Baltimore police officer Edward Nero, one of six being tried separately in relation to the arrest and death of Freddie Gray, has been acquitted on all counts. The outcome for officer Nero was widely expected, but officials are nonetheless aware of the level of frustration and anger that remains in the city. Mayor Stephanie Rawlings Blake said: "We once again ask the citizens to be patient and to allow the entire process to come to a conclusion."

Since Baltimore came to national attention, Brookings scholars have probed the city’s challenges and opportunities, as well addressing broader questions of place, race and opportunity.

• In this podcast, Jennifer Vey describes how, for parts of Baltimore, economic growth has been largely a spectator sport: "1/5 people in Baltimore lives in a neighborhood of extreme poverty, and yet these communities are located in a relatively affluent metro area, in a city with many vibrant and growing neighborhoods."
• Vey and her colleague Alan Berube, in this piece on the "Two Baltimores," reinforce the point about the distribution of economic opportunity and resources in the city:
  

  In 2013, 40,000 Baltimore households earned at least $100,000. Compare that to Milwaukee, a similar-sized city where only half as many households have such high incomes. As our analysis uncovered, jobs in Baltimore pay about $7,000 more on average than those nationally. The increasing presence of high-earning households and good jobs in Baltimore City helps explain why, as the piece itself notes, the city’s bond rating has improved and property values are rising at a healthy clip."

• Groundbreaking work by Raj Chetty, which we summarized here, shows that Baltimore City is the worst place for a boy to grow up in the U.S. in terms of their likely adult earnings:

• Here Amy Liu offered some advice to the new mayor of the city: "I commend the much-needed focus on equity but…the mayoral candidates should not lose sight of another critical piece of the equity equation: economic growth."
• Following an event focused on race, place and opportunity, in this piece I drew out "Six policies to improve social mobility," including better targeting of housing vouchers, more incentives to build affordable homes in better-off neighborhoods, and looser zoning restrictions.
• Frederick C. Harris assessed President Obama’s initiative to help young men of color, "My Brother’s Keeper," praising many policy shifts and calling for a renewed focus on social capital and educational access. But Harris also warned that rhetoric counts and that a priority for policymakers is to "challenge some misconceptions about the shortcomings of black men, which have become a part of the negative public discourse."
• Malcolm Sparrow has a Brookings book on policing reform, "Handcuffed: What Holds Policing Back, and the Keys to Reform" (there is a selection here on Medium). Sparrow writes:
  

  Citizens of any mature democracy can expect and should demand police services that are responsive to their needs, tolerant of diversity, and skillful in unraveling and tackling crime and other community problems. They should expect and demand that police officers are decent, courteous, humane, sparing and skillful in the use of force, respectful of citizens’ rights, disciplined, and professional. These are ordinary, reasonable expectations."

Five more police officers await their verdicts. But the city of Baltimore should not have to wait much longer for stronger governance, and more inclusive growth.

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.

China's economy sailed through the financial crisis unscathed — at least in the short run.

When the global crisis hit, the country's government-owned banks started lending out lots more money. The money came largely from the savings accounts of ordinary Chinese people. It went largely to finance big construction projects, which helped keep China's economy growing.

"It sort of explains why China recovered so quickly," Hu Angang, an economist at Tsinghua University, told us. Indeed, China's strong showing through the crisis was seen by some as a vindication of the large role Chinese government plays in steering the country's economy.

But if it turns out China doesn't need all that new stuff it's building, the country will face an economic reckoning, says Michael Pettis, who teaches finance at Peking University in Beijing.

For Pettis, China's economic miracle is just the latest, largest version of a familiar story. A government in a developing country funnels tons of money into construction. This increases economic activity for a while, but the country ultimately overbuilds — and the loans start going bad.

"In every single case it ended up with excessive debt," Pettis says. "In some cases a debt crisis, in other cases a lost decade of very, very slow growth and rapidly rising debt. And no one has taken it to the extremes China has."

The counterpoint to Pettis's argument: China is extreme. It's a country of a billion people, growing at an incredible rate. The country needs to build lots of new stuff — new roads, new power plants, new buildings.

It's been this way for decades, says Arthur Kroeber, who runs the Chinese research firm Dragonomics. When he first arrived in Beijing in 1985, the city had just finished building a new ring road — a highway that runs in a loop circle around the city center. It was so empty that he and his wife rode their bikes down the middle of the highway.

Listen to the full interview on npr.org»

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.

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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.

