking under the hood at why some children succeed and others don't. But it can also be used to assess the likely impact of a variety of interventions designed to improve upward mobility. For one illustrative simulation, we hand-picked a battery of programs shown to be effective at different life stages – a parenting program, a high-quality early-edcation program, a reading and socio-emotional learning program in elementary school, a comprehensive high school reform model – and assessed the possible impact for low-income children benefiting from each of them, or all of them.

No single program does very much to close the gap between children from lower- and higher-income families. But the combined effects of multiple programs – that is, from intervening early and often in a child's life – has a surprisingly big impact. The gap of almost 20 percentage points in the chances of low-income and high-income children reaching the middle class shrinks to six percentage points. In other words, we are able to close about two-thirds of the initial gap in the life chances of these two groups of children. The black-white gap narrows, too.

Looking at the cumulative impact on adult incomes over a working life (all appropriately discounted with time) and comparing these lifetime income benefits to the costs of the programs, we believe that such investments would pass a cost-benefit test from the perspective of society as a whole and even from the narrower prospective of the taxpayers who fund the programs.

What Now?

Understanding the processes that lie beneath the patterns of social mobility is critical. It is not enough to know how good the odds of escaping are for a child born into poverty. We want to know why. We can never eliminate the effects of family background on an individual's life chances. But the wide variation among countries and among cities in the U.S. suggests that we could do better – and that public policy may have an important role to play. Models like the Social Genome are intended to assist in that endeavor, in part by allowing policymakers to bench- test competing initiatives based on the statistical evidence.

America's presumed exceptionalism is rooted in part on a belief that class-based distinctions are less important than in Western Europe. From this perspective, it is distressing to learn that American children do not have exceptional opportunities to get ahead – and that the consequences of gaps in children's initial circumstances might embed themselves in the social fabric over time, leading to even less social mobility in the future.

But there is also some cause for optimism. Programs that compensate at least to some degree for disadvantages earlier in life really can close opportunity gaps and increase rates of social mobility. Moreover, by most any reasonable reckoning, the return on the public investment is high.

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Editor's note: This piece originally appeared in the Milken Institute Review.

       

Editor's Note: In the coming decade, China’s economic growth is projected to slow from its long-run average annual rate of 10 percent, sustained over the past three decades. The imminent slowdown also reflects a variety of specific structural challenges. Arthur Kroeber argues that responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets.

In the coming decade, China’s economic growth will certainly slow from the long-run average annual rate of 10% sustained over the past three decades. In part this is a natural slowdown in an economy that is now quite large (around US$7 trillion at market exchange rates) and solidly middle-income (per capita GDP of about US$7,500, at purchasing power parity). Despite the certainty of this slowdown, China’s potential growth rate remains high: per-capita income is still far below the level at which incomes in the other major northeast Asian economies (Japan, South Korea and Taiwan) stopped converging with the US level; the per-capita capital stock remains low, suggesting the need for substantial more investment; and the supply of low-cost labor from the traditional agricultural sector has not yet been exhausted. All these factors suggest it should be quite possible for China to achieve average annual real GDP growth of at least 7% a year through 2020.[1]

But the imminent slowdown also reflects a variety of specific structural challenges which require active policy response. Inadequate policies could result in a failure of China to achieve its potential growth rate. Three of the most prominent structural challenges are a reversal of demographic trends from positive to negative; a substantial secular decline in the contribution of exports to growth; and the very rapid increase in credit created by the 2009-10 stimulus program, which almost certainly led to a substantial reduction of the return on capital. Responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets. This paper will argue that financial sector reform is the best and most direct way to overcome these three major structural challenges.

1. China’s growth potential

There are several strong reasons to believe that China has the potential to sustain a fairly rapid rate of GDP growth for at least another decade. We define “fairly rapid” as real growth of 7% a year, which is a very high rate for an economy of China’s size (US$7 trillion), but substantially below the average growth rate since 1980, which has been approximately 10%.

The most general reason for this belief is that China’s economic growth model most closely approximates the successful “catch-up” growth model employed by its northeast Asian neighbors Japan, South Korea and Taiwan in the decades after World War II. The theory behind “catch-up” growth is simply that poor countries whose technological level is far from the global technological frontier can achieve substantial convergence with rich-country income levels by copying and diffusing imported technology. Achieving this catch-up growth requires extensive investments in enabling infrastructure and basic industry, and an industrial policy that focuses on promoting exports. The latter condition is important because a disciplined focus on exports forces companies to keep up with improvements in global technology; in effect, a vibrant export sector is one (and probably the most efficient) mechanism for importing technology.

A survey of 96 major economies from 1970 to 2008 shows that 14 achieved significant convergence growth, defined as an increase of at least 10 percentage points in per capita GDP relative to the United States (at purchasing power parity). Eight of these countries were on the periphery of Europe and so presumably benefited from the spillover effects of western Europe’s rapid growth after World War II, and from the integration of eastern and western Europe after 1990. The other six were Asian export-oriented economies: Japan, South Korea, Taiwan, Malaysia, Thailand and China. Most of these countries experienced a period of very rapid convergence with US income levels and then a sharp slowdown or leveling off. On average, rapid convergence growth ended when the country’s per capita GDP reached 55% of the US level. The northeast Asian economies that China most closely resembles were among the most successful: convergence growth in Japan, Taiwan and South Korea slowed at 90%, 60% and 50% of US per capita income respectively. In 2010 China’s per capita income was only 20% of the US level. Based on this comparative historical experience, it seems plausible that China could enjoy at least one more decade of relatively rapid growth, until its per capita income reaches 40% or more of the US level.[2]

So China’s growth potential is fairly clear. But realizing this potential is not automatic: it requires a constant process of structural reform to unlock labor productivity gains and improve the return on capital. The urgency of structural reform is particularly acute now. To understand why, we now examine three structural factors that are likely to exert a substantially negative effect on economic growth in coming years.

