9/16/02


FOUR NOBEL LAUREATES DISCUSS GLOBAL ECONOMIC CHALLENGES

Gary Becker was awarded the Nobel prize in 1992 for developing the concept of human capital and is professor of economics at the University of Chicago. Robert Fogel, also at the University of Chicago and director there of the Center for Population Economics, won his Nobel prize in 1993 for applying quantitative analysis to economic and institutional change. Myron Scholes, professor of finance at Stanford University, won the Nobel Prize in 1997 for his ''option pricing'' model. Robert Mundell of Columbia University won the Nobel prize in 1999 for his work on optimal currency areas.

Recently the Milken Institute gathered four Nobel laureates together to discuss the economic challenges of the next few decades. The discussion was moderated by financier Michael Milken, who also heads the Milken Institute.


PART 1
GLOBAL OPPORTUNITIES AND CHALLENGES

MICHAEL MILKEN: What are two key examples of economic opportunities in the world today, as well as two challenges?

GARY BECKER: I'll begin with the challenges. One is that many countries are very rich and many others are very poor. Do we know enough to bring the poor countries' living standards closer to those of the rich?

The second challenge relates to low birth rates. If you count China (where birth control is not completely voluntary), something like 45 percent of the world's populations are reproducing below replacement levels. The world hasn't seen a situation like that for hundreds of years -- maybe never. And the consequences pose an enormous challenge.

The first opportunity is the other side of the challenge of raising the living standards of the poor nations. And I will just mention three factors that I think research has demonstrated are important -- maybe even necessary.

One is free markets, in particular, having flexible pricing in labor, product and financial markets. Two is investment in people, in their education and training. Three is having an open economy.
The second opportunity -- also a challenge -- is the environment. How do we bring economic analysis to bear on environmental problems, allowing us protect the environment without doing a lot of foolish things?

Take the example of water resources. Most of the water in the world is not priced. Yet most of the water in the world is used not for drinking and for cleaning, but for irrigation and for other agricultural and manufacturing activities. So obviously, we are going to use water recklessly.

ROBERT FOGEL: The greatest opportunity of the 21st century is to add as many years to life expectancy as we did during the 20th. Life expectancy in the rich countries at the beginning of the 20th century was about 45 years. At the end of the century, it was maybe 77. By the end of the 21st century, it could be close to 100 years.

Good health matters as much as longevity. In 1910, 95 percent of all Americans who lived to 65 had severe chronic conditions -- on average, six or seven chronic conditions. Today, less than half of all 65-year-olds are chronically ill. So I think we can not only live 30 years longer, but nearly all of it in good health.

The challenge is how to permit technological change to do its thing. The fundamental source of economic growth is technological change, but it is also a great disrupter. So our problem is how to have technological change without international and domestic conflict.

A second challenge is how to narrow the gap in longevity across countries. During the 20th century, China and India went from about 30 years life expectancy to 71 years and 60 years respectively. And they did that in about a third of the time it took Western Europe to make the transition. So I think we can make great progress throughout the Third World in narrowing that gap.

Finally, I see a challenge in privatizing health care so that it is available without long delays. We have the resources to manage that -- it is an issue of having the proper institutions to permit it to take place.

MYRON SCHOLES: I see a future of more and more chaotic events. That demands flexibility and an ever-increasing need for investment in education.

Second, we have a demand for capital around the world, but we also have a supply imbalance. Marrying the demanders of capital and the suppliers of capital more efficiently to end these imbalances is a challenge that will enhance wealth and value for society. In particular, this means providing liquidity and a reduction of information asymmetries.

Another challenge in a free society is building trust in people and markets rather than government. We know that markets (and people) are imperfect. But we also have to realize that the government is imperfect as well.

ROBERT MUNDELL: One major problem is that of global governance -- how to work out a system that is both effective and compatible with the configuration of power in the world economy.
We have the United Nations, of course, but it does not work very well. We have the big power arrangements -- and unilateralism. Thank heavens the only superpower is the United States and not some other country. But unilaternalism is not a viable system for the long run.

