Charter cities

The idea of charter cities, originally promoted by Stanford economist Paul Romer, sparked a lively academic debate in the field of economic development. The idea of charter city rests on the premise of creating special reform zones within countries. The reform zone would not be governed by the prevailing system of formal and informal rules within countries. The concept of charter city would serve as an intellectual laboratory of ideas in which governments would be let to quickly adopt innovative system of rules. The purpose of charter cities is the empowerment of incentives in world's less developed countries to develop human capital skills, hence, to increase the level of productivity and real wages that could foster the increase in the standard of living. By and large, the core idea of building a charter city means building a city of about 1000 sq. kilometers in the unoccupied land of the host country and adopting an innovative system of formal and informal rules provided by the source country. The example of charter city include selling Guantanamo to Canada and turning the little piece of Cuban land into Caribbean Hong Kong by adopting a formal system of rules and governance based on limited government, strong rule of law and free market; and turning the new territory into manufacturing hub that could serve as a source of income for workers across Caribbean islands such as Haiti. The charter city would not only provide the opportunity for testing intellectual ideas and innovations but also migrational opportunities for individuals from world's most impoverished countries such as Haiti. The coordination of the charter city is managed by a triangle. First, the host country would provide the piece of land. Second, the source country would provide the infrastructure, human capital and ideas. And third, the guarantor country would provide the assurance that the charter would be respected by both countries.

The concept of the charter city has gained significant attention by development experts in discussing developmental malaise in world's least developed countries in Africa. The empirical evidence on Africa's underdevelopment is striking. It suggests a blinking interplay of corruption, institutional fragility and state failure. According to African Development Indicators, about 75 percent of firms in Cote d'Ivoire identify corruption as the major constraint in doing business. In Ethiopia, less than 2 percent of females enroll tertiary education. Moreover, the average Ethiopian female can expect only 7 years of total schooling. In Liberia, about 11 percent of married women partake a contraceptive use by any method. Hence, one third of young Liberian women, aged 15-19. In addition, 60 percent of Liberians live below $2 per day. In Mozambique and Sierra Leone, only 45 percent of young women are literate. A female at birth in Sub-Saharan Africa can expect to experience no more than 8 years of total schooling throughout her life.

The perennial question in the establishment of charter cities is whether the idea can serve as a source of good rules, promoting good governance through low-cost contract enforcement. Institutional fragility of states across world's least developed countries is largely the economic outcome stemming from wrong development diagnostics, mismatched policy choices and a rigid structure of formal and informal institutional arrangements which resulted in a myriad of bad rules and corrupt political leadership across the specturm of world's poorest countries. The general conclusion from the lessons of development policy is that in the last century, development policy failed to facilitate meaningful prescriptions for a permanent rise of GDP per capita. In particular, the misdiagnosis of essential development dilemma is not a consequence of technical failure in delivering concrete solutions to applied issues of economic development but a consequence of mismatched theoretical foundations which supplied wrong assumptions. Theoretical models of economic growth and development in late 1950s and early 1960s rested on the assumption on output per worker as an increasing and diminishing function of the capital per worker. Although the validity of the neoclassical growth theory remains undisputed, development policy and international aid donors failed to recognize that increasing the amount of aid does not lead to better development outcomes. In fact, the majority of Sub-Saharan countries experienced the relative decline of GDP per capita in the 20th century. In 1913, the GDP per capita of Ghana (in 1990 international dollars) represented 42 percent of the average GDP per capita of European periphery. In 2008, Ghana's GDP per capita represented merely 8 percent of the average GDP per capita of European periphery. By the available statistics, Algeria was the second wealthiest country in Africa, only after South Africa. In 1913, Ghana was the fourth richest society in Africa, only after South Africa, Algeria and Egypt. In 2008, Ghana's GDP per capita was ranked 20th in Africa, in the same range as Angola, Lesotho and Nigeria.

The question surrounding the emergence of the charter city is whether it can serve as a treatment to the contagious sclerosis of fragile institutional structure in failed states, marred by poor governance and the lack of law and order, causing the failure to enforce private contracts as to ensure the rule of law and provide the institutional impetus for sound governance and better formal and informal rules. A notable criticism of the institutional fragility in world's less developed countries pertains to the capture of the state by the political elites. The political elites in world's poorest regions have provided sufficient conditions for the capture of government and judicial system by incorporating a system of powerful informal arrangements through bloated corruption which consequently impaired investment and ultimately resulted in the expropriation of private property rights. The institutional chaos in the most failed states of the world culminated into behavioral adaption to bad rules. The sequence of harmful economic policies eventually seized upon poor development outcomes such as high rates of poverty, stagnating income per capita, low life expectancy and poor health and education indicators.

The foremost task of the charter city should facilitate the institutional decency to enforce private contracts without transaction cost barriers and ensure a robust system of the rule of law since better rules nonetheless depend on how informal institutions such as culture, habits and behavior embrace the virtues of free markets, limited government and the rule of law. Aside from the essential infrastructural arrangements, the provision of institutional conditions for living under a different set of rules does not necessarily imply sufficient prerequisites for the productivity growth that could, in the long run, transform the charter city from low-wage pool of unskilled labor into high-wage urban agglomeration. What is needed for a charter city to flourish is the acceptance of informal institutions of the liberal society such as the freedom of contract and the freedom from corruption. One should not hesitate that economic and personal liberties in world's poorest countries are plagued by predatory rent-seeking political behavior as well as contended against the principles of adherence to formal rules. Without a sensory adherence to these principles, it would be impossible to envisage the charter city as a solution to world poverty and underdevelopment.

For a charter city to provide a clear and cohesive framework of rules, it is essential to provide the credibility and predictability of rules. In early 1950s, Hong Kong was a small island chartered by the British who established a system of credibility over centuries. Hong Kong was the only place where Chinese workers were allowed to migrate from the mainland China. The credibility of the rules, emphasizing limited government over extensive government intervention, free markets over regulated command-and-control economy and the rule of law over political discretion and interest-group politics, proved vital in Hong Kong’s steady economic growth in the 20^th century. In 1950, Hong Kong’s income per capita was around GBP 2,500. By 1997, the average income per capita rose to GBP 20,000.

The idea of building charter cities to boost income per capita by innovative framework of governance is a valuable alternative to the mainstream development policy. First, setting a charter city in regions such as Sub-Saharan Africa and Latin America would encourage seasonal and permanent migration flows from areas with low population density both on domestic and international scale. David McKenzie and John Gibson examined the impact of New Zealand’s Recognized Seasonal Employer program (link), aimed at encouraging seasonal migration from Pacific islands Tonga and Vanuatu to New Zealand, benefitting employers at home. The empirical evidence and policy conclusions suggest that seasonal migration is offering a triple win since a migrant, the sending country and the receiving country benefit from participating in seasonal migration program:

“Nevertheless, there are several caveats to these conclusions. The first is that development is a long-term process, and some of the effects of the RSE may only materialize over many years of community involvement. These could include positive effects such as greater asset-building, investments and skill development if workers return for many seasons, as well as potential longer-term negative effects of continual absence of family members on family and community relations. Secondly, while the gains to households from this seasonal migration are large, they still pale in comparison to the gains from permanent international migration (McKenzie et al, 2010). A key policy issue is therefore the extent to which seasonal migration can or cannot eventually open up avenues for permanent migration. Finally, as with all evaluations, there is the question of how far the policy details and findings can be extrapolated to other settings and that it was developed drawing on lessons from experiences around the world should provide some external validity. As temporary migration programs are increasingly emphasized in policy discussions, there is likely to be plenty of scope for governments and researchers to work together in the future in assessing how well these lessons translate.”

Second, charter cities would nevertheless spur the diffusion of knowledge into the countries of poor regions in the world. In its most distinctive form, charter cities would be similar to the role of small states in the global economy. For instance, consider Mauritius. Back in 1968, when the island gained the political independence from the United Kingdom, the economic prospects of the country were undermined by rapid population growth, rachitic productivity and overdependence on sugar as the only export industry. In addition, trade policy imposed high tariffs and import quotas to protect sugar manufacturers. Since it was impossible to dismantle the barriers to trade, the government of Mauritius responded by creating a virtual special export zone. Any foreign and domestic company could enter and exit the export zone by retaining the profits earned. Companies within the export zone operated under different rules with no trade restrictions such as tariffs, import quotas, voluntary export restraints etc. Hence, the only entry requirement for locating in the special zone was that companies manufacture only for exports as not to compete with domestic markets. The special export zone proved to be a success story. Productivity and employment rates increased sharply, boosting income per capita and standard of living. In 2010, Mauritius’s GDP per capita ($15,500) is the second highest in the region, only behind Gabon ($14,600). The experience of Mauritius with the special export zone and its consequent impact on the economic prosperity of the island, suggests that institutional competition ultimately rewards the institutional structure with better economic outcomes. The entire concept of the charter city is based on encouraging the institutional competition between charter cities and politico-economic systems in poorer countries where charter cities would be most likely to settle. Low initial level of income per capita in charter cities would encourage low-wage employment with unskilled labor. The experience of countries such as Mauritius, Singapore and Hong Kong suggests that favorable institutional features at the beginning stage of development result in better economic policies, ultimately leading to stable economic growth, higher standard of living and better education and health indicators. In Mauritius, the judicial independence from political influence has been enhanced by delegating the highest court of appeal to the British Privy Council, a royal judicial committee (link), full powers of judicial authority.

