Unemployment and the Unemployment Rate

Of all economic statistics, the unemployment rate is probably the one that gets the most headlines, so it is important to understand what it doesn't tell us. Doing so can help us understand why so many people seem unhappy with the state of the economy, even as the unemployment rate (4.9%) is low by historical standards.

In his Economic Scene column, David Leonhardt points us to the increase in the number of people who are not employed, but not looking for work (and therefore not counted as unemployed):

Consider this: the average unemployment rate in this decade, just above 5 percent, has been lower than in any decade since the 1960s. Yet the percentage of prime-age men (those 25 to 54 years old) who are not working has been higher than in any decade since World War II. In January, almost 13 percent of prime-age men did not hold a job, up from 11 percent in 1998, 11 percent in 1988, 9 percent in 1978 and just 6 percent in 1968.

Even prime-age women, who flooded into the work force in the 1970s and 1980s, aren’t working at quite the same rate they were when this decade began. About 27 percent of them don’t hold a job today, up from 25 percent in early 2000.

There are only two possible explanations for this bizarre combination of a falling employment rate and a falling unemployment rate. The first is that there has been a big increase in the number of people not working purely by their own choice. You can think of them as the self-unemployed. They include retirees, as well as stay-at-home parents, people caring for aging parents and others doing unpaid work.

If growth in this group were the reason for the confusing statistics, we wouldn’t need to worry. It would be perfectly fair to say that unemployment was historically low.

The second possible explanation — a jump in the number of people who aren’t working, who aren’t actively looking but who would, in fact, like to find a good job — is less comforting. It also appears to be the more accurate explanation.

Various studies have shown that the new nonemployed are not mainly dot-com millionaires or stay-at-home dads. (Men who have dropped out of the labor force actually do less housework on average than working women, according to Harley Frazis and Jay Stewart of the Bureau of Labor Statistics.)

Instead, these nonemployed workers tend to be those who have been left behind by the economic changes of the last generation. Their jobs have been replaced by technology or have gone overseas, and they can no longer find work that pays as well. West Virginia, a mining state, is a great example. It may have a record-low unemployment rate, but it has also had an enormous rise in the number of out-of-work men.

That is, we have seen an increase in the number of "discouraged workers" who no longer are actively looking for work. The unemployment rate is the percentage of the labor force who are unemployed; to be counted in the labor force, one must be working or looking for work. So when an unemployed person gives up looking and drops out of the labor force, the unemployment rate actually falls. An increase in discouraged workers would be reflected in a falling labor force participation rate (% of people over 16 who are in the labor force).

Although by the NBER's reckoning, the last recession ended in November 2001, the labor force participation rate (red line) has not recovered. It also takes an unemployed person longer to find a new job now - the median duration of unemployment spells (blue line) remains above its pre-recession level. On Sunday, the Times' Peter Goodman looked at the weakness of the labor market. The anecdotes in his article are a reminder that the pain that appears modest in aggregate economic statistics is really quite severe for some.

For more on labor force participation, see the links at the end of Mark Thoma's post on Leonhardt's column.

Democrats Should Listen to Robert Reich on Trade

In last week's Democratic debate, Tim Russert, in his customary fashion, pressed Barack Obama and Hillary Clinton on their criticisms of the 1993 North American Free Trade Agreement (NAFTA):

MR. RUSSERT: ..[I]n the debate that Al Gore had with Ross Perot, Al Gore said the following: "If you don't like NAFTA and what it's done, we can get out of it in six months. The president can say to Canada and Mexico, we are out. This has not been a good agreement." Will you as president say we are out of NAFTA in six months?

SEN. CLINTON: I have said that I will renegotiate NAFTA, so obviously, you'd have to say to Canada and Mexico that that's exactly what we're going to do. But you know, in fairness --

MR. RUSSERT: Just because -- maybe Clinton --

SEN. CLINTON: Yes, I am serious.

MR. RUSSERT: You will get out. You will notify Mexico and Canada, NAFTA is gone in six months.

SEN. CLINTON: No, I will say we will opt out of NAFTA unless we renegotiate it, and we renegotiate on terms that are favorable to all of America.