We need something like a Group of Seven -- a constellation of countries that can address the major issues. And we need specialized systems to handle specific problems. For example, for most of man's history there has been a kind of international monetary system based on one or more of the precious metals. But 30 years ago, that system broke down and we moved toward a nonsystem. We do not have an international monetary system now. And for the first time in 2,500 years, we do not have a global unit of account in international money.

That reality is not obvious to Americans because the United States accounts for 25 percent of world output and has a single currency. It has a perfect monetary system for all its internal trade. The dollar is used internationally, too, which certainly saves the world from a lot of problems. But it is still not an international monetary system, and we need to work toward that.

The lack of an international monetary system shows up in the extreme instability of exchange rates, which do not reflect differences in price levels or inflation rates. Just over the past three years you have seen the euro -- it is a great thing for Europe. But it is about 25 percent below the exchange value at which it started.

If you look back over the past history of the deutsche mark-dollar rate or the yen-dollar rate, we see doublings and triplings of the relative values of currencies. I attribute the Asian crisis to the sudden appreciation of the dollar against the yen: from April 1995 to June 1998 the dollar went from 78 yen to 148 yen. This not only dried up Japanese investment in Southeast Asia and shut off growth in those countries but created devastating problems for the Asian exporters that had tied their own currencies to the dollar.

The costs of this to all the small countries is enormous. Europe has now solved this problem by merging 12 currencies into the euro. But other countries are out of luck, and there is no leadership at the International Monetary Fund (IMF) or the World Bank to help them. I think this accounts for the devastating problems of poverty, which to a large extent have been driven by mismanagement of macroeconomic policies.

Let me make one last point. After World War II, we had the Bretton Woods arrangement based on gold and the dollar. The countries recovering from World War II could latch on to a system, giving them a ready-made macroeconomic policy framework. And that worked very well for 20 or 30 years.

Now that has broken down and the international institutions have nothing equivalent to offer to the 35 transition economies born with the collapse of communism. Five years after the end of the Cold War their output was about 40 percent below what it had been when they started getting advice from the IMF and the World Bank.

I have focused on the reform of the international monetary system (which people aren't champing at the bit to do quickly). My own plan would be to take the basket of the dollar, euro and yen, and build an international currency out of that. And I think, in the next 10 years, that would be feasible.

It is not just an academic idea. People like Paul Volker have argued that a global economy needs a global currency. Not a single currency, but a parallel international currency that can be used by everybody.

On the U.S. economy: it has been doing well. However, if the recovery sputters, two nagging problems are going to catch up to it.

One is the current account deficit, which was 4 percent of GDP last year. That amount is being added every year to the net debtor position of the United States.

The United States also had big deficits in the 1980s. But back then, the United States was a creditor country. Now the United States is the biggest debtor country in the world, with something like 25 percent of GDP in debt and growing at the rate of 4 and 5 percentage points every year.

That is not an immediate problem, but that is going to become a problem at some point. And it is necessarily going to lead to substantial depreciation of the dollar. This will only be a problem if the European and Japanese economies recover. Then there is going to be a big shift of the dollars into euros, and that is going to create a big adjustment problem. That is why it is a good time now for the United States to talk its partners in Europe and Japan into doing something about the instability of exchange rates.



PART 2
AROUND THE WORLD

EUROPE

MICHAEL MILKEN: If we look, for example, at job creation in Europe versus the United States over the past 30 years, it has been very low. Can the switch to one currency lead to job creation?

GARY BECKER: I don't think so. One currency may be desirable, but I do not think multiple currencies explained the flatness in the European employment growth. That comes down to microeconomic policies. I think Robert Mundell has overemphasized the macro policies at the expense of the micro.

Very heavy taxation of labor in Europe means that the cost of using labor is much higher than the wage the employees receive. This gap discourages firms from hiring labor.

