columbia economics review: fall 2010

Vol. I, No. 1 Fall 2010Columbia Economics Review

The Case of the Missing AllyThe War on Terror and the Political Economy of US-Pakistan Relations

I Dream of GiniIncome Inequality in the Chilean Neoliberal Model

Brain GainHow Empirical Economics can Improve our Schools

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Columbia Economics Review2010-2011 Editorial Board

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Note from the Editor

22 | Seeing the Forest for the Trees | Deforestation and Cost-Effective Regulation of the Timber Industry

Theory & Policy

17 | Networking and Interviewing | Tips by Columbia Women’s Business Society

18 | Gone in a Flash Sale | How Gilt Groupe is Rewriting the Rules of Retail

20 | The Bright Lights of Silicon Alley | New York City’s Growing Entrepreneurial Sector

Business Economics

14 | 10 Questions for Gurcharan Das

16 | Show Me the Treasury Bonds | Discussing the Second Round of Quantitative Easing

Interviews & Events

2 } The Case of the Missing Ally | The War on Terror and the Political Economy of US- Pakistan Relations

6 | Brain Gain | How Empirical Economics can Improve our Schools

10 | I Dream of Gini | Income Inequality in the Chilean Neoliberal Development Model

Features

Contents

Fall 2010

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The Case of the Missing AllyThe War on Terror and the Political Economy of US-Pakistan RelationsTaimur Malik

“Pakistan may be on its way toward an eco-nomic milestone that so far has been reached by one other populous country--the United States.”

When The New York Times wrote this in 1965, the leonine Field Marshal Ayub Khan was in charge of the country and his agenda of robust development was so promising it enticed South Korea to emulate it. This erstwhile optimism is a far cry from where Pakistan finds itself today: in the midst of a security crisis, internal fissures, and an economy that is in shambles. The contrast is truly sharp given that at many points in its history the Pakistani economy was perform-ing rather spectacularly. Only a decade ago, Pakistan’s economic growth hov-ered around 7 percent, a stark difference from the predicted growth of 2.5 percent this year--a rate all but nullified by pop-ulation increases. What is it that went so very wrong for Pakistan? A series of strategic decisions gone awry and an on-again, off-again rela-tionship with the United States con-tributed to the current state of affairs. In the 1960s, Pakistan was firmly in the anti-communist boat and a member of the U.S.-sponsored Central Treaty Or-ganization that ensured it was on the receiving end of much economic and military assistance. However, a sudden and disappointing stop to U.S. aid halt-ed economic progress and precipitated a change in political regime. The surge in anti-American feeling led to the rise of a socialist government under the char-ismatic Zulfiqar Ali Bhutto, whose poli-cies unfortunately left Pakistan in eco-nomic malaise for years. But when the Soviet Union occupied Afghanistan in the 1980s, Pakistan once again became the “front-line” ally of the U.S. in its fight against communism.

While the junta of General Zia-ul-Haq during the 1980s saw a boom in U.S. aid to Pakistan and rapid GDP growth, the 1990s is often referred to as Paki-stan’s “lost decade.” Politics in this era was essentially a game of musical chairs between a string of democratic govern-ments with short shelf lives and even shorter policy deliverables. Aside from the incompetence of governments under Benazir Bhutto and Nawaz Sharif, how-ever, Pakistan suffered from a cornuco-pia of regional and international prob-lems that compounded and perhaps even initiated its misery. Abandoned yet again by the U.S. and “sanctioned to the eyeballs,” as General Colin Powell put it, by its former chief ally, Pakistan was left too financially disadvantaged and politically alienated to effectively deal with the rather messy fallout of the Afghan situation, which is where much of this sordid story begins. According to Hassan Abbas, professor at Columbia University’s School of International and Public Affairs (SIPA) and Senior Fellow at Harvard University’s Belfer Center for Science and International Affairs, the decision to abandon Pakistan is one that American policymakers now recognize as a colossal mistake.

Great Games in Greater Central AsiaThe disintegration of the Soviet Union in the early 1990s ushered in a wealth of opportunities for Pakistan to forge economic ties with newly-formed states looking to open up their markets. About

the same time that Turgut Özal inspired Turkey to move closer to its post-Soviet Turkic neighbors, Pakistan’s industrial-ist Prime Minister, Nawaz Sharif, sent his Minister for Economics Affairs, As-eff Ahmad Ali, and a team of business-men to examine the prospects for trade in Turkmenistan, Uzbekistan, Tajikistan, Kazakhstan, and Kirgizia. There seemed to be enormous potential in these new Central Asian republics, whose people share historical ties with what is now Pakistan. For Pakistan, Central Asia provided an ideal destination for its ex-ports; for the new republics, Pakistani seaports held out the promise of world trade, given that much of Central Asia is landlocked. But the warring state of affairs in Af-ghanistan during the 1990s presented Pakistan with an unsavory strategic choice. Abandoned by the U.S. – which lost no time in disengaging from the re-gion after using Pakistan as a proxy to fight the Soviets – and faced with woe-begone economic conditions, the pur-suit of trade in Central Asia became a keystone of Pakistan’s national security calculus. At the same time, the post-Soviet power vacuum in Afghanistan led to the rise of the infamous Taliban regime under Mullah Omar and his band of disciplined Madrassah stu-dents, who won overwhelming support among many Afghanis as the only dis-ciplined force able to instill justice and order amidst endemic chaos. Under the circumstances, Pakistan reluctantly rec-ognized the Taliban, becoming one of only three countries in the world to do so. This was a move it thought would lead to unparalleled access to the Cen-tral Asian economies. The move backfired. Recognizing the obscurantist Taliban gave Pakistan much less influence over the recalci-


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Politics in this era was essen-tially a game of musical chairs between a string of democratic

governments.

trant regime than it had hoped for. For instance, Pakistan tried arduously to persuade the regime not to destroy the Buddha statues in Bamyan, but it all came to no avail. Nor did Pakistan gain any economic traction in the region. In-stead, it began to be perceived as a state going rogue and a sponsor of terrorist entities. The sword of Damocles finally fell on Pakistan’s head with the U.S. in-vasion of Afghanistan after September 11, 2001. The fallout from the war meant that militants fleeing from the U.S. es-caped across the porous Durand line and established sanctuaries in Pakistani territory.

Paying for the Sinews of WarTo this day Afghanistan’s situation neg-atively affects Pakistan and its economy in Brobdingnagian ways. Pakistan’s internal security has been significantly affected by the rise in terrorism and suicide bombings. More than 3,500 ter-rorist incidents have occurred in the country since 2007, killing an average of 84 people per month last year. Paki-

stan has also lost over 2,500 troops in the war over the last decade, including no less than four high-ranking generals – significantly more than the coalition forces in Afghanistan. But Pakistan has also had to deal with millions of inter-nally displaced persons who have been forced to flee from the large scale fight-ing in certain parts of the northwest re-gion bordering Afghanistan. Further burdening the already fragile exchequer have been the more than two million refugees from Afghanistan who arrived during the Soviet occupation and never left. In this gloomy climate Pakistan’s foreign direct investment (FDI) has been greatly affected. At a recent con-ference in Washington arranged by the U.S.-Pakistan Business Council, politi-cal analyst Shuja Nawaz laid out the ef-fects of the War on Terror on Pakistan’s investment environment. “There is a nexus between security and governance that is critical to the economic climate,” he said. “You need long-term stability to encourage economic growth. Com-

panies need a five-year time frame to make investment plans, not six months or so.” Doubts about the nation’s long-term security stemming from its role in the War on Terror have led to a decline in FDI from a decade height of approxi-mately $8 billion to less than $2.5 billion in the last fiscal year. Concurrently, the insurgency in and around Afghanistan has forced massive capital flight from Pakistan to the Persian Gulf. The IMF estimates that the cost of the war, including direct costs of re-source movements and indirect costs of lost exports, foreign investment, indus-trial output, and tax collection amount to more than $30 billion. In addition, since 2008 Pakistan’s economic outlook has taken a dramatic turn for the worse due to domestic financial troubles. The Economist reckons that inflation has been about 20 percent since this time, and the Pakistani rupee has gone from 60 rupees to U.S. dollar in 2007 to over 86 rupees. This currency depreciation has seriously corroded confidence in the country’s economy, resulting in capital flight and – by making imports even more expensive – further increased inflation. Combined with high glob-al commodity prices, the impact has shocked Pakistan’s economy with gap-ing trade deficits, high inflation, and a crash in the value of the rupee. For the first time in years, Pakistan had to seek external funding as balance of pay-ments support. With the IMF’s $7.5 bil-lion bailout package Pakistan’s overall debt has soared.

Feeding the Rentier StateOne thing the War on Terror did for Pa-kistan was to bring it back into the ambit of U.S. economic assistance; in an all too familiar pattern, the country’s foreign debt got rescheduled and economic aid began to trickle in once Washington de-cided it needed Pakistan again. But the Pakistani economy has over the years developed a heavy reliance on U.S. aid in times when the latter is in need of Pakistan’s services. As a “strategic part-ner,” the U.S. uses the carrot it waves best – civil and military aid. But this aid could never be sufficient to cover the losses that Pakistan continues to incur. Moreover, tied aid – in the form of pro-

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curement of goods and services sourced from the donor country – reduces the net benefits to the recipient country. The USAID is particularly notorious in this respect: it is popularly believed that as many as 70 cents per aid dollar ends up in the hands of U.S.-based private con-tractors, consultants, administrators, and suppliers. This form of assistance hardly creates a significant number of jobs in the local economy. Because of a general mistrust of gov-ernment agencies in developing coun-tries, flows of aid often bypass them. This has created more distortions in the economy. Instead of strengthening the capacity of government institutions in charge of delivering basic services to the people, NGOs are permitted to act as in-termediaries in the execution of projects. They hire technocrats and professionals on very high compensation packages, depleting the human resource reser-voir available to the government and

impairing its capacity. In an interview, Columbia University professor Akbar Zaidi said that the USAID money going to NGOs run by family members of the old entrenched elites does nothing to al-leviate the suffering of Pakistanis. Zaidi advocates a complete halting of such aid, not least because he believes it contributes to poor governance and eco-nomic inefficiencies by providing short-term, stop-gap arrangements of cash flow. This leads to another drawback of aid: the much dreaded “Dutch disease,” in which appreciation of the domestic currency from an infusion of foreign money discourages exports and makes investments in non-traded goods rela-tively more attractive. The overall effect is to exacerbate inefficiency and non-competitiveness among local exporters. The economy becomes a “rentier state,” receiving rent (in the form of aid) for ser-vices merited to its foreign donor, in this case the U.S., which the rentier state then

uses for patronage purposes. The result is that incentives for competition within the economy are significantly reduced. General Pervez Musharraf seemed to have realized the limited and tempo-rary panacea that is aid and on one of his last trips to the EU, begged the West to “please give Pakistan trade, not aid!” Columbia University professor Has-san Abbas echoes the same sentiment against the current U.S. aid regime, which is comprised of a multitude of small-scale projects addressing vague issues like “democratization and civic engagement.” Stalin may have found that “quantity has its own kind of qual-ity,” but in an interview with this au-thor Professor Abbas stated his belief that thinking big is the solution. “I told Holbrooke and Hillary Clinton in my meetings with them that this aid regime is flawed – what you need is a few mas-sive scale projects.” There is therefore a need to fundamentally change the na-ture of the Pakistan-U.S. relationship, transitioning from meager aid to robust trade and from small gestures to big in-vestments.