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

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• Uncorrected Transcript (.pdf)

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• 20130416_china_economy

The much anticipated Third Plenum of the Chinese Communist Party’s 18^th Congress closed its four-day session last Tuesday. A relatively bland initial communiqué was followed today by a detailed decision document spelling out major initiatives including a relaxation of the one-child policy, the elimination of the repressive “re-education through labor” camps, and a host of reforms to the taxation and state-owned enterprise systems. Today’s blizzard of specific reform pledges allays earlier concerns that the new government led by party chief Xi Jinping and premier Li Keqiang would fail to set major policy goals. But is this enough to answer the three biggest questions analysts have had since Xi and  Li ascended a year ago?

Those questions are, first, do Xi and his six colleagues on the Politburo standing committee have an accurate diagnosis of China’s structural economic and social ailments? Second, do they have sensible plans for addressing these problems? And third, do they have the political muscle to push reforms past entrenched resistance by big state owned enterprises (SOEs), tycoons, local government officials and other interest groups whose comfortable positions would be threatened by change? Until today, the consensus answers to the first two questions were “we’re not really sure,” and to the third, “quite possibly not.”

These concerns are misplaced. It is clear that the full 60-point “Decision on Several Major Questions About Deepening Reform”[1] encompasses an ambitious agenda to restructure the roles of the government and the market. Combined with other actions from Xi’s first year in office – notably a surprisingly bold anti-corruption campaign – the reform program reveals Xi Jinping as a leader far more powerful and visionary than his predecessor Hu Jintao. He aims to redefine the basic functions of market and government, and in so doing establish himself as China’s most significant leader since Deng Xiaoping. Moreover, he is moving swiftly to establish the bureaucratic machinery that will enable him to overcome resistance and achieve his aims. It remains to be seen whether Xi can deliver on these grand ambitions, and whether his prescription will really prove the cure for China’s mounting social and economic ills. But one thing is for sure: Xi cannot be faulted for thinking too small.

Main objective: get the government out of resource allocation

The four main sources we have so far on Xi’s reform strategy are the Plenum’s Decision, the summary communiqué issued right after the plenum’s close,[2] an explanatory note on the decision by Xi,[3] and a presumably authoritative interview with the vice office director of the Party’s Financial Leading Small Group, Yang Weimin, published in the People’s Daily on November 15, which adds much useful interpretive detail.[4] Together they make clear that the crucial parts of the Decision are as follows:

• China is still at a stage where economic development is the main objective.
• The core principle of economic reform is the “decisive” (决定性) role of market forces in allocating resources (previous Party decisions gave the market a “basic” (基础）role in resource allocation.
• By implication, the government must retreat from its current powerful role in allocating resources. Instead, it will be redirected to five basic functions: macroeconomic management, market regulation, public service delivery, supervision of society (社会管理), and environmental protection.

In his interview, Yang Weimin draws a direct comparison between this agenda and the sweeping market reforms that emerged after Deng Xiaoping’s southern tour in 1992, claiming that the current reform design is a leap forward comparable to Deng’s, and far more significant than the reform programs of Jiang Zemin and Hu Jintao.

This a very bold and possibly exaggerated claim. But the basic reform idea – giving the market a “decisive” role in resource allocation – is potentially very significant, and should not be dismissed as mere semantics. Over the last 20 years China has deregulated most of its product markets, and the competition in these markets has generated enormous economic gains. But the allocation of key inputs – notably capital, energy, and land – has not been fully deregulated, and government at all levels has kept a gigantic role in deciding who should get those inputs and at what price. The result is that too many of these inputs have gone to well-connected state-owned actors at too low a price. The well-known distortions of China’s economy – excessive reliance on infrastructure spending, and wasteful investment in excessive industrial capacity – stem largely from the distortions in input prices.

Xi’s program essentially calls for the government to retreat from its role in allocating these basic resources. If achieved, this would be a big deal: it would substantially boost economic efficiency, but at the cost of depriving the central government of an important tool of macro-economic management, and local governments of treasured channels of patronage. As a counterpart to this retreat from direct market interference, the Decision spells out the positive roles of government that must be strengthened: macro management and regulation, public service delivery, management of social stability, and environmental protection. In short, the vision seems to be to move China much further toward an economy where the government plays a regulatory, rather than a directly interventionist role.