And because the workers are only getting a fraction of what they cost employers, they are discouraged from working -- particularly since Western Europe has had a very generous policy of payments to the unemployed. I always distinguish Great Britain from the other parts of Western Europe.

MILKEN: Why don't we take a look at that. There has been a dramatic change in unemployment between the U.K. on the one hand, and France, Germany, Italy and Western Europe on the other, in the past decade.

BECKER: I am glad you have these facts, Mike, when they confirm what I say. The U.K. has what is called, derisively by some Europeans, ''Anglo-Saxon labor market policy'' -- namely, flexibility on the part of firms to hire and fire workers. In the French, German and Italian systems, it is very difficult to get rid of workers once you hire them. The latter systems are good for the people who have jobs, but very bad for those trying to get them.

These labor-market issues have very little to do with currencies. Well, maybe the commonality of the policies that you are trying to generate in Western Europe under the rubric of a common currency will push countries in the right direction. But the basic problem for the Frances, Germanys and Italys is threefold: high taxes on labor, great restrictions on the ability to hire and fire workers, and very generous payments to people who are not employed. These policies are sometimes used to encourage workers to retire early -- the average retirement age in continental Europe is just 58.

MILKEN: Advanced financial technology has allowed the United States to flourish compared to Western Europe. Isn't it ironic that much of this financial technology, such as the securitization of loans, is now owned by European financial institutions?

MYRON SCHOLES: Europe lacks a capital market as we know it in the United States. We are very much equity-based in the United States, while Europe is mainly bank-based.

European corporations are coddled by their banks -- the relationships are very cozy. So there has never been the same market-driven discipline in Europe that has existed in the United States since the development of financial technologies in the 1970s.

Well-developed equity markets quickly punish failure and reward success, directing capital to the right investments. That is missing in Europe. It is one thing to own the financial institutions that own the sophisticated financial technology. It is quite another to be able to use the technology efficiently. Europe will need more developed equity markets before we see as great a use of this technology in Europe.


MEXICO AND RUSSIA

MILKEN: Essentially, the United States has moved to a market economy -- rather than a bank- or a relationship-fueled economy -- where assets are in the hands of tens of thousands of money managers. This democratization of financial assets has led to the democratization of industrial assets, which has led to the democratization of career opportunities.

Moving on: two countries that are instructive to compare: -- Russia and Mexico. Russia has nuclear weapons; Mexico has a huge population on our southern border. Russia encompasses about 17 million square kilometers -- more than eight times the size of Mexico. The population of Russia today is 145 million,
about 50 percent bigger than Mexico's. And Russia consumes four times as much energy as Mexico. Yet Mexico's economy is more than twice the size of Russia's today, as measured in dollar terms.

BECKER: There is often an enormous overemphasis on the role of natural resources in economic progress. Russia has lots of oil -- a big source of its exports now -- plus a variety of other minerals.
Nevertheless, not only Russia but also a lot of other countries in the world with substantial natural resources do not rank very high in per-capita income. Why? That is one of the challenging questions in understanding the difference in poverty and wealth across different nations.

Russia illustrates a number of principles. One, the economic system matters enormously in terms of how well you harness your human and your natural resources to produce real wealth. You can have enormous resources sitting there, but they do not amount to anything unless you have the right incentives.

Throughout the Communist era, Russia had high levels of education, just as Cuba does now. But what the average educated person did with those skills -- where they worked, how hard they worked and so on -- was badly distorted by the incentive structure. And so the Soviet Union wasted a lot of its investment in human capital. Post-Soviet Russia is only slowly getting its act together.

The difference between Mexico and Russia, in a nutshell, I think, is that Mexico has made much better use of its human capital, through a better economic system and a wiser investment pattern.

MILKEN: Actually, Russia's top export is not oil, but human capital. As much as a trillion dollars worth of human capital has left Russia for the rest of the world. Europe, the United States and Israel have really benefited from that movement.