Many smaller countries in the 20^th century, known for good development outcomes, have adopted roughly similar institutional impetus for economic growth and development. In Africa, countries with the highest level of economic freedom and the lowest perception of corruption, such as Mauritius, Botswana and Namibia, enjoy the highest level of GDP per capita in the African continent. In spite of the abundance of natural resources, Botswana adopted market-friendly economic policies in the second half of the 20^th century, conducive to private enterprise and investment. According to World Bank, it takes 152 hours to pay taxes in Botswana compared to Sub-Saharan average of 315 days. In addition, a claimant in Botswana can expect to recover 63.7 cents per $1 from an insolvent firm compared to 8.4 cents per 1$ in Angola, 16 cents per 1$ in Niger and 0 cents per 1$ in Madagascar.

And third, charter cities would vastly improve the infrastructure of the residents, choosing freely to enter and exit the city. Households in countries such as Guinea still lack the access to electricity, forcing students to do the homework under streetlights and use the car park lights to review school notes (link). Despite being one of the largest receivers of aid per capita, Guinea still suffers from the lack of widespread access to electricity. One could hardly believe that the efforts pledged by international aid donors to reduce poverty and improve the standard of living across the African continent, were not sufficient. What created the black hole, such as the above in Guinea, is the institutional structure plagued by persistent corruption, political cronyism and bad governance, creating bad rules and wrong incentives. Charter cities would ingeniously cure the widespread persistence of misrule and political misconduct since the system of rules would be defined by the founding charter of the city. Good prospects of charter cities would require free entry and exit from the city as well as transparent and honest oversight of the respect for rules by independent judicial authority, managed by a guarantor country such as the United Kingdom, U.S. or Canada. In the proposed form, a typical charter city would become a manufacturing hub. In particular, it would enable access to low labor costs and significant economies of scale to technology entrepreneurs from rich countries as well as transparent contract enforcement, law and order and the security of private property rights. On the other hand, cities would enable millions of people from poor countries to migrate to chartered cities and seek employment opportunities in an environment, safe from corruption, political restraint, violence and bad governance. Hence, charter cities would provide a necessary input to the intellectual competition of ideas in economics, law and political philosophy and elsewhere to be implemented in chartered cities.

The concept enables social scientists and development experts a real-world experiment of ideas. Hence, charter cities could provide a safe haven for prosecuted individuals in poor countries, suffering from judicial errors, physical and military violence or illicit property expropriation. The UN estimates that, over the next few decades, 3 billion people will move to cities. The inflow exerts a growing pressure on urban agglomerations. The lack of basic infrastructure and the continuity of predatory misrule could cause a rapid growth of slums in larger cities which, by and large, are the main source of infectious diseases, HIV prevalence and youth crime since the absence of access to clean water, electricity and education are the major impediment to the improvement of development outcomes in poor countries. A charter city could flourish to become an impulsive alternative to the current state of overdependence on foreign aid. However, it should be unambiguously clear that adherence to good rules and governance requires a bold and decisive change in the set of informal behavior; in which corruption, crime and nepotism are doomed to the fullest possible extent by the full enforcement of private contracts and the rule of law.

Foreign aid and development economics

The aim of main research agenda of development economics in the last century was to provide an evolving approach to curing the persistence of poverty and underdevelopment in world's least developed and developing countries. High economic growth in developing countries in the last decades has changed many developing nations into middle-income countries. For instance, real economic growth rate in China and India from 1960 onwards averaged 6.67 percent and 3.49 percent, respectively. In 2010, China and India were already classified as lower middle-income countries, belonging to the same income group as El Salvador, Armenia and Philippines. In the recent year, China's GDP per capita was higher than GDP per capita of many high-growing developing nations such as Ukraine, Nambia, Armenia and Bosnia and Herzegovina, and roughly at the same level as Algeria. Over the last decade, the economic growth in developing countries accelerated, driven by an increase in global commodity prices, robust investment rates, expansionary monetary policy and a growing domestic consumption. The economic growth in a majority of African states stagnated, consequently leading to a decrease in the overall standard of living. Between 1960 and 2009, average real GDP growth was negative in countries such as Congo, Democratic Republic (-2.26 percent), Liberia (-1.51 percent), Niger (-1.02 percent), Zambia (-0.52 percent) and Zimbabwe (-0.02 percent) with many other African countries with little or no growth in the second half of the 20th century. The stagnation of income per capita in countries such as Sierra Leone is largely the result of civil war and severe political instability, creating domestic violence and the persistence of poverty, malnutrition and AIDS/HIV prevalence. From the second half of the 20th century onwards, international aid donors have contributed significant amounts of foreign developmental assistance in various forms such as medical care and vaccination against polio, AIDS/HIV, measles and malaria, direct cash transfers and physical infrastructure. Despite significant official and unofficial developmental assitance from international aid donors, dispersion of real income per capita, measuring the level of cross-country convergence or divergence of income per capita, the gap in economic development widened in the course of the last century. In 2010, the percentage of countries with the level of real GDP per capita $1,500 or below equaled almost 20 percent (link).

The rise of development economics in the 20th century was a natural response to growing disparities in income per capita between rich and poor countries. In the framework of neoclassical theory, development economics emerged from a neoclassical growth theory, pioneered by the famous Solow-Swan model. In the simplest possible form, the growth of output per capita depends on the capital per worker and the initial level of output under stable rate of national saving and capital depreciation. Assuming diminishing returns to scale and constant rate of population growth, the increase in capital per worker would increase the output per worker that would, hence, approach its steady-state equilibrium. Theoretical notions of the Solow-Swan model were tested against the empirical data on economic growth. The key assumption of the neoclassical growth model is that poor countries would tend to catch-up rich countries, assuming higher output growth in poor countries. The convergence of income per capita would imply a neg relationship between the initial level of output per capita and output growth over time. Thus, countries with lower levels of output per capita in the initial period would experience faster rates of output growth. Consequently, the output per capita and the standard of living would approach to the level in rich countries. The empirical tests of the Solow-Swan model failed to confirm the theoretical hypothesis since economic growth rates in 20th century in developed countries were higher compared to developing countries. The divergence of income per capita led to the subsequent modifications of the Solow-Swan model. In fact, the main criticism of the model points out that the model itself failed to capture the role of technological progress in determining the level of output per worker. The mysterious growth episode in Japan and other East Asian nations posed a difficult question. How can a country with low initial level of output per worker at the end of the WW2, exceed the productivity level in rich countries? The obvious answer is that Solow-Swan growth model failed to capture the role of technology shocks which violate the assumption of diminishing capital returns, what could explain why initially poor countries subsequently converged to the level of productivity in rich countries and then exceeded the level. The phenomenon, known as growth residual, has subsequently reduced the predictive power of the Solow-Swan model since a considerable share of economic growth was not ascribed to capital and labor inputs but rather to the persistent role of technological change.

Policy implications from Solow-Swan model imply that the essential requirement to boost economic growth in a country with low initial level of output per capita is to increase the amount of capital per worker, namely by boosting public and private investment in infrastructure. From 1950s onwards, World Bank had repeatedly boosted the growth of infrastructure by facilitating developmental assistance into world's least developed countries. According to the neoclassical growth theory, higher capital-labor ratio would provide additional investment stimulus, thereby increasing the employment-to-population ratio. Proponents of the foreign aid provided the rationale for higher foreign aid spending by the analogy of post-WW2 Europe when Marshall Plan provided $13 billion, or roughly $100 billion in today's prices, to Western European economies to recover the physical infrastructure which had been destroyed during WW2. Marshall Plan intervention was rather short, quick and finite. The efficacy of foreign aid in Africa is questionable since little or no growth occured in many African states such as Burundi, Benin, Zimbabwe and Congo. Official forecasts from the United Nations from 1950s onwards, based on the famous Harrod-Domar growth model (link), often assumed a rapid increase in the level of GDP per capita in response to the increase in investment rates. The forecasts, based on the theoretical assumption of diminishing capital returns, predicted a persistent convergence of GDP per capita to the level sustained in richer countries. The fact that the launch of extensive investment in infrastructure resulted in further economic stagnation of many African states, has questioned both the validity and quality of prescriptions laid by the mainstream development economics.

The philosophy of the mainstream development economics was sharply criticized in the light of the fact that foreign aid failed to alleviate poverty and made the growth of African economies slower. The efforts by the World Bank have been diverted from correct diagnosis of the developmental issues in African states to repeated initiatives such as the commitment of the international community to increase the share of foreign aid to least-developed countries to at least 1 percent of the GDP. The criticism of the mainstream development economics was already formulated in 1958 when Mont Pelerin Society organized the 9th meeting and development economics seminar where professor Herbert Frankel of the Nuttfield College put forth the criticism of foreign aid and the failure of development economics:

"The lesson that flows from it is that it does pay to go to these remote areas and find out what the problem is, instead of assuming that one knows the problem before one begins. Until recent years, people have simply assumed in many of these territories in Africa, that there were no real, positive signs of enterprise among the indigenous population, which was supposed to be so uninstructed or inert that it was not able to fend for itself, experiment for itself, or improve itself. It was not realised that a reason why there was this apparent lack of initiative in the population was that there were serious customary or legal obstacles to the exercise of ordinary enterprise, even on a small scale."