Keep the SOEs, but make them more efficient

Before we get too excited about a “neo-liberal” Xi administration, though, it’s necessary to take account of the massive state-owned enterprise (SOE) complex. While Xi proposes that the government retreat from its role in manipulating the prices of key inputs, it is quite clear that the government’s large role as the direct owner of key economic assets will remain. While the Decision contains a number of specific SOE reform proposals (such as raising their dividend payout ratio from the current 10-15% to 30%, and an encouragement of private participation in state-sector investment projects), it retains a commitment to a very large SOE role in economic development. The apparent lack of a more aggressive state-sector reform or privatization program has distressed many economists, who agree that China’s declining productivity growth and exploding debt are both substantially due to the bloated SOEs, which gobble up a disproportionate share of bank credit and other resources but deliver ever lower returns on investment.

The communiqué and the Decision both make clear that state ownership must still play a “leading role” in the economy, and it is a very safe bet that when he retires in 2022, Xi will leave behind the world’s biggest collection of state-owned enterprises. But while privatization is off the table, subjecting SOEs to much more intense competition and tighter regulation appears to be a big part of Xi’s agenda. In his interview, Yang Weimin stresses that the Plenum decision recognizes the equal importance of both state and non-state ownership – a shift from previous formulations which always gave primacy to the state sector. Moreover, other reports suggest that the mandate of the State-owned Assets Supervision and Administration Commission (Sasac), which oversees the 100 or so big centrally-controlled SOE groups, will shift from managing state assets to managing state capital.[5] This shift of emphasis is significant: in recent years SOEs have fortified their baronies by building up huge mountains of assets, with little regard to the financial return on those assets (which appears to be deteriorating rapidly). Forcing SOEs to pay attention to their capital rather than their assets implies a much stronger emphasis on efficiency.

This approach is consistent with a long and generally successful tradition in China’s gradual march away from a planned economy. The key insight of economic reformers including Xi is that the bedrock of a successful modern economy is not private ownership, as many Western free-market economists believe, but effective competition. If the competitive environment for private enterprises is improved – by increasing their access to capital, land and energy, and by eliminating regulatory and local-protectionist barriers to investment – marginal SOEs

must either improve their efficiency or disappear (often by absorption into a larger, more profitable SOE, rather than through outright bankruptcy). As a result, over time the economic role of SOEs is eroded and overall economic efficiency improves, without the need to fight epic and costly political battles over privatization.

Can Xi deliver?

Even if we accept this view of Xi as an ambitious, efficiency-minded economic reformer, it’s fair to be skeptical that he can deliver on his grand design. These reforms are certain to be opposed by powerful forces: SOEs, local governments, tycoons, and other beneficiaries of the old system. All these interest groups are far more powerful than in the late 1990s, when Zhu Rongji launched his dramatic reforms to the state enterprise system. What are the odds that Xi can overcome this resistance?

Actually, better than even. The Plenum approved the formation of two high-level Party bodies: a “leading small group” to coordinate reform, and a State Security Commission to oversee the nation’s pervasive security apparatus. At first glance this seems a classic bureaucratic shuffle – appoint new committees, instead of actually doing something. But in the Chinese context, these bodies are potentially quite significant.

In the last years of the Hu Jintao era, reforms were stymied by two entrenched problems: turf battles between different ministries, and interference by security forces under a powerful and conservative boss, Zhou Yongkang. Neither Hu nor his premier Wen Jiabao was strong enough to ride herd on the squabbling ministers, or to quash the suffocating might of the security faction. By establishing these two high-level groups (presumably led by himself or a close ally), Xi is making clear that he will be the arbiter of all disputes, and that security issues will be taken seriously but not allowed to obstruct crucial economic or governance reforms.

The costs of crossing Xi have also been made clear by a determined anti-corruption campaign which over the last six months has felled a bevy of senior executives at the biggest SOE (China National Petroleum Corporation), the head of the SOE administrative agency, and a mayor of Nanjing infamous for his build-at-all-costs development strategy. Many of the arrested people were closely aligned with Zhou Yongkang. The message is obvious: Xi is large and in charge, and if you get on the wrong side of him or his policies you will not be saved by the patronage of another senior leader or a big state company. Xi’s promptness in dispatching his foes is impressive: both of his predecessors waited until their third full year in office to take out crucial enemies on corruption charges.

In short, there is plenty of evidence that Xi has an ambitious agenda for reforming China’s economic and governance structures, and the will and political craft to achieve many of his aims. His program may not satisfy market fundamentalists, and he certainly offers no hope for those who would like to see China become more democratic. But it is likely to be effective in sustaining the nation’s economic growth, and enabling the Communist Party to keep a comfortable grip on power.

Editor's Note: Arthur Kroeber is the Beijing-based managing director of Gavekal Dragonomics, a global macroeconomic research firm, and a non-resident fellow of the Brookings-Tsinghua Center. A different version of this article appears on www.foreignpolicy.com.

