Financial advisors offer their clients many advantages, such as setting reasonable savings goals, avoiding fraudulent investments and mistakes like buying high and selling low, and determining the right level of risk for a particular household. However, these same advisors are often incentivized to choose funds that increase their own financial rewards, and the nature and amount of the fees received by advisors may not be transparent to their clients, and small-scale savers may not be able to access affordable advice at all.  What is in the best interest of an individual may not be in the best interest of his or her financial advisor.

To combat this problem, the Department of Labor (DoL) recently proposed a regulation designed to increase consumer protection by treating some investment advisors as fiduciaries under ERISA and the 1986 Internal Revenue Code.  The proposed conflict of interest rule is an important step in the right direction to increasing consumer protections.  It addresses evidence from a February 2015 report by the Council of Economic Advisers suggesting that consumers often receive poor recommendations from their financial advisors and that as a result their investment returns on IRAs are about 1 percentage point lower each year.   Naturally, the proposal is not without its controversies and it has already attracted at least 775 public comments, including one from us .

For us, the DoL’s proposed rule is a significant step in the right direction towards increased consumer protection and retirement security.  It is important to make sure that retirement advisors face the right incentives and place customer interests first.  It is also important make sure savers can access good advice so they can make sound decisions and avoid costly mistakes.  However, some thoughtful revisions are needed to ensure the rule offers a net benefit. 

If the rule causes advisors’ compliance costs to rise, they may abandon clients with small-scale savings, since these clients will no longer be profitable for them.  If these small-scale savers are crowded out of the financial advice market, we might see the retirement savings gap widen.  Therefore we encourage the DoL to consider ways to minimize or manage these costs, perhaps by incentivizing advisors to continue guiding these types of clients.  We also worry that the proposed rule does not adequately clarify the difference between education and advice, and encourage the DoL to close any potential loopholes by standardizing the general educational information that advisors can share without triggering fiduciary responsibility (which DoL is trying to do).  Finally, the proposed rule could encourage some advisors to become excessively risk averse in an overzealous attempt to avoid litigation or other negative consequences.  Extreme risk aversion could decrease market returns for investors and the ‘value-add’ of professional advisors, so we suggest the DoL think carefully about discouraging conflicted advice without also discouraging healthy risk.

The proposed rule addresses an important problem, but in its current form it may open the door to some undesirable or problematic outcomes.  We explore these issues in further detail in our recent paper.

Americans are enjoying longer lifespans than ever before. Living longer affords individuals the opportunity to make more contributions to the world, to spend more time with their loved ones, and to devote more years to their favorite activities – but a longer life, and particularly a longer retirement, is also expensive. The retirement security landscape is evolving as workers, employers, retirees, and financial services companies find their needs shifting. Once, many workers planned to stay with a single employer for most or all of their careers, building up a sizeable pension and looking forward to a comfortable retirement. Today, workers more and more workers will be employed by many different employers.  Additionally, generous defined benefit (DB) retirement plans are less popular than they once were – though they were never truly commonplace – and defined contribution (DC) plans are becoming ever more prevalent.  

Figure 1, below, shows the change from DB to DC that has occurred over the past three decades.

In the past many retirees struggled financially towards the end of their lives, just as they do now, but even so, the changes to the retirement security landscape have been real and marked, and have had a serious impact on workers and retirees alike. DB plans are dwindling, DC plans are on the rise, and as a result individuals must now take a more active role in managing their retirement savings. DC plans incorporate contributions from employees and employers alike, and workers much choose how to invest their nest egg.  When a worker leaves a job for retirement or for a different job he or she will often roll over the money from a 401(k) plan into an Individual Retirement Account (IRA). While having more control over one’s retirement funds might seem on its face to be a net improvement, the reality is that the average American lacks the financial literacy to make sound decisions (SEC 2012).