But let's be fair here, Tim. There are lots of parts of New York that have benefitted, just like there are lots of parts of Texas that have benefitted. The problem is in places like upstate New York, places like Youngstown, Toledo, and others throughout Ohio that have not benefitted. And if you look at what I have been saying, it has been consistent....

...But let's talk about what we're going to do. It is not enough just to criticize NAFTA, which I have, and for some years now. I have put forward a very specific plan about what I would do, and it does include telling Canada and Mexico that we will opt out unless we renegotiate the core labor and environmental standards -- not side agreements, but core agreements; that we will enhance the enforcement mechanism; and that we will have a very clear view of how we're going to review NAFTA going forward to make sure it works, and we're going to take out the ability of foreign companies to sue us because of what we do to protect our workers....

MR. RUSSERT: But let me button this up. Absent the change that you're suggesting, you are willing to opt out of NAFTA in six months?

SEN. CLINTON: I'm confident that as president, when I say we will opt out unless we renegotiate, we will be able to renegotiate.

MR. RUSSERT: Senator Obama, you did in 2004 talk to farmers and suggest that NAFTA had been helpful. The Associated Press today ran a story about NAFTA, saying that you have been consistently ambivalent towards the issue. Simple question: Will you, as president, say to Canada and Mexico, "This has not worked for us; we are out"?

SEN. OBAMA: I will make sure that we renegotiate, in the same way that Senator Clinton talked about. And I think actually Senator Clinton's answer on this one is right. I think we should use the hammer of a potential opt-out as leverage to ensure that we actually get labor and environmental standards that are enforced. And that is not what has been happening so far...

The Canadians are not amused. The Canadian Broadcasting Corporation reported:

Prime Minister Stephen Harper issued a friendly warning to Democratic presidential hopefuls south of the border on Thursday, saying it would be a "mistake" for the United States to reopen the North American Free Trade Agreement...

"If any American government ever chose to make the mistake of opening that, we would have something we would want to talk about as well," the prime minister said with a smile, in response to a question from NDP Leader Jack Layton.

He didn't elaborate, but earlier this week, Trade Minister David Emerson and Finance Minister Jim Flaherty said U.S. officials should not forget the benefits of the agreement and hinted Canada could respond to a NAFTA pull-out by renegotiating U.S. access to Canada's oil.

There have been reports that Obama economic advisor Austan Goolsbee has been quietly reassuring the Canadians that he doesn't really mean it... (see also Andrew Leonard's take).

If the Democrats wanted to say something intelligent about trade, they might listen to former labor secretary Robert Reich, who writes:

...It’s a shame the Democratic candidates for president feel they have to make trade – specifically NAFTA – the enemy of blue-collar workers and the putative cause of their difficulties. NAFTA is not to blame. Consider the numbers. When NAFTA took effect, Ohio had 990,000 manufacturing jobs. Two years later, in 1996, it had 1,300,000 manufacturing jobs. The number stayed above a million for the rest of the 1990s. Today, though, there are about 775,000 manufacturing jobs in Ohio. What happened? The economy expanded briskly through the 1990s. Then it crashed in late 2000, and the manufacturing jobs lost in that last recession never came back. They didn’t come back for two reasons: In some cases, employers automated the jobs out of existence, using robots and computers. In other cases, employers shipped the jobs abroad, mostly to China – not to Mexico.

NAFTA has become a symbol for the mounting insecurities felt by blue-collar Americans. While the overall benefits from free trade far exceed the costs, and the winners from trade (including all of us consumers who get cheaper goods and services because of it) far exceed the losers, there’s a big problem: The costs fall disproportionately on the losers -- mostly blue-collar workers who get dumped because their jobs can be done more cheaply by someone abroad who’ll do it for a fraction of the American wage. The losers usually get new jobs eventually but the new jobs are typically in the local service economy and they pay far less than the ones lost.