JAPAN

MILKEN: What do you see as Japan's potential? Here we have a country with enormous liquidity, that has very, very low yields on that liquidity, and an aging population. Could that capital be deployed throughout Asia for development? Could it be deployed within the country itself? What needs to happen to unlock assets measured in tens of trillions of dollars?

ROBERT MUNDELL: Japan got into great difficulty managing its economy, in large part because of the mismanagement of exchange rates all the way back to the 1980s.

Between 1955 and 1970 the Japanese economy grew at an average annual rate of 12 percent -- the most rapid growth sustained for such a long time in history. And they did it with a very explicit policy -- a fixed exchange rate of 360 yen to the dollar. That became their monetary policy. Money creation came solely as a result of purchases of foreign exchange.

Along with the rapid growth came rising tax revenues and a budget surplus, making tax cuts possible almost every year during the 1960s. So that there was a systematic process of tax cuts, combined with a fixed exchange rate and market-driven monetary policy. It is no accident that, when I first was working out some of the propositions of supply-side economics, I looked at the Japanese economy. Japan was the perfect case in point.

MILKEN: In 1950, Japan made up 9 percent of the world's stock market capitalization. By 1988, Japan actually surpassed the United States and made up 40 percent of the world's stock market capitalization.

MUNDELL: That 1988 figure was a gross distortion. It was the time when people were saying that the value of the Imperial Gardens in the middle of Tokyo was equal to the value of all the land in Canada. What got Japan into its current problems was mismanagement of the exchange rate.

In the winter of 1985-86 came this huge fall in oil prices. Oil prices went from $34 down to around $10 a barrel. And this is what exploded the Japanese economy.

Along with the real estate boom came the appreciation of the yen. The yen tripled in value from the summer of 1985 to April of 1995. Any country in the world that has its currency triple against the dollar, which was not in an inflationary mode, is asking for trouble.

The appreciation weakened the value of stocks of a wide range of Japanese companies. It ruined the balance sheets of a lot of those companies, which wrecked the Japanese banking system. Unfortunately, we are now past the point where the reversal of that overappreciation can solve the problem.

SCHOLES: There are other aspects of the Japanese situation that were unattended to for a lot of years. A change in policy could have ended some of the difficulty in Japan much sooner.

For example, Sweden had a real estate bust that caused its banks to fail. But instead of waiting for 12 years to do something about it, Sweden decided to recapitalize the banks and go on with life.
The United States recently had a ''bubble'' as well. (Chairman of the Federal Reserve Alan) Greenspan quickly reduced interest rates, providing a lot of liquidity to the system that ended some of the difficulty. Japan waited around for four years before doing anything to revive liquidity. In fact, in 1990, interest rates actually went up, which led to a lot of bankruptcies. And when you have bankruptcies it takes time to work things out.

MILKEN: The U.S. economy is quite different from those of Japan and Germany, in that we have more assets with money managers than we do with banks. Japan and Germany have relied on the banks to finance their economy.

In 1980, the largest bank in the world was the Bank of America. By the end of the 1980s, Bank of America had shrunk by half. But our economy did not need commercial bank lending to grow in tandem.



CHINA

ROBERT FOGEL: We should not lose sight of the real side of the economy. The financial side can either support or interfere with the real side. But economic growth depends primarily on the real side of the economy.

Japan's period of very rapid growth was 1950 to 1970. Long before it got into financial difficulties, its growth rate was down by 50 percent. And the great period of growth for the Asian tigers -- South Korea, Singapore, Hong Kong and Taiwan -- was 1970 to 1990. In other words, growth slowed substantially long before the 1997 crisis.

Since 1990, the great growth has been in China. Although external finance has played what I would call a strategic role, most of the growth in China has been internally financed. External finance has been a way of bringing in technology, which was necessary for the kind of transformation that we have been seeing.

I think the great growth area for the next two or three decades is going to be China. I expect the economy to grow at 6 to 8 percent annually. If China keeps growing in that neighborhood and sustains the current income elasticity of the demand for cars, China is going to be consuming 45 million cars a year by 2020 or 2030 -- which is about the world's current production of cars. So poor countries like China are going to be a great source for stimulating the richer economies of the world.

