Editor’s note: The following remarks were prepared and delivered by Gary Burtless at a roundtable sponsored by the American Tax Policy Institute on January 7, 2016. Video of Burtless’ remarks are also available on the Institute’s website. Download the related slides at the right. 

To eliminate suspense from the start: Nothing I am about to say undermines the popular narrative about recent inequality trends.  For the past 35 years, U.S. inequality has increased.  Inequality has increased noticeably, no matter what income definition you care to use.  A couple of things you read in the newspaper are untrue under some income definitions. For example, under a comprehensive income definition it is false to claim that all the income gains of the past 2 or 3 decades have gone to the top 1 percent, or the top 5 percent, or the top 10 percent of income recipients.  Middle- and low-income Americans have managed to achieve income gains, too, as we shall see.

Tax policy certainly affects overall inequality, but I shall leave it for Scott, David, and Tracy to take that up. Let me turn to my main job, which is to distinguish between different reasonable income measures.

The crucial thing to know is that contradictory statements can be made about some income trends because of differences in the definition of income.  In general, the most pessimistic statements about trends rely on an income definition that is restrictive in some way.  The definition may exclude important income items, items, for example, that tend to equalize or boost family incomes.  The definition may leave out adjustments to income … adjustments that tend to boost the rate of income gain for low- or middle-income recipients, but not for top-income recipients.

The narrowest income definition commonly used to evaluate income trends is Definition #1 in my slide, “pretax private, cash income.”  Columnists and news reporters are unknowingly using this income definition when they make pronouncements about the income share of the “top 1 percent.”  The data about income under this definition are almost always based on IRS income tax returns, supplemented with a bit of information from the Commerce Department’s National Income and Product Account (NIPA) data file.

The single most common income definition used to assess income trends and inequality is the Census Bureau’s “money income” definition, Definition #2 on the slide.  It is just the same as the first definition I mentioned, except this income concept also includes government cash transfer payments – Social Security, unemployment insurance, cash public assistance, Veterans’ benefits, etc.

A slightly more expansive definition (#3) also adds food stamp (or SNAP) benefits plus other government benefits that are straightforward to evaluate. Items of this kind include the implicit rent subsidy low-income families receive in publicly-subsidized housing, school lunch subsides, and means-tested home heating subsidies.

Now we come to subtractions from income. These typically reflect families’ tax obligations.  The Census Bureau makes estimates of state and federal income tax liabilities as well as payroll taxes owed by workers (though not by their employers).  Since income and payroll taxes subtract from the income available to pay for other stuff families want to buy, it seems logical to also subtract them from countable income. This is done under income Definition #4.  Some tax obligations – notably the Earned Income Credit (EIC) – are in fact subtractions from taxes owed, which would not be a problem in the case of families that still owe positive taxes to the government.  However, the EIC is refundable to taxpayers, meaning that some families have negative tax liabilities:  The government owes them money.  In this case, if you do not take taxes into account you understate low-income families’ incomes, even as you’re overstating the net incomes available to middle- and high-income families.

Now let’s get a bit more complicated.  Forget what I said about taxes, because our next income definition (#5) also ignores them.  It is an even-more-comprehensive definition of gross or pretax income.  In addition to all those cash and near-cash items I mentioned in Definition #3, Definition #5 includes imputed income items, such as: 

• The value of your employer’s premium contribution to your employee health plan;
• The value of the government’s subsidy to your public health plan – Medicare, Medicaid, state CHIP plans, etc.
• Realized taxable gains from the sale of assets; and
• Corporate income that is earned by companies in which you own a share even though it is not income that is paid directly to you.

This is the most comprehensive income definition of which I am aware that refers to gross or pre-tax income.

Finally we have Definition #6, which subtracts your direct and indirect tax payments.  The only agency that uses this income definition is principally interested in the Federal budget, so the subtractions are limited to Federal income and payroll taxes, Federal corporate income taxes, and excise taxes.

Before we go into why you should care about any of these definitions, let me mention a somewhat less important issue, namely, how we define the income-sharing group over which we estimate inequality.  The most common assessment unit for income included under Definition #1 (“Pre-tax private cash income”) is the Federal income tax filing unit.  Sometimes this unit has one person; sometimes 2 (a married couple); and sometimes more than 2, including dependents.

The Census Bureau (and, consequently, most users of Census-published statistics) mainly uses “households” as reference units, without any adjustment for variations in the size of different households.  The Bureau’s median income estimate, for example, is estimated using the annual “money income” of households, some of which contain 1 person, some contain 2, some contain 3, and so on.

Many economists and sociologists find this unsatisfactory because they think a $20,000 annual income goes a lot farther if it is supporting just one person rather than 12.  Therefore, a number of organizations—notably, the Luxembourg Income Study (LIS), the Organisation of Economic Cooperation and Development (OECD), and the Congressional Budget Office (CBO)—assume household income is equally shared within each household, but that household “needs” increase with the square root of the number of people in the household.  That is, a household containing 9 members is assumed to require 1½ times as much income to enjoy the same standard of living as a family containing 4 members.  After an adjustment is made to account for the impact of household size, these organizations then calculate inequality among persons rather than among households.

How are these alternative income definitions estimated?  Who uses them?  What do the estimates show?  I’ll only consider a two or three basic cases.

First, pretax, private, cash income. By far the most famous users of this definition are Professors Thomas Piketty and Emmanuel Saez.  Their most celebrated product is an annual estimate of the share of total U.S. income (under this restricted definition) that is received by the top 1 percent of tax filing units.

Here is their most famous chart, showing the income share of the top 1 percent going back to 1913. (I use the Piketty-Saez estimates that exclude realized capital gains in the calculation of taxpayers’ incomes.) The notable feature of the chart is the huge rise in the top income share between 1970—when it was 8 percent of all pretax private cash income—and last year—when the comparable share was 18 percent.  

I have circled one part of the line—between 1986 and 1988—to show you how sensitive their income definition is to changes in the income tax code.  In 1986 Congress passed the Tax Reform Act of 1986 (TRA86). By 1988 the reform was fully implemented.  Wealthy taxpayers noticed that TRA86 sharply reduced the payoff to holding corporate earnings inside a separately taxed corporate entity. Rich business owners or shareholders could increase their after-tax income by arranging things so their business income was taxed only once, at the individual level.  The result was that a lot of income, once earned by and held within corporations, was now passed through to the tax returns of rich individual taxpayers. These taxpayers appeared to enjoy a sudden surge in their taxable incomes between 1986 and 1988.  No one seriously believes rich people failed to get the benefits of this income before 1987.  Before 1987 the same income simply showed up on corporate rather than on individual income tax returns.