A New Pakistan-U.S. Partnership What Pakistan needs is a multi-pronged, multi-year engagement which the U.S. must deliver. The U.S. needs Pakistan’s help in the Afghan end-game and the U.S. has a moral responsibility to help its vital ally as it suffers acutely from U.S. boots on the ground in the region. Americans must invest in long-

term and large-scale projects in Pakistan that are high-impact and high-visibility, and they should do so by targeting sev-eral key areas, beginning with energy generation. As Pakistan hungers for energy with shortages running into thousands of


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General Pervez Musharraf seemed to have realized the

limited and temporary panacea that is aid and on one of his

last trips to the EU, begged the West to “please give Pakistan

trade, not aid!”

megawatts, Central Asia could poten-tially provide a solution. Tajikistan is ready to export electricity to Pakistan, while Turkmenistan is eying the Turk-menistan-Afghanistan-Pakistan-India (TAPI) pipeline. However, both options would require grids to pass through Afghan territory, something impossible to achieve without complete cessation of military hostilities there. In order to diversify its energy mix, Pakistan has repeatedly asked the U.S. for a civilian nuclear energy deal along the lines of what Washington is offering its neigh-bor and fellow Nuclear Non-Prolifera-tion Treaty (NPT) non-signatory, India. So far the U.S. has refused to even con-sider the possibility of such an arrange-ment. Many analysts, such as Michael O’Hanlon of the Brookings Institution, question the wisdom of this intransi-gence. In fact, in some quarters there is now clear recognition of the need for in-vestments in energy. The previous U.S. ambassador to Pakistan, Anne Patter-son, was working on a U.S.-sponsored economic package that would help mitigate the resentment created by the U.S.’s “12-year divorce” from the re-gion after the Red Army’s exit from Af-ghanistan. “We are trying to get people to see that we’re committed by helping with investment,” Patterson told Forbes magazine, “because you meet older people and they will say to you, ‘Oh, I remember dam such-and-such, and the Americans built that.’ That is the kind of synergy we look for, because it builds goodwill for both of us.” A dam is not a bad place to start. With nuclear energy an apparent stum-bling block and the situation in Af-ghanistan not warranting energy access through the Central Asian corridor, the U.S. should make amends by investing in a mega-dam in Pakistan. Such a dam would be of immense value to the Pa-kistani people. It would help minimize the energy shortfall, counter dwindling water resources caused by glacial melt-ing, and bring new life to Pakistan’s stagnant agricultural production, which will in turn greatly benefit poor farm-ers. In fact, the consultancy Weidemann Associates prepared a report commis-sioned for a USAID study on Pakistan’s agriculture that suggests that 3.5 times

more employment is generated by ag-riculture and its spillovers within the rural non-farm sector as in the urban sector. Thus, a dam would be especially effective in alleviating rural poverty. Add to this open access of U.S. mar-kets to Pakistani exporters and we have a Pakistan that is better integrated into the global economy, with entrepreneurs and industry doing well. The U.S. has so far refused to sign a free trade agree-ment (FTA) with Pakistan, thus limiting the country’s greatest export, textiles, which in 2008 alone brought $8 billion to the national kitty. However, there is potential for much more robust growth, especially since Pakistan’s industries are suffering heavily from acute compe-tition from China and Bangladesh. As a Least Developed Country (LDC) desig-

nated by the U.N., Bangladesh receives preferential access for its exports while Pakistan gets neither free trade nor any guaranteed quota. Greater access for Pakistani textiles would provide a ma-jor fillip to the industry and also employ many workers who have lost their jobs since the downturn. Another U.S. trade-related scheme that has been kept on the back burner has been the creation of “Reconstruc-tion Opportunity Zones (ROZ)” in the troubled and impoverished northwest-ern regions of Pakistan. Under the pro-posed plan, any goods assembled or made within ROZs would reach the U.S. market without any tariffs or barriers. The aim of the program was to generate employment in least developed regions that are most susceptible to the recruit-ment efforts of terrorist groups. Unfor-tunately, the U.S. seems to have balked at this Bush-era promise. Closely linked to the integration of Pakistan’s economy with that of the U.S. is the rise of an emerging Muslim

middle class. This will tremendously dampen extremism and will lead to so-cial and economic reform in the Muslim world, bringing the region much closer to democratic and capitalist governance than any other forced-down-the-throat pill that Langley or Foggy Bottom could concoct. In his book Forces of Fortune, Council on Foreign Relations fellow Vali Nasr makes an excellent case for court-ing a pious but entrepreneurial Muslim middle class. The area where large investment is needed is in top-quality universities, which this country of 175 million has a paucity of. Every year hundreds of thousands of Pakistanis graduate from good high schools with British A-Level diplomas but have limited options when it comes to quality Pakistani universi-ties. An American University of Karachi or Lahore would be a fantastic starting point. If Iraq has an American Univer-sity then Pakistan surely deserves one. Pakistan’s burgeoning middle class aches for high standard education and the U.S. can win both urban and rural support with investments in institutions of higher education. This will drastically reduce anti-American sentiment among ordinary people, reassuring them that Uncle Sam is a sincere friend and is not merely running with the hare and hunt-ing with the hound – a major security bane for the U.S.

Time for a Media Make-OverThe last and most important prong of this strategy is perhaps hardest to im-plement, and has to do with how Pa-kistan is presented in the Western, and most importantly, U.S. media. Harvard professor Michael Porter and his team at AllWorld Network, a global growth initiative, developed the theory of “visibility economics.” The idea is simple: entrepreneurial endeav-ors in the developing world can be en-hanced by bringing successful compa-nies which the media otherwise takes little note of to the world stage and creating a brand image for them. The image of Pakistan as a nation is similar; while it gets more than its fair share of mention in the media these days, the overwhelming majority of it is nega-tive. The visibility economics approach

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Pakistan’s burgeoning middle class aches for high standard

education and the U.S. can win both urban and rural support

with investments in insitutions of higher learning.

of Professor Porter seeks to find hidden entrepreneurs, credential them, and put them on the world’s radar; markets, Porter believes, will do the rest. The U.S. must aim to do this with Pakistan as a country. To start with, the American government must make an effort to ap-pear in the U.S. media with a focus on non-negative aspects of its “strategic al-liance” with Pakistan. The good cop-bad cop routine that American politicians play in their state-ments on Pakistan, while apposite to the ear canals of their domestic audi-ence, is widening the gap between the two countries and is hardly endearing to Pakistanis. An interesting example of this dichotomous game can be seen in diametrically opposed statements

from two important US figures. Rich-ard Armitage in a new task force report asks the U.S. government to up the ante against Pakistan and demand that it do more against terrorist groups like the Haqqani network by threatening U.S. surgical strikes against Pakistan in the event of an attack on U.S. soil. In antipo-des to this view is Colin Powell’s recent interview urging the U.S. government to provide more money, hardware, and intelligence to the Pakistani army, which does not have the wherewithal to go af-ter the Haqqanis. Pakistanis are deeply hurt by this mudslinging and saber-rattling, whether due to domestic U.S. politics or other factors. The image of Pakistan currently peddled by the U.S. media also ends up badly compromis-

ing Pakistan’s economic potential. Pakistan’s economy has followed a unique trajectory since the 1950s, one in which the U.S. has played a most cru-cial role; its temperamental relationship with the country auguring both good times and bad. Pakistan has always sought out the U.S. to enhance its eco-nomic machine, which has suffered in times when U.S. strategic objectives no longer required Pakistan’s cooperation. As a strategic ally, however, Pakistan needs a deeper economic partnership with the U.S., not least to offset many of the costs incurred during the last time Pakistan was drawn into Afghanistan. The steps outlined here provide a blue-print for the solution to Pakistan’s eco-nomic woes.

Brain GainHow Empirical Economics Can Improve our SchoolsSkanda Amarnath

The recent release of “Waiting for Su-perman,” a documentary about the pit-falls of the American school system, as well as ongoing television coverage on the subject, such as the somewhat farci-cal “Teach: Tony Danza” and MSNBC’s week-long “Education Nation” special, have been the latest in the continuing at-tempt to emphasize the issue of educa-tion in the nation’s spotlight. Yet when-ever there is genuine discussion over potential reforms, the debate quickly boils down to liberals supporting in-creased spending for the established system and conservatives antagonizing unions and promoting vouchers as the best and only alternative. If we wish to make any serious progress on edu-cation policy, we will need to focus on more rigorous analysis of the underly-ing problems within the system. All sides in the debate invoke vague terms like “better schools.” What exactly are “better schools” though and how do they – if they do at all – improve student achievement? The answers can be found

in empirical studies, which convincing-ly capture the meaning of this ambigu-ous term and support an affirmative an-swer. Clearing the debate of ambiguity where it is possible will help achieve the progress America needs.