The Council of Economic Advisers (CEA) expressed concern earlier this year that savers with IRA accounts may receive poor investment advice, particularly in cases where their financial advisors are compensated through fees and commissions. “[The] best recommendation for the saver may not be the best recommendation for the adviser’s bottom line” (CEA 2015). President Obama echoed these concerns in a speech at AARP in February, asking the Department of Labor (DoL) to update its rules for financial advisors to follow when handling IRA accounts (White House 2015). The DoL receives its authority to craft such rules and requirements from the 1974 Employee Retirement Income Security Act (ERISA) (DoL 2015a).

The DoL recently proposed a regulation designed to increase consumer protection by treating some investment advisors as fiduciaries under ERISA and the 1986 Internal Revenue Code (DoL 2015b). The proposed rule has generated heated debate, and some financial advisors have responded with great concern, arguing that it will be difficult or impossible to comply with the rule without raising costs to consumers and/or abandoning smaller accounts that generate little or no profit. Advisors who have traditionally offered only the proprietary products of a single company worry that the business model they have used for many years will no longer be considered to be serving the best interests of clients.

Rather than offering detailed comments on the DoL proposals, this paper will look more broadly at the problem of saving for retirement and the role for professional advice. This is, of course, a well-travelled road with a large literature by academics, institutions and policy-makers, however, it is worthwhile to think about market failures, lack of information and individual incentives and what they imply for the investment advice market.

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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.}

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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.

Mercutio: I am hurt. A plague a’ both your houses! I am sped. Is he gone and hath nothing? — Romeo and Juliet, Act 3, scene 1, 90–92

The eurozone crisis, which includes the Greek crisis but is not restricted to it, has undermined the credibility of the EU institutions and left millions of Europeans disillusioned with the European Project. The euro was either introduced too early, or it included countries that should never have been included, or both were true. High rates of inflation left countries in the periphery uncompetitive and the constraint of a single currency removed a key adjustment mechanism. Capital flows allowed this problem to be papered over until the global financial crisis hit.

The leaders of the international institutions, the European Commission, the European Central Bank, and the International Monetary Fund, together with the governments of the stronger economies, were asked to figure out a solution and they emphasized fiscal consolidation, which they made a condition for assistance with heavy debt burdens. The eurozone as a whole has paid the price, with real GDP in the first quarter of 2015 being about 1.5 percent below its peak in the first quarter of 2008, seven years earlier, and with a current unemployment rate of 11 percent. By contrast, the sluggish U.S. recovery looks rocket-powered, with GDP 8.6 percent above its previous peak and an unemployment rate of 5.5 percent.

The burden of the euro crisis has been very unevenly distributed, with Greece facing unemployment of 25 percent and rising, Spain 23 percent, Italy 12 percent, and Ireland 9.7 percent, while German unemployment is 4.7 percent. It is not surprising that so many Europeans are unhappy with their policy leaders who moved too quickly into a currency union and then dealt with the crisis in a way that pushed countries into economic depression. The common currency has been a boon to Germany, with its $287 billion current account surplus, but the bane of the southern periphery. Greece bears considerable culpability for its own problems, having failed to collect taxes or open up an economy full of competitive restrictions, but that does not excuse the policy failures among Europe’s leaders. A plague on both sides in the Greek crisis!

During the Great Moderation, it seemed that the Bretton Woods institutions were losing their usefulness because private markets could provide needed funding. The financial crisis and the global recession that followed it shattered this belief. The IMF did not foresee the crisis, nor was it a central player in dealing with the period of greatest peril from 2007 to 2009. National treasuries, the Federal Reserve, and the European Central Bank were the only institutions that had the resources and the power to deal with the bank failures, the shortage of liquidity, and the freezing up of markets. Still, the IMF became relevant again and played an important role in the euro crisis, although at the cost of sharing the unpopularity of the policy response to that crisis.

China’s new Asian Infrastructure Investment Bank is the result of China’s growing power and influence and the failure of the West, particularly the United States, to come to terms with this seismic shift. The Trans-Pacific Partnership trade negotiations have deliberately excluded China, the largest economy in Asia and largest trading partner in the world. Reform of the governance structure of the World Bank and the IMF has stalled with disproportionate power still held by the United States and Europe. Unsurprisingly, China has decided to exercise its influence in other ways, establishing the new Asian bank and increasing the role of the yuan in international transactions. U.S. policymakers underestimated China’s strength and the willingness of other countries to cooperate with it, and the result has been to reduce the role and influence of the Bretton Woods institutions.