2. Challenges to growth

When considering China’s structural growth prospects, it is necessary to take account of at least three major challenges to growth. Over the past three decades, rapid economic growth has been supported by favorable demographics, a very strong contribution from exports, and a large increase in the stock of credit. The demographic trend is now starting to go into reverse, the export contribution to growth has slowed dramatically in the last few years, and the expansion of credit cannot be safely sustained for more than another year or two at most.

Demographics. From 1975 to 2010, China’s “dependency ratio”—the ratio of the presumably non-working (young people under the age of 15 and old people above the age of 64) to the presumably working (those aged 15-64) fell from approximately 0.8 to 0.4. Over the same period the “prime worker ratio”—the ratio of people aged 20-59 to those 60 and above—stayed roughly stable at above 5. Both of these ratios indicate that China’s economy enjoyed a very high ratio of workers to non-workers. This situation is favorable for economic growth, because it implies that with a relatively small number of dependent mouths to feed, workers can save a higher proportion of their incomes, and the resulting increase in aggregate national saving becomes available for investment in infrastructure and basic industry.

Over the next two decades, however, these demographic trends will reverse. The dependency ratio will rise, albeit slowly at first, and the prime worker ratio will decline sharply from 5 today to 2 in the early 2030s. These demographic shifts are likely to exert a drag on economic growth, for two reasons.

The first impact, which is already being felt, is a reduction in the supply of new entrants into the labor force—those aged 15-24. This cohort has fluctuated between 200m and 230m since the early 1990s, and in 2010 it stood at the upper end of that range. By 2023 it will have fallen by one-third, to 150m, a far lower figure than at any point since China began economic reforms in 1978. Because the supply of new workers is falling relative to demand for labor, wage growth is likely to accelerate above the rate of labor productivity growth, which appears to be in decline from the very high levels achieved in 2000-2010. As a result, unit labor costs will start to rise (a trend already in evidence in the manufacturing sector since 2004) and inflationary pressures will build. In order to keep inflation at a socially acceptable level, the government will be forced to tighten monetary policy and reduce the trend rate of economic growth.

The second impact will be the large increase in the population of retirees relative to the number of workers available to support them. This is the effect described by the prime worker ratio, which currently shows that there are five people of prime working age for every person of likely retirement age. As this ratio declines, the overall productivity of the economy slows, and the health and pension costs of supporting an aging population rise. The combination of these two effects can contribute to a dramatic slowdown in economic growth: during the period when Japan’s prime worker ratio fell from 5 to 2 (1970-2005), the trend GDP growth rate fell from 8% to under 2% (though demographics, of course, does not explain all of this decline). Over the next 20 years China’s prime worker ratio will decline by exactly the same amount as Japan’s did from 1970-2005.

Export challenge. Another element of China’s extraordinary growth was its rapidly growing export sector. Exports are a crucial component of catch-up growth in poor economies because, as explained above, they act as a vector of technology transfer: in order to remain globally competitive, exporters must continually upgrade their technology (including their processes and management systems) to keep up with the continuous advance of the global technological frontier.

Precisely measuring the impact of exports on economic growth is tricky, because what matters is not headline export value (which contains contributions from imported components and materials), but the domestic value added content of exports. In addition, a dynamic export sector is likely to have indirect impacts on the domestic economy through the wages paid to workers, the long-run effect of technological upgrading and so on. If we ignore these second-round impacts and focus simply on the direct contribution to GDP growth of domestic value added in exports, we find that exports contributed 4.6 percentage points to GDP growth on average in 2003-07. In other words, exports accounted for about 40% of economic growth during that period.[3]

Such a high export contribution to growth is on its face unsustainable for a large continental economy like China’s, and in fact the export contribution has slowed substantially since the 2008 global financial crisis. In 2008-11 the average contribution of export value added to GDP growth was just 1.5 percentage points – about one-third the 2003-07 average. It is likely that the export contribution to growth will fall even further in coming years.

Credit challenge. China responded to the global financial crisis with a very large economic stimulus program which was financed by a large increase in the credit stock. The ratio of non-financial credit (borrowing by government, households and non-financial corporations) rose from 160% in 2008 to over 200% in 2011. While the overall credit/GDP ratio remains lower than the 250% that is typical for OECD nations, a rapid increase in the credit stock in a short period of time, regardless of the level, is frequently associated with financial crisis. In China’s case, it is evident that the majority of the increase in the credit stock reflects borrowing by local governments to finance infrastructure projects which are likely to produce economic benefit in the long run but which in many cases will result in immediate financial losses.[4] To avert a potential banking sector crisis, therefore, it would be prudent for government policy to target first a stabilization and then a decline in the credit/GDP ratio.