Given that conservatives often tout the value of switching to an education system that relies more on vouchers in order to empower consumers with the option to choose their own schools, it is helpful at the outset to investigate what that sort of system would entail. The argument hinges on the idea that if we subsidize all education, rather than just public education, the private sec-tor would no longer become crowded out such that there would be sufficient

demand for quality education among all income levels. Better schools would then attract more students and, hence, become more profitable. There are many counterarguments to this stance, but one that typically gets overlooked in this debate is whether going to a so-called “better” school will actually lead to im-proved individual academic achieve-ment. The answer seems obvious at first. Going to a “better” school should intui-tively improve one’s academic achieve-ment. Yet by simply observing higher education in America, it is difficult to determine whether students with nearly identical academic and extra-curricular achievements would accomplish or earn more if they went to an “elite” school rather than a less prestigious university; in fact, Dale and Krueger (2002) found that “students who attended more selec-tive colleges earned about the same as students of seemingly comparable abil-ity who attended less selective schools.” Cullen, Jacob, and Levitt (2005) exploit-ed the randomization that occurs in


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It we wish to make any serious progress on education policy, we will need to focus on more

rigorous analysis.

charter school lotteries in determining that students who transfer to higher-achieving high schools do not actually show any demonstrable improvement in test scores or academic achievement. Hence, existing empirical evidence has not simply confirmed our intuition. Much of this elusive empirical evidence was finally captured when Miguel Urquiola and Cristian Pop-El-eches, professors of economics at Co-lumbia University, published their find-ings in “The Consequences of Going to a Better School” in 2008 and “Going to a Better School: Effects and Behavioral Responses” in 2010. Their research was largely based on statistics from Roma-nian schools, utilized because the pro-cess of choosing schools in Romania is so systematic that it largely resembles a controlled experiment. At the end of eighth grade, for example, all Romanian students take a test and are then asked to state their preference for their choice of secondary school as well as the aca-demic track they wish to pursue. Stu-dents rank the schools and tracks they wish to attend, and the higher a student scores on the test, the more likely that student is to attend their first-choice school. Given that all of these schools are subject to limits with respect to ca-pacity, each school has a de facto cutoff score to limit the number of students who attend their school. Since Urquiola aand Pop-Eleches had access to the cut-off score for each school, they could then rank the schools based on each school’s score. Using these cutoff scores as well as each student’s scores on the eighth grade exam and the 12th grade bacca-laureate exam, Urquiola and Pop-El-eches utilized a regression discontinuity design to test their hypotheses on school quality and student achievement. The regression discontinuity design centers on determining whether students who scored just above the cutoff score and thus were able to attend a more highly ranked School A performed significant-ly better than students who scored just below the cutoff score and could only attend a lower ranked School B. There is a positive relationship between stu-dent scores on the eighth grade exam and one’s score on the baccalaureate

exam. However, if the school one at-tends makes no difference to the aca-demic achievement of a student, this

positive relationship and trend should be continuous through the cutoff score. In contrast, if School A had some posi-tive effect on the academic achievement levels of its students relative to School B, we would see a break at the cutoff score with students who scored above the cutoff doing significantly better on the baccalaureate exam than the students attending School B. The vast amounts of data that Ur-quiola and Pop-Eleches were able to col-lect allowed them to test their hypoth-eses numerous times, and they found, quite consistently, that there existed discontinuities when analyzing stu-dent performance at each cutoff. Thus, it seems clear that students visibly ben-efited from attending a better school.

Some point out that this result could be the product of students of similar aca-demic achievement levels learning and spending more time in school together in a phenomenon known as the “peer ef-fect,” hence leading to greater academic stratification. However, many of the cutoffs that Urquiola and Pop-Eleches used were not necessarily for attend-ing different schools but rather for dif-ferent tracks within the same school. As noted in Pop-Eleches and Urquiola (2010), the students in each track “take all their classes together and do not take courses with members of other tracks, although they share inputs like facilities and a principal.” Therefore, Urquiola and Pop-Eleches were able to control, at least in large part, for peer-quality effects and conclude that, even if a stu-dent went to the same school, his or her academic achievement level would dra-matically improve if he or she were in a “higher” track. These powerful new findings beg a new question: how do we increase the quality of education for more people, given the existence of positive school ef-fects? As an additional concern, how do we increase the quality of education for lower-income students? Most societies spend on education as a means to com-bat excessive income inequality. Even in the United States, where concerns of income inequality often take a back seat to economic growth, public edu-cation is provided in the hopes that it will help create equal opportunities for all, although none will claim that pub-lic education is successful in creating equal outcomes. Americans would ide-ally prefer a system in which any intel-ligent and hard-working person could achieve nearly the same results regard-less of his or her socioeconomic status as a student. The reality is that the idea of equal opportunity, while reflecting a desire for more equal outcomes in aca-demic achievement, merely translates more often than not to a redistribution of wealth through the subsidization of education. Given Urquiola and Pop-Eleches’s conclusion, it is safe to say that there are two potential solutions: one would focus on expanding school choice to create a marketplace where profit mo-

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Even in the United States, where concerns of income in-equality often take a back seat

to economic growth, public edu-cation is provided in the hopes that it will help create equal

opportunities for all.

tives catalyze improvements in school quality, while the other would be more concerned with enhancing the direct mechanisms by which school quality can be improved. Those who hold the conservative view that vouchers are the solution would claim that we would then empower all consumers. Families and students would have the neces-sary income to be able to choose the best available school, thereby encourag-ing competition between schools and, presumably, improving the quality of education. Ostensibly, such competition would then spur schools to improve the value they add to each student’s aca-

demic achievement level. However, this notion is not entirely rooted in reality if we once again look at recent empiri-cal research, which demonstrates how the existence of fixed capacities and an “anti-lemons effect” can create major problems for vouchers. The empirical evidence and analy-sis found in Emiliana Vegas and Jenny Petrow (2007) examines the role of vouchers in Chile, a country where the private education sector is substantially larger that its public counterpart and subsidized much more heavily than that in the United States. The study showed that Chilean educational performance is below the Organization of Economic Cooperation and Development (OECD) average and more comparable to that of other Latin American countries with lower relative income per capita. Much of this seems to stem from the inability to expand a school’s capacity to edu-cate more students. The best schools in Chile typically must limit the number of students they admit by raising the cost of tuition. Thus, school choice actually leads to increased stratification and in-come inequality. This is not to say that a voucher-based system is significantly

worse either, but the costs involved in switching to a system that produces in-significantly different outcomes make such a transformation unwarranted. Many argue, however, that a voucher system would benefit lower-income areas such as inner cities where the ex-isting public education system can be corrupt. This claim is rooted in empiri-cal evidence, as W. Bentley Macleod and Urquiola (2009) found in their paper that “subsidizing for-profit schools via vouchers is shown to be particularly beneficial to lower income students… it also raises the likelihood that high productivity schools enter the market to serve them.” However, there are still limits to the effectiveness of vouch-ers for lower-income students; this ap-proach has not shown success across all income levels. With regard to income levels, a key problem that typically goes ignored in policy discussions is the “anti-lemons effect.” The lemons effect alludes to the occurrence of adverse selection in markets; the uninformed consumer typically chooses the “lemon” because the owner of the lemon, or defective good, is willing to sell at a lower price than the owner of the well-maintained good. Thus, the lack of information for the consumer leads to the selection of a lower quality car. The anti-lemons ef-fect, as Macleod and Urquiola define in their paper, refers to schools’ knowl-edge of a student’s test scores, leading to the selection of students with higher test scores. The problem lies in that test scores are highly correlated to socioeco-nomic status; McEwan, Urquiola, and Vegas (2008) note in the specific case of Chile that “schools’ average test scores are a very good proxy for average stu-dent income.” Thus schools with excel-lent reputations might be more inclined to screen for higher quality students, rather than focusing their efforts on in-creasing the value added for each stu-dent. Such a system does not represent that of a true market in which firms (schools) are competing to improve the quality of their product (value added with respect to academic achievement). A good way to view the potential an-ti-lemons effect is through the American higher education system and the specif-

ic case of Columbia University, a univer-sity with a considerable reputation in academic and professional circles. What exactly does the Columbia University brand name represent? A student who attends Columbia University has prov-en that he or she is intelligent and dili-gent enough to gain admission to this selective university. In addition, a stu-dent at Columbia University has lived and studied with other smart, hard-working students for four years, which has had some beneficial effects as well. Consequently, Columbia University has an incentive to select high-achieving students and high-achieving students have an incentive to choose Columbia. But is there any way to test whether Columbia University actually improves student achievement level beyond peer-quality effects? If Columbia University truly added significantly more value to a given student’s achievement level than other universities, then even a relatively uneducated person should be able to significantly improve his aca-demic achievement level by attending this school. However, Columbia Uni-versity does not accept the uneducated so there is no way to put this question to the test. This largely explains why, even though going to a better school can im-prove academic and financial outcomes, there exists limited evidence that in-

troducing voucher-based school choice leads to improved academic outcomes or that elite schools significantly out-perform less prestigious schools. Yet the earlier question still remains: how can we deliver higher quality education to more students than what the established system currently provides? As mentioned earlier, the other solu-tion that has been frequently proposed is to focus on enhancing the precise mechanisms by which school quality is determined. Pop-Eleches and Urquiola


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Schools with excellent reputa-tions might be more inclined to screen for higher quality

students, rather than focusing their efforts on increasing the value added for each student.

“Is there any way to test wheth-er Columbia University actu-ally improves student achieve-ment level beyond peer-quality

effects?”

(2008) highlight how “more selective schools might be able to attract better teachers, be run by better administra-tors, or even receive favorable treatment from national or regional authorities.” With regards to teacher quality specifi-cally, Eric Hanushek and Steven Rivkin (2003) aptly point out that there exists a mystery with respect to teacher qual-ity, since there exists “both the large im-pact of teachers on student learning and the lack of explanatory power of tradi-tional quality measures.” According to the teachers’ union, teachers’ experi-ence and educational background are key inputs in improving teacher qual-ity. Accordingly, they reason, teachers should be paid based on their seniority and university degrees. As Hanushek points out, however, empirical analyses have shown that “the amount of experi-ence in the classroom--with the excep-tion of the first few years – also bears no relationship to performance” and “that master’s degrees bear no consist-ent relationship with student achieve-

ment.” The evidence in Pop-Eleches and Urquiola (2010) seems to support this viewpoint since students who finished below and above the cutoff had teachers of similar experience and educational background. In fact, the only input they

found to significantly differ between teachers of students above and below the cutoff was the amount of homework assigned. Nevertheless, it remains safe to assume that the given background characteristics are not the source of posi-tive school effects. Thus, while we know that raising the quality of teachers can have a strong positive effect on student achievement, we are not aware of what precisely makes a great teacher. The easiest way to get around this problem of insufficient teacher com-pensation is to pay based not on inputs, such as experience and one’s higher ed-ucation, but on outputs, namely gains in student achievement. This might seem rather intuitive since it directly incen-tivizes teachers and administrators to improve the academic outcomes of stu-dents. The best teachers would earn the most since everyone is paid for what he or she produces and the students gain from receiving a better education. Such a system, however, does not take into account the fact that a student’s income-level is a great predictor of how much more he or she can achieve in a given year. Yet, suppose we control test scores for differences in socioeconomic status. Shouldn’t a teacher’s value-added then be revealed? The simple answer is yes, but that would be misleading. McEwan, Urquiola, and Vegas (2008) demonstrate that “test-score volatility is even more pronounced when we use measures that arguably do a better job of controlling for student socioeconomic status,” and thus a teacher’s value-added becomes incredibly volatile from year-to-year.