MILKEN: How is China going to maintain social stability with 300-400 million people moving to cities in the next few decades?

BECKER: Well, let me go back a little. Urbanization has been a key part of economic development. Modern economies are based on specialization and technology. And cities are much better at producing new knowledge and encouraging the degree of specialization needed to make the products of modern economies. So it is no great surprise that we get this great urbanization along with economic development. As China continues to develop, we should see the same sort of movements in China as we have seen elsewhere.

China and Japan illustrate a couple of major points. When an economy is behind the rest of the world (as Japan was in 1950 and as China was in 1978 when it began its agricultural reform), if it implements decent economic policies, it has a great opportunity to catch up. All countries that have followed these rules have managed to catch up -- not always fully, but they have experienced rapid rates of growth.

That is the good news: We know something about what determines economic growth. If you put in a decent system, if you invest in your people, if you have an open economy, you are going to grow.

Japan did that; China has started to do that. Presumably, if China does not mess things up, it can continue to do that for a while.
Yes, Japan has gone through great difficulties. But it is still a very rich country. The 1990s were a period of stagnation in Japan, a disgraceful period for policymakers. But Japan has not had a major recession that has knocked income way down.

Some slowdown in rates of growth is inevitable, once you become a player in the rich countries of the world. You can no longer continue to grow at 6 or 7 percent a year. The question is, do you have in place good macro policies -- which are surely important -- and good micro policies -- which are at least equally important -- so that you can continue to grow at 2 to 3 percent? That is the challenge facing Japan.

A lot of people believed in the 1970s and 1980s that Japan was going to surpass the United States. That has not happened. Now I think we have gone too far in the direction of pessimism.
I have the same caution about China. China is doing great. But it has a lot of catching up to do. It is still a very poor country. If it does not mess things up, it can certainly do better.

Will it join the rich countries' club? I think we will have to wait before we can be sure about that. It could still mess things up.

MUNDELL: I want to say something about macro policies and micro policies because they have to work together. If you have bad macroeconomic policies -- for instance, if you have hyperinflation, if you have big budget deficits -- that dominates the concern of policymakers and nothing gets done on the micro side.
I pushed very strongly for the euro in Europe, mainly because it would get them on the right track on macro policies so they could then turn to their micro policies. I have said over and over again that Europe needs a supply-side revolution.

The real reason for rapid job growth in the United States has been the rapid growth of the American population. The European population has been stagnant, and so employment cannot rise very much.

But there is a major problem of unemployment in Europe. In the 1950s and 1960s, the star economic performers were not just Japan, but all the European economies -- the German miracle, the Austrian miracle, the Italian miracle and so on. Fixed exchange rate systems gave them their monetary policies. They had low inflation and low tax rates.

Today, Europe is in bad shape, Japan is in bad shape, and the United States is in great shape. What caused the reversal was the change in policies -- Europe started to imitate American policies. Meanwhile, America had a supply-side revolution in the 1980s, when the highest tax rate at the federal level went from 70 percent to 28 percent. The corporate tax rate came down from 48 percent to 34 percent.

Europe was going in the other direction. In the 1950s and 1960s, government spending in Europe was 25 percent to 30 percent of GDP. Now it is something like 50 percent of GDP. And in the Scandinavian countries, it is around 60 percent of GDP, because the principal focus of government in Europe has been the redistribution of income rather than the delivery of services.

Europe has to have a supply-side revolution. Every country in Europe has a labor law that says for firms with more than a certain number of employees -- 15 in Italy, for example -- they cannot fire people unless they go through the courts. Labor becomes a fixed factor. And what that has done is move the European unemployment rate, which was 2 and 3 percent in the 1950s and 1960s to something like 9 or 10 percent -- and 14
percent in Spain.