A final point:  The chart displayed in SLIDE #6 is the source of the widely believed claim that U.S. inequality is nowadays about the same as it was at the end of the Roaring 1920s, before the Great Depression.  That is close to being true – under this income definition.

Census “money income”: This income definition is very similar to the one just discussed, except that it includes cash government transfer payments.  The producer of the series is the Census Bureau, and its most famous uses are to measure trends in real median household income and the official U.S. poverty rate. Furthermore, the Census Bureau uses the income definition to compile estimates of the Gini coefficient of household income inequality and the income shares received by each one-fifth of households, ranked from lowest to highest income, and received by the top 5 percent of households.

Here is a famous graph based on the Bureau’s “median household income” series.  I have normalized the historical series using the 1999 real median income level (1999 and 2000 were the peak income years according to Census data).  Since 1999 and 2000, median income has fallen about 10 percent.  If we accept this estimate without qualification, it certainly represents bad news for living standards of the nation’s middle class. The conclusion is contradicted by other government income statistics that use a broader, more inclusive income definition, however.

And here is the Bureau’s most widely cited distributional statistic (after its “official poverty rate” estimate).  Since 1979, the Gini coefficient has increased 17 percent under this income definition. (It is worth noting, however, that the portion of the increase that occurred between 1992 and 1993 is mainly the result of methodological changes in the way the Census Bureau ascertained incomes in its 1994 income survey.)

When you hear U.S. inequality compared with that in other rich countries, the numbers are most likely based on calculations of the LIS or OECD.  Their income definition is basically “Cash and Near-cash Public and Private income minus Income and Payroll taxes owed by households.”  Under this income definition, the U.S. looks relatively very unequal and America appears to have an exceptionally high poverty rate.  U.S. inequality has been rising under this income definition, as indeed has also been the case in most other rich countries. The increase in the United States has been above average, however, helping us to retain our leadership position, both in income inequality and in relative poverty.

We turn last to the most expansive income definition:  CBO’s measure of net after-tax income.  I will use CBO’s tabulations using this income definition to shed light on some of the inequality and living standard trends implied by the narrower income definitions discussed above.

Let’s consider some potential limitations of a couple of those definitions.  The limitations do not necessarily make them flawed or uninteresting.  They do mean the narrower income measures cannot tell us some of the things that users claim they tell us.

An obvious shortcoming of the “cash pretax private income” definition is that it excludes virtually everything the government does to equalize Americans’ incomes.  Believe it or not, the Federal tax system is mildly progressive.  It claims a bigger percentage of the (declared) incomes of the rich than it does of middle-income families’ and especially the poor.  Any pretax income measure will miss that redistribution.

More seriously, it excludes all government transfer payments.  You may think the rich get a bigger percentage of their income from government handouts compared with middle class and poorer households.  That is simply wrong.  The rich get a lot less.  And the percentage of total personal income that Americans derive from government transfer payments has gone way up over the years.  In the Roaring 1920s, Americans received almost nothing in the form of government transfers. Less than 1 percent of Americans’ incomes were received as transfer payments.  By 1970—near the low point of inequality according to the Piketty-Saez measure—8.3 percent of Americans’ personal income was derived from government transfers.  Last year, the share was 17 percent. None of the increase in government transfers is reflected in Piketty and Saez’s estimates of the trend in inequality.  Inequality is nowadays lower than it was in the late 1920s, mainly because the government does more redistribution through taxes and transfers.

Both the Piketty-Saez and the Census “money income” statistics are affected by the exclusion of government- and employer-provided health benefits from the income definition. This slide contains numbers, starting in 1960, that show the share of total U.S. personal consumption consisting of personal health care consumption.  I have divided the total into two parts. The first is the share that is paid for out of our own cash incomes (the blue part at the bottom).  This includes our out-of-pocket spending for doctors’ charges, hospital fees, pharmaceutical purchases, and other provider charges as well as our out-of-pocket spending on health insurance premiums. The second is the share of our personal health consumption that is paid out of government subsidies to Medicare, Medicaid, CHIP, etc., or out of employer subsidies to employee health plans (the red part). 

As everyone knows, the share of total consumption that consists of health consumption has gone way up.  What few people recognize is that the share that is directly paid by consumers—through payments to doctors, hospitals, and household health insurance premium payments—has remained unchanged.  All of the increase in the health consumption share since 1960 has been financed through government and employer subsidies to health insurance plans. None of those government or employer contributions is counted as “income” under the Piketty-Saez and Census “money income” definitions.  You would have to be quite a cynic to claim the subsidies have brought households no living standard improvements since 1960, yet that is how they are counted under the Piketty-Saez and Census “money income” definitions.

Final slide: How much has inequality gone up under income definitions that count all income sources and subtract the Federal income, payroll, corporation, and excise taxes we pay?  CBO gives us the numbers, though unfortunately its numbers end in 2011.

Here are CBO’s estimates of real income gains between 1979 and 2011.  These numbers show that real net incomes increased in every income category, from the very bottom to the very top.  They also show that real incomes per person have increased much faster at the top—over on the right—than in the middle or at the bottom—over on the left.  Still, contrary to a common complaint that all the income gains in recent years have been received by folks at the top, the CBO numbers suggest net income gains have been nontrivial among the poor and middle class as well as among top income recipients.

Suppose we look at trends in the more recent past, say, between 2000 and 2011.  That lower panel in this slide presents a very different picture from the one implied by the Census Bureau’s “money income” statistics.  Unlike the “money income numbers” [SLIDE #9], these show that inequality has declined since 2000.  Unlike the “money income numbers” [SLIDE #8], these show that incomes of middle-income families have improved since 2000.  There are a variety of explanations for the marked contrast between the Census Bureau and CBO numbers.  But a big one is the differing income definitions the two conclusions are based on.  The more inclusive measure of income shows faster real income gains among middle-income and poorer households, and it suggests a somewhat different trend in inequality.

Voters and policy makers bemoan our crumbling roads, airports, and public transit systems, but few jurisdictions do much about it. The odd thing is that historically low interest rates now make it cheap to fix or improve our public facilities. The mystery is why decision makers have passed on this opportunity.

The sorry state of the nation’s roads, bridges, and public infrastructure has been widely reported. Every few years the American Society of Civil Engineers draws up a report card on U.S. infrastructure, highlighting its strengths and shortcomings in a variety of areas—drinking water systems, wastewater, dams, roads, bridges, inland waterways, ports. The report card spotlights areas where spending on maintenance falls short of the amount needed to keep our infrastructure functioning efficiently. For many kinds of infrastructure, a bigger population and heavier utilization require us to invest in brand new facilities. In its latest report card, the ASCE awards our public infrastructure a grade of D+.