Some might champion such a system wherein a teacher or administrator’s salary is largely tied to the value he or she adds, when differences in socioeco-nomic status are controlled. Yet which might a teacher find more attractive, a highly unstable but higher-paying sala-ry on average, or a slightly lower salary that stays constant from one year to the next? When we consider liquidity con-straints and the tendency towards risk aversion, the latter offer might very well be more attractive than the former. One way to mitigate this problem is to make only a fraction of a teacher’s salary directly tied to the test scores of his or her students. Given that under the status quo, salaries are almost entirely determined by inputs such as teacher education and experience, moving to-ward basing salaries on a more balanced mixture of inputs and outputs would seem most appropriate. In some private sectors, such as finance, there often ex-ists a tendency to overemphasize out-put over input, leading to issues with limited liability and excessive risk. Yet to place almost zero weight on output, as is the case for nearly all teachers at American public schools, seems equally foolish. There are no simple solutions for im-proving school quality, but when sala-ries are based at least in part on output, even if poorly measured, we will be able to create some direct incentive for enhancing potential mechanisms that determine school quality. When we in-corporate output into the incentive sys-tem there will be an impetus to create better measures of teacher output and methods for testing. Through gathering more data, we will also be able to find stable but effective proxies that more ac-curately estimate teacher quality. Know-ing that schools matter is crucial to fu-ture reforms: no longer can we accept the notion that student achievement is solely the product of a student’s actions and characteristics. The teachers and administrators matter as well and the sooner we move to better evaluate and incentivize performance, albeit in a re-sponsible and appropriate manner, the faster we can move towards a future in which all students can truly enjoy equal opportunity.

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Knowing that schools matter is crucial to future reforms: no longer can we accept the notion

that student achievement is solely the product of a student’s

actions and characteristics.

I Dream of GiniIncome Inequality in the Chilean Neoliberal Development ModelRoss Bruck

“Deeply involved in the preparation of the coup, the Chicago boys, as they are known in Chile, convinced the generals that they were prepared to supplement the brutality, which the military possessed, with the intel-lectual assets it lacked.”--Orlando Letelier, Chilean Minister of Interior under Salvador Allende, in an article published in The Na-tion (1976).

IntroductionOne of the most contentious debates in economic development theory cent-ers around the successes and failures of Chile’s neoliberal experiment, carried out by a group of Chilean economists trained at the University of Chicago un-der the likes of Milton Friedman and Ar-nold Harberger. The economic reforms, carried out by this legion of economists, shifted the course of Chile’s economic history towards the free market: trade

barriers were eliminated, industries were denationalized, and social goods like health care were privatized. Scholar-ship on this period has largely fallen into two distinct categories: one views the ef-fects of the reforms as miraculous while the other maintains that the policies resulted in economic and social catas-trophe. However, such polarized views of the period from Pinochet’s coup in 1974 to the transition to a democratically elected government in 1990 are incon-sistent with original source economic and social data from this era, which demonstrate that the neoliberal reforms were successful at accomplishing certain economic and social goals, such as tam-ing inflation and boosting exports, while failing to meet others, such as abating domestic inequality. The mid-1980s through the 1990s saw a major expansion of national in-

come, although the shares of this newly created wealth were by no means evenly distributed. Should a Chilean-style, free market approach to development be applied to current or future advancing nations, it is quite likely that a similar inequality versus overall growth co-nundrum would arise. What range of inequality, then, is optimal for positive economic and social outcomes? A dis-cussion of Chile’s growth between 1974-1990 leads us to how we might begin an-swering this difficult question. The late 20th century Chilean economic experi-ment, an archetypal implementation of Chicago-style neoliberal theory, is com-plex, nuanced, and an experiment which should be deconstructed and adapted rather than simply wholly embraced or wholly rejected. Similar nuance is re-quired when considering the advance-ment paths of today’s and tomorrow’s developing nations.

Chile Prior to 1974Before 1974, Chile faced enormous eco-nomic difficulties, including the highest inflation rate in the world, which stood at over 600 percent in 1973. Various pres-idents of the country had made attempts at economic reform, and immediately prior to the neoliberal experiment was Salvador Allende’s “Chilean Path to Socialism.” Furthermore, the country was confronted with a fiscal deficit of 20 percent of GDP along with low do-mestic savings and investment rates of 6 percent and 7.9 percent, respectively. For comparison, in 2009, the United States ran a fiscal deficit of around 12.3 percent and Greece, which suffered a near-catastrophic debt crisis, only had a deficit of around 15.4 percent. Figure 1 compares Chile’s investment rate in 1974 to the average investment rates from 1960 to 2000 of the United States, Japan, and Venezuela. Even by the rela-


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Figure 1: National Investment Rate of Return

tively lower regional standards of South America, Chile’s domestic savings and investment rates were inadequate. With regard to economic growth, the years between 1940 and 1970 show a cumu-latively modest, though certainly not abominable, record with real GDP grow-ing at an average rate of 3.7 percent per annum and real per capita GDP growing at 1.7 percent per annum. On average, between 1959 and 1973 the bottom 40 percent of Chilean society received 10.5 percent of GDP, the middle 40 percent received 32.4 percent, and the top 20 percent received 57.3 percent, and it was this inequality that was the im-petus for Allende’s policies. For much of this period, the Chilean government followed an import-substitution devel-opment strategy that intervened signifi-cantly in the economy; especially in the socialist overhaul, there was a strong egalitarian social agenda that sought to equalize Chilean society and expand public welfare services. Healthcare and education sectors were nationalized, as were different industries, while agricul-ture was collectivized; protectionism was a general economic policy. The ini-tial results were positive but gains were quickly reversed. In addition to loss of economic efficiency the ire of the United States increased to the point where it ap-plied pressure and convinced other na-tions to cut off Chilean credit as it had immediately following Allende’s elec-tion. This pressure culminated in the

support for Pinochet and the military to overthrow Allende in a coup in which the democratically-elected socialist pres-ident was removed from power and in fact committed suicide.

The Pinochet Era On September 11, 1973, the Chilean Armed Forces overthrew the elected government of Salvador Allende and in-stalled in its place a junta led by Augusto Pinochet. Almost immediately after tak-ing power, Pinochet, his advisors, and his crony government technocrats began to lay the groundwork for pioneering neoliberal economic reforms. The coup d’état ended the previous constitutional republic and radically reoriented policy from the “Chilean Path to Socialism” to free-market economics; in doing so the regime faced opposition from political and economic leftists that it overcame through oppression and “forced disap-pearances” of civilians. There is no ques-tion that these ideas were implemented on the country by force or that the social consequences of oppression were dire, but the consequences of political change must be separated from the effects of the economic transformation. Policies such as the privatization of most state-owned enterprises, reduction of government expenditures on social services, limitations on organized labor, affirmation of secure property rights, and the promotion of foreign capital inflows were implemented. Addition-

ally, Chile became much more open to foreign trade, lowering tariffs and elimi-nating other trade barriers. Essentially, the country adopted most of the 10 eco-nomic policy prescriptions of the Wash-ington Consensus. These reforms repre-sented a nearly complete overhaul of the nation’s economic institutions and regu-lations, and the relative rapidity of their implementation in just a few short years led to the dubbing of this practice as “shock therapy.” Certain policies, how-ever, such as the subsidization of several export industries, particularly fruit and lumber, bailouts of financial institutions, and the pegging of the Chilean peso to the U.S. dollar demonstrated that the re-gime was willing to break from neolib-eral dogma when pragmatism dictated a state-specific solution to an economic difficulty. To clarify nomenclature, the Chilean model refers to a generally or-thodox adaptation of neoliberal policies with the above exceptions.

Economic and Social Effects of ReformAs illustrated in Figure 2, the early eco-nomic effects of the neoliberal reforms can best be described as erratic and not exceedingly successful. Between 1950 to 1972, the Chilean annual GDP growth rate stood at 3.9 percent, falling to just 1.4 percent from 1974 to 1983. Years of economic catastrophe due to external shocks in 1975 and, according to Fried-man, the implementation of a fixed cur-rency in 1982, saw year-to-year GDP declines of 13 percent and 14 percent respectively, while 1977 to 1980 saw av-erage annual GDP growth of 8.5 percent. Figure 3 shows the dramatic fluctua-tions in real wages during the Pinochet era. Furthermore, the unemployment rate rose dramatically after the coup to a peak of 21.9 percent in the crisis of 1976, settling to a still high 15.1 percent in 1981. While the transition period in which structural adjustment dismantled so-cialist policies led to erratic growth in the early years, later economic growth was substantial. From the mid-1980s onward output grew by an average of six percent per year. This growth trajec-tory continued through the 1990s and, in 2009, Chile had the highest GDP per capita in South America with $14,700. Whether or not the growth that occurred

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Figure 2: Fluctuations in Chile’s GDP Growth (1971-2008)

after Pinochet’s rule can be attributed to his neoliberal policies is a fundamental question in assessing the successes and failures of the implementation of neo-liberal theory in Chile. If the scope of analysis is strictly limited to Pinochet’s rule, the economic consequences of his reforms seem less successful. The histor-ical record, however, suggests that the advancement of the Chilean economy after Pinochet left office can be ascribed to neoliberal theory since most of the regime’s policies and ideology carried over into subsequent administrations and the constitutional reform of July 1989 permanently established many of his administration’s policies in the long-standing economic policy of the nation. One of the primary criticisms of Chile’s neoliberal period is that it was responsible for dramatically increasing domestic income inequality. Indeed, many of the statistics regarding inequal-ity during the mid-1970s through the 1990s are concerning. Chile presents an enormous disparity between the income share of the top 20 percent and the in-come share of the bottom 20 percent of households. According to the Gini Index, which measures income inequality on a scale from zero (perfect equality) to 100 (perfect inequality), Chile ranked 14th worst in the world in 2003. Certainly, the result of the Chilean development model has been an imbalanced growth with far greater gains going to the top quintile.