Given the lack of the comprehensive diagnosis of the causes of underdevelopment in African countries, the mainstream development economics failed to capture the appropriate assumptions in the theoretical models of economic development, upon which developmental assistance was justified. A more reasonable theoretical solution to the economic stagnation and social conflict in Africa has been put forth by the human capital theory. In its broadest and most general form, the theory stated that the economic stagnation of African countries is a consequence of the lack of skills and investment in education that could provide the necessary input to increase the economic growth and, subsequently, alleviate the issues of AIDS/HIV, malaria, child malnutrition and domestic violence. There is no doubt that the growth of education initiatives in Africa has sent many children to school. In addition, many universities in Western Europe and the United States have expanded the initiative and offered students from African states preferential admission criteria in various forms such as graduate fellowships, student grants and lower required standardized test scores, to boost admission rates of African nationals at U.S. universities. The efforts of developed countries to bring educational initiatives to Africa encouraged school participation as well as international opportunities of African citizens to study abroad, even at world's most prestigious and highly-ranked universities. Notwithstanding the importance of education in creating the stock of human capital for the wealth of nations, educational initiatives should address the essential obstacles that creates the failure of African expatriates to return to home countries, hence, bring skills, knowledge and various other forms of human capital, which are essential to the process of long-run growth, the issues of labor market distortions in African countries. These distortions crucially impede the ability of young African graduates to matching jobs in regional labor market.

What the mainstream development economics failed to take into account is the institutional paralysis which prevails in a majority of African countries, plagued by the destructive tribal institutions based on widespread corruption, bribes and domestic violence as means of achieving political power. The prevalence of hybrid institutions, marred by the complete absence of the rule of law and judicial institutions that could facilitate efficient contract enforcement and the protection of private property rights, is not only a severe obstacle to higher economic growth but also the apparent mechanism that captures the set of explanatory features that could possibly account for what caused the misdiagnosis of the African development dilemma. Back in 2002, African Union estimated that each year, corruption costs African economies more than $148 billion or 25 percent of Africa's GDP. The significance of corruption in state structures in Africa manifests itself in poor quality and provision of public services, the absence of judicial independence from political regimes, cumbersome contract enforcement and unprotected private property rights. Such distortions impede the level of trust and provide evolving incentives to subvert the institutional independence into political cronyism, in which corruption substitutes the tax system through bribes and extortion as methods of lowering transaction costs in overcoming the malfunctioning of the judicial system. In 1978, Erwin Blumenthal of the central bank of the Federal Republic of Germany, warned the international community that "Zaire's political system is so corrupt that there's no prospect for Zaire's creditors to get their money back." (link)

The advancement of country's economic prospects requires not only transparent, sound and efficient regulations but, more importantly, highly efficient civil service. In 2010, Transparency International published Corruption Perception Index (link) by measuring the persistence of corruption in public sectors across the world. The findings showed that the vast majority of poor African countries were plagued by extensive and extortionate corruption and ranked in the bottom 20 percent of the distribution. Comparing the level bureaucracy against GDP per capita reveals the amplified evidence of the negative correlation between the efficiency of civil service and the GDP per capita. The ease of doing business in Africa in countries such as Botswana, Ghana, Mauritius and South Africa is remarkably easier with predictable, stable and efficient regulation, compared to countries such as Burundi, Burkina Faso, Côte d'Ivoire etc. where highly burdensome administrative procedures in doing business hamper capital formation and restrain productive investment in health-care, education and private-sector infrastructure that could provide the impetus to economic growth.

The relationship between the amount of foreign aid, received by the least-developed countries, and the scope of corruption as a rough approximation of the institutional quality in the least-developed states, could provide the answer to the question whether international donors consider the scope and significance of corruption in allocating the amount of foreign aid. The experience from the last century of development policy, suggest that international donors actually allocated more foreign aid to the countries, suffering from severe state failure, widespread corruption, government failure and the complete absence of judicial independence that could provide a system of checks and balances and the necessary restraint on the violiation of private property rights, extortion and violence by the political elites. In 1999, Alberto Alesina and Beatrice Weder (see "Do Corrupt Governments Receive Less Foreign Aid," American Economic Review, 92(4), pp. 1126-1137) found that, contrary to arguments of aid supporters, foreign aid is not used to reward good governments since more corrupt governments received more foreign aid and official development assistance from international donors. The most striking evidence, presented by Alesina and Weder, suggests that U.S donors seem to neglect the persistence of corruption in allocating foreign aid to poor countries while, on the other hand, Scandinavian donors deem the persistence of corruption as highly important, hence, rewarding governments with lower extent of corruption.

In the following graph, I estimated the impact of corruption on official development assitance in the sample of 41 least-developed countries in 2008. In the model, I set the official development assitance to be determined by the scope of corruption in least-developed countries. The official development assitance is expressed as a share of representative country's gross national income (GNI) for it provides a better measure of aid dependence than foreign aid per capita since the size of population is controlled by the main assumptions of the model. The data on official development assistance were download from World Bank's World Development Indicators (link). The data on the extent of corruption in least-developed countries were provided by Transparency International's 2008 Corruption Perception Index (link). The extent of corruption varies from 1 to 10, where lower values indicate more persistent corruption. I estimated whether countries with more corrupt governments receive a higher share of foreign aid from international donors. On the basis of 41 least-developed countries, sample estimates suggest that a 1 point improvment in corruption perception index tends to decrease, on average, the share of foreign aid in gross national income, on average, by 2.37 percentage points. Sample estimate of the slope coefficient is statistically significant at 5 percent level. Even though, the variation in corruption perception index accounts for 5.51 percent of the variation in official development assitance, the influence of the extent of corruption on the share of foreign aid in gross national income is not spurious but systematic and persistent.

Corruption and official development assistance

Source: World Bank, World Development Indicators, 2010. Transparency International, Corruption Perception Index, 2008.

The estimate suggests that international donors indeed reward more corrupt governments by increasing the share of official development assitance. In 2002, African Union estimated that corruption was costing the African continent $150 billion per year. The estimates of the total cost of corruption provide an ample evidence that, over the last century, international donors consistently allocated foreign aid to more corrupt governments, creating aid-dependent economies, prone to bloated bureaucracies and extractive institutions which subsequently led to the stagnation of income per capita in the last decades. An ample criticism of foreign aid initiative was put forth by Dambisa Moyo (link) in the WSJ two years ago: "The most obvious criticism of aid is its links to rampant corruption. Aid flows destined to help the average African end up supporting bloated bureaucracies in the form of the poor-country governments and donor-funded non-governmental organizations."

The consequence of rootedness of corruption and extractive political institutions in African tribal cultures can be, in a considerable part, drawn upon the colonial heritage that spread throughout the African continent from 19th century onwards. The colonial experience across the African continent (link) served not only as a conquest of newly discovered areas but, moreover, also as an experiment of developing political and economic institutions on the basis of European influence. The colonial heritage in Africa was mainly derived from the European occupation of African lands. Hereto, the presence of European colonisers in Africa provided a long-lasting foundation of the institutional lessons from which the African states went forth.

Given the heterogenity of the European perspectives on institutional development, the colonial period in Africa left a long-lasting impact on the economic and political development in Africa. Africa's richest countries, namely Botswana, South Africa and Mauritius, were influenced tremendously by the colonial heritage. In Botswana and South Africa, the colonial influence of English and Dutch on further economic development was mainly derived from setting strong institutional foundations of economic development such as the rule of law, judicial independence and limited government compared to other African states. Apart from the setting of formal institutions, fostering contract enforcement and the integrity of the political institutions, English and Dutch colonizers provided the establishment of cultural setting not prone to fraud, extortion and extractive institutions. Favorable institutional conditions furthered the advertance of trust and institutional efficiency, which are deemed essential in fostering the development of financial markets. Even the German presence in Namibia from 1884 to 1915 during Deutsch-Südwestafrika (link) fostered, to a certain extent, independent judiciary, relatively sound institutions and cohesive framework of the rule of law. As a result, Nambia retained the status of one of the least corrupt countries in Africa, known for relatively high degree of economic freedom in a regional comparison with other African states.

While the influence of German, English and Dutch colonizers was largely beneficial to African countries from the perspective of economic growth and development over the last century, the presence of French, Italian and Belgian colonizers arises serious concerns over the prospects of economic development across the African continent. The myraid of violence, in countries such as Congo Dem. Rep. and Somalia, which ultimately led to civil wars and the settlement of extractive institutions, largely reflects the innate ability of the colonial policies to provide the necessary conditions for the institutional integrity, the rule of law and stringent property rights that could underline the basis of economic development by restraining the power and domination of political elites and their ability to expropriate private property rights in pursuit of extractive monopoly rents from natural resources. That easily explains why countries such as Congo, Zambia, Nigeria and Zimbabwe, in spite of vast reserves of natural resources, were seized by the state capture of political elites. The colonial presence largely determined the size and scope of aid dependency in African states. The most plausible and persuasive explanation of the impact of European colonial policies in African countries was presented by Daron Acemoglu, Simon Johnson and David Robinson (see "Disease and Development" Journal of European Economic Association, 1(2/3), pp. 397-405):

"European colonists were much more likely to develop institutions of private property, encouraging economic and social development, in places where they settled. In contrast, in places where they did not settle, they were more likely to opt for extractive institutions, designed to extract resources without investing in institutional development. In these places, institutions were highly centralized, with political power concentrated in the hands of small elites and with almost no checks on this elite. The property rights and more general rights of the majority of the population were not protected."

