Bank stress tests

At the height of the financial crisis, in February 2009, US authorities announced an innovative policy designed to restore confidence in the financial system: the Supervisory Capital Assessment Program, better known as the stress test.

Taking their supervisory duties an unprecedented step further, regulators would reveal to the public detailed bank-by-bank results of a thorough inspection of balance sheets – outing weak banks as such and endorsing the strength of sound ones.

With this information, it was hoped, investors would regain their willingness to invest in US financial institutions. And so it proved.

Reflecting on the effectiveness of stress tests, Tim Geithner (former US Treasury secretary and a key architect of the policy) called this approach to disclosure and transparency “remarkably effective.”

Perhaps in recognition of this effectiveness, the Dodd-Frank Act – the most comprehensive overhaul of US banking legislation since the Great Depression, enacted five years ago this week – mandates a range of annual, publicly disclosed tests covering the majority of the US banking system.

At about the same time US lawmakers started work on Dodd-Frank in 2009, European authorities were conducting their own stress tests, but the design and effectiveness of these tests stood in stark contrast to the US. Most importantly, individual bank results were not disclosed. The tests were widely disbelieved and delivered few or none of the benefits of the US stress tests.

How can we explain European authorities’ failure to use stress tests effectively? And what are the broader lessons for government policy during a financial crisis?

These are the questions we ask in our paper “Runs versus Lemons: Information Disclosure and Fiscal Capacity.” We think the answers are found in understanding the link between a government’s willingness to publicly disclose information about banks and its capacity to raise tax revenue to pay for its expenditures (its fiscal capacity).

Information disclosure

Economic theory provides powerful arguments in favor of information disclosure. The financial system is a vast and complex web of contracts ultimately linking those in need of financing with savers.

Economists have come to understand that, in situations when one of the parties to such a contract has better information than the other, markets can break down due to what we call adverse selection.

Our research builds on the seminal work of economist George Akerlof. The “lemons” in our title is a reference to his celebrated article on adverse selection, in which he uses the market for used cars (a “lemon” is a defective car) as an example of how markets can function inefficiently when sellers are better informed about the quality of their goods than buyers.

Imagine that there are strong and weak banks looking for financing. If an investor was able to tell them apart, she would demand a lower return to finance a strong bank because it is likelier to pay her back.

What if only the bankers know whether their bank is strong or weak, and the investor has no way of finding out? In this case, she would demand a return that guarantees a profit irrespective of the strength of the bank to which she lends. If this return is too high for strong banks to find it worthwhile to borrow, these banks will choose not to seek funding – the safest banks will self-select out of the market (hence adverse selection).

Recognizing that only weak banks are left in the market, investors will demand even higher returns, resulting in only weak banks being funded if any are funded at all. As a consequence, banks grant fewer loans and do so at high interest rates. If the government steps in to reveal which banks are strong and which ones are weak, order is restored: strong banks can borrow at low and weak ones at higher returns.

Disclosure’s drawbacks

Unfortunately, there are also drawbacks to disclosing information, which stem from the way banks raise funds to make loans.

Banks accept deposits that can usually be withdrawn at a moment’s notice and use the proceeds to provide loans that are usually given for a fixed period of time and cannot be called back. (For illustration, we refer to “banks” and “deposits,” but the arguments apply equally to any financial institution, such as a money market fund or an investment bank, that funds longer-term assets with shorter-term liabilities.)

Banks therefore transform very short maturity deposits into longer maturity loans, which leaves them vulnerable to bank runs (as in our title). A run happens when many depositors demand their money back at the same time. If a bank is unable to call back loans quickly enough to meet these demands, it will eventually be unable to repay depositors and be forced into bankruptcy.

Imagine again that there are strong and weak banks, and to begin with, depositors are unable to tell them apart. What if all depositors in a bank suddenly learn that their bank is weak? They will run to withdraw their money, causing the bank to fail.

As we learned at great cost during the financial crisis, bank failures can be very expensive and have far-reaching consequences. Governments are therefore reluctant to risk causing them by announcing that some banks are frail.

Lemons or bank runs

It would appear that any government deciding on how much information to produce and disclose has to choose between adverse selection and runs.