The good news is that China has recent experience of deflating a credit bubble. In the five years after the Asian financial crisis (1998-2003), the credit/GDP ratio rose by 40 percentage points (the same amount as in 2008-11) as the government financed infrastructure spending to offset the impact of the crisis. Over the next five years (2003-08), the credit/GDP ratio fell by 20 points, as nominal GDP growth (17% a year on average) outstripped the annual growth in credit (15%). This experience suggests that, in principle, it should be possible to reduce the annual growth in credit significantly without torpedoing economic growth.

The bad news is that the 2003-08 deleveraging occurred within the context of the extremely favorable demographics, and unusually robust export growth that we have just described. Not only are these conditions unlikely to be repeated in the coming decade, both these factors are likely to exert a drag on GDP growth. Given this backdrop, any reduction in the rate of credit growth must be accompanied by extensive measures to ensure that the productivity of each yuan of credit issued is far higher than in the past.

3. The role of financial sector reform

The three growth challenges described above are diverse, but they are reflections of a single broader issue which is that China’s ability to maintain rapid growth mainly through the mobilization of factors (labor and capital) is decreasing. Much of the high-speed growth of the last decade derived from a rapid increase in labor productivity which was in turn a function of an extremely high investment rate: as the amount of capital per worker grew, the potential output of each worker grew correspondingly (“capital deepening”). But the investment rate, at nearly 49% of GDP in 2011, must surely be close to its peak, since it is already 10 percentage points higher than the maximum rates ever reached by Japan or South Korea. So the amount of labor productivity gain that can be achieved in future by simply adding volume to the capital stock must be far less than during the last decade, when the investment/GDP ratio rose by 10 percentage points.

The obvious corollary is that if China’s ability to achieve rapid gains in labor productivity and economic growth through mobilization of capital is declining, these gains must increasingly be achieved by improved capital efficiency. More specifically, the tightening of the labor supply implied by the demographic transition means that unit labor cost growth will accelerate; all things being equal this means that consumer price inflation will be structurally higher in the next decade than it was for most of the last. This in turn means that nominal interest rates will need to be higher. As the cost of capital rises, the average rate of return on capital must also increase; otherwise a larger share of projects will be loss-making and the drag on economic growth will become pronounced.

On the export side, the dramatic slowdown in the contribution to economic growth from exports means the loss of a certain amount of “easy” productivity gains. Greater productivity of domestic capital could help offset the deceleration in productivity growth from the external sector. Finally, as just noted, the need to arrest or reverse the rapid rise in the credit/GDP ratio means that over the next several years, a given amount of economic growth must be achieved with a smaller amount of credit than in the past—in other words, the average return on capital (for which credit here serves as a proxy) must rise.

Conceptually this is all fairly straightforward. The problem for policy makers is that measuring the “productivity of capital” on an economy-wide basis is not at all straightforward. In principle, one could measure the amount of new GDP created for each incremental increase in the capital stock (the incremental capital output ratio or ICOR). But in practice calculating ICOR is cumbersome, and depends heavily on various assumptions, such as the proper depreciation rate. Moreover, in an industrializing economy like China’s, the ratio of capital stock to GDP tends to rise over time and therefore the ICOR falls; this does not mean that the economy misallocates capital but simply that it experiences capital deepening. Sorting out efficiency effects from capital deepening effects is a vexing task.[5]

A more practical approach is simply to examine the ratio of credit to GDP. There is no one “right” level of credit to GDP, since different economies use different proportions of debt and equity finance. But the trends in the credit to GDP ratio in a single country (assuming there is no major shift in the relative importance of debt and equity finance), which are easily measured, can serve as a useful proxy for trends in the productivity of capital, and provide some broad guidelines for policy.

Figure 1 shows the ratio of total non-financial credit to GDP in China since 1998 (all figures are nominal). Total non-financial credit comprises bank loans, bonds, external foreign currency borrowing, and so-called “shadow financing” extended to the government, households and non-financial corporations; it excludes fund-raising by banks and other financial institutions. This measure is similar to the measure of “total social financing” recently introduced by the People’s Bank of China. 

This shows, as noted previously, that the credit to GDP ratio rose sharply from 160% of GDP in 2008 to 200% in 2010. The current ratio is not abnormally high: many OECD countries have credit/GDP ratios of 250% or so, and Japan’s is around 350%. But it is obvious that the trend increase is worrying: if credit/GDP continues to rise at 20 percentage points a year then by 2015 it would hit 300%, a level much higher than is normal in healthy economies. It seems intuitively clear that to ensure financial stability, policy should target a stabilization or decline in the credit/GDP ratio. Success in this policy would imply that the productivity of credit, and capital more generally, improves.

The large increase in the credit/GDP ratio in 2008-10 is not unprecedented. Following the Asian financial crisis of 1997-98, the total credit stock rose from 143% of GDP in 1998 to 186% in 2003, an increase of 43 percentage points in five years, as a result of government spending on infrastructure and the creation of new consumer lending markets (notably home mortgages). During this period the credit stock grew at an average annual rate of 15.9%, but nominal GDP grew at just 10% a year.

Over the next five years, 2004-08, the average annual growth in total credit decelerated only slightly, to 14.8%. But thanks to a gigantic surge in productivity growth—caused by a combination of the delayed effect of infrastructure spending, deep market reforms (such as the restructuring of the state owned enterprise sector), and a boom in exports—nominal GDP growth surged to an average rate of 18.3%. As a consequence, the credit/GDP ratio declined to 160% in 2008, a decline of 26 percentage points from the peak five years earlier.