The political and economic circumstances of the European institutional legacy in African states imparted aid dependency on those countries where the combination of tribal institutions, hostile to free enterprise and judicial restraint of political dictatorships, and unequivocally detrimental colonial policies dominated the development of political and economic institutions, setting the rules of the game. Therefore, the inability of many African societies to establish sensible and effective institutions resulted in the political capture of the state by the elites. The monopoly power of the political elites, enforcing anti-growth public policies, led to consistently poor economic outcomes, plagued by high rates of poverty and infectious diseases such as polio, malaria and measles.

The challenge of development economics is not to design aid schemes, which inevitably lead to aid dependency, marred by persistent corruption and political fraud, but to ascertain correct diagnosis of why foreign aid repeatedly resulted in the poor economic outcomes and the consequent stagnation of income per capita in many African states in 20th century. The failure of African societies to establish a rigorous system of incentives, which could significantly improve economic outcomes, is not a response to market failures (which deemed highly of early development economics) but a result of severe government failure to establish effective institutions of the rule of law, contract enforcement and stringent property rights. These institutions are the broadest foundations of economic development and the only viable alternative to political nepotism and the power of elites which, as poor development outcomes in Africa show, ultimately impose extractive institutions, causing the persistence of poverty and underdevelopment.

Artificial states

The question of the artificial states has recently been brought up by the referendum in Southern Sudan on whether the southern part of the country should declare political independence from the northern part of the country. An article in New York Times (link) succintly discussed few notable fact-checked evidence of the increasing ethnic, political and economic North-South division within the country. As a single country, Sudan performed terribly in development outcomes. According to CIA World Factbook (link), the country suffers from high rates of extreme poverty and illiteracy. For instance, the official share of population below poverty line is estimated at 40 percent - almost twice the average of North African states. In addition to poor development outcomes, the country is plagued by significant political and ethnic fragmentation into largely Muslim, Arab-speaking north and predominantly Christain, English-speaking south. The political independence of South Sudan is the only contemporary evidence of the re-establishment of land borders alongside the ethnic division.

In the recent paper entitled Artificial States, Alberto Alesina, William Easterly and Janina Matuszeski presented two formal measures of artificial states. Aside from the measure of ethnic division, the authors constructed the measure of straightness of border lines. The hypothesis suggests that squiggly geographic border lines separate the states alongside the ethnic division. On the contrary, straight border lines suggest increase the probability of the emergence of artificial states plagued by ethnic and linguistic fractioning. The authors presented the empirical evidence, suggesting that fractional land borders are highly correlated with the GDP per capita. In addition, the share of ethnically partitioned population within the country is systematically decreasing the GDP per capita in cross-country comparison. The intuitive ideas behind the empirical evidence suggest that at the end of colonial period, colonizers that set straight borderlines between the emerging countries incured significant economic cost to newly formed African countries in terms of lost GDP. The evidence from Alesina-Easterly-Matuszeski study suggest that a 1 percentage point increase in the fraction of country's population belonging to groups partitioned by the border would decrease the GDP per capita by 1.3 percent. On the other hand, countries with squiggly geographic borderlines enjoy significantly higher GDP per capita.

The post-colonial period in Sudan was characterized by two civil wars which outbroke in 1972 and 1983. In 1956, Sudan gained the political independence from Great Britain. Contemporary borderlines were predominantly determined by the colonial authorities in African states prior to the wave of independence of many African nations. The emergence of the artificial states is rather a consequence of poor colonial policies than of high bargaining cost of ethnic groups within the country in setting country borderlines. Hence, the economic effects of colonial legacy can persist over time. Consider the evidence from Cameroon. The country was originally colonized by Germany. During the World War I, Northern Cameroon was occupied by Germany while the rest of the country was colonized by the French. Between 1916 and 1960, the country was a unique experiment of how the establishment of the institutional setting of European countries affects domestic development outcomes. A recent study by Alexander Lee and Kenneth Schultz (link) suggests that in the areas formerly occupied by the British enjoy higher levels of wealth and improved access to clean water while the rest of the rural country, after having been colonized by the French, suffers from significantly hindered access to clean water and worse provision of public goods. Even though the colonial patterns do not apply to urban areas, lessons from Cameroon suggest that the impact of post-independence public policies and colonial legacy on the level of wealth is of the same importance even when linguistic and ethnic fragmentation persists over time.

In spite of considerable degree of inefficiency, the persistence of inefficient and ethnically fragmented states is continuously marked by poor economic and development outcomes, often accompanied by civil-war conflicts such as military violence and genocide by the Sudanese army in Darfur. An interesting theory has been recently put forth by Daron Acemoglu, Davide Ticchi and Andrea Vindigni (link) who suggest that rich political elites seize state capture and democratic politics by expanding the size of bureaucracy. Hence, to gain political support, the coalition of elites chooses an inefficient structure and organization of the state.

The phenomenon of artificial states is not abridged to least-developed countries and developing world. Even in the group of advanced countries, several countries emerged despite a considerable degree of linguistic, ethnic and cultural fractioning within country borders. The evidence from Switzerland suggests that a continuous transition to a peaceful and stable democracy is possible. Amid highly fragmented linguistic and cultural characteristics such as four official languages and the persistence of GDP per capita divergence between high-income German cantons and low-income French cantons, Switzerland is characterized by envious political stability and economic performance. The genuine feature of federal political system is a consistent fiscal decentralization such as jurisdictional competition between units within the federalized structure in various areas such as taxation, regulation, health care etc. Hence, a decentralized fiscal structure and division of powers require a limited federal government and a high degree of autonomy within the federation. Thus, despite a multilingual population, the Swiss model of federalism is marked by political stability, peace and prosperity.

The phenomenon of artificial states in advanced countries is not confined to Switzerland itself. What distinguishes the Swiss model of federalism from centralist political systems in its neighboring countries is a high degree of political autonomy in Swiss cantons. Competition between jurisdictions within the federation nonetheless generates different economic outcomes. However, the outcomes generated by jurisdictional competition preclude adverse effects caused by either state capture of democratic politics or redistributive taxation between jurisdictions. In Switzerland, cantons with favorable public policies such as low tax rates on labor and capital, sound regulation and competitive provision of health care, have enjoyed persistently higher levels of wealth compared to cantons in the rest of the country. Of course, the coexistence of diverse ethnic and lingual groups within the single state requires common values, integrated into formal institutions.

Contrary to common perception, the artificial state may not be characterized exclusively by ethnic and linguistic fragmentation. To a large extent, Germany and Belgium could be classifed as artificial states. In Belgium, Flemmish-speaking north of the country consistently outperformed French-speaking south on various indicators and outcomes, including income per capita, international test scores and employment-to-population ratio. The political and linguistic division of Belgium into high-income Flemmish part and less developed French part reflects the essential dilemma of artificial states - should a single country with fragmented and heterogenous population be abandonded and whether ethnicity borders should represent country borderlines. In fact, linguistic fragmentation of Belgium to the extent that Flemmish and French part of the country adopted different administrative and education systems, led to persistent inability of two majorities to form a government. In 2007, The Economist opined that Belgium should cease to exist. The unification of Germany (Wiedervereinigung) integrated two parts of the country with vastly different institutional setting into a single political unity. However, Eastern and Western Germany were known for completely different political and economic system. The unification has incured many adverse effects. A significant difference in wage and price levels between East Germany and West Germany caused continuous migration of East German labor into West Germany, thus decreasing the productivity growth in East Germany. Consequently, the unification of the country led to the adoption of West Germany level of prices and wages in Eastern part of the new country. The artificial increase in price-wage level increased the unemployment rate in Eastern Germany to double-digit level, not least triggered brain-drain and capital flight. Hence, the unification of Germany as an artificial state resulted in persistent income per capita divergence between high-income West Germany and low-income East Germany. The unification of Germany into a single country should indeed never happen. In fact, adverse effects of the unification on East German productivity and wages would not lead to continuous increase in unemployment rate. If East Germany maintained a high degree of political autonomy, the transition to market economy would not be restrained by the adoption of West German price-wage level that could not be sustained by low productivity level in East Germany. To avoid the pitfalls of the artificial states, West and East Germany would be better off, had the countries never been reunified.

Recent national referendum in South Sudan on whether the southern part of the country should declare political independence from Sudan again pondered over the persistence of artificial states. The empirical evidence on poor development outcomes in several African countries suggests that borderlines, disregarding the ethnic distribution of the population within the country, are highly correlated with low income per capita. The unique solution of the artificial states is the adoption of political federalism. Under fiscal decentralization and limited government, federalism enables peaceful and prosperous existence of fragmented ethnic and linguistic structure in a single state. For instance, former Yugoslavia, known for highly fragmented ethnic, linguistic and economic disparities, ceased to exist not because federalism would not be a genuine political system but, ultimately, because of severe economic mismanagement, powerful and centralized government that disdained the principles of political autonomy and market economy, causing severe hyperinflation and the collapse of the federation that eventually resulted in a decade of civil wars and military violence. The evidence from Yugoslavia suggests that between 1950 and 1990, drastic economic divergence occured. The lesson suggests that the essential condition for the efficiency of federalism as a political system is high political autonomy and fiscal decentralization, both of which enable the competition between public policies.

Amid linguistic fragmentation, the competition between jurisidictions rewards competitive public policies by higher income per capita which ultimately boost the inception of public policies in less developed parts of the federation. Hence, without jurisdictional competition and political autonomy, ethnic and linguistic fragmention of the country may ultimately result in political instability which, in addition, generates poor economic outcomes.