Can the old institutions be reinvented and made more effective? In Europe, the biggest problem is that bad decisions were made by national governments and by the international institutions (although the ECB policies have been generally good). The World Bank and IMF do need to reform their governance, but it may be too late to bring China back into the fold.

Can this sector be saved? We often hear sentiments like: "Does America still produce anything?" and "The good jobs in manufacturing have all gone." There is nostalgia for the good old days when there were plentiful well-paid jobs in manufacturing. And there is anger that successive U.S. administrations of both parties have negotiated trade deals, notably NAFTA and the admission of China into the World Trade Organization, that have undercut America's manufacturing base.

Those on the right suggest that if burdensome regulations were lifted, this would fire up a new era of manufacturing prowess. On the left, it is claimed that trade agreements are to blame and, at the very least, we should not sign any more of them. Expanding union power and recruiting are another favorite solution. Despite his position on the right, Donald Trump has joined those on the left blaming China for manufacturing’s problems.

What is the real story and what needs to be done to save this sector? The biggest factor transforming manufacturing has been technology; and technology will largely determine its future.

Disappearing jobs

Employment in the manufacturing sector declined slowly through the 1980s and 1990s, but since 2000, the decline has been much faster falling by over 6 million workers between 2000 and 2010. There were hopes that manufacturing jobs would regain much of their lost ground once the recession ended, but the number of jobs has climbed by less than a million in the recovery so far and employment has been essentially flat since the first quarter of 2015. Manufacturing used to be a road to the middle class for millions of workers with just a high school education, but that road is much narrower today—more like a footpath. In manufacturing’s prime, although not all jobs were good jobs, many were well paid and offered excellent fringe benefits. Now there are many fewer of these.

Sustained but slow output growth

The real output of the manufacturing sector from 2000 to the present gives a somewhat more optimistic view of the sector, with output showing a positive trend growth, with sharp cyclical downturns. There was a peak of manufacturing production in 2000 with the boom in technology goods, most of which were still being produced in the U.S. But despite the technology bust and the shift of much of high-tech manufacturing overseas, real output in the sector in 2007 was still nearly 11 percent higher than its peak in 2000.

Production fell in the Great Recession at a breathtaking pace, dropping by 24 percent starting in Q3 2008. Manufacturing companies were hit by a bomb that wiped out a quarter of their output. Consumers were scared and postponed the purchase of anything they did not need right away. The production of durable goods, like cars and appliances, fell even more than the total. Unlike employment in the sector, output has reclaimed it previous peak and, by the third quarter of 2015, was 3 percent above that peak. The auto industry has recovered particularly strongly. While manufacturing output growth is not breaking any speed records, it is positive.

Understanding the pattern

The explanation for the jobs picture is not simple, but the Cliff Notes version is as follows: manufacturing employment has been declining as a share of total economy-wide employment for 50 years or more—a pattern that holds for all advanced economies, even Germany, a country known for its manufacturing strength. The most important reason for U.S. manufacturing job loss is that the overall economy is not creating jobs the way it once did, especially in the business sector. This conclusion probably comes as a surprise to most Americans who believe that international trade, and trade with China in particular, is the key reason for the loss of jobs. In reality, trade is a factor in manufacturing weakness, but not the most important one.

The most important reason for U.S. manufacturing job loss is that the overall economy is not creating jobs the way it once did, especially in the business sector.

The existence of our large manufacturing trade deficit with Asia means output and employment in the sector are smaller than they would be with balanced trade. Germany, as noted, has seen manufacturing employment declines also, but the size of their manufacturing sector is larger than ours, running huge trade surplus. In addition, right now that there is global economic weakness that has caused a shift of financial capital into the U. S. looking for safety, raising the value of the dollar and thus hurting our exports. In the next few years, it is unlikely that the U.S. trade deficit will improve—and it may well worsen.