It’s hard to think of a time more attractive for public investment than years when total demand for goods and services is depressed. The Treasury’s borrowing cost for investment funds is near historical lows. Since 2011, the interest rate on 10-year government bonds has averaged 2.3 percent. Savers buying inflation-protected bonds have been willing to lend funds to the federal government at a real interest rate of just 0.22 percent.

So long as there is excess unemployment, especially in the building trades, the labor resources needed to fix or improve public facilities should be abundant and relatively inexpensive. Employment in the construction industry has rebounded as home building and business investment have improved. Nonetheless, construction employment has recovered only half the loss it experienced between its pre-recession peak in 2006 and its post-recession low in 2011. Skilled labor is not nearly as abundant as it was in 2011, but the trend in wage inflation does not suggest employers are bidding up worker salaries.

The federal government’s failure to use fiscal policy and, in particular, public investment policy to bring the nation closer to full employment represents a notable lapse in policymaking, perhaps the most grievous lapse since the crisis began. It unnecessarily prolonged the suffering of the nation’s long-term unemployed and it wasted a rare opportunity to rebuild the nation’s public infrastructure at relatively low cost.

Why did this failure occur? One reason is that policy makers were too optimistic when the financial crisis took place back in 2008. Most public and private forecasts at the time understated the severity of the economic fallout from the bank meltdown. Decision makers in Congress and the Administration may have believed infrastructure investment would be unhelpful in the recovery. Well-conceived infrastructure projects take many months to design and many years to complete. Policy makers may have believed the economic crisis would be over by the time federally infrastructure spending reached its peak.

When forecasters and Democratic policy makers recognized their error, voters had elected a Congress that supported only one kind of fiscal policy to deal with the crisis—big tax cuts focused on high-income tax payers. Whether or not such a policy could have been effective, it would not make additional funds available for infrastructure projects.

Harvard’s Lawrence Summers and Rachel Lipset recently pointed to another reason voters have failed to back a big program to boost infrastructure investment—government ineptitude. In the Boston Globe they documented the painfully slow progress of the Massachusetts Department of Transportation in overhauling a bridge across the Charles River. The bridge, which was built over 11 months back in 1912, has so far required four years for its reconstruction. No end date is in sight. In addition to the over-budget cost of the project, the overhaul has also caused massive and highly visible inconvenience for drivers, cyclists, and pedestrians trying to move between Boston and Cambridge.

Few readers can be under the illusion Boston’s experience is exceptional. Many of us pass near or use public facilities that are being rebuilt or repaired. We often see bafflingly little progress over a span of months or even years. As Summers and Lipset note, the conspicuous failure of public managers to complete capital projects speedily and on budget undermines voters’ confidence that infrastructure projects can be worthwhile.

Despite wide agreement the nation’s infrastructure needs to be modernized, we have made little progress toward that goal. On the contrary, government capital spending has shrunk significantly as a share of the economy. In 2014, net government investment spending on items other than defense dipped to a 60-year low when spending is measured as a percent of GDP. Using this indicator, net government investment has shrunk almost half compared with its level in the first decade of the century. For many reasons this is a good time to fix our public infrastructure. It is also an excellent time to overhaul public management of government capital projects.

Editor's note: This piece originally appeared in Inside Sources.

Unlike prime-age Americans, who have experienced declines in employment and labor force participation since the onset of the Great Recession, Americans past 60 have seen their employment and labor force participation rates increase.

In order to understand the contrasting labor force developments among the old, on the one hand, and the prime-aged, on the other, this paper develops and analyzes a new data file containing information on monthly labor force changes of adults interviewed in the Current Population Survey (CPS).

The paper documents notable differences among age groups with respect to the changes in labor force transition rates that have occurred over the past two decades. What is crucial for understanding the surprising strength of old-age labor force participation and employment are changes in labor force transition probabilities within and across age groups. The paper identifies several shifts that help account for the increase in old-age employment and labor force participation:

• Like workers in all age groups, workers in older groups saw a surge in monthly transitions from employment to unemployment in the Great Recession.
• Unlike workers in prime-age and younger groups, however, older workers also saw a sizeable decline in exits to nonparticipation during and after the recession. While the surge in exits from employment to unemployment tended to reduce the employment rates of all age groups, the drop in employment exits to nonparticipation among the aged tended to hold up labor force participation rates and employment rates among the elderly compared with the nonelderly. Among the elderly, but not the nonelderly, the exit rate from employment into nonparticipation fell more than the exit rate from employment into unemployment increased.
• The Great Recession and slow recovery from that recession made it harder for the unemployed to transition into employment. Exit rates from unemployment into employment fell sharply in all age groups, old and young.
• In contrast to unemployed workers in younger age groups, the unemployed in the oldest age groups also saw a drop in their exits to nonparticipation. Compared with the nonaged, this tended to help maintain the labor force participation rates of the old.
• Flows from out-of-the-labor-force status into employment have declined for most age groups, but they have declined the least or have actually increased modestly among older nonparticipants.

Some of the favorable trends seen in older age groups are likely to be explained, in part, by the substantial improvement in older Americans’ educational attainment. Better educated older people tend to have lower monthly flows from employment into unemployment and nonparticipation, and they have higher monthly flows from nonparticipant status into employment compared with less educated workers.

The policy implications of the paper are:

• A serious recession inflicts severe and immediate harm on workers and potential workers in all age groups, in the form of layoffs and depressed prospects for finding work.
• Unlike younger age groups, however, workers in older groups have high rates of voluntary exit from employment and the workforce, even when labor markets are strong. Consequently, reduced rates of voluntary exit from employment and the labor force can have an outsize impact on their employment and participation rates.
• The aged, as a whole, can therefore experience rising employment and participation rates even as a minority of aged workers suffer severe harm as a result of permanent job loss at an unexpectedly early age and exceptional difficulty finding a new job.
• Between 2001 and 2015, the old-age employment and participation rates rose, apparently signaling that older workers did not suffer severe harm in the Great Recession.
• Analysis of the gross flow data suggests, however, that the apparent improvements were the combined result of continued declines in age-specific voluntary exit rates, mostly from the ranks of the employed, and worsening reemployment rates among the unemployed. The older workers who suffered involuntary layoffs were more numerous than before the Great Recession, and they found it much harder to get reemployed than laid off workers in years before 2008. The turnover data show that it has proved much harder for these workers to recover from the loss of their late-career job loss.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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With Washington adrift and the United Nations climate change panel again calling for action, the search for new clean energy finance solutions continues.  