The results of the recent French elections are cause for optimism because President Jacques Chirac is going to be able kill the Franco-German plan for a Socialist Europe. Because essentially, you are now getting the right-of-center instead of left-of-center governments in Europe. You are going to have a real chance to have a major revolution that will turn Europe around.
I attribute this crisis in part to Europe's demographic problem. Thirty years ago, there were five or six or seven workers for every pensioner, and now it is getting down to be two or three. So their pension systems that start at the age of 55 are no longer viable.


UNITED STATES

MILKEN: How do we get wealth out of the underground and into an official economy? How do we move these underground economies? How do we free up the assets?

Also, how do we provide adequate service to an aging population? In the United States, health care is at least 15 percent of GDP, with much of the cost induced by lifestyle.

BECKER: The problem of the underground economy is pretty straightforward. When you tax the above-ground economy heavily, when you have very substantial regulatory obstacles for starting new businesses, when you heavily regulate the use of labor, there is a great incentive to avoid government. So people set up firms, or they work, and don't report the activity.

Somebody will say, well, what is the harm? It is, indeed, better than the alternative of not having the economic activity at all. But there is a downside: Among other problems, it is very hard to become big, to be publicly noticed and so forth. So you get a lot of smaller companies, often at less-than-efficient levels of operation.
On medical care: We've had significant growth in consumption, and a lot of that, I think, is highly desirable. People are willing to spend on improving both the quality and the quantity of their lives.

There are really two problems here, though. One, we underinvest in basic medical research. The federal government puts about $35 billion a year into medical research, and I think that figure should be higher. I think the return here is big.

On the other hand, a lot of important and significant powerful interest groups -- the elderly and others -- have the political clout to demand excessive expenditures on medical care for themselves.

So while I think it is good to have a high expenditure on medical care, there are a number of misallocations we have to address. One is the basic research; another is the distribution of benefits among groups.

FOGEL: England was the first country that was more than 50 percent urbanized. Why? Because English agriculture was incredibly productive. And so it took fewer and fewer people to produce the food.

In the United States in 1800, it took five people working on the farm to support one person working off the farm. Today, 2 percent of the labor force not only feeds -- and overfeeds -- the United States, but another 300 million people around the world as well.

So the key to being able to do everything else is to have very productive agriculture. And labor productivity in U.S. agriculture continues to grow in the neighborhood of 3 to 4 percent a year.

That sort of transformation is going to solve our health care problem. We can afford to spend not only the current 14 percent of GDP on health care, but considerably more: I forecast that in the next generation the figure will rise to 21 percent. That's because the production of food, clothing, shelter and consumer durables is becoming so incredibly cheap as a result of continued growth in productivity.

Let me conclude with one point. The share of the labor force in manufacturing today in the United States is lower than it was at the time of the Civil War -- again, because productivity in that area has just leaped along.

SCHOLES: I think that I will talk a little bit about real estate. The U.S. economy is now pretty competitive and deregulated, and we have a pretty healthy financial system. The information and communication revolutions over the last number of years have helped in that regard, and we have higher productivity growth now.

We also have lower inflation and less government interference, some budget discipline, and a pretty decisive Federal Reserve. With our diversified economy, that tends to reduce risk premiums on investment; it tends to reduce the volatility we might otherwise see and insulates us better from shocks.

Much of this is missing in the less-developed countries. As a result, it is much harder to think about borrowing very much against assets -- in particular, housing.

One thing I worry about in the United States is that if we have this continual refinancing of mortgages, which allows for individuals to consume and to redeploy their assets elsewhere, we could end up with a situation like some U.S. corporations -- one where senior executives borrow a tremendous amount against their stock, thinking it can only go up.

If we do end up with a market shock, the value of housing and real estate could fall quite dramatically, as people have to abandon or pay off their accumulated debts.




(c) 2002, Milken Institute/Global Economic Viewpoint. Distributed by Los Angeles Times Syndicate International, a division of Tribune Media Services.
For immediate release (Distributed 9/16/02)

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