The privatization of state owned enter-prises allows for investors and entrepre-neurs to amass great wealth, as does the deregulation of major markets. Those benefiting are often those with access to greater wealth and social capital, and it is for this reason that some increase in inequality is to be expected. Cuts in edu-cation and healthcare spending, similar-ly, make upward mobility by the lowest classes much more difficult. While greater income and wealth disparity is certainly troubling, the eco-nomic growth that has accompanied the reforms of the 1970s and 1980s has increased the absolute income of the bot-tom quintiles of Chilean society. Com-bining data on national GDP and in-come shares by quintile reveals that the annual absolute incomes of the bottom two quartiles were higher in 1974-1989 than in 1971-1973 by $13.1 million and $18.5 million respectively (1970 PPP$). This represents absolute income gains of about five percent for the bottom quintile and three percent for the sec-ond quintile. By contrast, the top quin-tile averaged an income $1640.3 million per year higher during 1974-1989 versus 1971-1973, representing a gain of about 35 percent. More importantly, the modest gains in income for the bottom quintile were accompanied by substantial gains in quality of life. According to the Unit-ed Nations Development Programme

(UNDP), the year Pinochet stepped down from power, 1990, was the year Chile ranked first in South America on the Human Development Index (HDI). The HDI, measured on a scale from 0 to 1, is a composite of several measures of well-being including income, literacy rate, infant mortality, and others. Chile notably enjoyed a life expectancy at birth of 72 years, an adult literacy rate of 98 percent, 97 percent of its population having access to health services, and an average daily calorie supply of 106 per-cent of necessary daily intake, among other high statistics. This was the result of an upward trend from when the HDI was first defined in 1980 over the re-mainder of the rule of Pinochet’s junta, and this trend continued in the years after his policies were constitutionally enshrined. Even leading in 1980, Chile bested the Latin American average with an HDI of .607 to the average .578, and expanded its lead to the present, enjoy-ing a score of .783 over the average .706. It seems, then, that the welfare of the citizenry is determined more by over-all wealth than by income distribution; most likely, qualities calculated in the HDI like education, life expectancy, and social welfare are more easily improved by increases in total wealth. Nonetheless, one of the major eco-nomic shortcomings of the Pinochet era unevenly distributed income growth. A tremendously disproportionate amount of GDP growth went to the richest 20 per-cent and the bottom 40 percent was left with very modest increases in absolute overall income. Although no real-world economy can be manipulated to deliver strictly equal growth rates for the full spectrum of a society (and whether this is the correct goal is debatable), starkly unequal societies suffer both economi-cally and socially (due to greater over-all instability, higher crime rates, more drug and alcohol abuse, lower educa-tion attainment, among a litany of oth-ers ills). While balanced growth remains the ideal, the case of Chile allows us to question what level of inequality can or should be tolerated. To begin, it is essential to understand that inequality and growth are not iso-lated economic issues but are actually closely linked. Traditional thinking has

Figure 3: Fluctuations in the Chilean Real Wage* (1970-1990)


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seen such an imbalance as inevitable, with the majority of growth for the poor following the growth of the rich akin to trickle-down theory; recently there have been calls for a focus on “pro-poor growth” to mitigate the effects of ine-quality. Thus, the question at hand is not how much growth should be sacrificed to achieve greater equality. Rather, it is what level of inequality promotes the highest growth rates while avoiding the aforementioned social and moral issues that arise with large income disparities. As discussed by Giovanni Andrea Cornia and Julius Court in their United Nations Policy Brief, there exists an “ef-ficient inequality range” above or below which growth tends to suffer. If inequal-ity is too high, the economy suffers from incentive traps, the erosion of social co-hesion, social conflicts, and uncertain property rights. If inequality is too low, however, incentive traps, free-riding, labor shirking, and high supervision

costs diminish growth. These particular authors found that this efficient range lies roughly between a Gini Index of 25 and 40. As mentioned above, in 2003 Chile had a Gini Index of 54.9. While at-tempting to quantify a target range of inequality is always somewhat arbitrary, the empirical evidence gathered and analyzed by Cornia and Court seems to suggest that their conclusion is fairly accurate. Clearly, inequality in Chile is greatly above that range and thus pre-sumably, the nation will realize lower long-run growth rates than would be possible given more a more condensed income spectrum.

ConclusionWhile not perfect, Chilean neoliberalism created high overall growth rates that raised the wealth and quality of life of most segments of society and eventually led to a free, democratic political system, accomplishments which should not be

dismissed lightly. The model also dem-onstrates that significant problems often arise when large-scale economic trans-formation occurs, even when the trans-formation is to a vastly improved frame-work. Policy should aim to minimize these issues as best as possible, but they must be endured until the society accli-mates to the new environment since the goal of real economic growth is the only means to significantly and perpetually increase the wealth, and consequently the welfare, of a society. Finally, after examining the Chilean case study, it seems that the model en-acted by Pinochet should certainly not be implemented wholesale in today or tomorrow’s developing economies. In-come gains of 35 percent by one quintile and only 3 percent by another quintile are not symptoms of a perfectly ordered economic model. Despite these short-comings, the period 1974 through 1990 should be viewed as a qualified success in that it was able to stabilize the chaos of the fiscal budget while still deliver-ing income growth for virtually all seg-ments of Chilean society. The model did, in fact, accomplish important economic goals. Pinochet’s policies successfully stabilized the Chilean government’s fiscal situation while delivering, by the mid-1980s, relatively high growth rates. The major disadvantage of these poli-cies, however, was their failure to evenly distribute income growth. Countries which, in the future, choose to adopt neoliberal policies must be conscien-tious of this phenomenon and realize that inequality higher than the “efficient range” described above may lead to an array of social issues as well as dimin-ished overall growth rates. In transitions from state-run economies to free-market economies, an attempt should be made, through policies including progressive tax structure, relatively high minimum wage, and expanded welfare and educa-tion services, to mitigate the inevitable shock that will come with the transi-tion. In such a manner, gains in income may be more equally distributed across the social spectrum and the society may avoid the worst excesses of inequality, as experienced by Chile under Pinochet, while preserving its growth-inducing ef-fects.

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10 Questions for Gurcharan Das

Photo courtesy of The Deccan Chronicle

Gurcharan Das is a noted public intellectual, best-selling author, and management expert. He is the author of The Difficulty of Be-ing Good: On the Subtle Art of Dharma, a recently published book about the ethics of capitalism in India, and has written many other fiction and non-fiction works including the international bestseller India Unbound. After graduating from Harvard Business School, Das worked as CEO of Procter & Gamble India and Managing Direc-tor of Proctor & Gamble Worldwide. Das currently authors a weekly column at The Times of India and has been a guest columnist at The Wall Street Journal, Foreign Affairs, and The Financial Times. The Columbia Economics Review sat down with Das to discuss his thoughts and opinions on India’s unique brand of economic and business policy.

Columbia Economics Review: In a 2006 report on India’s growth in Foreign Affairs you assert that Prime Minister Man-mohan Singh’s government is not doing enough to educate voters about the benefits of economic reforms. You state “it is not too late for Singh and the reformers in his administration (Chidambaram1 and Ahluwalia22) to start appearing on tel-evision to conduct lessons in basic economics.” What would lesson one of Indian Economics 101 look like?

Gurcharan Das: It is essentially what every person instinctively knows in his head as common sense but needs to be reminded about: that markets should be competitive, that competition en-sures honesty, that competitive markets perform far better than state monopolies, and that people need to be reassured that some

1. Former Finance Minister and current Union Minister of Home Affairs.2. Deputy Chairman of Indian Planning Commission, which sets economic policy.

of the state monopolies that we have can be wound up and, re-ally, that opening up [to the free-market system] has helped us as an economy. Foreign investment is also good. For example, in the area of retail trade, we do not yet allow companies like Walmart. But you have to show that it is exactly these kinds of companies that have the capability of creating a core change for Indian farmers. You have to show that cold storage and cold transportation in trucks that are air-conditioned will solve the problem of 25 percent of our produce rotting in the fields. Also, the farmer right now cannot sell directly to a customer but if he were allowed to do so, there would be competition so farm-ers would be helped--but also consumers because large chains always give you more competitive prices than the mom-and-pop stores do as this country, and everywhere else, has shown. At the same time, the employees of the retail stores are helped because if you’re working for the Walmarts and the Reliance Freshs of today, you need employees who are much better edu-cated--so they educate them, they train them in computers, etc. You earn more as an employee than you would at a neighbor-hood store. And ultimately, you actually create more jobs than you destroy. So these are the kinds of things: our agriculture desperately needs investment, and whether it is private or pub-lic investment, both investments are good, but in the end we need investment. If the government is not investing, the private sector will--if you give them the chance. So these are the things that I would have these people talk about.

CER: Professor Aravind Panagariya at Columbia University’s School of International and Public Affairs (SIPA), lists in his acclaimed book, India: The Emerging Giant, priority sectors for future reform in which the government is the principal sup-plier. These areas include power, education, health, water and sanitation--sectors that the Indian government has historical-ly proven extremely weak. Based on your experience with cor-porate India, can private entrepreneurial actors fill this large void and, if so, to what extent?

Das: Well, yes, the answer is yes. And I think the answer lies in enlightened regulation because what you don’t want is crony capitalism. India, because of the poor capacity of the state, will produce a new governance model for the world. There are lots of things you associate with delivery by the government--in India it will be delivered by the private sector, and not for any other reason other than [that] the government is not capable of doing this. The corruption is just a symptom of incompetence. Ironi-cally, some of our state institutions were quite good 40-50 years ago. We were quite proud of them then, but they have frayed very badly and those institutions now need to be reformed. To-day, I think that is what the government is trying--struggling, I would say--to do now through public-private partnerships, and things are improving. For example, the recent airports in Delhi


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and Hyderabad. I believe we can do this in lots of areas, includ-ing schools. The government has a responsibility to ensure that all children get a decent education, but it doesn’t have to pro-duce it, it doesn’t have to run schools by civil servants.

CER: Talking about your experiences at Proctor & Gam-ble India in the Harvard Business Review you say “I…began to think of my work as a part of nation building, especially training and developing the next generation of young man-agers who would run the company and the country.” What specifically would you teach Indian bureaucrats about management, given your experience at Proctor & Gamble?

Das: Ultimately, the main thing that the Indian government needs to learn from the private sector is accountability. It will not only make it more efficient, but also raise the level of hap-piness in our society. When the bureaucrat is more accountable (accountable for results), it will improve governance. We have very good bureaucrats but 80 percent--well, nobody knows what percentage--are bad and it seems like everything you want from the state is, as I said in my book [The Difficulty of Being Good], is morally flawed. I need to get a new driver’s license and I am already worried: will I have to pay a bribe in order to get that license? But behind that, about 20 percent of bureaucrats work very, very hard and it’s not fair to them because they don’t get any reward; in fact, they are punished. So we need to create a system where good people are rewarded and bad people are punished, and that’s what the private sector does very well.

CER: Given your experiences, what can India do to train its civil servants, who are known to be among the brightest in the country but lack managerial skills, with a better understand-ing of supervisory techniques that work in local settings?

Das: The whole system in which they are operating is rotten. As you said yourself, these are the brightest people in the coun-try but they very quickly lose that sense of purpose because the system is rewarding bad behavior and not rewarding good behavior or hard work. A starting point? When people are wait-ing in line for you to give them their passport, talk to them and ask them how you can make their life a little bit better, make the line shorter, make the line more orderly. Just pay attention to your customers. That’s the heart of the market, it rewards you--those companies--that listen to the customers-- they’re re-warded through higher market share and so, it pays to be good.

CER: Regulatory capture has often hindered the work of Indi-an bureaucratic institutions. One situation that comes to mind is the plight of India’s struggling railways which lost $4 bil-lion last year, and yet cannot increase fares. Has the promised provision of public goods damaged the collective good?