This experience shows that, in a developing country like China, it is quite possible to deflate a credit bubble relatively quickly and painlessly. To do so, however, two conditions must be met: the projects financed during the credit bubble must, in the main, be economically productive in the long run even if they cause financial losses in the short run; and structural reforms must accompany or quickly follow the credit expansion, in order to unlock the productivity growth that will enable deleveraging through rapid economic growth rather than through a painful recession. These conditions were clearly met during the 1998-2008 period: the expanded credit of the first five years mainly went to economically useful infrastructure such as highways, telecoms networks and port facilities; and deep structural reforms improved the efficiency of the state sector, expanded opportunities for the private sector, and created a new private housing market. This combination of infrastructure and reforms helped lay the groundwork for the turbo-charged growth of 2004-08.

The credit expansion of 2008-10, following the global financial crisis, was about the same magnitude as the credit expansion of a decade earlier: the credit/GDP ratio rose 40 percentage points, from 160% to 200%. But the expansion was much more rapid (occurring over two years instead of five), and while the bulk of credit probably did finance economically productive infrastructure, there is evidence that the sheer speed of the credit expansion led to far greater financial losses. A large proportion of the new borrowing was done by local government window corporations, often with little or no collateral and in many cases with no likelihood of project cash flows ever being large enough to service the loans. A plausible estimate of eventual losses on these loans to local governments is Rmb2-3 trn, or 4-7% of 2011 GDP.

Furthermore, whereas in the late 1990s restructuring of the state enterprise sector and creation of the private housing market took off at the same time the government began to expand credit, the 2008-10 credit expansion occurred without any significant accompanying structural reforms. In sum we have significantly less reason to be confident about the foundations for economic growth over the next five years than would have been the case in 2003.

On the assumption that the trend rate of nominal GDP growth over the next five years is likely be quite a bit less than in 2003-08, just how difficult will it be for China to stabilize or better yet reduce the credit to GDP ratio? For the purposes of analysis, Figure 1 proposes two scenarios. Both assume that nominal GDP will grow at an average rate of 13% in 2012-2015 (combining real growth of 7.5% a year with economy-wide inflation of 5.5%). The “stabilization” scenario assumes that total credit grows at the same 13% rate, stabilizing the credit/GDP ratio at around 200%. The “deleveraging” scenario assumes that credit growth falls to 9.5% a year, enabling a reduction in the credit/GDP ratio of 25 percentage points to 175%--about the same magnitude as the reduction of 2003-08.

A quick glance suggests that achieving either of these two outcomes will be far more difficult than in the previous deleveraging episode. In 2003-08, the average annual rate of credit growth was just one percentage point lower than during the credit bubble of 1998-2003. In other words, the work of deleveraging was accomplished almost entirely through economic growth, rather than through any material constraint on credit.

In the three years following the global financial crisis, by contrast, total credit expanded by 22.7% a year, generating nominal GDP growth of 14.1% on average. The required drop in average annual credit growth is 10 percentage points under the stabilization scenario and 13 points under the deleveraging scenario, while nominal GDP growth declines by only a point. In other words, this episode is likely to be the reverse of the 2003-08 episode: deleveraging will need to come almost entirely from a constraint on credit, rather than from economic growth.



Another way of looking at this is to examine the relationship between incremental credit and incremental GDP—that is, how many yuan of new GDP arise with each new yuan of credit. This calculation is presented in Figure 2. This shows that in 1998-2003 each Rmb1 of new credit generated Rmb0.39 of new GDP; this figure rose to 0.72 in 2003-08, an 84% increase in the productivity of credit. The GDP payoff from new credit in 2008-10 was far worse than in 1998-2003. Simply to stabilize the credit/GDP ratio at its current level will require a 73% increase in credit productivity. To achieve the deleveraging scenario, a 150% improvement will be required.

The good news is that under the deleveraging scenario, the average productivity of credit in 2011-2015 only needs to be the same as it was in 2003-08. In principle, this should be achievable. But as previously noted, the mechanism of improvement needs to be quite different this time round. In 2003-08, the productivity of credit rose because credit growth remained roughly constant while GDP growth surged, thanks to structural reforms that accelerated returns to both capital and labor. Over the next several years, by contrast, the best that can be hoped for is that GDP growth will remain roughly constant. Consequently any improvement in credit productivity must come from constraining the issuance of new credit, while substantially raising the efficiency of credit allocation and hence the returns to credit.

What are the main mechanisms for improving the efficiency of credit, and of financial capital more generally? Broadly speaking, there are two: diversification of credit channels, and more market-based pricing of credit. Historically most credit has been issued by large state-owned banks, which are subject to political pressure in their lending decisions, and the majority of credit has gone to state-owned enterprises. Diversifying the channels of credit to include a broader range of financial institutions, a more vigorous bond market, and even by encouraging the creation of dedicated small- and medium-size enterprise lending units within the big banks, should improve credit allocation by giving greater credit access to borrowers who were previously shut out simply by virtue of a lack of political connections. Over the past decade government policy has been broadly supportive of the diversification of credit channels: specialized consumer credit, leasing and trust companies have been allowed to flourish, and there is some anecdotal evidence that SME lending at the state owned banks has begun to pick up steam.