Against this backdrop, the Metro Program has worked with state- and city-oriented partners to highlight such responses as repurposing portions of states’ clean energy funds and creating state green banks.  Likewise, the Center for American Progress just recently highlighted the potential of securitization and investment yield vehicles, called yield cos. And last week an impressive consortium of financiers, state agencies, and philanthropies announced the creation of the Warehouse for Energy Efficiency Loans (WHEEL) aimed at bringing low-cost capital to loan programs for residential energy efficiency. WHEEL is the country’s first true secondary market for home energy loans—and a very big deal. 

Another big deal is the potential of bond finance as a tool for clean energy investment at the state and local level. That’s the idea advanced in a new paper released this morning that we developed with practitioners at the Clean Energy Group and the Council for Development Finance Authorities.

Over 100 years, the nation’s state and local infrastructure finance agencies have issued trillions of dollars’ worth of public finance bonds to fund the construction of the nation’s roads, bridges, hospitals, and other infrastructure—and literally built America. Now, as clean energy subsidies from Washington dwindle, these agencies are increasingly willing to finance clean energy projects, if only the clean energy community will embrace them.

So far, these authorities are only experimenting. However, the bond finance community has accumulated significant experience in getting to scale and knows how to raise large sums for important purposes by selling bonds to Wall Street. Accordingly, the clean energy community—working at the state and regional level—should leverage that expertise. The challenge is for the clean energy and bond finance communities to work collaboratively to create new models for clean energy bond finance in states, and so to establish a new clean energy asset class that can easily be traded in capital markets.

Along these lines, our new brief argues that state and local bonding authorities, clean energy leaders, and other partners should do the following: 

• Establish mutually useful partnerships between development finance experts and clean energy officials at the state and local government levels
• Expand and scale up bond-financed clean energy projects using credit enhancement and other emerging tools to mitigate risk and through demonstration projects
• Improve availability of data and develop standardized documentation so that the risks  and rewards of clean energy investments can be better understood
• Create a pipeline of rated and private placement deals, in effect a new clean energy asset class, to meet the demand by institutional investors for fixed-income clean energy securities

State and local bond finance represents a powerful but underutilized tool for future clean energy investment.

For 100 years, the nation’s state and local infrastructure finance agencies have issued trillions of dollars’ worth of public finance bonds to fund the construction of the nation’s roads, bridges, hospitals, and other infrastructure—and literally built America. Now, as clean energy subsidies from Washington dwindle, these agencies are increasingly willing to finance clean energy projects, if only the clean energy community will embrace them.

So far, these authorities are only experimenting. However, the bond finance community has accumulated significant experience in getting to scale and knows how to raise large amounts for important purposes by selling bonds to Wall Street. The challenge is therefore to create new models for clean energy bond finance in states and regions, and so to establish a new clean energy asset class that can easily be traded in capital markets. To that end, this brief argues that state and local bonding authorities and other partners should do the following:

• Establish mutually useful partnerships between development finance experts and clean energy officials at the state and local government levels
• Expand and scale up bond-financed clean energy projects using credit enhancement and other emerging tools to mitigate risk and through demonstration projects
• Improve the availability of data and develop standardized documentation so that the risks and rewards of clean energy investments can be better understood
• Create a pipeline of rated and private placement deals, in effect a new clean energy asset class, to meet the demand by institutional investors for fixed-income clean energy securities

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Nearly 30 years ago, the economists Robert Solow and Stephen Roach caused a stir when they pointed out that, for all the billions of dollars being invested in information technology, there was no evidence of a payoff in productivity. Businesses were buying tens of millions of computers every year, and Microsoft had just gone public, netting Bill Gates his first billion. And yet, in what came to be known as the productivity paradox, national statistics showed that not only was productivity growth not accelerating; it was actually slowing down. “You can see the computer age everywhere,” quipped Solow, “but in the productivity statistics.”

Today, we seem to be at a similar historical moment with a new innovation: the much-hyped Internet of Things – the linking of machines and objects to digital networks. Sensors, tags, and other connected gadgets mean that the physical world can now be digitized, monitored, measured, and optimized. As with computers before, the possibilities seem endless, the predictions have been extravagant – and the data have yet to show a surge in productivity.

A year ago, research firm Gartner put the Internet of Things at the peak of its Hype Cycle of emerging technologies.

As more doubts about the Internet of Things productivity revolution are voiced, it is useful to recall what happened when Solow and Roach identified the original computer productivity paradox. For starters, it is important to note that business leaders largely ignored the productivity paradox, insisting that they were seeing improvements in the quality and speed of operations and decision-making. Investment in information and communications technology continued to grow, even in the absence of macroeconomic proof of its returns.

That turned out to be the right response. By the late 1990s, the economists Erik Brynjolfsson and Lorin Hitt had disproved the productivity paradox, uncovering problems in the way service-sector productivity was measured and, more important, noting that there was generally a long lag between technology investments and productivity gains.

Our own research at the time found a large jump in productivity in the late 1990s, driven largely by efficiencies made possible by earlier investments in information technology. These gains were visible in several sectors, including retail, wholesale trade, financial services, and the computer industry itself. The greatest productivity improvements were not the result of information technology on its own, but by its combination with process changes and organizational and managerial innovations.

Our latest research, The Internet of Things: Mapping the Value Beyond the Hype, indicates that a similar cycle could repeat itself. We predict that as the Internet of Things transforms factories, homes, and cities, it will yield greater economic value than even the hype suggests. By 2025, according to our estimates, the economic impact will reach $3.9-$11.1 trillion per year, equivalent to roughly 11% of world GDP. In the meantime, however, we are likely to see another productivity paradox; the gains from changes in the way businesses operate will take time to be detected at the macroeconomic level.

One major factor likely to delay the productivity payoff will be the need to achieve interoperability. Sensors on cars can deliver immediate gains by monitoring the engine, cutting maintenance costs, and extending the life of the vehicle. But even greater gains can be made by connecting the sensors to traffic monitoring systems, thereby cutting travel time for thousands of motorists, saving energy, and reducing pollution. However, this will first require auto manufacturers, transit operators, and engineers to collaborate on traffic-management technologies and protocols.

Indeed, we estimate that 40% of the potential economic value of the Internet of Things will depend on interoperability. Yet some of the basic building blocks for interoperability are still missing. Two-thirds of the things that could be connected do not use standard Internet Protocol networks.

Other barriers standing in the way of capturing the full potential of the Internet of Things include the need for privacy and security protections and long investment cycles in areas such as infrastructure, where it could take many years to retrofit legacy assets. The cybersecurity challenges are particularly vexing, as the Internet of Things increases the opportunities for attack and amplifies the consequences of any breach.