Even though it will not spark a jobs revival, manufacturing is still crucial for the future of the U.S. economy, remaining a center for innovation and productivity growth and if the U.S. trade deficit is to be substantially reduced, then manufacturing must become more competitive. The services sector runs a small trade surplus and new technologies are eliminating our energy trade deficit. Nevertheless a substantial expansion of manufactured exports is needed if there is to be overall trade balance.

Disruptive innovation in manufacturing

The manufacturing sector is still very much alive and reports of its demise are not just premature but wrong. If we want to encourage the development of a robust competitive manufacturing sector, industry leaders and policymakers must embrace new technologies. The sector will be revived not by blocking new technologies with restrictive labor practices or over-regulation but by installing them—even if that means putting robots in place instead of workers. To speed the technology revolution, however, help must be provided to those whose jobs are displaced. If they end up as long-term unemployed, or in dead-end or low-wage jobs, then not only do these workers lose out but also the benefits to society of the technology investment and the productivity increase are lost.

The manufacturing sector performs 69 percent of all the business R&D in the U.S. which is powering a revolution that will drive growth not only in manufacturing but also in the broader economy as well. The manufacturing revolution can be described by three key developments:

1. In the internet of things, sensors are embedded in machines, transmitting information that allows them to work together and report impending maintenance problems before there is a breakdown.
2. Advanced manufacturing includes 3-D printing, new materials and the “digital thread” which connects suppliers to the factory and the factory to customers; it breaks down economies of scale allowing new competitors to enter; and it enhances speed and flexibility.
3. Distributed innovation allows crowdsourcing is used to find radical solutions to technical challenges much more quickly and cheaply than with traditional R&D.

In a June 2015 Fortune 500 survey, 72 percent of CEOs reported their biggest challenge is that technology is changing fast, naming it as their number one challenge. That new technology churn is especially acute in manufacturing. The revolution is placing heavy demands on managers who must adapt their businesses to become software companies, big data companies, and even media companies (as they develop a web presence). Value and profit in manufacturing is shifting to digital assets. The gap between current practice and what it takes to be good at these skills is wide for many manufacturers, particularly in their ability to find the talent they need to transform their organizations.

Recent OECD analysis highlighted the large gap between best-practice companies and average companies. Although the gap is smaller in manufacturing than in services because of the heightened level of global competition in manufacturing, it is a sign that manufacturers must learn how to take advantage of new technologies quickly or be driven out of business.

Closing the trade deficit

A glaring weakness of U.S. manufacturing is its international trade performance. Chronic trade deficits have contributed to the sector’s job losses and have required large-scale foreign borrowing that has made us a net debtor to the rest of the world -- to the tune of nearly $7 trillion by the end of 2014. Running up endless foreign debts is a disservice to our children and was one source of the instability that led to the financial crisis. America should try to regain its balance as a global competitor and that means, at the least, reducing the manufacturing trade deficit. Achieving a significant reduction in the trade deficit will be a major task, including new investment and an adjustment of today’s overvalued dollar.

The technology revolution provides an opportunity, making it profitable to manufacture in the U.S. using highly automated methods. Production can be brought home, but it won’t bring back a lot of the lost jobs. Although the revolution in manufacturing is underway and its fate is largely in the hands of the private sector, the policy environment can help speed it up and make sure the broad economy benefits.

First, policymakers must accept that trying to bring back the old days and old jobs is a mistake. Continuing to chase yesterday’s goals isn’t productive, and at this point it only puts off the inevitable. Prioritizing competitiveness, innovativeness, and the U.S. trade position over jobs could be politically difficult, however, so policymakers should look for ways to help workers who lose jobs and communities that are hard hit. Government training programs have a weak track record, but if companies do the training or partner with community colleges, then the outcomes are better. Training vouchers and wage insurance for displaced workers can help them start new careers that will mostly be in the service sector where workers with the right skills can find good jobs, not just dead-end ones.