The government has been far more reluctant, however, to embrace systematic measures for improving the pricing of credit. Bank interest rates remain captive to the policy of regulated deposit rates. Guaranteed low deposit rates means that banks have little incentive to seek out and properly price riskier assets, and are content to earn a fat spread on relatively conservative loan books. Bond markets, which in more developed economies form the basis for pricing of financial risk, are in China large in primary issuance, but small in trading volumes. The majority of bonds are purchased by banks and other financial institutions and held to maturity, make them indistinguishable from bank loans. Active secondary market trading by a wide range of participants is the essential mechanism by which bond prices become the basis for financial risk pricing.

4. Conclusions and recommendations

China still has potential for another decade of relatively high speed growth, but a combination of structural factors means that “high speed” in future likely means a trend GDP growth rate of around 7%, well below the historic average of 10%. Moreover, a combination of negative trends in demographics and the external sector, and the need to constrain credit growth after the enormous credit expansion of 2008-2010, mean the obstacles to realizing this potential growth rate are quite large. In order to overcome these obstacles, the efficiency of credit, and of capital more generally, must be improved. A large increase in credit efficiency was achieved in the previous economic deleveraging episode of 2003-08, but that increase in efficiency resulted mainly from an acceleration in GDP growth due to capital deepening, rather than from a constraint on credit. Over the next several years, the best that can plausibly be achieved is a stabilization of nominal GDP growth at approximately the current level. Any increase in credit efficiency must therefore come from a constraint on credit growth and direct improvements in credit allocation, rather than from capital-intensive economic growth.

In order to achieve this improvement in credit efficiency, three improvements to China’s financial architecture are urgently needed. First, the diversification of financial channels should continue to be expanded, notably through the acceptance and proper regulation of so-called “shadow financing” activities, which reflect market pressure for higher returns to depositors and greater credit availability (at appropriate prices) for riskier borrowers. Second, the ceiling on bank deposit rates should gradually be lifted and ultimately abolished, in order to give banks incentives for increased lending at appropriate prices to riskier borrowers who (it is to be hoped) will deliver a higher risk-adjusted rate of return than current borrowers. Third, steps should be taken to increase secondary trading on bond markets, in order to enable these markets to assume their appropriate role as the basis of financial risk pricing. Particular stress should be laid on diversifying the universe of financial institutions permitted to trade on bond markets, to include pension funds, specialized fixed-income mutual funds and other institutional investors with a vested interest in active trading to maximize both short- and long-term returns.

 

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Following the global financial crisis of 2008, China’s authorities took a number of steps to internationalize the use of the Chinese currency, the renminbi. These included the establishment of currency swap lines with foreign central banks, encouragement of Chinese importers and exporters to settle their trade transactions in renminbi, and rapid expansion in the ability of corporations to hold renminbi deposits and issue renminbi bonds in the offshore renminbi market in Hong Kong.

These moves, combined with public statements of concern by Chinese officials about the long-term value of the central bank’s large holdings of U.S. Treasury securities, and the role of the U.S. dollar’s global dominance in contributing to the financial crisis, gave rise to widespread speculation that China hoped to position the renminbi as an alternative to the dollar, initially as a trading currency and eventually as a reserve currency.

This paper contends that, on the contrary, the purposes of the renminbi internationalization program are mainly tied to domestic development objectives, namely the gradual opening of the capital account and liberalization of the domestic financial system. Secondary considerations include reducing costs and exchange-rate risks for Chinese exporters, and facilitating outward direct and portfolio investment flows. The potential for the currency to be used as a vehicle for international finance, or as a reserve asset, is severely constrained by Chinese government’s reluctance to accept the fundamental changes in its economic growth model that such uses would entail, notably the loss of control over domestic capital allocation, the exchange rate, capital flows and its own borrowing costs.

This paper attempts to understand the renminbi internationalization program by addressing the following issues:

1. Definition of currency internationalization

2. Specific steps taken since 2008 to internationalize the renminbi

3. General rationale for renminbi internationalization

4. Comparison with prior instances of currency internationalization, notably the U.S. dollar after 1913, the development of the Eurodollar market in the 1960s and 1970s; and the deutsche mark and yen in 1970-1990

5. Understanding the linkage between currency internationalization and domestic financial liberalization

6. Prospects for and constraints on the renminbi as an international trading currency and reserve currency

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• China’s Global Currency: Lever for Financial Reform

      

       

       

       

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• The potential and limitations of impact bonds: Lessons from the first five years of experience worldwide (PDF)

      

This week the Dutch Ministry of Security and Justice announced that it will pay for the successful achievement of employment and prison recidivism outcomes among short-term adult prisoners as part of the new “Work After Prison” social impact bond (SIB)—the fifth such transaction in the Netherlands and one of about 60 in the world. In a SIB—which is a mix of results-based financing, a public-private partnership, and impact investing—private investors provide upfront capital for preventive social services, and in turn an outcome funder (usually government) pays them back plus a return contingent upon the achievement of agreed-upon outcomes. Where consistent social outcomes achievement poses challenges, this model has considerable potential to create a path forward.

What is the social challenge?

Each year in the Netherlands, around 40,000 adults are incarcerated and about 30,000 are released. What’s troubling is that the rate of recidivism two years after release from prison is nearly 50 percent. And the costs of successful reintegration and reduced recidivism rates are high and include enormous amounts of social benefits paid out to previously incarcerated individuals. Multi-pronged approaches are often necessary including programs that address housing needs, employment, mental health and substance abuse issues, and debt settlement. Addressing all of these challenges simultaneously is difficult and often the right incentives are not in place for the outcomes of importance to be at the forefront of decision-making. But SIBs may offer a promising way to meet these hurdles.