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While countless factors have contributed to China’s dramatic economic transformation, the groundbreaking economic reforms instituted by Premier Zhu Rongji from 1998 to 2003 were critical in setting the stage for China to become one of the world’s dominant economic powers. From combatting corruption and inefficient state-owned enterprises at home to engineering China’s ascension to the World Trade Organization, Zhu left behind a legacy on which successive administrations have sought to build. What similarities, differences or parallels can be drawn between Zhu’s time and today? And what lessons can China’s current leaders learn from Zhu’s reforms?

On January 9, the John L. Thornton China Center at the Brookings Institution launched the second English volume of Zhu Rongji: On The Record (Brookings Press, 2015), which covers the critical period during which Zhu served as premier between 1998-2003. In addition to highlighting Zhu’s legacy, this event also featured public panel discussions outlining the past, present and future of Chinese economic reform and its impact domestically and internationally.

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• Chinese Economic Reform: Past, Present and Future - Part 1
• Chinese Economic Reform: Past, Present and Future - Part 2

Transcript

• Transcript (.pdf)

Event Materials

• 20150109_china_economic_reform_transcript

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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Prime Minister Shinzo Abe has been promoting the increased participation of women in the Japanese economy, a policy popularly known as womenomics, as a pillar of his campaign for economic revitalization. While significant strides have been made with regard to increasing female workforce participation, corporate efforts to introduce flexible working practices, and spurring the promotion of women on the corporate ladder, womenomics will be incomplete if it remains confined to the established corporate structure. Unleashing the creative potential of half of Japan’s population will require an equally sustained effort to promote female entrepreneurship. This is a tall order for Japan where female entrepreneurs face a two-fold challenge: the modest development of venture capital and a host of legal and cultural hurdles to individual entrepreneurship; plus the additional hurdles for women in gaining access to the assets widely perceived as essential to success such as business networks, financing, technology, and access to markets at home and abroad. However, entrepreneurship offers Japanese women significant benefits through the opportunity to bypass rigid corporate hierarchies, custom tailor their workloads to better achieve work-life balance, and offer new and innovative products and services to the Japanese consumer.

On February 8, the Center for East Asia Policy Studies at Brookings hosted a distinguished group of policy experts and entrepreneurs for a discussion on the current state of female entrepreneurship in Japan and concrete strategies to promote female-run businesses in the country. They compared Japan and the United States, both in terms in differing results but also on-going common challenges, and discussed their own personal experiences.

Join the conversation on Twitter using #Womenomics

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• Womenomics 2.0: The potential of female entrepreneurs in Japan
• The importance of mentors for female entrepreneurs
• Female entrepreneurs: Different options and different styles
• Female leadership creates opportunities

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• Womenomics 2.0: The potential of female entrepreneurs in Japan

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• Uncorrected Transcript (.pdf)

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• Kurihara Presentation for website
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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

On Valentine’s Day, even a dismal scientist’s mind turns to love. It’s a powerful feeling, with a value that goes far beyond the millions of chocolate boxes and bouquets that will be delivered this Feb. 14.

Survey data from the Gallup Organization, where Justin works as a senior scientist, allow us to take a uniquely deep look at the state of love around the world. In 2006 and 2007, Gallup went to 136 countries and asked people, “Did you experience love for a lot of the day yesterday?” It’s the largest such dataset ever collected.

The good news: Ours is a loving world. On a typical day, about 70 percent of people worldwide reported a love-filled day. In the U.S., 81 percent felt love, as did 81 percent of Canadians and 79 percent of Italians. Germany and the U.K. were less loving, with slightly less than 3 in 4 people reporting feeling loved. Surprisingly, the same was true of the supposedly romantic French. And if you’re in Japan, please hug someone: Only 59 percent of Japanese said they had experienced love the previous day.

Across the world as a whole, the widowed and divorced are the least likely to experience love. Married folks feel more of it than singles. People who live together out of wedlock report getting even more love than married spouses -- an interesting factoid for conservatives worried about the effects of cohabitation. Women get more love than men, particularly in the U.S.

Young Love

If you’re young and not feeling all that loved this Valentine’s Day, don’t despair: You’re not alone. Young adults are among the least likely to experience love. It gets better with age, ultimately peaking in the mid-30s or mid-40s in most countries before fading again into the twilight years.

Money is related to love. Those with more household income are slightly more likely to experience the feeling. Roughly speaking, doubling your income is associated with being about 4 percentage points more likely to be loved. Perhaps having more money makes it easier to find time for love.