Das: I do not believe so but, again, our institutions must change to keep up with the times. If we had clear titles on land in our system, for example—that is one of the defects in our system--if the poor had a clear title then they could actually go to a lend-ing institution and collateralize it to start a business. I wrote a

column about this [in the Times of India] titled “Give People Ti-tles, Not Cakes.” The whole idea is to make it easier for peo-ple. In India today, the vast majority of people are in the in-formal economy, and actually the informal economy is actually a very entrepreneurial economy. To survive on such a low in-come you have to be entrepreneurial. But what the states can do is to make it easier for them. Today, a fellow who sells on the street constantly has to pay a hafta [bribe] to the police--it is extorted from that poor fellow. So give hawkers spaces from where they can legitimately sell their wares: we have a nation of entrepreneurs so we must make it market-friendly to these entrepreneurs. See, when we think of entrepreneurs, we think of Mukesh Ambani, but every Indian is really an entrepreneur. Unfortunately, the License Raj still exists for these poor en-trepreneurs very strongly. Every year the World Bank does a study called “Doing Business” and we rank among the lowest because we are so unfriendly and this especially hurts the poor. The number of days it takes to start a business, the number of people you have to bribe to start a business--if all that can be made easier, think of the possibilities! In some countries, you can just start your company on the Internet; all the forms are there and you are in business the next day. If we can do that, then we make it easier for people. They will have titles, they will have security.

CER: Indian entrepreneurs claim that they are hardier because they have had to fight not only their competitors, but also state inspectors. In China, however, local communist boards create everything from co-op boards to entire R&D divisions to help their industries flourish. Do you think this short-run disadvantage will help India’s companies compete with their Chinese counterparts in the long run global marketplace?

Das: Well, theoretically, if you start the entrepreneurial game early, you have a first mover advantage. Because the Chinese entrepreneurs are in the government, meaning that they are state-owned enterprises but very cleverly they have aligned the interests of the party and the state functionaries, there is a reward for entrepreneurial behavior and so that is why those enterprises are doing well. So in effect what you have done is created millions of Chinese communist party or state entre-preneurs because they have a cut, a kind of benefit from those state enterprises. And maybe those state enterprises will slowly begin to resemble private companies and everything will work out very well, one doesn’t know what will happen to those en-terprises. In reality, in some ways today, the Chinese system is a lot more market-friendly because the regulators and the state officials have a vested interest in the success of their enterprises and, thus, are more market friendly to investment and growth. But how that will play out in the end, I do not know, it is hard to say. As I said, the race between India and China will be won not by who creates prosperity faster but by whether India fixes its governance before China fixes its politics, and it is hard to forecast either.

To read the remainder of this interview, please visit our website at ColumbiaEconReview.com.

Fall 2010

Interviews & Events 15

Show Me the Treasury BondsDiscussing the Second Round of Quantitative Easing

In November 2010, Sally Davidson, an adjunct professor of economics, and an inti-mate group of concerned students sat down in Lerner Hall for a discussion of the causes and consequences of the Federal Reserve’s second round of quantitative easing. Over hot pizza and the cold objective geometry of economic models, the first Economics Forum of the year touched on a slew of issues in cen-tral banking ranging from inflation expecta-tions to interest rates.

As it stands today, economic indi-cators widely believed to track fluc-tuations of the business cycle have per-formed quite well, even pointing to an uptick in economic activity in the spring of 2011. However, there are still major drags in the economy, and the largest of which is the housing sector. When asked if housing prices are likely to dip again, Davidson replied that due to “shadow inventory,” another dip is not out of the question. This shadow inventory in-cludes houses in foreclosure that have yet to be sold and houses that owners have yet to put on the market as they wait for a resurgence in the housing market. According to Davidson, “if that shadow inventory comes into the mar-ket, there may be a temporary stabiliz-ing in housing prices, but we could have another dip.” This state of affairs is primarily why the Fed finds itself implementing its second round of quantitative easing, or QE2. On August 23 last year, when Fed-eral Reserve Chairman Ben Bernanke first broached the possibility of imple-menting QE2, expected inflation was hovering at around 2 percent, slightly above the established federal target. Pri-or to the financial crisis, the Fed’s policy tools for such a situation were limited to open market operations, which include lowering the discount rate and federal funds target rate and issuing “moral

suasion” via public statements. When the federal funds rate reached the lower bound of zero on December 18, 2008, market-watchers became concerned about the possibility of further dips. With interest rates at zero percent, Da-vidson noted that the Fed certainly “can-not ease in a traditional way.” To tackle the economic slump, the Fed utilized all the aforementioned policy tools; it tinkered with the federal funds rate, adjusted the discount rate, and repeatedly issued official statements to sway market expectations. However, none of these has sufficiently reinvigor-ated “animal spirits.” Enter quantitative easing. The first round of quantitative easing, QE1, began in 2009 with a plan to purchase $1.5 trillion of mortgage-backed securities to bolster financial institutions. QE2, which commenced in November 2010, is a process wherein the Fed plans to inject up to $600 billion of liquidity into the economy through the purchase of treasury securities. Put another way, the Fed uses the size of its balance sheet to affect credit conditions. Between the start of the financial cri-sis in mid-2007 and the failure of Lehman Brothers in September 2008, the size of the Fed’s balance sheet remained largely unchanged. Most research found that the effective long-term rates dropped at most 100 basis points thanks to the Fed’s first round of quantitative easing. However, Davidson remarked that QE2 is “a little bit different” since its main goal was presumably to lower mortgage lending rates. After the Fed announced that it was going to implement QE2, it publicied its plan to purchase over $600 billion worth of long-term treasuries by late 2011. This amounts to $75 billion of treasury securities per month. As an in-dicator of QE2’s potential, consider the moral suasion effects of its announce-ment: when Bernanke first started talk-

ing about QE2, long-term treasury rates declined around 20-25 basis points. What, then, is the downside to QE2? “The liability side of the balance sheet has to increase along with the increase in assets,” Davidson stated. The major problems lies in the accumulation of ex-cess reserves. Banks are holding trillions of dollars in reserves on deposit at the Fed. If the Fed does not tighten mone-tary policy in time, the excess reserves could result in high inflation if and when banks start to loan this into the economy, causing the Fed to lose credibility. Although the Fed has several exit strategies, none is ideal. “You could try to shrink the balance sheet by letting things [long-term treasuries] mature,” Davidson said, “but that takes time.” In-stead, the Fed must find a way to shift the money from excess reserves to an-other category where the banks cannot immediately lend it out. Repurchase agreements, or repos – the practice of temporarily selling securities with an agreement to buy them back – are one possible option; the Fed could then move funds out of excess reserves and pay interest to a small group of banks known as primary dealers. What is most troubling, however, is the dire situation we might see ourselves in if all other options fail. Davidson ru-minated on the possibility in which the Fed not only fails to remit profits to the Treasury but also experiences a shortfall. As she sees it, if the Fed has to go to Con-gress hat in hand, pleading for money, the central bank will lose credibility and possibly even a fair degree of independ-ence. This could be the end of central banking as we know it. Monetary policy, it seems to Davidson, can only do so much.

To subscribe to the Economics Forum listserv, please send an email to [email protected]

E C O N O M I C S F O R U M


16 Interviews & Events

E C O N O M I C S F O R U M Tips for Networking and InterviewingBy Lucia Manzo and Gabrielle Berg

Networking InterviewingHave an answer preparedEvery interview begins with some form of the question, “Tell me a little about yourself.” This question, usually one of the first asked, is one of the few times in the interview where you can take control. Keep your self-introduction brief and rele-vant; condense your answer to four to six key “bullet points” to present in one or two minutes. To avoid digressing, script your response and practice aloud beforehand.

Know your resumeThink of ways in which you can relate your activities to the skills required of the job. If your resume lists high school ac-tivities or awards, make sure you can still explain them. Resist the urge to inflate your resume; if you took two years of el-ementary Spanish but can barely compose a sentence, do not write “fluent in Spanish”. The last thing you want is for your your interview to begin with “¿Cómo es usted?”

Know the companyResearch the company and the role you applied for. Informa-tion on corpoate websites can provide invaluable background knowledge for the interview. In particular, read through the company’s “About Us,” “Careers” and “Our Team” sections. Moreover, keep up with current news of the company.

Have examples readyInterviewers love asking for examples of experiences that demonstrate skills relevant to the job. For example, if you are applying for a job that entails collaboration, the interviewer might ask about your past teamwork. Ponder experiences that can illustrate your work ethic, determination, creativity, or ability to work well with others.

Ask a question or two:Every interview concludes with, “Any questions for us?” Have at least one question prepared, perhaps about the con-tent of the interview or the company itself. This is your chance to demonstrate to the interviewer your interest and initiative.

FocusResearch the firms and industries you find appealing and rel-evant to your background. Ask yourself, do I see myself grow-ing at this company and improving or gaining skills sets? Does this firm value young employees and their careers?

PreparePosition your resume and cover letter with your best attrib-utes; apply your experiences to justify how your qualities will benefit each employer. This brainstorming will help prepare you for articulating your skill set in interviews.

Be YourselfAsk yourself: am I coming across as me? Am I genuinely inter-ested? Take some time to investigate the qualities and attrib-utes you value in yourself and your firm. Remember, you will be devoting much of your life to your career, so choose a path that represents yourself!

Be ConfidentHave faith in your preparations. Remain focused and know yourself. Balance your confidence with humility.

ConnectBe sure to gain exposure to your desired firms through infor-mation sessions and campus events. Listen to the firm’s em-ployees, who have taken the time to share their views. Be pre-pared to ask intelligent questions.

ReconnectReconnecting is crucial. Continue to reach out to those with whom you have made a connection. Though you will not be able to connect with everyone, focus on the individuals you feel you have made an impression on. A concise email with a few good questions can lead to more conversations. Keep up with your network; after all, even an occasional email can help maintain relationships.

Everyone gets a little nervous and it is easy to become quiet and reserved, but avoid appearing disinterested or lacking in personality and passion. When you describe an activity on campus that you are involved with, let your enthusiasm for that activity shine through. After all, who wants to associate with someone with a monotone, melancholy aura? Remind yourself that connecting with someone involves merely a conversation. Above all, remember to be upbeat and enthusiastic.