Who are the players in the SIB?

In a typical SIB, the players at the table include an outcome funder (government), investors (usually impact investors including foundations), a service provider or providers (usually a non-governmental entity but it can also be public), and the beneficiary population. In addition, there can be external evaluators who assess whether or not the agreed-upon outcome has been achieved; and, in many SIBs, there is also an intermediary party that brings the stakeholders to the table, structures the deal, manage the deal, or conducts performance management for the service provider.

The Dutch SIB for prison recidivism has a total of 10 players not including the beneficiary population. Most interestingly, this deal differs from all four previous SIBs in the Netherlands in that the outcome funder, the Ministry of Security and Justice, is at the national level rather than subnational level—the previous outcome funders were all municipal governments. Notably, less than half of the SIBs in the world have a national-level outcome funder. The Dutch bank ABN Amro, the Start Foundation, and Oranje Fonds are equal investors (and have all invested in previous Dutch SIBs). Three organizations that are part of the Work-Wise Direct Consortium—Exodus Foundation, Restart, and Foundation 180—will provide services to the population in need. Society Impact, an organization supporting social entrepreneurship and innovative financing in the Netherlands, acted as a matchmaker in the transaction by helping to bring all parties to the table. An evaluation arm of the Ministry of Security and Justice and a research entity, Panteia will evaluate whether or not outcomes are achieved.

The beneficiary population includes 150 adults who have been in prison between three and 12 months. There is no targeting based on type of crime, age, or gender and consent must be provided by the participant and the municipality.

What’s at stake?

There are two outcome metrics established in this SIB. In a period of two and half years, the outcome funder will repay investors the principal investment of 1.2 million euros plus a maximum return of 10 percent of the investment (but expected return is around 5 percent) contingent upon: 1) a 25 to 30 percent decrease in the social benefits issued to the previously incarcerated participants (which is estimated to require a 882-month increase in labor force participation by the entire group); and 2) a 10 percent reduction in recidivism among the participants.

Who will benefit?

The beneficiary population

In theory, with all eyes on the target (outcomes), beneficiary populations have a greater chance of success with this results-based financing mechanism compared to traditional input-based financing contracts. The potential for greater collaboration among stakeholders, performance management, and adaptive learning should all bode well for the delivery of the set goals. This could allow for improvements even beyond the targets within the impact bond structure such as improved family life, higher earnings, and increased civic participation.

The outcome funder (and taxpayers)

For the Ministry of Security and Justice, the SIB provides an opportunity to shift to private investors the implementation and financial risk of funding social service programs. If outcomes are achieved, then the ministry repays the investors an amount that represents the value they place on outcome achievement, and if outcomes are not achieved, then they do not pay. What’s more, the ministry could benefit from reduced costs as a result of shifting from remedial to preventive services. Additional cost savings, in particular the reduction in social welfare benefits, and other inherent benefits will be accrued to other government entities as well as society as a whole.

The service providers

There can be multiple benefits for services providers. First, the availability of upfront capital allows them to do their job better. Second, the longer-term (multi-year) contract reduces time spent on grant proposals and allows for more steady funding flows. Third, the SIB can provide an opportunity to strengthen the providers’ systems of data collection. Fourth, it allows the service providers to conduct a rigorous evaluation of their program. Further, SIBs can allow for flexibility and learning-by-doing in the delivery of the social services.

The investors

The three investors in this SIB have an opportunity to earn a financial return of maximum 10 percent if outcomes are successfully achieved. In addition, they benefit from having contributed to the improvement of the lives of the target population and their families. Furthermore, they could generate an impact that goes way beyond the SIB itself. They have the potential to create larger systemic change in the provision of social services by shifting government’s focus away from how services are delivered to which outcomes they want to achieve and by helping to build systems of monitoring and evaluation that allow for systematic assessment of those outcomes.

A way forward

Six years after the implementation of the first SIB for prison recidivism in the United Kingdom, this creative idea has spread to at least 12 other countries with the aim of tackling some of the world’s most intractable social problems. The Netherlands, known globally as a leader on many social and environmental issues, is taking a leading role in the adoption of this mechanism. Moving forward, the rest of the world will be watching to see what lessons can be gleaned from these early experiments as the burden of tough societal issues and potential solutions become increasingly global in nature.

       

       

       

       

       

       

       

       

       

Abstract

Progress in closing differences in many objective outcomes for blacks relative to whites has slowed, and even worsened, over the past three decades. However, over this period the racial gap in wellbeing has shrunk. In the early 1970s data revealed much lower levels of subjective well-being among blacks relative to whites. Investigating various measures of well-being, we find that the well-being of blacks has increased both absolutely and relative to that of whites. While a racial gap in well-being remains, two-fifths of the gap has closed and these gains have occurred despite little progress in closing other racial gaps such as those in income, employment, and education. Much of the current racial gap in well-being can be explained by differences in the objective conditions of the lives of black and white Americans. Thus making further progress will likely require progress in closing racial gaps in objective circumstances.

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• Subjective and Objective Indicators of Racial Progress

      

After being made aware of their racial biases in referee calls through widespread media exposure, individual National Basketball Association referees became unbiased, suggesting that raising awareness of even subtle forms of racism can bring about meaningful change.

The authors examined a real-world setting—professional sports referees who had big incentives to make unbiased decisions but were still exhibiting significant amounts of racial bias—and found that after learning of their bias via media coverage of a major academic study, their behaviors changed.