However, governments can (and very much do) use their ability to spend today and tax tomorrow to prevent bank runs. If a stress test reveals banks to be weak, the government can promise to repay those banks’ deposits in full. As long as the government can afford to keep its promises, this deposit insurance convinces depositors in weak banks not to withdraw their money, saving the banks from bankruptcy.

And again, the same argument applies to other types of insurance. For example, during the crisis, the US Department of the Treasury announced guarantees for investors in money market funds.

In our work, we show that governments with deeper pockets are able to offer more comprehensive deposit insurance programs and are therefore more willing to undertake and disclose informative stress tests. In contrast, fiscally constrained governments cannot afford to guarantee as many deposits and will therefore not risk disclosing detailed information that could cause bank runs.

This is our explanation for the contrasting experiences of US and European authorities.

At the time of the crisis, there was no mechanism in place that would pass part of the bill for guaranteeing the deposits of a Spanish bank to a German taxpayer – the European Union lacked a common resolution mechanism for banks.

In the US, on the other hand, the federal government can use taxes raised in New York to pay for spending in California. Supported by this much larger fiscal backstop, US authorities could afford to be much more transparent about the state of the banking system.

This article is published in collaboration with The Conversation. Publication does not imply endorsement of views by the World Economic Forum.

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Authors: Miguel Faria-e-Castro is PhD Student in Economics at New York University. Joseba Martinez is PhD Student in Economics at New York University. Thomas Philippon is Professor of Finance at New York University.

Innovation and Europe

What will it take to make Europe more innovative? 

As the World Economic Forum’sGlobal Competitiveness Report has consistently indicated, increasing the quantity, quality and impact of innovation is one of the biggest challenges facing Europe’s economy. And it’s a very interesting challenge indeed – while Europe has six of the top 10 innovative economies in the world, on average the region performs poorly when compared to other key benchmark economies such as the United States, Japan and Korea, while countries such as China are fast catching up to Europe’s innovation levels in terms of capabilities and output of new commercial ideas.

One way of supporting European innovation is to promote entrepreneurs and fast-growing companies, a topic we explored in last year’s report on Fostering Innovation-Driven Entrepreneurship in Europe, which highlighted the challenge of scaling innovative ideas in a fragmented, regulatory complex regional market where access to growth capital is limited. This report showed that Europe does not have a significant shortage of entrepreneurial talent or ambition – but it does have a shortage of dynamic firms that grow rapidly in both value and employment terms, with entrepreneurs and large businesses increasingly concerned about how they can innovate successfully in today’s highly competitive global markets.

Taking inspiration from its new status as the International Institution for Public-Private Cooperation, the Forum today launched a new report, Collaborative Innovation: Transforming Business, Driving Growth, which highlights the potential for thoughtful and strategic partnerships between young, dynamic firms and established businesses to improve European innovation.

Based on more than 80 interviews and nine workshops over the last year, the report presents ways in which firms and policy-makers can support collaborative approaches to innovation, thereby helping high-potential ventures overcome the market failures and fragmentation that can hold firms back. The work reveals a number of important challenges facing both young and established firms, as well as strategies that can be implemented by business leaders and policy-makers to improve Europe’s innovation ecosystem.

This is not to say that collaboration is a “silver bullet” or a straightforward process. Even the most complementary partnerships are risky and complex, and involve specific skills. However, the benefits to young firms, established companies and their surrounding economies can be huge, as innovation that may not otherwise have occurred is realized and brought to scale across Europe.

The report, Collaborative Innovation: Transforming Business, Driving Growth,is available here.

Have you read?

What is the link between innovation and social mobility?

How can business clusters drive success?

Are you an undercover entrepreneur?

Author: Nicholas Davis, Head of Society and Innovation, World Economic Forum

Image: Employees have a discussion at the innovation lab of Swiss bank UBS in Zurich January 16, 2015. REUTERS/Arnd Wiegmann

Death by Debt

My Response to The German Finance Ministry, by Jeffrey Sachs

Posted on August 1, 2015 by yanisv

Dr. Ludger Schuknecht, senior economist at the Germany Finance Ministry, explains his ministry’s viewpoint regarding Greece. This viewpoint essentially holds that Eurozone countries should live within their means; adjust to their debt burdens; and take their reform medicine as needed. If they do so, they will be successful, as illustrated by Ireland, Spain, and Portugal. Greece has only itself to blame, and indeed was on track to recover as of late 2014 if it had not deviated from its course.  