But, as in the 1980s, the biggest hurdles for achieving the full potential of the new technology will be organizational. Some of the productivity gains from the Internet of Things will result from the use of data to guide changes in processes and develop new business models. Today, little of the data being collected by the Internet of Things is being used, and it is being applied only in basic ways – detecting anomalies in the performance of machines, for example.

It could be a while before such data are routinely used to optimize processes, make predictions, or inform decision-making – the uses that lead to efficiencies and innovations. But it will happen. And, just as with the adoption of information technology, the first companies to master the Internet of Things are likely to lock in significant advantages, putting them far ahead of competitors by the time the significance of the change is obvious to everyone.

Editor's Note: This opinion originally appeared on Project Syndicate August 6, 2015.

Introduction

I would like to thank the Department for giving me the opportunity to testify on this important issue. The document I submitted to you is more general than most of the comments you have received, talking about the issues facing retirement savers and policymakers, rather than engaging in a point-by-point discussion of the detailed DOL proposal¹.

Issues around Retirement Saving

1. Most workers in the bottom third of the income distribution will rely on Social Security to support them in retirement and will save little. Hence it is vital that we support Social Security in roughly its present form and make sure it remains funded, either by raising revenues or by scaling back benefits for higher income retirees, or both.

2. Those in the middle and upper middle income levels must now rely on 401k and IRA funds to provide income support in retirement. Many and perhaps most households lack a good understanding of the amount they need to save and how to allocate their savings. This is true even of many savers with high levels of education and capabilities.

3. The most important mistakes made are: not saving enough; withdrawing savings prior to retirement; taking Social Security benefits too early² ; not managing tax liabilities effectively; and failing to adequately manage risk in investment choices. This last category includes those who are too risk averse and choose low-return investments as well as those that overestimate their own ability to pick stocks and time market movements. These points are discussed in the paper I submitted to DoL in July. They indicate that retirement savers can benefit substantially from good advice.

4. The market for investment advice is one where there is asymmetric information and such markets are prone to inefficiency. It is very hard to get incentives correctly aligned. Professional standards are often used as a way of dealing with such markets but these are only partially successful. Advisers may be compensated through fees paid by the investment funds they recommend, either a load fee or a wrap fee. This arrangement can create an incentive for advisers to recommend high fee plans.

5. At the same time, advisers who encourage increased saving, help savers select products with good returns and adequate diversification, and follow a strategy of holding assets until retirement provide benefits to their clients.

Implications for the DoL’s proposed conflicted interest rule

1. Disclosure. There should be a standardized and simple disclosure form provided to all households receiving investment advice, detailing the fees they will be paying based on the choices they make. Different investment choices offered to clients should be accompanied by a statement describing how the fees received by the adviser would be impacted by the alternative recommendations made to the client.

2. Implications for small-scale savers. The proposed rule will bring with it increased compliance costs. These costs, combined with a reluctance to assume more risk and a fear of litigation, may make some advisers less likely to offer retirement advice to households with modest savings. These households are the ones most in need of direction and education, but because their accounts will not turn profits for advisors, they may be abandoned. According to the Employee Benefits Security Administration (EBSA), the proposed rule will save families with IRAs more than $40 billion over the next decade. However, this benefit must be weighed against the attendant costs of implementing the rule. It is possible that the rule will leave low- and medium-income households without professional guidance, further widening the retirement savings gap. The DoL should consider ways to minimize or manage these costs. Options include incentivizing advisors to continue guiding small-scale savers, perhaps through the tax code, and promoting increased financial literacy training for households with modest savings. Streamlining and simplifying the rules would also help.

3. Need for Research on Online Solutions. The Administration has argued that online advice may be the solution for these savers, and for some fraction of this group that may be a good alternative. Relying on online sites to solve the problem seems a stretch, however. Maybe at some time in the future that will be a viable option but at present there are many people, especially in the older generation, who lack sufficient knowledge and experience to rely on web solutions. The web offers dangers as well as solutions, with the potential for sub-optimal or fraudulent advice. I urge the DoL to commission independent research to determine how well a typical saver does when looking for investment advice online. Do they receive good advice? Do they act on that advice? What classes of savers do well or badly with online advice? Can web advice be made safer? To what extent do persons receiving online advice avoid the mistakes described earlier?

4. Pitfalls of MyRA. Another suggestion by the Administration is that small savers use MyRA as a guide to their decisions and this option is low cost and safe, but the returns are very low and will not provide much of a cushion in retirement unless households set aside a much larger share of their income than has been the case historically.

5. Clarifications about education versus advice. The proposed rule distinguished education from advisement. An advisor can share general information on best practices in retirement planning, including making age-appropriate asset allocations and determining the ideal age at which to retire, without triggering fiduciary responsibility. This is certainly a useful distinction. However, some advisors could frame this general information in a way that encourages clients to make decisions that are not in their own best interest. The DoL ought to think carefully about the line between education and advice, and how to discourage advisors from sharing information in a way that leads to future conflicts of interest. One option may be standardizing the general information that may be provided without triggering fiduciary responsibility.

6. Implications for risk management. Under the proposed rule advisors may be reluctant to assume additional risk and worry about litigation. In addition to pushing small-scale savers out of the market, the rule may encourage excessive risk aversion in some advisors. General wisdom suggests that young savers should have relatively high-risk portfolios, de-risking as they age, and ending with a relatively low-risk portfolio at the end of the accumulation period. The proposed rule could cause advisors to discourage clients from taking on risk, even when the risk is generally appropriate and the investor has healthy expectations. Extreme risk aversion could decrease both market returns for investors and the “value-add” of professional advisors. The DoL should think carefully about how it can discourage conflicted advice without encouraging overzealous risk reductions.

The proposed rule is an important effort to increase consumer protection and retirement security. However, in its current form, it may open the door to some undesirable or problematic outcomes. With some thoughtful revisions, I believe the rule can provide a net benefit to the country.

^{1. Baily’s work has been assisted by Sarah E. Holmes. He is a Senior Fellow at the Brookings Institution and a Director of The Phoenix Companies, but the views expressed are his alone.}

^{2. As you know, postponing Social Security benefits yields an 8 percent real rate of return, far higher than most people earn on their investments. For most of those that can manage to do so, postponing the receipt of benefits is the best decision.}

Downloads

• Download the full testimony

Earlier this summer, we examined how the Big Four banks – Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo – performed before, during, and after the 2007-09 financial crisis.  We also blogged about the lending trends within these large banks, expressing concern about the growing gap between deposits taken and loans made by the Big Four, and calling on policymakers to explore the issue further.  We have conducted a similar analysis on the regional banks - The regional banks: The evolution of the financial sector, Part II - and find that these smaller banks are actually faring somewhat better than their bigger counterparts.