Even though the winners from free trade could theoretically compensate the losers and still come out ahead, they don’t. America doesn’t have a system for helping job losers find new jobs that pay about the same as the ones they’ve lost – regardless of whether the loss was because of trade or automation. There’s no national retraining system. Unemployment insurance reaches fewer than 40 percent of people who lose their jobs – a smaller percentage than when the unemployment system was designed seventy years ago. We have no national health care system to cover job losers and their families. There's no wage insurance. Nothing. And unless or until America finds a way to help the losers, the backlash against trade is only going to grow.

Reich also has some scoop on Clinton's claim that she privately opposed the deal during her husband's administration.

In any event, hopefully this primary race comes to an end Tuesday. If it continues on to Pennsylvania we may get the unedifying spectacle of Clinton and Obama trying to outdo each other in praise of our "antidumping" rules, which are often applied to protect the steel industry.

The first person I ever voted for was Paul Tsongas; if only were still with us to call out the "Pander Bears", sigh...

Update (3/3): New details emerge on l'affaire Goolsbee. Also, Jagdish Bhagwati believes an Obama administration is the "less disturbing prospect" for trade.

Update #2 (3/5): Willem Buiter weighs in, responding to Bhagwati.

Lin on Institutions and Development

We can count Justin Lin, the new chief economist of the World Bank, among those who believe that institutions are crucial for economic growth. He told the Wall Street Journal:

At the beginning, people put a lot of emphasis on resources, and that’s why we had family-planning policy, not only in China but in other parts of the world. [The thinking was that] The more resources per capita, the wealthier the nation. Later on people thought that natural resources may not be so important, they think that capital and technology are important. Now economists start to understand that for all those things — capital needs to be accumulated, technology needs to be adopted, human capital also needs to be accumulated — you need to understand the incentive, the motivation behind those kind of human choices.

These kind of traditional factors of wealth are just some kind of proximate causes. It’s like you say rich people have a lot of money, but you need to understand why they have a lot of money. Now you need to look into what is the deep cause, the real fundamental cause of development. I think increasingly people now understand that institutions are the most fundamental cause.

Because institutions will shape the incentive structure in an economy, about people’s motivation and willingness to engage in work, lending, accumulation of capital. Now people understand that to understand why a country is performing well or performing poorly, institutions are the key. Fundamentally all economic progress needs to be achieved by people’s effort. We need to understand people’s incentives, and people’s incentives are shaped by the institutions in a country.

Although we recognize institutions’ importance, that institutions matter, from what I see, institutions are an area that requires more research. They are often second-best, they are a choice under a certain kind of constraint. If we do not remove those kinds of constraints, if we want to change the institution, you may jump from the second-best to the third-best. Many interventions did not achieve the intended goal, it’s because they did not really address the cause of those kind of distortions.

It sounds like he is reading his Dani Rodrik, and indeed, Professor Rodrik is pleased.

Academia: Not Like Business

On his NY Times blog, Stanley Fish weighs in on the controversy over the appointment of a businessman who lacks an advanced degree as the new president of the University of Colorado. Fish explains why business acumen may not be so useful in running a university:

It is no doubt true that an experienced executive will quickly learn the ropes of an industry new to him. The product may be different, but the tasks will be basically the same: assess market share, learn the routes of distribution, fine-tune the relationship between inventory and demand, increase efficiency perhaps by downsizing the workforce.

But in the academy there is no product except knowledge, and that may take decades to develop, if it develops at all. The concept of market share is inapposite; efficiency is not a goal; and there is no inventory to put on the shelves. Instead the norms are endless deliberations, explorations that may go nowhere, problems that only five people in the world even understand, lifetime employment that is not taken away even when nothing is achieved, expensively labor-intensive practices and no bottom line. What is an outsider to make of that?

Candidates on the March

in the wrong direction....

In the Senate, John McCain opposed the 2001 and 2003 tax cuts, but now he is out to prove that he has imbibed the supply-side kool aid with a tax plan that shows the zeal of the converted. Len Burman of the Tax Policy Center looks at it and says "McCain calls Bush, and Raises Big Time" -

Some conservatives back huge tax cuts because they think the government would just waste the money that would otherwise pour into government coffers. While it's true that a growing economy (and the voracious AMT) would cause federal revenues to grow to over 20 percent of GDP by 2018 under current law, the Post reports (based on my estimates) that Mr. McCain's tax cuts would slash tax revenues to 16.6 percent of GDP in 2018. By comparison, the postwar average of tax revenues was over 18 percent of GDP, and the federal government will face enormous pressures as the baby boomers begin to retire.