Fall 2010

Business Economics 17

Gone in a Flash SaleHow Gilt Groupe is Rewriting the Rules of Retail Caroline Casey, Benjamin Eckersley, Hadi Elzayn, and Dasha Wise

In the 1990s, when e-commerce first appeared on the business scene, web-sites were little more than mail order catalogues transplanted onto the Inter-net. Today, however, second-generation websites arriving in the wake of the so-cial networking hype of the mid-2000s make full use of technology in order to achieve a high level of consumer cus-tomization and access to target niche markets. In doing so, these new web-sites have revolutionized the traditional model of retail sales and, in particular, the business of online luxury retail. Ac-cording to Bloomberg Businessweek in 2009, while specialty retail chains suf-fered a 5-7 percent decline in sales, top private-sale sites actually experienced a fivefold increase in sales per year. Gilt Groupe, a particularly successful online luxury retailer, through its use of “flash sales,” a precisely targeted and highly effective marketing strategy and an in-ventory model that is quickly changing the way even traditional brick-and-mor-tar retailers do business, has piqued the interest of industry leaders, fashion de-signers, and customers alike, even going so far as to alter consumer demands and expectations. Founded in 2007 by an innovative group of entrepreneurs, Gilt Groupe offers members a range of luxury mer-chandise, such as men’s and women’s clothing and accessories, high-end home products, and extravagant vacation packages. Although Gilt’s flash sales are a derivative of traditional in-store sample sales, Gilt’s model is unique not only due to the steep discounts offered (as large as 70 percent off retail price) but also the limited-time sale format, typically lasting only 36 to 48 hours. Al-though membership can be requested through Gilt’s website, it is generally by invitation only and most members

join as a result of having been invited by friends or acquaintances who receive a gift card from Gilt when one of their in-vitees makes a purchase. Apart from ex-clusivity, these sites also employ a sense

of urgency in order to induce sales. The flash sales and their interface (the clock and the members’ carts) reduce the an-onymity and convenience of Internet shopping. In terms of competition, this atmosphere is more akin to physical shopping with a deadline that employs some aspects of auctions. Exploiting human psychology lies at the heart of Gilt’s social e-commerce model. Gilt’s marketing strategy, then, is non-traditional insofar as it focuses more on interpersonal connections rather than direct advertising to build brand awareness. This low-cost strategy appears to have been nevertheless ef-fective, as membership in this pseudo-exclusive and chic club currently stands at approximately two million and has grown exponentially from the date of its establishment. Given its customized shopping structure and product offer-ings, Gilt attains its success largely by catering to the interests and demands of a precisely targeted customer base. According to data, most visitors to Gilt.com are childless Caucasians and col-lege graduates with incomes of more than $100,000 who typically browse from work. In addition to its sales strategy, Gilt, along with other retail reselling sites, also utilizes a unique model of inven-tory management by buying the excess inventory of wholesalers at discounted prices and reselling them at lower pric-es for consumers. With its flash sales, Gilt is able to maintain a quick rollover time between products. The countdown clock, the expiration of items from shop-pers’ carts, and the air of competition all work to ensure that customers act quick-ly to lock down scant items; altogether, this minimizes inventory risk, and, un-like the wholesalers the company buys from, Gilt manages to empty nearly


18 Business Economics

Exploiting human psychology lies at the heart of Gilt’s social

e-commerce model.

all of its inventory. However, while its sales format and service offerings have certainly translated into significant rev-enue for Gilt and allowed the nascent company to weather one of the worst economic downturns of our times, Gilt’s success may, in the long-term, come at the expense of the luxury goods indus-try.

Andrew Rice, writing for New York magazine puts forth exactly this ques-tion: if Gilt continues to expand its mem-bership base and its ubiquity within the market for luxury goods, will customers still be willing to pay full price for the same brands that they can otherwise purchase through Gilt at an enormous discount? If they are not, then perhaps the very brands that currently partner with Gilt have a reason to actually wor-ry about the exposure that they take on through the partnership. While it is still too early to gauge the extent and mag-nitude of such an effect, it is reasonable to believe that consumers accustomed to Gilt’s deep discounts may significantly reduce their estimations of the fair value of the featured luxury merchandise or, perhaps, luxury products in general. Thus, while in the past three years we have witnessed tremendous growth and financial success from Gilt Groupe and similar online retailers, it remains to be seen how such platforms will affect the demand and profitability of traditional sales of luxury brands as well as the in-ventory management models of tradi-tional department stores. There are some indications, how-ever, that the stunning success enjoyed by these sites may not last. According to Steven Dennis, a marketing consultant with 25 years of experience, the overall decrease in demand seen during the eco-nomic downturn left wholesalers with excessive inventory, and it is largely due

to this reason that resale sites like Gilt have been able to provide such hefty discounts on high fashion items. As the economy has begun to emerge from the recent recession, wholesalers are left with less excess inventory, and sites like Gilt have already begun offering smaller discounts. In addition, Gilt has begun to expand to other areas beyond its initial market, such as travel bookings, wine, and spa packages, and this suggests a somewhat saturated market in the ini-tial niche; Dennis says it “smacks of des-peration.” At the least, there will have to be some sort of evolution in this trendy model if it is to continue growing with the same robustness it has shown in the past. Although the concept of online re-tailing is an extension of the traditional brick-and-mortar store model, the suc-cess of Gilt and similar sites has re-flected influence in the opposite direc-tion, pressuring conventional retailers and department stores to modify their marketing and distribution practices. Many have experimented with similar strategies: Neiman Marcus, for example, has incorporated in-store sales just two hours in length, hoping adrenaline-fren-zied consumers will flock to stores and make purchases essentially on impulse. Saks Fifth Avenue has launched its own

version of a flash-sales website, “Fashion Fix,” with exclusive invitation by e-mail for 36-hour sales, while eBay, noting the success of this trend, has introduced a “Fashion Vault” section with similar flash sales and designer merchandise to boost diminished sales brought on by the recession. In another twist in the e-commerce model, Nordstrom Rack part-nered with the site Groupon to provide 50 percent discounted coupons to online customers, a venture that resulted in the sale of thousands of such coupons a day, vastly increasing turnout in the physical store. It appears that Gilt Groupe, along-side other second-generation e-com-

merce business models, is forcing on-site luxury retailers to rethink many of their traditional operating paradigms.

Conclusion The success of Gilt certainly empha-sizes the growing importance of the In-ternet in the business of retail. Through its flash sales format, unique and highly targeted marketing strategy, and dis-tinct inventory model, Gilt has not only made luxury goods more affordable but also increased awareness and demand for these same goods. During its week-day sales, for example, Gilt logs well over 100,000 site visits by eager shop-pers in the immediate hour after the sale commences. “For that time, it might as well be the most crowded store in New York,” posits New York magazine. This competition has encouraged traditional retailers to expand their efforts onto the online realm, where they will likely borrow the same innovative sales tech-niques that Gilt and other such online retailers have instituted. The business of luxury retail has drastically changed for customers, fashion designers, and retail-ers alike: how much further these sec-ond-generation e-commerce websites can expand in this market however, is a question that remains to be answered.

Fall 2010


Gilt Groupe, alongside other second-generation e-commerce business models, is forcing on-site luxury retailers to rethink many of their traditionl operat-

ing paradigms.

The business of luxury retail has drastically changed for cus-tomers, fashion designers, and

retailers alike.

The Bright Lights of Silicon AlleyNew York City’s Growing Entrepreneurial SectorRaphaela Sapire

With over 45 startups, six venture capital firms, and five entrepreneurial working hubs, New York City’s startup scene is booming and shows no sign of slowing. A multitude of factors, such as a favorable economic environment, private and public funding initiatives, historical business leadership, and an overall decrease in startup costs all help to explain the burgeoning entre-preneurial landscape in New York that has come to be known as Silicon Alley. At a technology conference in rival Sili-con Valley, Mayor Michael Bloomberg highlighted New York City’s leadership across several industries and the result-ing advantages, emphasizing, “When you want to start a business, you don’t have any choice. This is where the best and the brightest are.” Despite the cur-rent economic climate, the evolution of Silicon Alley places New York City at the heart of a technological convergence that revives its historic entrepreneurial leadership.

Unique social and historical factors define the culture of entrepreneurship in New York City, setting it apart from that of any other city in the country. Un-like other colonial cities such as Boston or Philadelphia, New York was found-ed on the premise of entrepreneurship. The Dutch East India Company arrived in New York Harbor on September 3, 1609, and by 1624 the Dutch West India Company established New Amsterdam for the sole purpose of capitalizing on

the lucrative fur trade. This culture of openness and innovation sets the stage for a thriving entrepreneurial mindset throughout the 21st century, particu-larly in the financial, fashion, and me-dia industries. In 1792, the New York Stock Exchange played an indispensa-ble role in the growth of New York City as a commercial center. Edward Glaeser, professor of economics at Harvard Uni-versity, comments that in the 1960s, fi-nanciers’ “more sophisticated approach to risk and return” enabled entrepre-neurs to expand the volume trades on Wall Street such that by 1972, 32 million Americans owned securities, compared to only 12.5 million in 1965. Additionally, the garment industry exploded in New York City after the Civil War when newly arrived Jewish

immigrants formed small businesses specializing in the clothing industry. Manufacturing played an essential role in New York’s economy during and after the Industrial Revolution and to-day, New York is one of the fashion capitals in the world. Since the creation of the Penny Press in 1833, New York has served as the media center of the country, with most leading magazines, influential newspapers, and broadcast networks headquartered here. Histori-cal leadership in the financial, garment, and media industries positioned lo-cal entrepreneurs in these industries with distinct competitive advantages in relationships, resources, and pub-lic relations. Beginning with the Dutch emphasis on innovation and continu-ing to the inventors and entrepreneurs


20 Business Economics

[New York] pulled itself from the ashes of the dot-com crash

and has risen back to the upper echelons of the top tech cities.

responsible for today’s groundbreaking technologies, New York City’s technol-ogy startup space can be explained as an extension of the city’s historic entre-preneurial success onto the online plat-form. Dubbed “Silicon Alley” in refer-ence to its competitor Silicon Valley in the San Francisco Bay Area in Califor-nia, New York City is “now on its way to cementing its reputation beside Sili-con Valley as a driving global force in the industry,” according to Chris Cam-eron, a writer for ReadWriteWeb, one of the largest technology blogs in the world. Just as it had led the way in fi-nance, fashion, and media, New York in the late 1990s was on the cutting edge of web innovation during the dot-com bubble. For example, Prodigy, the first online service to provide access to the World Wide Web, emerged in 1993 in White Plains, New York. New York In-ternet companies such as Razorfish, DoubleClick, and Pseudo followed suit and with them came Union Square Ven-tures, a venture capital firm run by Fred Wilson. According to Wilson, in 1999 alone, over 500 startups were founded in New York City. The dot-com crash of 2001, however, resulted in the decline of venture-backed technology startups in generating economic activity in the city. Yet, as Cameron points out, in the dec-ade after the Internet bubble burst, New York “pulled itself from the ashes of the dot-com crash and has risen back to the upper echelons of the top tech cities.” Today, New York City boasts an im-pressive variety of successful startups and entrepreneurial resources. Accord-ing to CBInsights, a comprehensive database of private companies, New York City is uniquely specialized in In-ternet startups compared to California and Massachusetts. Between July and September of 2010 alone, New York City reaped 31 Internet-related fund-ing agreements garnering $126 million, while Silicon Valley acquired 21 deals bringing in $174 million. According to TechCrunch, six of the top ten startups with the most funding in New York City are in the finance, fashion, or media in-dustries, and all of them are web-based. Internet startups in finance include Se-condMarket, an online portal for trad-

ing shares, Fynanz, a private student loan platform, and Seeking Alpha, a stock market news community. Tech

startups specializing in fashion consist of Gilt Groupe, an online designer re-tailer, while social media sites such as Gawker and Thrillist also call New York City their home. The advent of the Inter-net necessitated that companies in eve-ry industry—from education to restau-rant—establish online capabilities, and with New York City’s historic business leadership, it is easy to see why the city has become a favorable environment for startups in these industries. Other trends explain New York City’s explosive startup scene. One ex-planation for the proliferation of Sili-con Alley is the ever-decreasing costs of starting web-based businesses, a fact that has enabled entrepreneurs to launch companies without venture capital backing. Entrepreneur Paul Gra-ham cites four reasons for the low costs of establishing a startup: “Moore’s law has made hardware cheap; open source has made software free; the web has made marketing and distribution free; and more powerful programming lan-guages mean development teams can be smaller.” Startups simply do not need legions of investors the way they did ten years ago.