Second, a vital part of the new manufacturing is the ecosystem around large companies. There were 50,000 fewer manufacturing firms in 2010 than in 2000, with most of the decline among smaller firms. Some of that was inevitable as the sector downsized, but it creates a problem because as large firms transition to the new manufacturing, they rely on small local firms to provide the skills and even the technologies they do not have in-house. The private sector has the biggest stake in developing the ecosystems it needs, but government can and has helped, particularly at the state and local level. Sometimes infrastructure investment is needed, land can be set aside, mentoring programs can be established for young firms, help can be given in finding funding, and simplified and expedited permitting processes instituted.

It is hard to let go of old ways of thinking. Policymakers have been trying for years to restore the number of manufacturing jobs, but that is not an achievable goal. Yes manufacturing matters; it is a powerhouse of innovation for our economy and a vital source of competitiveness. There will still be good jobs in manufacturing but it is no longer a conveyor belt to the middle class. Policymakers need to focus on speeding up the manufacturing revolution, funding basic science and engineering, and ensuring that tech talent and best-practice companies want to locate in the United States.

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)

Event Materials

• 20160211_economic_advisers_transcript

The support for Bernie Sanders among young people has stirred a debate about the merits of the American style of a market economy versus the European version, and particularly the Nordic version of capitalism seen in Denmark.

Of course, the chances that Sanders will actually become president are remote and the chances of his enacting his program, if he were to become president, are even more remote. Still, the debate is an interesting one. David Brooks (writing in his New York Times column February 12, 2016) says that Denmark and similar economies in Europe are stagnant and lack the dynamism of America. Sanders’ supporters wrote in response, pointing to the strengths of Denmark: the absence of extreme poverty, the guaranty of good quality health care, and the availability of free college education.

Denmark gets a lot of things right. It provides universal health care of high quality at only a fraction of the cost of the U.S. system. Health outcomes are at least as good as in the United States with Danish wait-times similar to those we have here and infant mortality much lower. Denmark also does well in its primary and secondary education and in its labor market programs. They use tough love on those who are out of work, providing generous income support and training, but if they do not find a job or accept one that is found for them, the unemployed lose their benefits. The Danish “flexicurity” system is much admired because it combines a flexible labor market with income security. People are not guaranteed to keep the job they are in, but they are pretty much guaranteed that they can have a job.

Brooks is correct in pointing to the negative impact of very high tax rates on work. In the Nordic economies and in Germany, the employment rate is high but people work a lot fewer hours than workers in the U.S. On average, employed workers work 1,788 hours a year in the U.S. and only 1,438 in Denmark, and even less in Germany at 1,363, according to the OECD. Of course the Europeans are choosing to work shorter hours, but that choice is made in the face of very high taxes. Consider a busy professional couple in Denmark who want a renovation done to their home. They take home only a fraction of their salary after paying taxes and then they pay a plumber or an electrician to work on their house, and each of these tradespeople gets to keep only a fraction of what they charge for their services. The couple may find it is better to forget about the renovation, or hire people off the books to avoid the prohibitive double taxation.

In terms of innovation, Europe does not have the equivalent of Silicon Valley or the innovation hubs around Cambridge, Massachusetts, or the National Institutes of Health in Maryland. These creative centers generate innovations made in the U.S. that spread around the world and benefit everyone. Denmark is too small to sustain such centers by itself, but the problem extends to Europe more broadly, where policymakers struggle to match American innovation. Brooks is also correct about the danger of universal free college education. Those who graduate from four-year colleges will usually be in the upper half of the income distribution and should not expect to get a free ride from taxpayers who are making far less themselves. At the same time, creating broad financial support to allow children from low-income families to attend college while avoiding crippling debts is absolutely the right policy.

The U.S. is an exceptional country with a dynamic and successful economy. Europe would profit from copying the innovation culture of America. American capital markets, notwithstanding the financial crisis, are much more efficient than those in Europe and offer financial support and mentoring to start-up companies. Going the other way, America could learn about ways to retrain workers and avoid the desperate poverty that afflicts too many of our citizens. We could learn about the benefits of negotiating for lower prices from doctors, hospitals and drug companies. Whoever wins the White House should be secure in their belief about America’s strengths and vitality, while admitting that we can learn from what other countries do well.