Student performance and economic growth

The 2009 PISA test study (link) of students' proficiency in reading, mathematics and science is a highly successful method of evaluating student performance across countries. In fact, the creation of human capital is the main endogenous feature of the long-run economic growth since the quality of schooling and education system are essential to the creation of human capital. The difference in GDP per capita across countries is both intuitive, theoretical and empirical challenge to search for the causes of the gap between the economic performance of nations.

PISA test scores are aimed mainly at the evaluation of student knowledge at primary and secondary level in the fields of reading, mathematics and science. The assessment of knowledge in a particular field is subdivided into six different proficiency levels, ranging from 1 to 6. For instance, students at the 1st reading proficiency level are characterized by innate recognition of simple ideas reinforced in the text while students at the 6th reading proficiency level are characterized by a full capability of making multiple inferences, comparisons and contrasts and integrating the ideas presented in the text into a coherent conceptual framework of abstract ideas, sound evaluation and reflection. While 98.6 percent of OECD students can perform reading tasks at level 1, only 1.1 percent of students across OECD countries can perform reading tasks at the highest proficiency level. In addition, 28.4 percent of students in OECD countries exceeded the 4th (mid-range) reading proficiency level.

The reading scale has been further divided in reading continuous and non-continuous texts. However, the evidence suggest no systematic difference in reading scores between the two fields. Countries with the highest performance, measured as mean score, in reading rank are Korea (89.8 percent), Finland (89.3 percent) and Canada (87.3 percent). Countries with the largest student populations such as United States, United Kingdom and France were ranked in the upper-middle range while percent, and Israel (79 percent), Luxembourg (78.6 percent) and Austria (78.3 percent) are the lowest-ranking high-income countries on the reading scale in the 2009 PISA assessment. In the field of mathematics, 8 percent of students in OECD countries perform below level 1, 31.4 percent of students can perform mathematical tasks at 4th (mid-range) proficiency level while 3.1 percent of students perform at the highest proficiency level. In the country distribution, the percentage of students in the 6th proficiency level is the highest in Korea and Switzerland (8 percent), Japan, Belgium and New Zealand (5 percent). In a regional distribution, more than 25 percent of students in Shanghai perform at the highest level of mathematical proficiency. The proportion of students in the 6th proficiency level is very high in Singapore, Chinese Taipei and Hong Kong - 15.6 percent, 11.3 percent and 10.8 percent respectively. In addition, performance disparity in mathematics varied significantly across countries. Less than 1 percent of students in Mexico, Chile, Greece and Ireland reached 6th proficiency level A brief overview of the main empirical findings suggests a rather rigorous disparities in country ranking and performance.

The assessment of student performance in science is similar to the distribution of mean scores in the field of mathematics. About 5 percent of students perform below 1st proficiency level. In addition, only 29.4 percent of the students in OECD countries is proficient at 4th (mid-range) proficiency level in science while an average 1.1 percent of students in OECD countries can perform at the highest level of scientific literacy. In addition, the percentage of students below the lowest level of scientific proficiency is highly negatively correlated with country ranking since the proportion of students below the 1st level is the lowest in Finland (8.3 percent), Korea (6.3 percent), Estonia (8.3 percent) and Canada (9.6). Higher country ranking would thus indicate a lower proportion of students below the 1st proficiency level. All of the aforementioned countries ranked in the highest 10 percent of the distribution. If Shanghai, Hong Kong, Macao and Taipei were independent countries, their respective ranking in the field of scientific literacy would be in the top 10 percent of the distribution.

The empirical data on the distribution of mean scores in reading, mathematics and science are highly relevant to the measurement of human capital since the impact of mean scores on economic growth would differ to the certain extent from other measures of human capital. Recent attempts to capture the effect of human capital on economic growth were aimed at the definition of human capital as total years of primary, secondary and tertiary schooling. For instance, Robert Barro and Jong Wha Lee have collected disaggregated data on the total years of schooling for 146 countries between 1950 and 2005 at five-year intervals (link). The empirical evidence from the country panel suggests a strong linkage between schooling and long-run economic growth and institutional country features (link). In addition, Barro and Lee estimated the implicit return from an additional year of schooling ranging from 5 percent to 12 percent.

Gary Becker (link) and Richard Posner (link) recently discussed the 2009 PISA findings and the impact of cultural, genetic and demographic disparities on mean test scores in the United States. United States ranked in the middle of the mean score distribution. The rank of the United States (17th out of 79 countries) is above average in reading and average rank in mathematics (31st out of 79 countries) and science (23rd out of 79 countries). As Becker and Posner indicate, the relative performance of the United States should be evaluated with the consideration of cultural and demographic differences since the mean score of White and Asian students is significantly higher than the mean score of African American and Hispanic students. Disparities in mean scores between different demographic groups are typical in largely heterogenous populations. In Belgium, the regional disparity in mean scores between French and Flemish communities is even more striking. While the mean score in mathematics in 2006 in Flemish community had beenabove the OECD average, the mean score in mathematics of students in French community had been 18.56 points below the OECD average while the mean score of students in Flemish community had been 30 points above the OECD average. In 2009, such a relative difference would place French community in the rank of Italy, Portugal and Spain. On the other hand, student performance in Flemish-speaking community would reach the rank of Canada, Switzerland and Japan.

In the U.S, the demographic disparities in mean scores in reading, mathematics and science do not reflect the quality of the American education system. While the overall quality of the public and private American high school education system raised considerable concerns in previous performance of U.S. students in international mathematics and science ranking, the ranking of U.S. universities in science, mathematics and social sciences is the highest in the world. The output U.S. universities resulted in the highest number of Nobel laureates in physics, chemistry, medicine and economics as well as into cutting-edge accomplishments in R&D and technology. The emphasis on creativity and innovative thinking embodied in the American education system has enabled the United States to emerge as a world leader in technology, R&D, innovation and entrepreneurship.

The openness of the U.S. education system to international students, ideas and creative thinking could account for the remarkable achievements and academic quality of top American universities. On the other hand, poor teacher quality in American high school system is detrimental to the reading and quantitative literacy of American high school graduates, as a consequence of what Becker calls "teaching-to-the-test" syndrom where many public school teachers teach students topics not relevant to the command of knowledge but to the tests since test scores presumably determine teacher pay. Eric Hanushek of Hoover Institution recently found (link) that replacing bottom 5-8 percent of high school teachers with average teachers could near the United States on top of the international mathematics and science ranking. In addition, the measure is worth $100 trillion according to Hanushek (2010).

In the international perspective, student performance has been viewed as a significant determinant of the difference in cross-country economic performance. Recent paper by Atherton, Appleton and Bleaney (2010) found that higher mean test scores in mathematics, reading and science significantly improve per capita GDP. The authors showed that holding per capita income constant, average years of schooling is less important than mean test scores in predicting the economic growth. The 2009 PISA study highlighted the relationship between international test scores and economic growth. The evidence suggests almost non-existent correlation between reading performance and GDP per capita and cumulative education expenditure. The evidence simply suggests that socioeconomic variables matter more for reading performance than simple and often inconclusive aggregate indicators. In analysing the impact of various social and economic variables on reading performance, the results suggest a high correlation between parents' education and children's reading performance. For instance, 1 percentage point increase in the percentage of the population aged 35-44 with tertiary education returns 1.36 point increase in average reading performance where parents' education accounts for 44 percent of the variation in children's reading performance. The impact is shown in the following graph.

Parents' education and student reading performance

Source: OECD, PISA 2009.

A brief look also reveals another striking implication: cross-country reading performance is strongly affected by social and cultural status of the child's parents. A simple estimate of the relationship between reading performance and socio-economic status suggests that 1 percentage point increase in the share of students with very low social, cultural and economic status tends to decrease the average reading score by 1.13 points. Hence, social, economic and cultural status explains about 46 percent of the variation in student reading performance.

A considerable improvement of primary and secondary education system is vitally essential to the long-run economic growth. International test scores are an important method of evaluating international disparities in student performance and the subsequent impact on economic growth. Modern knowledge-driven economy requires not only intelligence, attentiveness but also comprehensive, integrated and developed social skills. Low reading, mathematics and science performance is generally attributed to student's low social, cultural and economic status. Genetic, cultural and socioeconomic variables, rather than education expenditure and GDP per capita, tend to play a major role in early childhood development as a basis of future student performance.

The economic and social future of countries requires considerable investment in children and student. Professor James Heckman of the University of Chicago brilliantly argued in Heckman equation (link) why the most gainful benefit of early childhood development is increased social productivity, greater motivation and developmental stimulation that every child needs. Our society should be not neglect an indisputable fact that early childhood development is a major determinant of student performance which sets the conditions for future advantage in school, college, career and life in general. Without these essential measures, student performance would suffer heavily from the spread of crime, teenage violence and high dropout rates.

The evidence from the 2009 PISA study suggests that higher quality of the education system is a necessary condition for higher test scores in reading, mathematics and science. As the evidence suggests, that the quality of human capital is strongly associated with higher standard of living. Without a prudent step towards improving developmental stimulation of students, considerably low student performance may seriously harm the prospects of future generations.

Can the Eurozone survive?

The ongoing difficulties in overcoming the persistence of debt-to-GDP ratio in EU countries highlight the question whether the European Monetary Union can survive the set of shocks which prevailed since the 2008/2009 economic and financial crisis. Recently, European Commission has prested the 2010 review of public finances in EMU (link), suggesting that macroeconomic outlook for Eurozone economies has deteriorated in the light of a growing debt-to-GDP ratio.