That said, the data aren’t necessarily telling us that money can buy you love. It’s possible that other factors correlated with income, such as height or appearance, are the real source of attraction. Or maybe being loved gives you a boost in the labor market.

What’s perhaps more striking is how little money matters on a global level. True, the populations of richer countries are, on average, slightly more likely to feel loved than those of poorer countries. But love is still abundant in the poorer countries: People in Rwanda and the Philippines enjoyed the highest love ratios, with more than 9 in 10 people providing positive responses. Armenia, Uzbekistan, Mongolia and Kyrgyzstan, with economic output per person in the middle of the range, all had love ratios of less than 4 in 10.

Fun facts aside, we think there is a deeper and more consequential purpose to the study of love. Think about what love means to you. To us, it means caring about others and being cared for. Love is valuable, even if it is absent from both our national accounts and our political discourse.

In the language of economics, love is a form of insurance. It involves bonds of reciprocity that provide support when we’re feeling down, when we’re sick and when times are tough.

More broadly, love has the power to mitigate the free-rider and moral hazard problems associated with social (and private) insurance. Bailing out a bank might encourage executives to take bigger risks in the future, but helping loved ones down on their luck has fewer incentive problems because our loved ones typically care for us in return. Such mutually beneficial relationships make us all more resilient in times of crisis. This is why the household remains one of the most powerful institutions for organizing not just families but also our economic lives.

If we can find more love for our fellow citizens, our society will function better. Hard as this may be to achieve in an era when trust in government, business and one another is low, it’s worth the effort. When you expand the boundaries of trust and reciprocity, you expand the boundaries of what is possible.

Note: This content was first published on Bloomberg View on February 13, 2013.

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Justin Wolfers, professor of Economics and Public Policy at the University of Michigan, re-joins Brookings, Vice President and Economic Studies Co-Director Karen Dynan announced today.  Wolfers was a visiting fellow from 2010-2011.

A world-renowned empirical economist, Wolfers will continue in his role as co-editor, along with David Romer of the University of California, of the Brookings Papers on Economic Activity (BPEA), the flagship economic journal of the Institution.  He will continue his focus on labor economics, macroeconomics, political economy, economics of the family, social policy, law and economics, public economics, and behavioral economics. His appointment as senior fellow will last 13 months.

Wolfers is also a research associate with the National Bureau for Economic Research, a research affiliate of the Centre for Economic Policy Research in London, a research fellow of the German Institute for the Study of Labor, and a senior scientist for Gallup, among other affiliations. He is a contributor for Bloomberg View, NPR Marketplace, and the Freakonomics website and was named one of the 13 top young economists to watch by the New York Times.  Wolfers did his undergraduate work at the University of Sydney, Australia and received his Master’s and Ph.D. in Economics from Harvard University.  He is a dual Australian-U.S. national and was once an apprentice to a bookie which led to his interest in prediction markets. 

“We are pleased to re-welcome Justin back to Economic Studies,” said Dynan. “His work continues to challenge the conventional wisdom, and we look forward to collaborating with him once again.” 

“Justin is outstanding at communicating economic ideas to a wide audience, as evidenced by his regular writings for media as well as his large social media presence,” added Ted Gayer, co-director of Economic Studies.

“I have enormous affection for the Brookings Institution, which provides not only a home for deep scholarly research, but also an unmatched platform for engaging the policy debate,” said Wolfers.  “The Economic Studies program has a rich history of being the go-to place for policymakers, and I look forward to coming back and engaging in debate with my colleagues there.”

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Editor’s note: In a presentation to the 2011 International Conference on Early Childhood Development in Beijing, China, Jacques van der Gaag makes the economic case for investing in young children. He references the seminal works by several Nobel laureates in economics to demonstrate how development hinges on investments in early childhood, including health, nutrition, and education.

Thank you for inviting me to the 2011 International Conference on Early Childhood Development. I am very grateful to the organizers from the China Development Research Foundation for giving me a chance to make the economic case for investing in young children. While I have been giving these types of presentations for more than two decades in over a dozen countries worldwide, I prefer to have some back-up from a number of serious economists who, over time, have made major contributions to a key finding in development economics: countries prosper if they invest in their people, and the well-being of all people improves in a prosperous country that values equality.