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The financial crisis is now eight years behind us, but its legacy lingers on. Many Americans are concerned about their financial security and are particularly worried about whether they will have enough for retirement. Guaranteed benefit pensions are gradually disappearing, leaving households to save and invest for themselves. What role could equities play for retail investors?

Another concern about the lingering impact of the crisis is that business investment and overall economic growth remains weak compared to expectations. Large companies are able to borrow at low interest rates, yet many of them have large cash holdings. However, many small and medium sized enterprises face difficulty funding their growth, paying high risk premiums on their borrowing and, in some cases, being unable to fund investments they would like to make. Equity funding can be an important source of growth financing.

On Friday, April 15, the Initiative on Business and Public Policy at Brookings examined what role equity markets can play for individual retirement security, small business investment and whether they can help jumpstart American innovation culture by fostering the transition from startups to billion dollar companies.

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

Video

• Keynote address by Richard G. Ketchum
• Panel Discussion
• Keynote address by Roger Ferguson

Audio

• Not just for the professionals? Understanding equity markets for retail and small business investors

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• Equity Markets Retirement Security 2016 Apr 15 (2)
• 20160415_equity_markets_transcript

A major oil spill will result in cleanup spending that boosts GDP, but no one thinks oil spills are good. Oil spills and other forms of pollution are examples of negative externalities — harm caused to others by the economic activity of a firm or industry. These externalities represent a failure of the market, and unless there is corrective action, their presence means that there is too much production of something that causes negative spillovers.

That criticism can be applied to the financial services industry. Many say that it grew too large, triggered a financial crisis and damaged the rest of the economy. Is that still the case, and is financialization spoiling the economy? Despite the alarmist rhetoric around today’s finance sector, the answer is generally “no” because of changes made to financial regulation.

First, a check on the facts: How large is the industry and how much has it grown? The broad definition of the financial sector includes finance, insurance and real estate, known by the acronym “FIRE.” It was 17.5 percent of gross domestic product in 1990 and rose to 20.0 percent in 2014, but that figure is misleading as it includes office and apartment rents and leases — stuff that has little to do with Wall Street.

Finance and insurance separately peaked well before the financial crisis at 7.7 percent of GDP, which was up from 5.8 percent in 1990. In 2014, it was 7.0 percent of GDP. Employment in finance and insurance has been on a downtrend since 2003 and is currently 4.25 percent of total nonfarm payrolls. Most of those jobs are in offices and bank branches around the country. (The output data given here are drawn from the Bureau of Economic Analysis, GDP by Industry data. The employment data are from the Bureau of Labor Statistics, Payroll Employment data. Author’s calculations.)

Still, salaries and bonuses at the top are extremely attractive, so perhaps the externality plays out by drawing the best and brightest away from other more productive activities. The Harvard Crimson reported that in 2007, 23 percent of graduating Harvard seniors said they planned to enter finance. That is an impressive number, but things turned around sharply, with the 23 percent figure falling to 11.5 percent in 2009 after the financial crisis. At this point, the financial industry really isn’t large enough to crowd out other parts of the economy.

Meanwhile, the insurance industry serves an important social purpose providing life, property, and casualty insurance. AIG got into trouble in the crisis because it strayed into providing very risky financial services, not because of its main insurance business. Likewise, the core value of banks is financial intermediation between savers and investors, giving savers relatively secure and liquid assets while also funding investment.

There are critics of how well our banking industry serves this core purpose, a quality that is hard to determine. My judgment is that it does the job pretty well compared to most other countries. As the IMF reported in September 2015, the non-performing loan problem among European banks remains severe, whereas most U.S. banks now have strong balance sheets. Good financial intermediation means that most of the savings dollars are transferred to investors and are not lost through inefficient bank operations. A 2002 study that I participated in found bank productivity higher in the United States than in France or Germany.