The launch of government bailouts in various European countries has added considerable amount to the stock of public debt across the Eurozone. Since 2008/2009, general government balance in Eurozone countries has continually resulted in persistent government deficits which further added to the stock of debt. Since public debt is by definition the sum of previous deficits, the European macroeconomic outlook suffers significantly from downgraded stability of public debt.

The anatomy of sluggish economic recovery in Eurozone consists of different set of economic policies. Countries at the European periphery (Portugal, Ireland, Greece, Italy, Spain) seem to be hit most by the sluggish economic recovery. From the viewpoint of macreconomic stability, the economic policymakers in these countries have pursued the most discretionary economic policies to mitigate the effects of decline in GDP on employment, earnings and tax revenues. In addition, highly expansionary monetary policy by the European Central Bank provided a bulk of quantitative easing, resulting flooding liquidity to supplement the interbank lending and, hence, to contain the effect of overleveraged financial sector on macroeconomic stability. In Ireland, income per capita in 2010 notably decline back to 2004 level (link). As I previously emphasized in one of my previous posts (link), the depth of the economic crisis in Ireland is largely attributed to the overleveraged banking sector, vulnerable to the interbank interest rate increases. Since the sovereign CDS spread on Ireland exceeded 500 basis points in late September this year, the Irish public finance outlook deteriorated significantly in the light of the innate ability of the Irish government to bailout Anglo-Irish Bank. Recently, the IMF estimated (link) that by 2012, Irish debt-to-GDP ratio would reach 67 percent, up from 12 percent in 2005.

A prudent reduction in debt-to-GDP would be accomplished only under restrictive fiscal policy based on the reduction in government spending and a permanent fiscal rule on budget surplus at a given target level. If Irish government set the surplus target at 3 percent of GDP in the next ten years, debt-to-GDP ratio could be considerably reduced within the range of Maastricht fiscal criteria.

The macroeconomic outlook in peripheral countries suffers from high fiscal expenditures and rigid labor market institutions. By 2012, Portugal's debt-to-GDP ratio is expected to reach nearly 85 percent of GDP. In addition to soaring public debt, the Mediterranean part of the EMU suffers heavily from high unemployment rate. Eurostat recently reported that, by October 2010, the unemployment rate in Spain reached an astonishing 20.7 percent. Double-digit unemployment rate in Spain, Greece (12.2 percent) and Portugal (11 percent) hamper the economic recovery since, in the past, these countries exercised expansionary fiscal policy and the policy of automatic stabilizers to mitigate the effects of high unemployment on aggregate consumption decline. In the aftermath of financial crisis, these countries experienced recessionary output gap in which economic contraction is marred by unchanged inflationary pressures.

Since EMU countries withheld domestic currencies and adhered the adoption of the Euro, the macroeconomic adjustment to the recovery is possible only by a prudent fiscal policy. High unemployment rates and a persistent divergence of economic policies in EMU countries could substantially increase discretionary fiscal policies that would eventually result in the serious possibility of country default. The economic crisis in Greece resulted in 11 percent cumulative GDP decline between 2010 and 2012. In the same period, government net debt is expected to reach the 120 percent of GDP thresold. A divergence between Member States towards highly discretionary fiscal policy would probably alleviate the persistence of high unemployment but at the expense of bold increase in the rate of inflation as well as in the persistence of debt-to-GDP ratio and large government imbalances. Hence, the survival of the Eurozone would depend on the ability of EU Member States to adjust government balance by reducing fiscal expenditure and adopt the fiscal rule to pursue fiscal surplus in the coming years as to reduce the stock of public debt.

Even though a common fiscal policy could accomplish the goals of stabilization policy, the mitigation of fiscal asymmetries would be easily accomplished by labor market integration. A currency union between different countries implies integrated and assimilated labor markets under relatively homogenous preferences. It would be nearly impossible to envision the European Monetary Union without these key macroeconomic features.

Bush tax cuts and economic growth

In 2001 and 2003, former U.S president George W. Bush signed Economic Growth and Tax Relief Act (EGTRAA) and Jobs and Growth Tax Relief Reconciliation Act (JGTRAA). EGTRAA reduced personal income tax rates, increased child tax credit, decreased estate tax and introduced a various range of tax-favored retirement savings plans. In 2003 when EGTRAA was enacted, the Congress cut the top capital gains tax rate from 20 percent to 15 percent while the individual dividend tax rate was reduced from 35 percent to 15 percent.

Bush tax cuts are set to expire in 2011. Hence, a bold increase in marginal tax rates is expected. David Leonhardt recently asked whether the Bush tax cuts were good for economic growth amid the fact that under Bush administration, the U.S economic growth was the lowest since the World War II. Eight years of Bush administration were known for the largest expansion of federal government spending compared to the six preceding presidents. In eight years, President Bush increased discretionary federal outlays by 104 percent compared to 11 percent increase under President Clinton.

Under Bush tax cuts, the reduction in personal income tax rates was imposed across all income brackets. Tax Policy Center estimated that extending Bush tax cuts in 2011 would increase the after-tax income across all income quintiles but it differed substantially. For instance, the increase in after-tax income in the lowest quintile would represent 12.19 percent of the increase in after-tax income of the highest quintile. The average federal tax rate would decrease by 2.5 percentage points. The reduction in average federal tax rate would be the most significant for top 1 percent and 0.1 percent cash income percentile, -3.8 percentage points and -4.4 percentage points respectively. Assuming the extension of the Bush tax cuts, the average federal tax rate, which includes indvidual income tax rate, corporate income tax rate, social security, Medicare and estate tax, would be substantially lower compared to Obama Administration's FY2011 Budget Proposal. The increase in the average federal tax rate would be roughly proportional across the cash income distribution. The federal tax rate would increase by 1 percentage point for the lowest quintile and 3.1 percentage point for the top quintile. The federal tax rate would for earners in top 1 percent of cash income distribution would increase by 4.2 percentage point. The chart shows the distribution of average effective tax rates and current law and current policy of Bush tax cuts not assumed to expire in 2011. The current proposal would increase the effective tax rate across all income quintiles. The highest increase (3.3 percentage points) would hit the earners in top 20 percent of income distribution.

Effective Tax Rates: A Comparison

Source: Urban-Brookings Tax Policy Center Microsimulation Model

The expiration of the Bush tax cuts would substantially increase the effective tax burden across the cash income distribution. Recently, Center on Budget and Policy Priorities estimated that letting the Bush tax cuts expire would create a net gain of $22 billion in economic activity. Hence, allowing high-income tax cuts expire would, on impact, result in a net gain of $42 billion in economic activity which is about five times the economic stimulus from extending high-income tax cuts.

The years of the Bush administration were earmarked by the escalation of federal government spending both in absolute and relative terms. The growth in federal government spending was driven mostly by discretionary defense spending while non-discretionary federal outlays increased as well. Since 2001, the federal government spending in the Bush administration increased by 28.8 percent with a 35.7 percent growth in non-defense discretionary spending. The growth of the federal government under Bush administration was the highest since the presidency of Lyndon B. Johnson and Richard Nixon. The Independent Institute compared the growth of federal government spending from Lyndon B. Johnson onwards.

Letting the Bush tax cuts expire would probably not impose a negative effect on small businesses since less than 2 percent of tax returns in the top 2 income brackets are filed by taxpayers reporting small business. William Gale contends that the Bush tax cuts significantly raised the government debt. The economic consequences of the 9/11 and wars in Iraq and Afghanistan were detrimental. William Nordhaus estimated that the total cost of war in Iraq between 2003 and 2012 could exceed $1 trillion in 2002 dollars considering unfavorable and protracted cost scenario. To a large extent, the wars in Iraq and Afghanistan have added substantially to the increase in government spending. However, even after excluding defense outlays from the spending structure, the increase in non-defense discretionary spending exceeded the growth of the federal government spending by 5.6 percentage points. Between 2000 and 2008, the number of federal subsidy programs increased from 1,425 to 1,804 - a 26 percent increase compared to 21 percent increase during Clinton years.

The Bush tax cuts failed to result in a Laffer curve effect mostly because they were implemented alongside a bold and significant increase in federal government spending. Had a substantial reduction in government spending been enforced, the tax cuts would not place should an enormous weight in the growth of federal debt. Higher federal debt would inevitably ponder the structural fiscal imbalance. Since debt interest payments would increase, a combination of tax cuts and spending growth would stimulate investment demand, creating an upward pressure on interest rates, especially during the economic recovery when the difference between potential output and real output is expected to diminish.

Critics of the Bush tax cuts often claim that cuts amassed a growing fiscal deficit. However, in 2007, the fiscal deficit stood at 1.2 percent of the U.S GDP while in 2009, the deficit increased to 9.9 percent of the GDP as a result of $787 billion fiscal stimulus from Obama Administration. Since tax cuts were enacted in 2001 and 2003 respectively, something else is to blame for the deficit.

U.S Federal Debt: Long-Term Forecast

Source: Office of Budget and Management; author's own estimate

The main premise of the economic policy of the Bush administration had been a significant increase in federal government spending. Spending policies were mostly aimed at covering the growing cost of the Iraqi war. In addition, domestic non-defense outlays on social security and domestic priorities grew significantly, creating an upward pressue on federal debt. The growth of entitlments such as Social Security and Medicare poses a serious long-term risk regarding the sustainability of federal government spending. In the upper chart built a simple forecasting framework to estimate the long-run level of U.S federal government debt as a percent of the GDP. Surprisingly, time trend accounts for 85 percent of the variability of the share of federal debt in the GDP. A more robust framework would include the lagged dependent variable and several regressors in the set of explanatory variables to increase the share of variance explained by independent effects of regressors. The results indicate that by 2020, the federal debt could easily reach the 90 percent thresold.