According to the CBO, federal government spending amounted to 20% of GDP in fiscal year 2007, so that would leave a big gap (especially if we have more war). McCain likes to talk up his opposition to Congressional "earmarks" for projects back home, but even eliminating them entirely would not make much of a dent in the deficit (they totaled $18.3 billion - less than one percent of federal outlays).

Newsweek's Daniel Gross thinks McCain doesn't really mean it. One can hope.

And hopefully the Democratic candidates don't really mean some of the things they're saying either. As the campaign rolls into Ohio, Obama and Clinton are fighting over who hates international trade more. Although there are more nuances than economists sometimes care to acknowledge - I have some sympathy with Dani Rodrik's defense of Clinton (see this previous post) - the Lou Dobbsian rhetoric is taking us further away from a serious discussion of the challenges, and opportunities, of a global economy. Or, as Lawrence MacDonald puts it on the Center for Global Development's blog: "Earth to Dems: Enough with the Trade Bashing Already."

As if trashing NAFTA weren't enough, Obama also has floated a proposal to give to give tax breaks to "Patriot Employers." Last week, Clive Crook described it as "barking" (which I believe is British for "insane"). He went on to say: "It would take a lot to persuade me that Obama is the wrong choice for Democratic nominee, but if he keeps this up he might do it." Indeed. Count me as one Ohio Democratic primary voter who is unimpressed.

Neither Democratic nor Republican trends are encouraging, but McCain's silliness (if sincere) is likely of more practical import than Democrats'. The scheduled expiry of the 2001 and 2003 tax cuts means that the next President definitely will face some serious decisions about tax policy. It is not clear that there will any decisive moments on trade in the foreseeable future: the current round of WTO negotiations seems hopelessly stalled, leaving us with mostly symbolic tussles over various and sundry small potatoes regional trade agreements.

Update (2/26): Willem Buiter and Anne Sibert say the "Patriot Employer" proposal is "reactionary, populist, xenophobic and just plain silly," but The Economist's Free Exchange blog thinks their criticisms are overstated. For a more optimistic take, see this New Republic article on Obama's policy advisors (he actually cares what experts think - wow!) (Hat tip: Greg Mankiw).

Update #2 (2/26): The Washington Post fact-checker looked the argument between Clinton and Obama over NAFTA (the North American Free Trade Agreement between the US and Canada) and concluded: "You would not think it from the way they have been attacking each other, but Clinton and Obama are not all that far apart on NAFTA. They both believe in free trade, but they both argue that the U.S. has got a bad deal from the way NAFTA and other trade deals have been enforced. Both candidates have used quotes selectively to slam the other."

Update #3 (2/28): The NY Times' David Leonhardt thinks they don't really mean it. Also, Economists' View has more here, and here.

Steven Pearlstein Takes on Wall Street

In his Washington Post column last week, Steven Pearlstein offered a scathing multi-count indictment against Wall Street's purveyors of "financial innovation":

For starters, these innovations have helped to create a cycle of financial booms and busts that have a tendency to spill over into the real economy, contributing to a heightened sense of insecurity.

They have shortened the time horizons of investors and corporate executives, who have responded by under-investing in research and the development of human capital.

They have contributed significantly to massive misallocation of capital to real estate, unproven technologies and unproductive financial manipulation.

They have made it easy and seemingly painless for businesses, households and even countries to take on dangerous levels of debt.

They have given traders a greater ability to secretly manipulate markets.

They have given corporations clever new tools to hide risks, liabilities and losses from investors.

And by giving banks the tools to circumvent reserve requirements and make more loans with less capital, they have enormously increased the leverage in the financial system and with it the risk of a financial meltdown.

But far and away the greatest damage from all this financial wizardry is the obscene levels of compensation it has generated for a select group of Wall Street executives and money managers.