I have enormous respect for Dr. Schuknecht as an able and thoughtful economist. Yet I believe that he misses a historical reality. While his policy prescription is certainly correct most of the time – countries should repay their debts and take the reform actions necessary to do so – it is also sometimes wrong.  It is wrong when debt servicing, combined with other economic ills, can push society to the breaking point.  The wisdom is to recognize the times that it is wrong and to act creatively at those times.

It was wrong in the case of Weimar Germany in the 1920s and early 1930s, when Germany was pushed into hyperinflation and then depression. Germans pleaded to the US for long-term financial relief from reparations and debt payments, but didn’t get it in time.  First came the hyperinflation; then mass unemployment; then a banking collapse; and then a full run on the German banking system in 1931, leading to a closure of the banks (as in Greece today).  President Herbert Hoover eventually granted a debt moratorium but too late: Hitler came to power in January 1933.

It was wrong in the case of many Latin American countries in the 1980s.  During the 1970s, unwise US bank lending and unwise borrowing by Latin governments led to the calamitous Latin American debt crisis of the 1980s following the sharp rise in US interest rates in 1981.  For several years in the 1980s, the US insisted on a policy of “extend-and-pretend,” that is, to lend the debtor country the money needed to pay debt service. Yet these countries tumbled into high inflation and political instability.  Eventually, the US brokered a package of reforms and debt relief.

It was certainly wrong in Poland in 1989, when Soviet-era debt was killing hope, creating high inflation, threatening to kill the nascent post-communist democracy in the crib.  I was Poland’s economic advisor at the time, and I strongly urged that the G7 countries grant debt relief to Poland.  The US quickly and wisely agreed. The other G7 countries soon joined the US.  Germany joined last, but Poland did get its debt relief, and its economy recovery and new democracy thrived.

It was wrong to insist on full debt servicing by Russia in 1992, when Yeltsin inherited a bankrupt post-Soviet economy.  As in Poland in 1989, I strongly urged debt relief for Russia.  Yet this time, the US, Germany and others rejected the advice. The consequence was that Russia experienced several years of financial upheaval and instability, resulting in the public’s loss of faith in the new and fragile democratic institutions. The West’s approach towards Russia fostered a nationalist backlash inside Russia, similar to the backlash in Weimar Germany to the harsh postwar reparations.

My point is that believing that indebted sovereign governments should always service their debts is a good working principle nine-tenths of the time, but can be a disaster the tenth time around.  We must not push societies to the breaking point, even when they have only themselves to blame for their indebtedness.

Did postwar Germany “deserve” the Marshall Plan?  No.  Was the Marshall Plan and the 1953 debt agreement wise policies to give Germany a fresh start?  Yes.  Did Russia “deserve” debt relief in 1992?  No.  Would it have been wise to offer Russia such relief?  Yes.

Does Greece “deserve” debt relief?  No.  The Greek economy has been badly managed for a long time.  Would debt relief for Greece be a good idea?  Yes.

Greece borrowed too much; failed to crack down on cronyism and corruption; and failed to foster new, competitive industries.  The result is that Greece cannot service its debts in full. The economy is broken.  The export base is too narrow to allow the country to pursue export-led growth – as done successfully in Ireland and elsewhere.  The banks are broken, so firms can’t get working capital to retool.  Greece is in a death spiral of austerity, de-capitalization, brain drain, capital flight, and growing social unrest.

How do I know?  I have watched daily for six years, and have tried to help several Greek governments – left, right and center – to have an intelligent settlement with Germany and the rest of the Eurozone to foster a recovery.  Yet in my experience the German Ministry of Finance has not searched for a true solution during all these years.