To begin with, I would like to introduce my fellow countryman Jan Tinbergen, who received the first Nobel Prize in Economics, in 1969, for his work on economic development. Being a physicist by training, he pioneered the use of mathematical models to mimic the working of a country’s economy. The equations he used to formulate these models will probably look very foreign to you, but the important point I want to make is that these early models already included people, in the form of labor. People were seen as an input in the production process. Since there was an abundance of people in the developing world, and a shortage of capital, the development process, it was argued, could be sped up by providing more capital to low income countries to invest in infrastructure, factories, and other forms of physical capital. And to invest in human capital -- people. The economy needs all forms of human capital, from unskilled labor to highly skilled labor, and therefore investment in people, through education, was considered an integrated part of the development process.

Another well-known economist (Theodore W. Schulz, Nobel prize 1979) emphasized an important difference between physical capital and human capital: people respond to incentives. Thus, when food prices are being kept artificially low (to allow wages in the cities to stay low), farmers may decide that it is no longer worth their while to produce food, and they may migrate to the cities to work in the new factories. In other words, it is important to invest in human capital to stimulate the economy, but the broad preferences of the (working) population should not be overlooked.
 
Robert W. Fogel (Nobel laureate in 1993) underscored the role of workers in the production process by emphasizing the importance of health and nutrition to enhance productivity. Indeed, he calculated that about half of the speedy growth of the British economy during the Industrial Revolution was the result of better health and nutrition conditions of the working population. In turn, of course, the economic growth made the improvements in sanitation and the increased availability of (better) food possible.

A major breakthrough in the thinking about development (note that I am no longer saying “economic development”) came with the work of Amartya Sen (Nobel prize winner in 1998). His work has led to a re-definition of the development process from one that focuses solely on economic growth to one in which the fruits of economic growth benefits the population in terms of higher literacy rates and education levels, better health and nutrition, higher levels of social cohesion and social skills, and more equality. These four broad dimensions of well-being, together with economic growth, are now the building blocks of the Human Development Index. Indeed, human development, as currently understood, has been further specified in the Millennium Development Goals that drive today’s development discussion and policies in every corner of the world.

Before I finish my very brief (and very selective) history of development economics, allow me to mention the work of one more Nobel laureate in economics: Jim Heckman (2000). Heckman understands, of course, the importance of investing in people to increase a country’s human capital. But he also understands both the economics of early childhood development (ECD) and its scientific underpinnings. In recent work, he has extensively referred to the scientific basis that shows the causal link between deprivations early in life and education, social and health outcomes later in life. His economic work on ECD confirms what others have been saying for decades: The highest economic returns to investments in people come from the investments that occur in the early years of life.  

In sum, with an increased understanding of the basic development process, in which people are both the driving force for development and its main beneficiaries, the importance of investing in very young children is now seen as a key factor in the broad human development process of a country.
Taking care of very young children has long been on the development agenda. Immunization programs have been pushed to improve the health status of young children, nutrition programs have been implemented to prevent malnutrition and hunger, schooling has been emphasized as important for prosperity later in life, and as a possible “equalizer” of society. What the recent literature on brain development, on the interaction of genes and the environment, on the importance of cognitive and non-cognitive skill development (“social skills”), and on the link between early deprivations and a variety of problems later in life (from health problems to increased delinquency) has added to these efforts, is a better understanding of the long-term economic implications of these interventions.
 
Simply stated, economists look at investments in human capital as a means to increase lifelong “productivity”. The easiest way to measure differences in productivity is by comparing differences in wage rates (in well functioning labor markets) among workers with different levels of education (skills). Higher levels of education (more and better skills) lead to higher productivity, and this advantage can be maintained during one’s entire (working) life. Of course, not everyone works for wages, but similar results (more educated workers are more productive) have been found in agriculture and other forms of self-employment. Indeed, even the productivity of people who do not work in the labor market can be improved by education. Case in point: women who finished secondary education are much better equipped to address the health and nutrition needs of their children than illiterate mothers (and they have fewer children and make sure that these children go to school).

When economist do the numbers, solely based on increased productivity in the labor market, the economic returns to ECD are impressive (see slides 21 and 22). Integrated ECD programs reduce infant and child mortality, increase children’s nutritional and health status, increase on-time school enrollment, decrease drop-out and repetition rates, and increase progression to higher levels of education. All this leads to a more productive labor force. The economic returns from these ECD benefits alone are estimated to be in the 7 percent to 12 percent range, with some estimates being much higher. When ECD interventions are properly seen as investments in the human development of a country, the benefits are very large indeed.
 