For when you look over the long term, at the good periods and the bad, it is obvious that the pay collected by these masters of the universe has been grossly excessive -- out of line with the personal financial risk they have taken, out of line with their skills relative to the next-best performers and certainly out of line with the returns earned by investors...

It would be bad enough if the consequences of this excessive pay were confined to Wall Street. Unfortunately, it has not worked out that way. For the prospect of earning untold wealth also has attracted an enormous amount of young talent that could have been more productively used in science, engineering, medicine, teaching, public service and businesses that generate genuine long-term value.

Is it not fair to ask whether the United States can remain the world's most prosperous and innovative economy when half of the seniors at the most prestigious colleges and universities now aspire to become "i-bankers" at Goldman Sachs?

So I hope you'll forgive me, dear readers, when I say that the best thing that could happen to our economy is for a dozen high-profile hedge funds to collapse; for investment banking to enter a long, deep freeze; for a major bank to fail; and for the price of a typical Park Avenue duplex to fall by 30 percent. For only then might we finally stop genuflecting before the altar of unregulated financial markets and insist that Wall Street serve the interest of Main Street, rather than the other way around.

So, what is to be done? Some of the implications came up in Pearlstein's "chat" with readers. One is better regulation:

Boston, Mass.: Citigroup, State Street, and myriad other US banks hid billions in contigent SIV liabilities off-balance sheet, often using off-shore tax havens. What does this say about the FED's competence as a regulator? Or do you think it's a matter that the FED is corrupt and turned a willful blind eye to all of these off-balance sheet transactions? Is it time to combine regulators so that there is one sole financial markets regulator? Thanks Steve!

Steven Pearlstein: The Fed is not corrupt but they have been blinded by the mindless regulatory philosophy of the Greenspan era and they do look on the big bans and the holding companies as their charges -- institutions to be protected, part of a financial system that needs to be protected -- so they never utter a bad word about them and try to handle things quietly and without penalty. The result is that they give up the deterrant aspect of regulation, which is to have a ritual hanging every couple of years and scare the bejezzus out of people so they behave better in between the hangings. The Fed doesn't believe in that. They also don't believe they should substitute their judgment for the markets, which is crazy, because in financial regulation, that is exactly the purpose of regulation. Otherwise, you'd just leave things to markets. It is a form of modesty that they have taken to gross excess. And frankly it is not going to change until someone like Barney Frank finally makes such an example of a Fed chairman of the head of the Fed's banking regulation department that they get fired for being a bad regulator. Greenspan got out before he could be fired, but there are others who should be held accountable so that their unpleasant dismissal will be a lesson that will be remembered by their successors.

(N.B. Barney Frank is Chairman of the House Financial Services Committee). Pearlstein isn't the only one calling for more effective regulation - Martin Feldstein, one of Ronald Reagan's economic advisors (i.e., not a lefty), recently did so. The economic market failures that necessitate regulation are primarily of the "imperfect information" variety - i.e. that when people (or institutions) buy a financial asset they have a limited knowledge of the underlying risks. This problem seems to get worse as the financial assets become more complicated.

Another, more profound, issue that deserves more thought than it gets is the type of behavior that receives approbation in our society:

Potomac, Md.: Steven, thank you for your comment on the status of America's financial system today. As a 24 year-old finance professional looking to apply to business school in the coming years, I hope to shift into a line of work that generates "genuine long-term value." I remember at graduation the air of superiority surrounding my classmates who landed jobs as analysts on Wall Street. For many of us at "elite" Northeast schools, they seem to be the only jobs out there, because everyone is gunning for them. How can the other industries appeal to the talented kids who are so easily swayed by the glamour of I-banking salaries and bonuses?

Steven Pearlstein: That's a simple question that probably doesn't have a simple answer. But one thing we could do is not to glamorize Wall Street so much in the press or in movies, and begin to show more appreciation for real enterpreneurs and public servants and scientists and engineers. I think a lot of this is as much cultural as economic.

The "credit crunch" resulting from some of these "financial innovations" turning out badly is one of the reasons the US economy may be headed into a slump. That is, if there is a recession, we have partly to blame our excessive zeal for "de-regulation," "free markets," and greed (er, "rational self-interest"). The age of Milton Friedman, indeed.