The parts of the financial sector that give rise to the most concern are market-making, deal-making and the creation and trading of derivatives on Wall Street. The volume of market trading has increased exponentially because of the increased speed of computers and communications. Up to a certain point, the increased volume is helpful because it adds to the liquidity of markets, but the advent of high-frequency trading has taken us over the top. As Michael Lewis describes in his book Flash Boys, the high speed traders are finding ways to shave milliseconds off the time needed to make trades. That is thoroughly wasteful. As for deal-making, it has been going on for a long time — indeed the go-go years for deals were in the 1980s — so it is hard to blame the recent slowing of economic growth on this activity.

Still, the explosion of derivatives and other overly-complex instruments was problematic, and it is crystal clear that the mortgage market became too opaque and removed accountability from the system. The layering of complex derivatives on top of lousy mortgages (and other shaky assets) distorted the economy, resulted in the overbuilding of houses, and caused the financial crisis. There are plenty of people at fault besides the bankers, but the smart people on Wall Street were driving the process, and they should have known better. The excessive financialization obscured the reality of loans that depended upon ever-rising home prices and thus were never going to be paid back. There was an externality because the private calculations of potential profit ignored the risks being imposed on society.

Is that still the situation today? No. Things have changed. Banks and other financial institutions that create risks for the whole economy are now required to hold sufficient capital to cover losses even in periods of economic and financial stress, plus a liquidity buffer (they must pass “stress tests” administered by the Federal Reserve). The screws have been turned pretty tight, and the owners of large financial institutions will bear the costs of future failures — not taxpayers. This brings private incentives in line with the public interest, getting rid of the externality that gave us too much financialization in the first place. But to keep the future safe, we’ll have to make sure no one forgets what happened in the last crisis, and ensure that new risks are not created in other, less-regulated parts of the industry.

Editor's note: This piece originally appeared in the Washington Post.

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On June 23, voters in the United Kingdom will go to the polls for a referendum on the country’s membership in the European Union. As one of the EU’s largest and wealthiest member states, Britain’s exit, or “Brexit”, would not only alter the U.K.’s institutional, political, and economic relationships, but would also send shock waves across the entire continent and beyond, with a possible Brexit fundamentally reshaping transatlantic relations.

On May 6, the Center on the United States and Europe (CUSE) at Brookings, in cooperation with the Heinrich Böll Stiftung North America, the UK in a Changing Europe Initiative based at King's College London, and Wilton Park USA, will host a discussion to assess the range of implications that could result from the United Kingdom’s referendum. 

After each panel, the participants will take questions from the audience.

Join the conversation on Twitter using #UKReferendum

Audio

• Brexit—in or out? Implications of the United Kingdom’s referendum on EU membership

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20160506_uk_eu_brexit_transcript

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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.

Join the conversation on Twitter using #USFrance

Video

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

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20160720_france_defense_transcript

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Last month, Russian President Vladimir Putin made his fourth visit to China since President Xi Jinping became top party leader in 2012. During this latest meeting, the two countries inked more than 30 deals, including an oil supply contract, and issued numerous joint statements, one of which criticized the United States for its plans to deploy missile defense systems on the Korean Peninsula and in the Balkans. Chinese state media speculate that this year’s China-Russia joint naval exercises, held annually since 2005, will likely be led by the South China Sea Fleet, reinforcing a general perception in China and elsewhere that U.S. policies are pushing Chinese leaders to consolidate ties with Russia.

On July 26, the John L. Thornton China Center at Brookings hosted a discussion on the U.S.-China-Russia trilateral relationship, the shape and scope of which carries far-reaching consequences for international order and global economic growth. Brookings President Strobe Talbott, who served as deputy secretary of state and ambassador-at-large on the new independent states following the Soviet breakup, provided an introduction. A panel of experts—J. Stapleton Roy, Fiona Hill, Yun Sun, and Cheng Li—discussed the current and historical dynamics at play, including expectations and recommendations for the future.

Video

• Is the United States losing China to Russia?

Audio

• Is the United States losing China to Russia?

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20160726_china_russia_us_transcript