Greece has an economic crisis no less dramatic that Germany faced under Heinrich Brüning in 1930-33.  The unemployment rate is equal to 27 percent; the youth unemployment is equal to nearly 50 percent; output is down by 30 percent; the banks are in panic and collapse.  Greece is at the breaking point.  Germany can give Greece all of the lectures it wants and make all of the demands that it wants, but Greece will collapse if it is forced to service all its debt and cut public spending accordingly.  These policies are impossible to pursue – as was also the case in Germany under Brüning. As a result no democratically elected government in Greece will be able to survive for more than a few months at a time. The current path will only lead to disaster for Greece.

The German taxpayers believe that they have been extremely generous to Greece, giving Greece repeated financial loans.  Yet this is partly a mirage.  The taxpayers have been generous to their own banks, not to Greece.

Greece was required to use the first bailout of 100 billion euros in 2010 not for itself but to repay loans to banks, mostly German and French. Greece was similarly required to use the second and third bailouts to repay debts to external creditors.  Hardly any of the bailout funds were used to support the investment that Greece needs to achieve export-led growth or to meet urgent social needs.

Now Greece will get a fourth package, once again to be used to repay the IMF, ECB, European Financial Stability Fund, and other creditors, as well as to put money into its failed banks.  Yes, the German taxpayers have been generous – to Greece’s creditor banks and other institutions, not to the Greek people.

Debt servicing, in short, is a shell game: give Greece tens of billions of euros every couple of years so that Greece can repay the debts that it owes.  Professionals call this policy “pretend and extend.”  The problem is that the debt grows; the Greek banks die; and the Greek small and medium enterprises collapse.  The brain drain from Greece continues.  It is death by debt. The strategy did not work for Latin America in the 1980s, and it will not allow Greece to escape its economic death trap.

In short, when a crisis is as deep as Greece’s, the most powerful creditor on the scene has historic responsibilities.  Germany must help Greece to make a new start, not to collapse.  Germany needs to act and grant partial debt relief to Greece, in the name of European prosperity, democracy, and unity.

Of course, such debt relief must be accompanied by major structural reforms in Greece. However, as Germany knows all too well thanks to its own Agenda 2010 reforms enacted under Chancellor Schröder, reforms to the labor market, public administration, the judiciary, or the opening of “closed professions” take time to translate into higher economic growth. Back then Germany breached the Maastricht criteria in conjunction with its own the reforms. Today, Greece, in vastly worse shape, needs debt relief in order to succeed in its reform efforts.

http://international.sueddeutsche.de/post/125522613465/death-by-debt-my-response-to-the-german-finance

Jeffrey Sachs, 60, Director of The Earth Institute Columbia University and Special Advisor to United Nations Secretary-General Ban Ki-moon on the Millennium Development Goals.

L’Europe dont nous ne voulons plus

Un mouvement jeune et plein d’énergie entendait transformer une nation et réveiller le Vieux Continent. L’Eurogroupe et le Fonds monétaire international (FMI) ont écrasé cette espérance.

 

Au-delà du choc que les événements grecs représentent pour certains des partisans du projet européen, trois enseignements s’en dégagent. D’abord, la nature de plus en plus autoritaire de l’Union à mesure que l’Allemagne y impose sans contrepoids ses volontés et ses obsessions. Ensuite, l’incapacité d’une communauté fondée sur une promesse de paix à tirer la moindre leçon de l’histoire, même récente, même violente, dès lors qu’il lui importe avant tout de sanctionner les mauvais payeurs, les fortes têtes. Et enfin, le défi que pose ce césarisme amnésique à ceux qui voyaient dans l’Europe le laboratoire d’un dépassement du cadre national et d’un renouveau démocratique.

 

Au départ, l’intégration européenne a prodigué à ses citoyens les avantages matériels collatéraux de l’affrontement Est-Ouest. Dès le lendemain de la guerre, le projet fut impulsé par les Etats-Unis, qui recherchaient un débouché pour leurs marchandises et un glacis contre l’expansion soviétique. Mais Washington avait alors compris que, si le monde qui se disait « libre » voulait concurrencer efficacement les républiques « démocratiques » membres du pacte de Varsovie, il devait conquérir les cœurs et les esprits en démontrant sa bonne volonté sociale. Depuis que cette corde de rappel stratégique n’existe plus, l’Europe se dirige comme le conseil d’administration d’une banque.