The growing stock of entitlements such as Social Security and Medicare are central to understanding the looming pressure on federal budget to tackle the challenges of ageing population and demand for health care. The tax cuts imposed by the Bush administration reduced average federal tax rates across quintiles in cash income distribution. However, tax cuts were no supplemented by the reduction in federal government spending. Consequently, the growth of federal government spending increased future interest debt payments and failed to take into account the long-term pressure of Medicare and Social Security on federal budget set. Extending the Bush tax cuts would be superior to letting them expire. But lowering tax burden should nevertheless be comprehended by the reduction in federal government spending.

Public pension crisis in OECD countries

The central aim of my bachelor's thesis is to demonstrate the unsustainability of public pension system in OECD countries in the longer run through the lens of a rigorous theoretical and empirical analysis.

The origins of contemporary public pension schemes date back to 19th century when Bismarckian Germany in 1881 first adopted a universal old-age public pension system based on pay-as-you-go (PAYG) funding principle. The principle itself captures full advantages of high (stationary) population growth rate. In the simplest form, PAYG pension scheme is based on the notion of generational solidarity upon which current generations pay mandatory social security contribution into the public scheme. Aggregate contributions are then paid out to current retirees. The cycle is then expanded through generations. However, PAYG funding scheme is sustainable as long as the population growth is high and above the marginal productivity of the capital. Back in 19th century, public pension schemes were adopted under unrealistic assumptions about future population prospects. In 19th century, advanced countries experienced high population growth rate, high fertility rate and an extremely low share of dependent old population that was receiving universal old-age support from PAYG pension schemes. These set of assumptions was crucial to the stability of government-provided old-age support embodied in the public pension schemes.

The sustainability of PAYG pension system requires the equivalence of population growth rate and real interest rate. In the early 20th century, the advanced world shifted towards aging population, declining fertility rates and lower labor market entry rate. In broad terms, a growing old-age dependency ratio led to the pure disequilbrium effects. In a theoretical framework, I re-examined the neoclassical framework of lifecycle hypotheses embodied in Samuelson and Cass-Yaari models of life-cycle utility maximization. The lifecycle hypothesis is based upon the assumption of the three-period model where individuals maximize the consumption in the course of a lifetime. In the first period, individuals do not discount the future consumption since, in this period, individuals acquire the human capital. In the second period individuals enter the working age and discount the future consumption. Hence, in the third period, individuals retire consume the output produced in the working-age period. Since future discounting is compounded, the lifetime consumption increases geometrically. In purely analytical terms, the individuals maximize the utility of consumption through time preference rate.

Considering the abovementioned equivalence between population growth rate and real interest rate, the stability of the equilibria requires the period discount rate to equal the population growth rate. If population growth rate decreases, the stability of the equilibria requires that individuals decrease the future discount rate by the same rate to keep the PAYG pension system within the theoretical limit. The rigorous theoretical formulation of the neoclassical model of lifetime consumption, which essentially captures the necessary conditions for equilibrium stability of public pension schemes, had been put forth by Paul A. Samuelson in his seminal contribution to the theoretical foundations of stationary "PAYG" public pension scheme .

In the course of the last decades, OECD countries have experienced a significant drop in fertility rates, population growth and, under the political climate of social democracy, a widespread adoption of early retirement schemes and generous social security benefits. In addition, labor market exit age dropped significantly, initiating a trend towards the unprecendent growth of generational indebtedness.

The OECD estimated that between 2000 and 2050, old-age dependency ratio is forecast to increase to the largest extent in Japan (193 percent), Spain (136 percent), Portugal and Greece (135 percent). The astonishing increase in the estimated old-age dependency ratio directly reflects the declining fertility rate in OECD countries from 1960s onwards. I estimated the ratio of fertility rate between 1960-1970 and 2000-2006 for OECD countries at around 2, which means that average fertility rate between 1960-1970 was twice the fertility rate between 2000-2006. The highest fertility ratios were found in Spain (2.23), Italy (1.96), Ireland (2.00) while the lowest ratios were found in Denmark (1.37), Netherlands (1.72) and the United States (1.46).

High and stable effective retirement age is the main assumption underlying the stationary stability of PAYG pension system. In the 20th and 21st century, OECD countries have experienced an unprecendent decline in effective retirement age. Blöndal and Scarpetta (2002) estimated the decline in labor market exit age for OECD countries between 1960 and 1995. The female labor market exit age had declined significantly in Ireland (10.7 years), Spain (9.1 years) and Norway (8.8 years). Male labor market exit age exerted persistent decline in all developed OECD countries except for Iceland. The exit age declined significantly in the Netherlands (7.3 years) and Spain (6.5 years).

In a large part, declining labor market exit age has confluenced the rapid growth of unemployment and disability benefits and early retirement incentives from the second half of the 20th century onwards. As the OECD correctly contemplated, in a number of countries, disability pensions and unemployment benefits can be used as de facto early retirement schemes. In a large part, widespread growth of early retirement schemes and implicit incentives for moral hazard in retiring too early via unemployment and disability schemes is held responsible by generous welfare states in the aftermath of the World War II.

When I examined various features affecting early retirement choices, I came across an interesting finding. I regressed labor market exit age and marginal tax rate in a cross section of 23 OECD countries in 2007. I estimated the relationship between exit age and marginal tax rate using a classical OLS linear regression model. The estimate suggests that, holding all other factors constant, if marginal tax rate increases by 1 percentage point, average labor market exit age decreases by 1.88 months. Surprisingly, 51.74 percent of sample variation is explained by marginal tax rate alone. The sample constant is statistically significant, suggesting that if the hypothetical marginal tax rate were zero, the average labor market exit age in randomly chosen country from OECD sample would be 69.65 years. The sample constant is consistent with a prior theoretical expectations since it concurs with the "substitution effect" hypothesis that higher marginal tax rate leads to lower labor supply and fewer working hours.

The cost of early retirement in OECD countries

Source: T.T. Herbertsson & J.M. Orszag, The Cost of Early Retirement in OECD, 2001. OECD, Pensions at Glance, 2009.

Fiscal imbalances arising from unsustainable PAYG public pension systems in OECD countries cannot be assessed without a sufficient estimate of economic costs of unfunded pension liabilities. I approximated the cost of early retirement using Auerbach-Kotlikoff-Gokhale (1999) methodology that directly estimates the size of generational imbalances created by public social security systems. Large and rapidly unsustainable net pension liabilities occured in late 1980s. Van den Noord and Herd (1993) estimated the size of net pension liabilities in seven major OECD countries. The results suggest that continental European countries have had the largest net pension liabilities in terms of GDP. The size of pension liabilities in France and Italy had been about 2.5 times the size of their respective GDPs and twice the stock of the public debt.

Gokhale (2008) directly estimated fiscal imbalances arising from unfunded pension liabilities to current and prospective generations. The size of generational fiscal imbalance, as a share of the GDP, is extremely large and rapidly unsustainable in all OECD countries. In fact, the size of the imbalance is the most severe in Greece (875 percent of the GDP), France, Finland and the Netherlands (500 percent of the GDP) while it is more than twice the size of the GDP in all OECD countries except for the United States, Canada, Australia and New Zealand.

Fiscal imbalance in OECD countries

Source: J. Gokhale, Measuring Unfunded Obligations of European Countries, 2009.

I built the econometric model of public pension expenditure for a cross section of 23 OECD countries in 2007 to assess which variables might explained the cross-country variation in public pension expenditures. I've been aware of the possible drawbacks of choosing a cross-section model since it might be vulnerable to specification errors and the unbiasedness of regression coefficients. To account for possible specification bias, I conducted Kolmogorov-Smirnov, Shapiro-Wilk and Jarque-Bera normality tests. By performing normality tests, I have examined whether the normality assumption of normally distributed error terms is valid in the studied sample of 23 OECD countries considering error terms as identically and independently distributed.

In the set of explanatory variables that might yield consistent and robust estimates of regression coefficients I chose 10 various demographic, economic and institutional independent variables. Apart from demographic and economic variables, institutional variables are dichotomous since the institutional features can be captured by binary modes of choice. The dependent variable is the size of public pension expenditures in the share of the GDP.

The results suggest that public pension expenditures are positively correlated with the share of population aged 65 and older (0.746**), difference in life expectancy after age 65 between 1960 and 2005 (0.477*) and dichotomous variable for continental European countries (0.697**) where * and ** indicate the statistical significant of the sample correlation coefficient at the 5% and 1% level. The estimates suggests that the probability of higher pension expenditures in the share of the GDP is likely to occur in a continental European country known for a relatively large share of older population and a high difference in life expectancy after age 65 between 1960 and the present. On the other hand, public pension expenditures are negatively correlated with average effective retirement age (-0.475**), private pension funds as a share of GDP (-0.658**), labor market exit age (-0.523**), dichotmous variable for Anglo-Saxon countries (-0.544**) and a dichotomous variable for private pension system (-0.672**), where ** denotes the statistical significant of the sample correlation coefficient at the 1% level. Again, the estimates suggest that the probability of lower pension expenditure is likely to occur if a randomly chosen country from the OECD sample is Anglo-Saxon and has a high effective retirement age, large private pension funds as a share of the GDP, high labor market exit age and a mandatory private pension system. The coefficients suggest that in repeated sampling, the estimated sample correlation coefficient will include the true or correct population value in 99 percent of cases.