Chances are that you were a little surprised to get a lecture on the “the history of development economics” at a conference about early childhood development. But the organizers asked me to make the economic case for investing in young children. I decided that I could do this as forcefully as possible by invoking the help of no fewer than five Nobel laureates in economics. Development is now understood as a process by people for people. All the evidence shows that investment in the health, in nutrition, and in cognitive and non-cognitive skill development is crucial for a prosperous and equal society. Of all the investments in people one can make, investments in the very young have the highest economic returns.

I congratulate our organizers from the China Development Research Foundation for their work on ECD to benefit the children of poor minorities in western China, providing them with a chance to benefit from China’s impressive growth record. And I thank you again for the opportunity to address this distinguished audience on such an important topic.

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A conversation with U.S. Secretary of Commerce Penny Pritzker

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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.

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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.

In partnership with the ESADE Business School and the City of Barcelona, the Metropolitan Policy Program planned and participated in three intensive days of learning in Barcelona in June 2011.  The focus of the session was to look at examples of strategies Barcelona, Spain and its greater metropolitan region is embracing to rebuild and re-invent their economies.  The goal is to share innovative ideas with U.S. metros engaged in similar initiatives as they face the challenge of moving to a new economic growth model.

This paper features brief synopses of the tours and meetings held with the City of Barcelona and the Catalonia Region on their economic development strategies.

Specific strategies include:

Barcelona Activa »

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Productivity growth in the United States slowed sharply around 2005, which has contributed to slow growth in wages and downward revisions to estimates of long run economic growth. The global economy has grown incredibly fast since 1950, with global GDP expanding six-fold and average per capita income nearly tripling. A larger workforce and increased productivity spurred this growth. However, the global workforce is expected to grow more slowly over the coming years, and peak in size around 2050. If strong economic growth is to be achieved, in both the United States and globally, productivity must increase strongly.

On Wednesday, April 8, the Initiative on Business and Public Policy hosted an event exploring these and related issues. The event featured keynote remarks by Jason Furman, Chairman of the Council of Economic Advisers, and Alan Greenspan, former Chairman of the Federal Reserve Board. James Manyika and Jaana Remes of the McKinsey Global Institute considered the potential for faster global productivity growth. Marco Annunziata of General Electric will gave his perspective, and Martin Baily looked at explanations for slow growth in the U.S. economy.

Download a McKinsey report on global productivity trends »

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Washington is again paralyzed and pulling back on clean energy economic development. Deficit politics and partisanship are firmly entrenched and the raft of federal financial supports made available through the 2009 stimulus law and elsewhere is starting to expire.

No wonder it’s hard to imagine—especially if you’re sitting in the nation’s capital—how the next phase of American clean energy industry growth will be financed or its next generation of technologies and firms supported.

And yet, one source of action lies hidden in plain sight. With federal clean energy activities largely on hold, a new paper we are releasing today as part of the Brookings-Rockefeller Project on State and Metropolitan Innovation argues that U.S. states hold out tremendous promise for the continued design and implementation of smart clean energy finance solutions and economic development.

Specifically, we contend that the nearly two dozen clean energy funds (CEFs) now running in a variety of mostly northern states stand as one of the most important clean energy forces at work in the nation and offer at least one partial response to the failure of Washington to deliver a sensible clean energy development approach.

To date, over 20 states have created a varied array of these public investment vehicles to invest in clean energy pursuits with revenues often derived from small public-benefit surcharges on electric utility bills. Over the last decade, state CEFs have invested over $2.7 billion in state dollars to support renewable energy markets, counting very conservatively.  Meanwhile, they have leveraged another $9.7 billion in additional federal and private sector investment, with the resulting $12 billion flowing to the deployment of over 72,000 projects in the United States ranging from solar installations on homes and businesses to wind turbines in communities to large wind farms, hydrokinetic projects in rivers, and biomass generation plants on farms. 

In so doing, the funds stand well positioned—along with state economic development and other officials—to build on a pragmatic success and take up the challenge left by the current federal abdication of a role on clean energy economic development.

Yet here is the rub: For all the good the funds have achieved, project-only financing—as needed as it is—will not be sufficient to drive the growth of large and innovative new companies or to create the broader economic development taxpayers demand from public investments.  Also needed will be a greater focus on the deeper-going economic development work that can help spawn whole new industries. 

All of which points to the new brand of fund activity that our paper celebrates and calls for more of. 

In recent years, increasingly ambitious efforts in a number of states have featured engagement on at least three major fronts somewhat different from the initial fund focus: (1) cleantech innovation support through research, development, and demonstration (RD&D) funding; (2) financial support for early-stage cleantech companies and emerging technologies, including working capital for companies; and (3) industry development support through business incubator programs, regional cluster promotion, manufacturing and export promotion, supply chain analysis and enhancement, and workforce training programs.