Certains acteurs de la guerre froide, comme l’Organisation du traité de l’Atlantique nord (OTAN), ont survécu à la chute du Mur en s’inventant d’autres monstres à détruire sur d’autres continents. Les institutions européennes ont elles aussi redéfini leur adversaire. La paix et la stabilité dont elles se gargarisent réclament dorénavant à leurs yeux la neutralisation politique des populations et la destruction des outils de souveraineté nationale dont celles-ci disposent encore. C’est l’intégration à marche forcée, la (...)

 

par Serge Halimi, août 2015

 

http://www.monde-diplomatique.fr/2015/08/HALIMI/53505

 

 

Wages vs Jobs

Krugman´s view

 

Hillary Clinton gave her first big economic speech on Monday, and progressives were by and large gratified. For Mrs. Clinton’s core message was that the federal government can and should use its influence to push for higher wages.

Conservatives, however — at least those who could stop chanting “Benghazi! Benghazi! Benghazi!” long enough to pay attention — seemed bemused. They believe that Ronald Reagan proved that government is the problem, not the solution. So wasn’t Mrs. Clinton just reviving defunct “paleoliberalism”? And don’t we know that government intervention in markets produces terrible side effects?

No, she wasn’t, and no, we don’t. In fact, Mrs. Clinton’s speech reflected major changes, deeply grounded in evidence, in our understanding of what determines wages. And a key implication of that new understanding is that public policy can do a lot to help workers without bringing down the wrath of the invisible hand.

Many economists used to think of the labor market as being pretty much like the market for anything else, with the prices of different kinds of labor — that is, wage rates — fully determined by supply and demand. So if wages for many workers have stagnated or declined, it must be because demand for their services is falling.

In particular, the conventional wisdom attributed rising inequality to technological change, which was raising the demand for highly educated workers while devaluing blue-collar work. And there was nothing much policy could do to change the trend, other than aiding low-wage workers via subsidies like the earned-income tax credit.

You still see commentators who haven’t kept up invoking this story as if it were obviously true. But the case for “skill-biased technological change” as the main driver of wage stagnation has largely fallen apart. Most notably, high levels of education have offered no guarantee of rising incomes — for example, wages of recent college graduates, adjusted for inflation, have been flat for 15 years.

Greece last act

NEW YORK – European Union leaders continue to play a game of brinkmanship with the Greek government. Greece has met its creditors’ demands far more than halfway. Yet Germany and Greece’s other creditors continue to demand that the country sign on to a program that has proven to be a failure, and that few economists ever thought could, would, or should be implemented.

The swing in Greece’s fiscal position from a large primary deficit to a surplus was almost unprecedented, but the demand that the country achieve a primary surplus of 4.5% of GDP was unconscionable. Unfortunately, at the time that the “troika” – the European Commission, the European Central Bank, and the International Monetary Fund – first included this irresponsible demand in the international financial program for Greece, the country’s authorities had no choice but to accede to it.

The folly of continuing to pursue this program is particularly acute now, given the 25% decline in GDP that Greece has endured since the beginning of the crisis. The troika badly misjudged the macroeconomic effects of the program that they imposed. According to their published forecasts, they believed that, by cutting wages and accepting other austerity measures, Greek exports would increase and the economy would quickly return to growth. They also believed that the first debt restructuring would lead to debt sustainability.

The troika’s forecasts have been wrong, and repeatedly so. And not by a little, but by an enormous amount. Greece’s voters were right to demand a change in course, and their government is right to refuse to sign on to a deeply flawed program.

Having said that, there is room for a deal: Greece has made clear its willingness to engage in continued reforms, and has welcomed Europe’s help in implementing some of them. A dose of reality on the part of Greece’s creditors – about what is achievable, and about the macroeconomic consequences of different fiscal and structural reforms – could provide the basis of an agreement that would be good not only for Greece, but for all of Europe.