Despite the mergers and acquisitions that happened during the crisis, the Big Four banks are a smaller share of banking today than they were in 2007.  The 15 regionals we evaluated, on the other hand, are thriving in the post-crisis environment and have a slightly larger share of total bank assets than they had in 2007.  The Big Four experienced rapid growth in the years leading up to the crisis but much slower growth in the years since.  The regionals, however, have been chugging along: with the exception of a small downward trend during the crisis, they have enjoyed slow but steady growth since 2003.

There is a gap between deposits and loans among the regionals, but it is smaller than the Big Four’s gap.  Tellingly, the regionals’ gap has remained basically constant in size during the recovery, unlike the Big Four’s gap, which is growing.  Bank loans are important to economic growth, and the regional banks are growing their loan portfolios faster than the biggest banks.  That may be a good sign for the future if the regional banks provide more competition for the big banks and a more competitive banking sector overall.

Community banks play a key role in their local communities by offering traditional banking services to households and lending to nearby small businesses in the commercial, agriculture, and real estate sectors. Because of their close relationship with small businesses, they drive an important segment of economic growth. In fact, compared to all other banks (and to credit unions), small banks devote the greatest share of their assets to small business loans.

In this paper, titled "The community banks: The evolution of the financial sector, Part III," (PDF) Baily and Montalbano examine the evolution of community banks before, through, and after the financial crisis to assess their recovery.

The authors find that despite concerns about the long-term survival of community banks due a decline in the number of banks and increased Dodd-Frank regulations, they continue to recover from the financial crisis and are in fact out-performing the Big Four banks in several key measures.

Although the number of community banks has been steadily declining since before 2003, most of the decline has come from the steep drop in the smallest banking organizations—those with total consolidated assets of less than $100 million. Community banks with total consolidated assets that exceed $300 million have in fact increased in number. Most of the decline in community banks can be attributed to the lack of entry into commercial banking.

In a previous paper, Baily and Montalbano showed that the gap in loans and leases among the Big Four has widened since the financial crisis, but the new research finds that community banks seem to be returning to their pre-crisis pattern, although slowly, with the gap between deposits and loans shrinking since 2011. While total deposits grew gradually after 2011, though at a pace slower than their pre-crisis rate, loans and leases bottomed out in 2011 at $1.219 trillion.

The authors also examine community banks' return on assets (ROA), finding it was lower overall than for the Big Four or for the regionals, and has come back to a level closer to the pre-crisis level than was the case for the larger banks. The level of profitability was slightly lower for community banks in 2003 than it was for the larger banks—about 1.1 percent compared to 1.7 percent for the regional banks—but it did not dip as low, reaching a bottom of about -0.1 percent compared to -0.8 percent for the regional banks.

Baily and Montalbano also find that total assets of the community banks increased 22.5 percent (adjusted for inflation, the increase was 7 percent); the average size of community banks has increased substantially; total bank liabilities grew steadily from 2003-2014; the composition of liabilities in post-crisis years looked largely similar to the composition in the pre-crisis years; and securitization—which plays a relatively small role in the community banking model—has been steadily increasing in the time period both before and after the crisis. 

To read more, download the full paper here.

The paper is the third in a series that examines how the financial sector has evolved over the periods both before and after the financial crisis of 2007-2008. The first paper examines the Big Four banks, and the second takes a closer look at regional banks.

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

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

You can join the conversation and tweet questions for the panelists at #CEAat70.

Video

• Panel 1: The CEA in Moments of Crisis
• Panel 2: The CEA and Policymaking
• Panel 3: Current Economic Policy Issues

Audio

• The Council of Economic Advisers: 70 years of advising the president

Transcript

• Uncorrected Transcript (.pdf)

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• 20160211_economic_advisers_transcript

Neel Kashkari, the newly appointed President of the Federal Reserve Bank of Minneapolis, is super-smart with extensive experience in the financial industry at Goldman Sachs and then running the government’s TARP program, but his call to break up the big banks misses the mark.

Sure, big banks, medium-sized banks and small banks all contributed to the devastating financial crisis, but so did the rating agencies and the state-regulated institutions (mostly small) that originated many of the bad mortgages.  It was vital that regulation be strengthened to avoid a repetition of what happened – and it has been.  There should never again be a situation where policymakers are faced with either bailing out failing institutions or letting them fail and seeing financial panic spread.

That’s why the Dodd-Frank Act gave the authorities a new tool to avoid that dilemma titled “Orderly Liquidation Authority,” which gives them the ability to fail a firm but sustain the key parts whose failure might cause financial instability.  Kashkari thinks that the authorities will not want to exercise this option in a crisis because they will be fearful of the consequences of imposing heavy losses on the original owners of the largest banks.  It’s a legitimate concern, but he underestimates the progress that has been made in making the orderly liquidation authority workable in practice.  He also underestimates the determination of regulators not to bail out financial institutions from now on.

To make orderly liquidation operational, the Federal Deposit Insurance Corporation (FDIC) devised something called the “single point of entry” approach, or SPOE, which provides a way of dealing with large failing banks.  The bank holding company is separated from the operating subsidiaries and takes with it all of the losses, which are then imposed on the shareholders and unsecured bond holders of the original holding company, and not on the creditors of the critical operating subs and not on  taxpayers.  The operating subsidiaries of the failing institution are placed into a new bank entity, and they are kept open and operating so that customers can still go into their bank branch or ATM and get their money, and the bank can still make loans to support household and business spending or the investment bank can continue to help businesses and households raise funds in securities markets.  The largest banks also have foreign subsidiaries and these too would stay open to serve customers in Brazil or Mexico.

This innovative approach to failing banks is not magic, although it is hard for most people to understand.  However, the reason that Kashkari and other knowledgeable officials have not embraced SPOE is that they believe the authorities will be hesitant to use it and will try to find ways around it.  When a new crisis hits, the argument goes, government regulators will always bail out the big banks.

First, let’s get the facts straight about the recent crisis.  The government did step in to protect the customers of banks of all sizes as well as money market funds.  In the process, they also protected most bondholders, and people who had lent money to the troubled institutions, including the creditors of Bear Stearns, a broker dealer, and AIG, an insurance company.  This was done for a good reason because a collapse in the banking and financial system more broadly would have been even worse if markets stopped lending to them.  Shareholders of banks and other systemically important institutions lost a lot of money in the crisis, as they should have.  The CEOs lost their jobs, as they should have (although not their bonuses).  Most bondholders were protected because it was an unfortunate necessity.