Stagflation Redux?

The latest inflation report from the BLS has generated some concern about "stagflation," an ugly artifact of the 1970's, making a comeback (can avocado appliances be far behind?). The word is a combination of "stagnation" (i.e. high unemployment and slow growth) and "inflation." We already knew that unemployment has been creeping up (4.9% in January, up from 4.4% last March). And now we learn that over the past 3 months, CPI inflation has been running at a 6.8% annual rate. Partly that reflects oil prices - just as 1970's inflation did - but the "core" CPI (i.e. with food and energy prices removed) has been increasing at a 3.1% annual rate. Ominous portents, but we have some distance to go before things look this bad:
(the red line is the unemployment rate, and the blue is CPI inflation)

One reason stagflation is so pernicious is that it puts the Fed in an awkward spot. High inflation requires the Fed to tighten monetary policy (i.e. raise the fed funds rate target), while the proper response to stagnation is to loosen. At Econbrowser, James Hamilton examines the numbers and the Fed's dilemma.

Paul Krugman believes the appropriate parallel is to early 1990's rather than the late 1970's. He writes:

...I don’t believe we’re really facing anything comparable to 1970s stagflation. For one thing, we’re less dependent on oil: America has more than twice the real G.D.P. it had in 1979, but consumes only slightly more oil. For another, there’s no sign of the wage-price spiral that once drove inflation into double digits — in fact, wage growth has been declining even as inflation rises.

What’s much more likely is that we’ll have an economy like that of the early 1990s, only worse.

The first President Bush presided over the 1990-1991 recession. But his real problem came during the alleged recovery, which was hobbled by financial problems at many banks, which had been badly damaged by the collapse of the late-1980s real estate bubble, and by sluggish consumer spending, held down by high levels of household debt.

As a result, the unemployment rate just kept rising, not reaching its peak of 7.8 percent until June 1992.

If all this sounds familiar, it should. Many economists have pointed out the parallels between the current situation and the early 1990s: another real estate bubble, subprime playing more or less the same role formerly played by bad loans by savings and loan institutions, financial trouble all around.

The difference is that the problems look a lot worse this time: a much bigger bubble, more financial distress, deeper consumer indebtedness — and sky-high oil prices added to the mix...

This Wall Street Journal article has some very informative background on stagflation, including:

British Parliamentarian Iain Macleod is credited with first using the word stagflation in 1965. "We now have the worst of both worlds -- not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation."

None More Black

This has nothing to do with economics, but I can't resist. The Washington Post reports:

Researchers in New York reported this month that they have created a paper-thin material that absorbs 99.955 percent of the light that hits it, making it by far the darkest substance ever made -- about 30 times as dark as the government's current standard for blackest black...

"It's very deep, like in a forest on the darkest night," said Shawn-Yu Lin, a scientist who helped create the material at Rensselaer Polytechnic Institute in Troy, N.Y. "Nothing comes back to you. It's very, very, very dark."

Or, in the immortal words of Nigel Tufnel: "It's like, 'how much more black could this be?' and the answer is none. None more black."

Helping Africa?

The NY Times reports that President Bush accentuated the positive on his trip to Africa:

“This is a large place with a lot of nations, and no question, everything is not perfect,” Mr. Bush said during a brief visit to Benin before arriving Saturday evening here in the capital of Tanzania. “On the other hand, there’s a lot of great success stories, and the United States is pleased to be involved with those success stories.”

Mr. Bush’s short stay in Benin — just three hours, enough time for an airport news conference with President Thomas Yayi Boni and for Air Force One to refuel — made him the first American president to visit that tiny West African nation. It was on Mr. Bush’s itinerary because it represents the kind of success he wants to highlight — how American aid has helped fight poverty and disease in some of the world’s poorest nations.