These new economic development efforts—on display in California, Massachusetts, New York, and elsewhere—show the next era of state clean energy fund leadership coming into focus. States are now poised to jumpstart a new, creative period of expanded clean energy economic development and industry creation, to complement and build upon individualistic project financing. 

Such work could not be more timely at this moment of federal gridlock and market uncertainty.

Along these lines, then, our paper advances several recommendations for moving states more aggressively into this new period of clean energy economic development. We suggest that:

• States should reorient a significant portion (at least 10 percent of the total portfolio) of state CEF money to clean energy-related economic development

• States, as they reorient portions of their CEFS to economic development, should better understand the market dynamics in their metropolitan regions.  They need to lead by making available quality data on the number of jobs in their regions, the fastest-growing companies, the critical industry clusters, gaps in the supply chain for those industries, their export potential, and a whole range of economic development and market indicators

• States also should better link their clean energy funds with economic development entities, community development finance institutions (CDFIs), development finance organizations and other stakeholders who could be ideal partners to develop decentralized funding and effective economic development programs

In addition, we think that Washington needs to recognize the strength and utility of the CEFs and actively partner with them:

• The federal government should consider redirecting a portion of federal funds (for instance, from federal technology support programs administered by the Department of Energy and other programs meant for federal-state cooperation) to provide joint funding of cluster development, export programs, workforce training, and other economic development programs  through matching dollars to state funds that now have active economic development programs, and to provide incentives to states without such programs to create them

• The federal government should create joint technology partnerships with states to advance each state’s targeted clean energy technology industries, by matching federal deployment funding with state funding.

• The states and the federal government, more generally, should look to “decentralize” financing decisions to local entities with street knowledge of their industries, relying on more “development finance” authorities that have financed traditional infrastructure and now could finance new clean energy projects and programs

In sum, our new paper proposes a much greater focus in U.S. clean energy finance on “bottom up,” decentralized clean initiatives that rely on the states to catalyze regional economic development in regions. Such an approach—which reflects the emergence of an emerging “pragmatic caucus” in U.S. economic life—is currently demanded by federal inaction. However, it might also be the smartest, most durable way to develop the clean energy industries of the future without the partisan rancor and obtuseness that has stymied federal energy policy. State clean energy funds—having funded thousands of individual projects—bring significant knowledge to bear as they focus now on building whole industries. For that reason, the funds’ transition from project development to industry creation should be nurtured and supported.

State clean energy funds (CEFs) have emerged as effective tools that states can use to accelerate the development of energy efficiency and renewable energy projects. These clean energy funds, which exist in over 20 states, generate about $500 million per year in dedicated support from utility surcharges and other sources, making them significant public investors in thousands of clean energy projects.

However, state clean energy funds’ emphasis on a project finance model—which directly promotes clean energy project installation by providing production incentives and grants/rebates—is by itself not enough to build a statewide clean energy industry. State clean energy funds also need to pay attention to other critical aspects of building a robust clean energy industry, including cleantech innovation support through research and development funding, financial support for early-stage cleantech companies and emerging technologies, and various other industry development efforts.

As it happens, some of these state clean energy funds are already supporting a broader range of clean energy-related economic development activities within their states. As more and more states reorient their clean energy funds from a project finance-only model in order to encompass broader economic development activities, clean energy funds can collectively become an important national driver for economic growth.

To become true economic development engines in clean energy state clean energy funds should:

• Reorient a significant portion of their funding toward clean energy-related economic development
• Develop detailed state-specific clean energy market data
• Link clean energy funds with economic development entitites and other stakeholders in the emerging industry
• Collaborate with other state, regional, and federal efforts to best leverage public and private dollars and learn from each other's experiences

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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. 

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The White House Council of Economic Advisers (CEA) was created by Congress in 1946 to advise the president on ways “to foster and promote free competitive enterprise” and “to promote maximum employment, production and purchasing power.” President Truman, who signed the Employment Act of 1946 into law, was unenthusiastic about the Council and didn’t nominate members for nearly six months. Yet the CEA, comprised of three individuals whom Congress says are to be “exceptionally qualified,” has not only survived but also prospered for 70 years and remains an important part of the president’s economic policy decisionmaking.

On February 11, the Hutchins Center on Fiscal and Monetary Policy at Brookings marked this anniversary by examining the ways the CEA and other economists succeed and fail when they set out to advise elected politicians and tap the expertise of some of the “exceptionally qualified” economists who have chaired the Council over the past four decades.

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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.