Some in Europe, especially in Germany, seem nonchalant about a Greek exit from the eurozone. The market has, they claim, already “priced in” such a rupture. Some even suggest that it would be good for the monetary union.

I believe that such views significantly underestimate both the current and future risks involved. A similar degree of complacency was evident in the United States before the collapse of Lehman Brothers in September 2008. The fragility of America’s banks had been known for a long time – at least since the bankruptcy of Bear Stearns the previous March. Yet, given the lack of transparency (owing in part to weak regulation), both markets and policymakers did not fully appreciate the linkages among financial institutions.

Indeed, the world’s financial system is still feeling the aftershocks of the Lehman collapse. And banks remain non-transparent, and thus at risk. We still don’t know the full extent of linkages among financial institutions, including those arising from non-transparent derivatives and credit default swaps.

In Europe, we can already see some of the consequences of inadequate regulation and the flawed design of the eurozone itself. We know that the structure of the eurozone encourages divergence, not convergence: as capital and talented people leave crisis-hit economies, these countries become less able to repay their debts. As markets grasp that a vicious downward spiral is structurally embedded in the euro, the consequences for the next crisis become profound. And another crisis in inevitable: it is in the very nature of capitalism.

ECB President Mario Draghi’s confidence trick, in the form of his declaration in 2012 that the monetary authorities would do “whatever it takes” to preserve the euro, has worked so far. But the knowledge that the euro is not a binding commitment among its members will make it far less likely to work the next time. Bond yields could spike, and no amount of reassurance by the ECB and Europe’s leaders would suffice to bring them down from stratospheric levels, because the world now knows that they will not do “whatever it takes.” As the example of Greece has shown, they will do only what short-sighted electoral politics demands.

The most important consequence, I fear, is the weakening of European solidarity. The euro was supposed to strengthen it. Instead, it has had the opposite effect.

It is not in the interest of Europe – or the world – to have a country on Europe’s periphery alienated from its neighbors, especially now, when geopolitical instability is already so evident. The neighboring Middle East is in turmoil; the West is attempting to contain a newly aggressive Russia; and China, already the world’s largest source of savings, the largest trading country, and the largest overall economy (in terms of purchasing power parity), is confronting the West with new economic and strategic realities. This is no time for European disunion.

Europe’s leaders viewed themselves as visionaries when they created the euro. They thought they were looking beyond the short-term demands that usually preoccupy political leaders.

Unfortunately, their understanding of economics fell short of their ambition; and the politics of the moment did not permit the creation of the institutional framework that might have enabled the euro to work as intended. Although the single currency was supposed to bring unprecedented prosperity, it is difficult to detect a significant positive effect for the eurozone as a whole in the period before the crisis. In the period since, the adverse effects have been enormous.

The future of Europe and the euro now depends on whether the eurozone’s political leaders can combine a modicum of economic understanding with a visionary sense of, and concern for, European solidarity. We are likely to begin finding out the answer to that existential question in the next few weeks.

Joseph Stiglitz

Read more at http://www.project-syndicate.org/commentary/greece-creditor-demands-by-joseph-e--stiglitz-2015-06#akmcmFItSxr1MUM1.99

Middle Income Trap

SANTIAGO – Aside from an established tradition of bad macroeconomics, what do Greece and Argentina have in common? One answer is that they were the world’s longest-held captives of the so-called middle-income trap – and remain within its reach to this day. With countries in Asia, Eastern Europe, and Latin American fearing that, having reached the international middle class, they could be stuck there, Greece and Argentina shed light on how that might happen.

A recent paper by economists from Bard College and the Asian Development Bank categorizes the world economy according to four groups – with the top two categories occupied by upper-middle-income and high-income countries – and tracks countries’ movements in and out of these groups. Which countries were stuck for the longest period in the upper-middle-income category before moving to high income? You guessed it: Greece and Argentina.

Correcting for variations in the cost of living across countries, the paper concludes that $10,750 of purchasing power in the year 1990 is the threshold for per capita income beyond which a country is high income, while $7,250 makes it upper-middle income. (These thresholds may sound low, but the World Bank uses similar cutoffs.)