The original study, authored by Price and Wolfers and in 2007, looked at nearly two decades of NBA data (1991-2002) and found that personal fouls are more likely to be called against basketball players when they are officiated by an opposite-race refereeing crew than when officiated by an own-race refereeing crew. The results received widespread media attention at the time, with a front-page piece in the New York Times and many other newspapers, extensive coverage on the major news networks, ESPN, talk radio and in the sports media including comments from star players at the time such as LeBron James, Kobe Bryant and Charles Barkley, to then-NBA Commissioner David Stern.

The new paper compares the next time period after the first study (2003-2006) to the timeframe immediately after the study was publicized (2007-2010). The authors found the bias continued in the first 3-year period after the study but that no bias was apparent after the widespread publicity of the first study’s findings. The researchers found that the media exposure alone was apparently enough to bring about the attitude change: the NBA reported that it not take any specific action to eliminate referee discrimination, and in fact never spoke to the referees about the study, nor change referee incentives or training.

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Abstract

Can raising awareness of racial bias subsequently reduce that bias? We address this question by exploiting the widespread media attention highlighting racial bias among professional basketball referees that occurred in May 2007 following the release of an academic study. Using new data, we confirm that racial bias persisted in the years after the study's original sample, but prior to the media coverage. Subsequent to the media coverage though, the bias completely disappeared. We examine potential mechanisms that may have produced this result and find that the most likely explanation is that upon becoming aware of their biases, individual referees changed their decision-making process. These results suggest that raising awareness of even subtle forms of bias can bring about meaningful change.

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Ahead of Tuesday’s primary elections in Ohio, Florida and other states, the 2016 presidential candidates have been talking about the future of Social Security and its funding shortfalls.

Over the next two decades, the money flowing into Social Security will be too little to pay for all promised benefits. The reserve fund will be exhausted soon after 2030, and the only money available to pay for benefits will be from taxes earmarked for the program. Unless Congress and the President change the law before the reserve is depleted, monthly benefits will have to be cut about 21%.

Needless to say, office holders, who must face voters, are unlikely to allow such a cut. Before the Trust Fund is depleted, lawmakers will agree to some combination of revenue increase and future benefit reduction, eliminating the need for a sudden 21% pension cut. The question is: what combination of revenue increases and benefit cuts does each candidate favor?

The candidate offering the most straightforward but least credible answer is Donald Trump. During the GOP presidential debate last week, he pledged to do everything within his power to leave Social Security “the way it is.” He says he can do this by making the nation rich again, by eliminating budget deficits, and by ridding government programs of waste, fraud, and abuse. In other words, he proposed to do nothing specifically to improve Social Security’s finances. Should Trump’s deal-making fail to make us rich again, he offered no back-up plan for funding benefits after 2034.

The other three GOP candidates proposed to repair Social Security by cutting future pensions. No one in the debate, except U.S. Sen. Marco Rubio from Florida, mentioned a specific way to accomplish this. Rubio’s plan is to raise the age for full retirement benefits. For many years, the full retirement age was 65. In a reform passed in 1983, the retirement age was gradually raised to 66 for people nearing retirement today and to 67 for people born after 1960. Rubio proposes to raise the retirement age to 68 for people who are now in their mid-40s and to 70 for workers who are his children’s age (all currently under 18 years old).

In his campaign literature, Rubio also proposes slowing the future rate of increase in monthly pensions for high-income seniors. However, by increasing the full retirement age, Rubio’s plan will cut monthly pensions for any worker who claims benefits at 62 years old. This is the earliest age at which workers can claim a reduced pension. Also, it is by far the most common age at which low-income seniors claim benefits. Recent research suggests that low-income workers have not shared the gains in life expectancy enjoyed by middle- and especially high-income workers, so Rubio’s proposed cut could seriously harm many low-income workers.

Though he didn’t advertise it in the debate, Sen. Ted Cruz favors raising the normal retirement age and trimming the annual cost-of-living adjustment in Social Security. In the long run, the latter reform will disproportionately cut the monthly pensions of the longest-living seniors. Many people, including me, think this is a questionable plan, because the oldest retirees are also the most likely to have used up their non-Social-Security savings. Finally, Cruz favors allowing workers to fund personal-account pensions with part of their Social Security contributions. Although the details of his plan are murky, if it is designed like earlier GOP privatization plans, it will have the effect of depriving Social Security of needed future revenues, making the funding gap even bigger than it is today.

The most revolutionary part of Cruz’s plan is his proposal to eliminate the payroll tax. For many decades, this has been the main source of Social Security revenue. Presumably, Cruz plans to fund pensions out of revenue from his proposed 10% flat tax and 16% value-added tax (VAT). This would represent a revolutionary change because up to now, Social Security has been largely financed out of its own dedicated revenue stream. By eliminating the independent funding stream, Cruz will sever the perceived link between workers’ contributions and the benefits they ultimately receive. Most observers agree with Franklin Roosevelt that the strong link between contributions and benefits is a vital source of the enduring popularity of the program. Social Security is an earned benefit for retirees rather than a welfare check.

Gov. John Kasich does not propose to boost the retirement age, but he does suggest slowing the growth in future pensions by linking workers’ initial pensions to price changes instead of wage changes. He hints he will impose a means test in calculating pensions, reducing the monthly pensions payable to retirees who have high current incomes. Many students of Social Security think this a bad idea, because it can discourage workers from saving for retirement.