I conducted the econometric model which consisted of 8 regression specifications. I chose double-logarithmic model which yields direct elasticities as regression coefficients. However, I added two exceptions. In regression specifications 5 and 6, I chose a mixed specification mostly due to the inclusion of private pension funds (assets) variable in the regression specification. Unfortunately, but the share of private pension funds in Greece in 2007 equals 0 percent of the GDP which does not enable the researcher to apply double-logarithmic model as the basis of regression specification.

The estimates suggest that the share of population aged 65 and older is statistically singificantly positively related to the share of public pension expenditures in the GDP. Hence, the elasticity of public pension expenditures with respect to effective retirement age ranges from -1.465 to -4.935, suggesting that an increase in effective retirement age by an additional year leads to per unit increase in public pension expenditures by more than a unit increase in the share of the GDP. The coefficient of private pension funds is highly statistically significant. The elasticity of public pension expenditures with respect to private pension funds (as a share of the GDP) ranges from -0.34 to -0.38 and is statistically significant at the 1% level. The elasticity suggests that a 10 percentage point increase in the share of private pension funds reduces the share of public pension expenditures in the GDP, on impact, by 3.4-3.8 percent, holding all other factors constant. In addition, the estimates of coefficients for dichotomous variables suggest the following: the probability of higher public pension expenditures (as a share of GDP) is likely to occur in continental European countries with mandatory private pension system. Five estimates of dichotomous coefficients are statistically significant at the less than 10% level.

The significance of dichotomous (dummy) coefficients has been tested by beta coefficient analysis to rank the magnitudes of separate effects of explanatory variables on public pension expenditures as dependent variable. The results suggest that continental European countries are significantly more likely to face higher public pension spending in the share of GDP compared to Anglo-Saxon countries.

Earlier I mentioned the necessity of normality assumption in yielding robust, consistent and unbiased estimates of regression coefficients. The assumption has been questioned by conducting Kolmogorov-Smirnov test (K-S), Jarque-Bera test (J-B) and Shapiro-Wilk (S-W) normality test. The aim of the testing the normality assumption is to observe whether error terms distribute normally so that estimated test statistics, standard errors and confidence intervals are reliable. In setting test statistic, I set the normality assumption as null hypothesis. The results from K-S, J-B and S-W tests show that the null hypothesis cannot be rejected at 5% level, suggesting that the normality assumption is valid in the studied sample. Hence, test statistics, standard errors and confidence intervals are both valid and reliable.

The meaningful question to evaluate the prospects of the coming public pension crisis is how to reverse the growth of fiscal imbalances and reform public pension system as to avoid erratic generational indebtedness. Aging population and the growth of old-age dependency ratio trigger an enormous future burden on public finances in OECD countries. Lower fertility rate and population growth shall place an incurable burden on the stability of PAYG public pension systems. The estimates suggest that life-expectancy after the age of 65 is likely to increase by 2050 and gradually approach the age of 90 for both male and female. Assuming the effective retirement age is 65, the remaining life expectancy is 25 years or almost one-third of the average lifetime. As Alemayehu and Warner (2004) suggest: "Old-age health care costs thus will impose increasingly severe pressure on private finances and government coffers. Indeed, applying our age-specific estimates to the age distribution anticipated for the year 2030, we find that if nothing is done to alter current patterns of health care, per capita health care expenditures will rise by one-fifth due to population aging alone."

The long-term pension reform that aging societies of the West should undertake is a complementary measures of three key policy features of the reform.

First, the transition to fully-funded retirement savings accounts is the only viable and sound pension reform that can alleviate the damage generated by the growing fiscal imbalances. The theoretical foundation of the transition from public pension systems to fully-funded pension system has been laid down by Feldstein and Liebman (2001). The authors derived an algebraic solution which suggests that keeping a PAYG public pension system does not attenuate the persistence of a growing demographic pressure on the stability of public pension system. As I discussed earlier, PAYG system crucially depends on three key assumptions: high fertility rate, very low share of population older 65+ and high population growth. These assumptions are incompatible with actual demographic parameters and, hence, OECD countries should undertake a drastic transition towards fully-funded pension systems based on individual savings accounts. Otherwise, the growing demographic pressure will inevitably result in the exponential growth of generational debt, creating an enormous deadweight loss for current and prospective generations.

Fully-funded pension system is based on the premise of investing pension contributions into the capital market, earning a compound interest over time. The stock of individual's lifetime earnings is paid in the form of annuities upon individual's withdrawal from the labor market. In addition, there is a growing disparity between the implicit return of PAYG public pension system and real rate of return in the capital market. Under realistic assumptions, such as that the marginal product of capital (MPK) is below the welfare-maximizing level and the real rate of return exceeds the implicit return from PAYG system, fully-funded pension system would not create a deadweight consumption loss to the working-age population. In fact, Feldstein and Liebman (2001) derived an analytic solution for the transition to fully-funded pension system in which the transition induces a short-term consumption loss in the next period while, at the same time, it creates a geometrically-growing future consumption for both retired and working-age population.

The only remaining question is whether the real rate of return would compensate the consumption loss of working-age population and, hence, increase the stock of future consumption to all generations. According to Feldstein and Liebman (2001), assuming 6.5 percent inflation-adjusted rate of return, the payroll cost of fully-funded pension system would represent only 27 percent of the payroll cost incured under PAYG public pension system. Tax rate, required to bear the cost of current stock of pension liabilities is 12.4 percent respectively.

According to Congressional Budget Office, the average real rate of return for large-company stocks between 1926 and 2000 is 7.7 percent, 9.0 percent of small-company stocks and 2.2 percent for long-term Treasury bonds. Feldstein (1997) estimated that PAYG implicit rate of return is 2.6 percent.

Assume an individual wants to maximize the lifetime earnings in the capital market. An individual is offered 2.6 percent implicit return from PAYG system. The individual enters the labor market at certain age, say 25, and intends to retire upon the age of 65. Assume he invests $10.000 annually in the capital market to create retirement annuities upon labor market withdrawal. Assuming the implicit rate of return (2.6 percent), the stock of overall annuity would be 10 times the initial investment in 90 years. Assuming the average long-run real rate of return from large-company stocks (7.7 percent), the the overall annuity would be 10 times the initial stock of investment in 31 years. Therefore, the individual would reach the desired level of lifetime earnings at the age of 56 or 9 years before the targeted retirement age.

I assumed the distribution of lifetime investment portfolio is weighted average of availible asset types: large-company stocks (33 percent), small-company stocks (19 percent), long-term corporate bonds (20 percent), long-term Treasury bonds (20 percent) and 3-month Treasury bills (8 percent). According to the average annual real rates of return in the United States (1926-2000), I calculated the weighted average real rate of return (5.247 percent). Investing $10.000 annually at the age of 25 would buy $100.000 annuity at 5.247 real rate of return in 45 years (the age of 70) compared to 90 years (the age of 115) under the PAYG implicit rate of return (2.6 percent). Of course, the time to buy the annuity would shift alongside the changing composition of portfolio.

In addition, OECD countries should immediately increase the effective retirement age. I believe the solution suggested by Gary Becker is both meaningful but sustainable in reversing the growth of generational debt. Becker (2010) suggested "One simple and attractive rule would be to raise retirement age by an amount that makes the ratio of years spent in retirement to years spent working equal to the ratio that existed at the beginning of the social security system."

When President Roosevelt signed the notorious Social Security Act in 1935, the normal retirement age was 65. However, life expectancy after the age of 65 was significantly lower than is today. In 1940, average life expectancy after 65 in the U.S was 13.7 years. In 2006, it stood at 18.6 years, according to OECD. In 1935, the average life expectancy at birth in the United States was 61.7 years. We assume that individuals in 1935 worked for 35 years and spent 12 years in retirement. The ratio is thus 0.4 (12/ 35=0.34). Today, if individuals retire at the age of 65, they can expect further 18.6 years in retirement. To equalize the ratio to the 1935 level, (18.6/x=0.34), individuals should spend 54.7 years working. The estimate time is an equivalent measure of years required to spend working if PAYG public pension system is left intact. Assuming the individuals enter the labor market at the age of 25, then the expected effective retirement age is the age of 80.

In the long run, PAYG public pension system is unsustainable since demographic parameters do not suffice the assumptions under which the PAYG system is possible without distortions of labor supply incentives. The future of OECD countries will be marked by aging population, lower fertility rates and a growing demographic pressure on public finances. Without bold and decisive pension reform, OECD countries will experience increasing pension deficits and, hence, an explosive growth of generational indebtedness.

Parametric pension reforms are not a substitute for the postponement of paradigmatic pension reform. Thus, implementing the transition to fully-funded pension system essentially requires higher effective retirement age. A comprehensive pension reform cannot be made possible without these measures. At last, but not least, the major challenge in the systematic pension reform in OECD countries to address the burden of global aging, is whether political courage will withstand the pressure of interest groups to maintain the status quo of early retirement incentives. Nonetheless, eliminating early retirement incentives is the essential step towards creating retirement system without perverse incentives to retire too early. Unless political leaders encourage a transition to fully-funded pension system, OECD countries will be unable to withstand the deadly consequences of an enormous generational indebtedness.