As a result of Dodd-Frank rules the situation is different now from what it was in 2007.  Banks are required to hold much more capital, meaning that there is more shareholder equity in the banks.  In addition, banks must hold long-term unsecured debt, bonds that essentially become a form of equity in the event of a bank failure.  It is being made clear to markets that this form of lending to banks will be subject to losses in the event the bank fails—unlike in 2008.  Under the new rules, both the owners of the shares of big banks and the holders of their unsecured bonds have a lot to lose if the bank fails, providing market discipline and a buffer that makes it very unlikely indeed that taxpayers would be on the hook for losses.

The tricky part is to understand the situation facing the operating subsidiaries of the bank holding company — the parts that are placed into a new bank entity and remain open for business.  The subsidiaries may in fact be the part of the bank that caused it to fail in the first place, perhaps by making bad loans or speculating on bad risks.  Some of these subsidiaries may need to be broken off and allowed to fail along with the holding company—provided that can be done without risking spillover to the economy.  Other parts may be sold separately or wound down in an orderly way.  In fact the systemically important banks are required to submit “living wills” to the FDIC and the Federal Reserve that will enable the critical pieces of a failing bank to be separated from the rest.

It is possible that markets will be reluctant to lend money to the new entity but the key point is that this new entity will be solvent because the losses, wherever they originated, have been taken away and the new entities recapitalized by the creditors of the holding company that have been “bailed in.”   Even if it proves necessary for the government to lend money to the newly formed bank entity, this can be done with reasonable assurance that the loans will be repaid with interest.  Importantly, it can be done through the orderly liquidation authority and would not require Congress to pass another TARP, the very unpopular fund that was used to inject capital into failing institutions.

There are proposals to enhance the SPOE approach by creating a new chapter of the bankruptcy code, so that a judge would control the failure process for a big bank and this could ensure there is no government bailout.  I support these efforts to use bankruptcy proceedings where possible, although I am doubtful if the courts could handle a severe crisis with multiple failures of global financial institutions.  But regardless of whether failing financial institutions are resolved through judicial proceedings or through the intervention of the FDIC (as specified under Title II of Dodd-Frank) the new regulations guaranty that shareholders and unsecured bondholders bear the losses so that the parts of the firm that are essential for keeping financial services going in the economy are kept alive.  That should assure the authorities that bankruptcy or resolution can be undertaken while keeping the economy relatively safe.

The Federal Reserve regulates the largest banks and it is making sure that the bigger the bank, the greater is the loss-absorbing buffer it must hold—and it will be making sure that systemically important nonbanks also have extra capital and can be resolved in an orderly manner.  Once that process is complete, it can be left to the market to decide whether or not it pays to be a big bank.  Regulators do not have to break up the banks or figure out how that would be done without disrupting the financial system.

Editor's note: This piece originally appeared in Bloomberg Government. 

For more than a decade, the economy’s rate of productivity growth has been dismal, which is bad news for workers since their incomes rise slowly or not at all when this is the case. Economists have struggled to understand why American productivity has been so weak. After all, with all the information technology innovations that make our lives easier like iPhones, Google, and Uber, why hasn’t our country been able to work more productively, giving us either more leisure time, or allowed us to get more done at work and paid more in return?

One answer often given is that the government statisticians must be measuring something wrong – notably, the benefits of Google and all the free stuff we can now access on our phones, tablets and computers. Perhaps government statisticians just couldn’t figure out how to include those new services in a meaningful way into the data?

A new research paper by Fed economists throws cold water on that idea. They think that free stuff like Facebook should not be counted in GDP, or in measures of productivity, because consumers do not pay for these services directly; the costs of providing them are paid for by advertisers. The authors point out that free services paid for by advertising are not new; for example, when television broadcasting was introduced it was provided free to households and much of it still is.

The Fed economists argue that free services like Google are a form of “consumer surplus,” defined as the value consumers place on the things they buy that is over and above the price they have paid. Consumer surplus has never been included in past measures of GDP or productivity, they point out. Economist Robert Gordon, who commented on the Fed paper at the conference where it was presented, argued that even if consumer surplus were to be counted, most of the free stuff such as search engines, e-commerce, airport check-in kiosks and the like was already available by 2004, and hence would not explain the productivity growth slowdown that occurred around that time.

The Fed economists also point out that the slowdown in productivity growth is a very big deal. If the rate of growth achieved from 1995 to 2004 had continued for another decade, GDP would have been $3 trillion higher, the authors calculate. And the United States is not alone in facing weak productivity; it is a problem for all developed economies. It is hard to believe that such a large problem faced by so many countries could be explained by errors in the way GDP and productivity are measured.

Even though I agree with the Fed authors that the growth slowdown is real, there are potentially serious measurement problems for the economy that predate the 2004 slowdown.

Health care is the most important example. It amounts to around 19% of GDP and in the official accounts there has been no productivity growth at all in this sector over many, many years. In part that may reflect inefficiencies in health care delivery, but no one can doubt that the quality of care has increased. New diagnostic and scanning technologies, new surgical procedures, and new drugs have transformed how patients are treated and yet none of these advances has been counted in measured productivity data. The pace of medical progress probably was just as fast in the past as it is now, so this measurement problem does not explain the slowdown. Nevertheless, trying to obtain better measures of health care productivity is an urgent task. The fault is not with the government’s statisticians, who do a tremendous job with very limited resources. The fault lies with those in Congress who undervalue good economic statistics.

Gordon, in his influential new book The Rise and Fall of American Growth, argues that the American engine of innovation has largely run its course. The big and important innovations are behind us and future productivity growth will be slow. My own view is that the digital revolution has not nearly reached an end, and advances in materials science and biotechnology promise important innovations to come. Productivity growth seems to go in waves and is impossible to forecast, so it is hard to say for sure if Gordon is wrong, but I think he is.

Fortune reported in June 2015 that 70% of its top 500 CEOs listed rapid technological change as their biggest challenge. I am confident that companies will figure out the technology challenge, and productivity growth will get back on track, hopefully sooner rather than later.

Editor’s note: This piece originally appeared in Fortune.

Twenty-five years ago, in March 1991, shaken by the fall of the Berlin Wall and the rise of nationalist-separatist movements in the Soviet Baltic and Caucasus republics, Mikhail Gorbachev held a historic referendum. He proposed the creation of a new union treaty to save the USSR. The gambit failed. Although a majority of the Soviet population voted yes, some key republics refused to participate. And so began the dissolution of the USSR, the event that current Russian President Vladimir Putin has called the “greatest geopolitical catastrophe” of the 20th century.

Today, in the wake of the referendum on leaving the European Union, British Prime Minister David Cameron seems to have put the United Kingdom on a similar, potentially catastrophic, path. Like the fall of the wall and the collapse of the Soviet Union, the fallout from Brexit could have momentous consequences. The U.K. is of course not the USSR, but there are historic links between Britain and Russia and structural parallels that are worth bearing in mind as the U.K. and the EU work out their divorce, and British leaders figure out what to do next, domestically and internationally.