By these criteria, Argentina became an upper-middle-income country all the way back in 1970, and then spent 40 years stuck in that category before reaching high-income status in 2010. Greece joined the international upper middle class in 1972, and then took 28 years to reach the top income group, in 2000.

No other country that became upper middle income after 1950, and then made the transition, took nearly as long. In fact, the average length of that transition was 14 years, with economies such as South Korea, Taiwan, and Hong Kong taking as little as seven years.

Data in the paper stop at 2010, but the story may well be worse today. According to IMF figures, Greece’s never-ending crisis has cut per capita GDP (in terms of purchasing power parity) by 10% since 2010, and by 18% since 2007. Indeed, Greece may have dropped out of the high-income category in recent years.

Argentina’s per capita income has risen, albeit slowly, during this period, but the country was never far from a full-blown macroeconomic crisis that could reduce household incomes sharply. So it seems fair to conclude that both countries are still caught in the middle-income trap.

What kind of trap is it? In Greece and Argentina, it is both political and economic.

Start with the politics. In their book Why Nations Fail, Daron Acemoglu and James A. Robinson argue that societies with political arrangements that concentrate power in the hands of a few seldom excel at innovation and growth, because innovators have no guarantee they will keep the fruits of their labors. And, to the extent that outsiders cannot generate wealth, they have few resources with which to challenge the power of insiders; as a result, exclusionary political arrangements are mostly self-sustaining.

That is a useful account of why there is a poverty trap – which is the question the book seeks to answer – but it does not clarify why there is a middle-income trap. Greece and Argentina are, after all, democracies, however imperfect, and so are most of the countries in Latin America or East Asia that worry about being stuck at middle-income level. The Acemoglu-Robinson account of a single small elite pulling all the strings needs to be replaced by a different narrative, in which an array of politically powerful groups exercise veto power over decisions that affect their economic interests.

Think of powerful business groups vetoing moves to improve tax collection or strengthen competition policy. This helps explain why the Greek and Argentine governments are perennially in deficit (until borrowing options dry up and adjustment is inevitable), or why prices – and profits – are high in sectors (for example, transportation and telecoms) that provide would-be entrepreneurs with crucial (but often unaffordable) inputs.

Or think of public-sector unions vetoing changes in benefits for their members. That goes a long way toward explaining (add a bit of ideology to the mix) why the current Greek government has gone to the brink of default before agreeing to restrain public-sector pensions, as its European Union partners demand. It also helps explain why both Greece and Argentina have sizeable governments (public spending accounts for 46% and 39% of GDP, respectively) but puny public investment and outdated infrastructure.

This is not a case of too much democracy, as conservative commentators sometimes claim, but of too little. Underdeveloped democratic institutions allow for decisions that are individually rational but collectively shortsighted and harmful.

And bad politics makes for bad economics. To go from middle-income to high-income status, countries have to redeploy resources to high-productivity, knowledge- and skill-intensive sectors. That is a transition that Greece and Argentina, with their financial instability, poor infrastructure, and weak education systems, have never made.

Greece exports refined petroleum products, olive oil, raw cotton, and dried fruit. Argentina exports corn, soybeans, fruits, and wine – as well as cars and auto parts to the rest of the regional Mercosur trade bloc, where it enjoys ample tariff protection against third-country competition.

According to the Atlas of Economic Complexity, developed by Ricardo Hausmann and colleagues at Harvard University, the 2008 gap between Greece’s income and the knowledge content of its exports was the largest in a sample of 128 countries. By 2013, Greece ranked 48th in the Atlas’s index of complexity of exports – by far the lowest of any developed country in Europe – while Argentina ranked 67th.

Sluggish exports mean slow growth, which in turn places limits on social mobility and the expansion of an entrepreneurial middle class. That helps preserve the political power of entrenched veto-wielding players, closing the trap. Perhaps a weighty tome entitled Why Middle-Income Nations Fail will tell the story in full. Societies will then understand why high-income status eludes them – and what they might do differently.

Andres Velasco

Read more at http://www.project-syndicate.org/commentary/greece-argentina-middle-income-trap-by-andres-velasco-2015-05#YxEEGa8u1I80lWZD.99