The administration considers its aid efforts to be one of its successes. In an interview with the Council on Foreign Relations, Steve Radelet of the Center for Global Development offers a mostly positive assessment of the administration's efforts. The centerpiece is the Millennium Challenge Corporation, a program Bush announced in 2002 - Radelet says:

The Millennium Challenge Corporation (MCC) has evolved into what I think is an imaginative and creative new way to think about foreign assistance. It has done many things well, in terms of how it is thinking about foreign assistance, but it has also been quite slow in getting off the ground and dispersing money. What it has done well is recognizing that not all countries are the same and that we should deliver assistance differently to different countries. It separates out those that are better governed, countries that have made choices toward democracy, toward better governance, and toward better health and education policies. It gives those countries the responsibility to set their priorities and design the programs. This is a huge change and a huge step forward in how we think about foreign assistance, to actually give the recipient countries much more responsibility....

They’ve been very slow to disperse the funds so there haven’t been huge benefits on the ground yet. The African countries that have qualified and have signed compacts include Benin, Cape Verde, Ghana, Lesotho, Madagascar, Mali, Morocco, Mozambique. Those are the African countries that have signed compacts for $3.8 billion, which are beginning to be implemented, but it’s still very early in the day. So far, the MCC has only dispersed $150 million worldwide. So, their disbursements have been slow. It still remains to be seen if the great promise of the MCC turns into reality in terms of real benefits for people on the ground.

The structure of the program represents the growing appreciation by economists (and others) of the importance of institutional factors like governance for development.

Since most people do not realize how small a fraction of our income is spent on foreign aid, it is useful to put it in context: According to the OECD, US "Official Development Assistance" was $23.5 billion in 2006. That's a large amount of money, but it is 0.18% of Gross National Income (aka GNP) and less than 0.9% of federal budget outlays - that is, less than one cent from each tax dollar. This chart breaks down American aid by region and category. Although the US is the largest giver by amount, most rich countries give a higher percentage of their incomes in development aid. In percentage terms, Sweden is the most generous (1.02%), followed by Luxembourg and Norway (both 0.89%). In dollar terms, Britain is #2 at $12.5 bn, followed by Japan at $11.2 bn.

But does it do any good? That is the subject of sometimes heated debate. A good starting point on this issue is Nicholas Kristof's review article in the New York Review of Books. Kristof, who is a NY Times columnist, will be speaking at Miami on Mar. 4.

Globalization and Divergence

The gap between the rich and poor nations has widened over the past two centuries, rather than narrowed as neoclassical growth theory (e.g. the Solow model) predicts. At Vox EU, Oded Galor and Andrew Mountford offer a hypothesis to explain this "great divergence":

[W]e suggest that international trade has played a significant role in the differential timing and pace of the demographic transitions across countries and has been a major determinant of the distribution of world population as well as the 'Great Divergence' in income per capita across countries. International trade has an asymmetrical effect on the evolution of industrial and non-industrial economies: While in the industrial nations the gains from trade have been directed primarily towards investment in education and growth in output per capita, a greater portion of the gains from trade in non-industrial nations has been channelled towards population growth...

The expansion of international trade has enhanced the specialisation of industrial economies in the production of industrial, skilled intensive, goods. The associated rise in the demand for skilled labour has induced a gradual investment in the quality of the population, expediting a demographic transition, stimulating technological progress and further enhancing the comparative advantage of these industrial economies in the production of skilled intensive goods. In non-industrial economies, in contrast, international trade has generated an incentive to specialise in the production of unskilled intensive, non-industrial, goods. The absence of significant demand for human capital has provided limited incentives to invest in the quality of the population and the gains from trade have been utilised primarily for a further increase in the size of the population, rather than the income of the existing population. The demographic transition in these non-industrial economies has been significantly delayed, increasing further their relative abundance of unskilled labour, enhancing their comparative disadvantage in the production of skilled intensive goods and delaying their process of development. This implies that international trade has persistently affected the distribution of population, skills, and technologies in the world economy, and has been a significant force behind the 'Great Divergence' in income per capita across countries...

The "demographic transition" they refer to is the reduction in fertility rates that tends to occur as countries develop. In contrast to neoclassical models, their hypothesis implies that investment in human capital and population growth be treated as endogenous variables - i.e. determined within the model, rather than taken as exogenously given.