A quick Russian history recap

The British and Russian empires formed at around the same time and frequently interacted. Queen Elizabeth I was pen pals with Ivan the Terrible. The union of the Scottish and English parliaments in 1707 that set the United Kingdom on its imperial trajectory coincided with the 1709 battle of Poltava, in which Peter the Great ousted the Swedes from the lands of modern Ukraine and began the consolidation of the Russian empire. The Russian imperial and British royal families intermarried, even as they jockeyed for influence in Central Asia and Afghanistan in the 19th century. The last Czar and his wife were respectively a distant cousin and granddaughter of British Queen Victoria. The Irish Easter Uprising and the Russian Revolution were both sparked by problems at home, imperial overstretch, and the shock of the World War I. 

Like the fall of the wall and the collapse of the Soviet Union, the fallout from Brexit could have momentous consequences.

Since the end of the Cold War, the U.K. and Russia have both had difficulty figuring out their post-imperial identities and roles. The U.K. in 2016 looks structurally a lot like the USSR in 1991, and England’s current identity crisis is reminiscent of Russia’s in the 1990s. After Gorbachev’s referendum failed to shore up the union, the Soviet Union was undermined by an attempted coup (in August 1991) and then dismantled by its national elites. In early December 1991, Boris Yeltsin, the flamboyant head of the Russian Federation, holed up in a hut deep in the Belarusian woods with the leaders of Ukraine and Belarus and conspired to replace the USSR with a new Commonwealth of Independent States (CIS). With Gorbachev and the Soviet Union gone by the end of December, the hangover set in. Boris Yeltsin was the first to rue the consequences of his actions. The CIS never gained traction as the basis for a new union led by Russia. 

The Ukrainians, Belarussians, and everyone else gained new states and new identities and used the CIS as a mechanism for divorce. Russians lost an empire, their geopolitical anchor, and their identity as the first among equals in the USSR. The Russian Federation was a rump state. And although ethnic Russians were 80 percent of the population, the forces of disintegration continued. Tatars, Chechens, and other indigenous peoples of the Russian Federation, with their own histories, seized or agitated for independence. Ethnic Russians were “left behind” in other republics. Historic territories were lost. Instead of presiding over a period of Russian independence, Boris Yeltsin muddled through a decade of economic collapse and political humiliation.

Separating the U.K. from Europe...could be as wrenching as pulling apart the USSR.

Is Britain laying the same trap?

Another Boris, the U.K.’s Boris Johnson, the former mayor of London and main political opponent of David Cameron, risks doing the same if he becomes U.K. prime minister in the next few months. Separating the U.K. from Europe institutionally, politically, and economically could be as wrenching as pulling apart the USSR. People will be left behind—EU citizens in the U.K., U.K. citizens in the EU––and will have to make hard choices about who they are, and where they want to live and work. The British pound has already plummeted. The prognoses for short- to medium-term economic dislocation have ranged from gloomy to dire. The U.K is a multi-ethnic state, with degrees of devolved power to its constituent parts, and deep political divides at the elite and popular levels. Scotland and Northern Ireland, along with Gibraltar (a contested territory with Spain), clearly voted to stay in the European Union. The prospect of a new Scottish referendum on independence, questions about the fate of the Irish peace process, and the format for continuing Gibraltar’s relationship with Spain, will all complicate the EU-U.K. divorce proceedings. 

Like Russia and the Russians, England and the English are in the throes of an identity crisis.

Like Russia and the Russians, England and the English are in the throes of an identity crisis. England is not ethnically homogeneous. In addition to hundreds of thousands of Irish citizens living in England, there are many more English people with Irish as well as Scottish ancestry––David Cameron’s name gives away his Scottish antecedents––as well as those with origins in the colonies of the old British empire. And there are the EU citizens who have drawn so much ire in the Brexit debate. 

As in the case of the USSR and Russia where all roads led (and still lead) to Moscow, London dominates the U.K.’s population, politics, and economics. London is a global city that is as much a magnet for international migration as a center of finance and business. London voted to remain in Europe. The rest of England, London’s far flung, neglected, and resentful hinterland, voted to leave the EU—and perhaps also to leave London. At the end of the divorce process, without careful attention from politicians in London, England could find itself the rump successor state to the United Kingdom. If so, another great imperial state will have consigned itself to the “dust heap of history” by tying its future to a referendum. 

Fiona Hill, director of the Center on the United States and Europe at Brookings and a senior fellow in Foreign Policy, discusses the decision of a majority of voters in Britain to leave the E.U. and the consequences of Brexit for the country’s economy, politics, position as a world power, and implications for its citizens.

Show Notes

Mr. Putin (New and Expanded)

The "greatest catastrophe" of the 21st century?

Brexit and the dissolution of the U.K. Brexit—in or out? Implications of the United Kingdom’s referendum on EU membership

EU: how to decide (Anand Menon)

Thanks to audio engineer and producer Zack Kulzer, with editing help from Mark Hoelscher, plus thanks to Carisa Nietsche, Bill Finan, Jessica Pavone, Eric Abalahin, Rebecca Viser, and our intern Sara Abdel-Rahim.

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Event Information

On July 20 and 21, defense ministers from several nations will gather in Washington, D.C. at the invitation of U.S. Secretary of Defense Ash Carter. The meeting will bring together representatives from countries working to confront and defeat the Islamic State (or ISIL). French Defense Minister Jean-Yves Le Drian will be among those at the summit discussing how to accelerate long-term efforts to fight ISIL in Iraq and Syria. The close relationship between France and the United States has provided a solid base for security cooperation for decades, and in recent years, France has become one of America’s strongest allies in fighting terrorism and a prominent member of the international coalition to defeat ISIL.

On July 20, the Foreign Policy program at Brookings hosted Minister Le Drian for a discussion on French and U.S. cooperation as the two countries face multiple transnational security threats. Since becoming France’s defense minister in 2012, Le Drian has had to address numerous new security crises emerging from Africa, the Middle East, and within Europe itself. France faced horrific terrorist attacks on its own soil in January and November 2015 and remains under a state of emergency with its armed forces playing an active role in maintaining security both at home and abroad. Le Drian recently authored “Qui est l’ennemi?” (“Who is the enemy?”, Editions du Cerf, May 2016), defining a comprehensive strategy to address numerous current threats.

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Video

• Introduction and featured speaker
• Discussion
• Introduction et conférencier invité
• Débat

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20160720_france_defense_transcript