All of the Republican candidates, except Trump, think Social Security’s salvation lies in lower benefit payouts. Nobody mentions higher contributions as part of the solution. In contrast, both Democratic candidates propose raising payroll or other taxes on workers who have incomes above the maximum earnings now subject to Social Security contributions. This reform enjoys broad support among voters, most of whom do not expect to pay higher taxes if the income limit on contributions is lifted. Sen. Bernie Sanders would immediately spend some of the extra revenue on benefit increases for current beneficiaries, but his proposed tax hike on high-income contributors would raise enough money to postpone the year of Trust Fund depletion by about 40 years. Hillary Clinton is less specific about the tax increases and benefit improvements she favors. Like Sanders, however, she would vigorously oppose benefit cuts.

None of the candidates has given us a detailed plan to eliminate Social Security’s funding imbalance. At this stage, it’s not obvious such a plan would be helpful, since the legislative debate to overhaul Social Security won’t begin anytime soon. Sanders has provided the most details about his policy intentions, but his actual plan is unlikely to receive much Congressional support without a massive political realignment. Cruz’s proposal, which calls for eliminating the Social Security payroll tax, also seems far outside the range of the politically feasible.

What we have learned from the GOP presidential debates so far is that Republican candidates, with the exception of Trump, favor balancing Social Security through future benefit cuts, possibly targeted on higher income workers, while Democratic candidates want to protect current benefit promises and will do so with tax hikes on high-income workers. There is no overlap in the two parties’ proposals, and this accounts for Washington’s failure to close Social Security’s funding gap.

Editor’s note: This piece originally appeared in Fortune.

       

       

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The financial sector has undergone major changes in response to the Great Recession and post-crisis regulatory reform, as a result of the Dodd-Frank Act and Basel III. These changes have created serious questions about the sector’s role in supporting economic growth and how it affects financial and overall economic stability.

On June 8, the Initiative on Business and Public Policy at Brookings explored the intersection of the financial system and economic growth with the goal of informing the public policy debate. The event featured a keynote address by Richard Berner, director of the Office of Financial Research and other participants with a wide range of views from a variety of backgrounds. Among other issues, the experts considered the changing landscape of the financial sector; growth-promoting allocation and investment decisions; credit availability for low- and moderate-income households; the ideal balance between growth and stability; and the impact of the 2014 midterm elections on regulatory reform.

 Follow the conversation at @BrookingsEcon or #Finance.

Video

• Keynote remarks by Richard Berner
• The financial sector: How has it changed?
• The view from the trenches
• The future of the U.S. financial sector

Audio

• Can the financial sector promote growth and stability?

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• Aaron Kleins presentation
• 20150608 BAER slides
• 20150608 MEHTA slides
• 20150608_financial_sector_stability_transcript

      

Executive Summary ¹

The regional banks play an important role in the economy providing funding to consumers and small- and medium-sized businesses. Their model is simpler than that of the large Wall Street banks, with their business concentrated in the U.S.; they are less involved in trading and investment banking, and they are more reliant on deposits for their funding. We examined the balance sheets of 15 regional banks that had assets between $50 billion and $250 billion in 2003 and that remained in operation through 2014.

The regionals have undergone important changes in their financial structure as a result of the financial crisis and the subsequent regulatory changes:

• Total assets held by the regionals grew strongly since 2010. Their share of total bank assets has risen since 2010.

• Loans and leases make up by far the largest component of their assets. Since the crisis, however, they have substantially increased their holdings of securities and interest bearing balances, including government securities and reserves.

• The liabilities of the regionals were heavily concentrated in domestic deposits, a pattern that has intensified since the crisis. Deposits were 70 percent of liabilities in 2003, a number that fell through 2007 as they diversified their funding sources, but by 2014 deposits made up 82 percent of the total.

• Regulators are requiring large banks to increase their holdings of long term subordinated debt as a cushion against stress or failure. The regionals, as of 2014, had not increased their share of such liabilities.

• Like the largest banks, the regionals increased their loans and leases in line with their deposits prior to the crisis. And like the largest banks, this relation broke down after 2007, with loans growing much more slowly than deposits. Unlike the largest banks, the regionals have increased loans strongly since 2010, but there remains a significant gap between deposits and loans.

• The regional banks’ share of their net income from traditional sources (mostly loans) has been slowly declining over the period.

• The return on assets of the regionals was between 1.5 and 2.0 percent prior to the crisis. This turned sharply negative in the crisis before recovering after 2009. Between 2012 and 2014 return on assets for these banks was around 1.0 percent, well below the pre-crisis level.

As we saw with the largest banks, the structure and returns of the regional banks has changed as a result of the crisis and new regulation. Perhaps the most troubling change is that the volume of loans lags well behind the volume of deposits, a potential problem for economic growth. The asset and liability structure of the banks has also changed, but these banks have a simpler business model where deposits and loans still predominate.

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This paper was revised in October 2015.

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^{1. William Bekker served as research assistant on this project until June 2015 where he compiled and analyzed the data. He was co-author of the first part of this series and his contributions were vital to the findings presented here. New research assistant Nicholas Montalbano has contributed to this paper.  We thank Michael Gibson of the Federal Reserve for helpful suggestions.}

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• Media summary

      

Now that interest rates have finally been increased, it is time to focus on something other than the Federal Reserve’s moves for a while and look at what is perhaps the single most important problem facing the American economy: the very slow growth of productivity.

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.