In addition to existing resources, public funding has also contributed to the rejuvenation of Silicon Alley. In a

2009 press release, Mayor Bloomberg, along with the NYC Economic Develop-ment Corporation, announced 11 initia-tives totaling $22 million to help support business innovation and entrepreneur-ship. Two such initiatives fund an incu-bator to help startups obtain office space at affordable rates. In addition, a $3 mil-lion investment in a program called the Angel Fund will provide financing to 250 New York-based startups over the next eight years. Small businesses create jobs, and in a city with a 9 percent un-employment rate, these initiatives will help spur job creation. The 2008 financial crisis has creat-ed a legion of talented, eager students looking for employment who otherwise would have gone to established banks and corporations. Universities such as Columbia University play an increas-ingly significant role in New York City’s emerging tech-based economy. Accord-ing to the Association of University Technology Managers, in 2007, 21 start-ups emerged out of the city’s major uni-versities. Over half of these originated from Columbia University, which spun off 12 startups – up from eight in 2002. David Lerner, director of the Columbia Venture Lab, calls student entrepreneur-ship an “emerging colossus” that is in-creasingly a part of Columbia Univer-sity’s educational mission. Mirroring the environment of the city, the entre-preneurship community on campus is gaining momentum and more and more becoming a career of interest to students who have come to realize the vast op-portunities available in the industry. A city’s past informs its future; the most significant quality in New York City throughout its history has been its ability to reinvent itself. During a 2010 conference hosted by Union Square Ventures, there was wide consensus that New York City had an “unprecedented opportunity to emerge as a global center for tech and media innovation and that technology startups could be the largest part of the New York City economy in 10 to 15 years.” As a rapidly growing industry, New York’s technology sector is an increasingly attractive option for bright college students with interests in industries as widespread as finance, fashion, and media.

Fall 2010


With New York City’s histori-cal leadership in finance, fash-

ion, and media, it is easy to see why the city has become a

favorable environment for start-ups in these industries.

Mirroring the environment in the city, the entrepreneurship

community on campus is gain-ing momentum.

Seeing the Forest for the TreesDeforestation and Cost-Effective Regulation of the Timber IndustryEllen Liu, Danni Pi, and Dasha Wise

In 2009, Elinor Ostrom received the Nobel Prize in Economics for her ground-breaking research regarding a localized and highly decentralized solution to the “tragedy of the commons” problem. This problem, as originally posited by ecologist Garrett Hardin in 1968, arises due to the fact that the use of common property cannot be restricted and that in such circumstances an individual’s mar-ginal benefit always exceeds his mar-ginal private cost (although not neces-sarily marginal social cost). This results in overexploitation of natural resources and net social welfare loss via economic inefficiency. Commonly advocated solu-tions to the commons problem include the privatization of common resources or extensive federal regulation. Ostrom proposes an alternative solution – that of local self-governing institutions. In her 2003 article “The Struggle to Govern the Commons,” co-authored with Thomas Dietz and Paul Stern, Os-trom posits that when certain conditions hold (including easy monitoring of re-sources, verifiable information, moder-ate rates of change, effective communi-cation, dense social networks, ability to exclude outsiders, and user monitoring plus enforcement) local communities are the most effective agents in prevent-ing the overexploitation of common re-sources. This is because local communi-ties have not only greater information about the importance and most effective utilization of a given resource, but are also able to effectively monitor and reg-ulate overexploitation of such resources at much lower cost through mechanisms such as social pressure. This process is what Ostrom refers to as adaptive gov-ernance, for it takes into great considera-tion local needs, resources, and abilities. Ostrom’s theory of adaptive gov-ernance may be employed in the global

forest reserve, an important example of a common resource whose exces-sive exploitation through deforestation remains one of the most important en-vironmental issues facing today’s inter-national community. Among the chief harms of deforestation are the emission of carbon dioxide and other greenhouse gases, contributing significantly to glob-al warming and climate change, and the loss of the very flora that serve as an invaluable carbon dioxide sink. De-forestation, then, is inextricably linked to the largest environmental concern of the 21st century. Other direct harms in-clude the loss of biodiversity, extinction of marginal species through the destruc-tion of natural habitats, the disruption of ecosystems, the desiccation of soil, the opportunity costs of potential future uses of forest resources, the aesthetic damage, the loss of tourism value, and the disruption of local villages and com-munities.

Hence, it is in the interest of all countries to protect their natural forest reserves since it is only through protect-ing these reserves that countries can implement a sustainable development strategy, attaining an optimal level of economic and social welfare while bal-ancing imminent concerns for the envi-ronment and natural resources. In this analysis, we will specifically examine the issue of deforestation in light of the commons problem and the efficiency and cost-effectiveness of employing a

local, decentralized regulatory approach in achieving sustainable practices for forestry regulation similar to the adap-tive governance suggested by Ostrom. Specifically, we will focus on the regula-tory policies of India and China, two of the most important decision makers on the global stage of timber industry reg-ulation and sustainable development, which have demonstrated effective im-plementation of a highly localized en-forcement regime with respect to the regulation of their lumber industries.

Case Study 1: Republic of IndiaIn the span of the past several decades, India’s economy has become the world’s fourth largest on the basis of purchasing power alone. In relation to the rest of the world, India has 2.5 percent of the world’s geographical area, 1.8 percent of the world’s forest area, and, as of 1996, 16 percent of the world’s popula-tion. For a landmass that was once 31.24 percent covered by forests and greenery, India is currently only 22.6 percent cov-ered by forests, 12.9 percent of which are dense forests. This decrease occurred despite precautionary and regulatory legislations that have been in place since the 1920s – a consequence of illegal log-ging on the part of commercial interests looking to fulfill demand in neighboring countries as well as ineffective oversight and management on the part of the gov-ernment. Under the Indian Forestry Acts, for-ests were divided into three categories: reserve, protected, and village forests. Forests deemed “reserved” are those in which people have no rights unless specifically recorded. Protective forests are those on hill slopes and riverbanks, where forest cover is dictated by physi-cal considerations of erosion, conserva-tion of moisture, and potential floods; in


22 Theory & Policy

The need for greater participa-tion and consensus remains a

key next step for the internation-al community to undertake.

such areas, all rights are expressly for-bidden. Village forests are fuel forests intended to meet the needs of the sur-rounding population. In accordance with the National For-est Policy, the main goals of manage-ment were based on paramount nation-al needs as opposed to local needs. The major national needs included develop-ing a system of balanced and comple-mentary land use, ensuring an increase in supplies of grazing, small wood, and firewood, and establishing a sustained supply of timber and other forest pro-duce for industry. However, as a result of loopholes in legislation, not only was the state government prohibiting villagers from accessing their own community’s re-sources but was also approving vast mega-projects involving large-scale destruction of large forest areas. From 1952 to 1980, over 4.3 million hectares of forestlands were lost to various purpos-es as a result of these loopholes (World Rainforest Movement). Over 2.3 million hectares of these lands were used for other agricultural activities, and over 130,000 hectares were diverted to indus-tries and townships. The 1988 Amend-ment to the earlier Forest Conservation Act of 1980 further limited the authority of state governments to turn over any land to private individuals, groups, or corporations, thus optioning the author-ity back to higher levels of government. Despite the shortcomings of this legislation, the central authority with respect to forest management was the National Forest Policy of 1988. The National Forest Policy introduced the scheme of Joint Forest Management (JFM) which at the most basic level is a forest management strategy wherein the Forest Department and the village communities jointly protect and man-age forestland. In return for this respon-sibility, the villages share in the profits of their management. To date, JFM has been implemented on more than 17 mil-lion hectares of degraded forest through over 63,000 Village Forest Committees and spanning 27 states of the Indian Un-ion. Under JFM, the village community receives greater access to a number of Non-Timber Forest Products, or NTFPs

(products such as nuts, roots, and other valuable plants that can sustain the vil-lage without impacting the trees), and a share of timber revenue in return for increased responsibility for their protec-tion from fire, grazing, and illicit har-vesting. For many poor villages, this is extremely important to economic wel-fare. In the state of West Bengal, forest communities derive as much as 17 per-cent of their annual household income from NTFP collection and sales. Further-more, as of the late 1990s, over 50 per-cent of national forest revenue and ap-proximately 70 percent of national forest export revenue comes from NTFPs. The strategies of JFM are reminiscent of the self-governing institutions pro-posed by Ostrom, who would consider this strategy most effective given the conditions of practicability, cohesion, and social pressure. For example, after the initial conflicts with timber thieves of neighboring villages, residents of Behroonguda, a small village in India,

collectively prepared themselves for change by forming a forest protection organization to address the conflict. The village induced rule compliance by ex-panding participation in an effort to in-clude a majority of the villagers; the per-ceived participation of the entire village is paired with an individual’s responsi-bility to uphold the expectations of JFM. These techniques fit squarely with the characteristics of adaptive governance outlined by Ostrom: conflict manage-ment, rule compliance, infrastructure, and preparation for change. Indeed, while at the beginning of 1990 the area surrounding Behroonguda was barren, by 1998 the 250 hectares of forestland that had received silvicul-tural protection and treatment were lush again, increasing their value to 147,897 rupees per hectare compared to the neighboring Chintapally, which did not employ JFM and held a forest value of 45,613 rupees per hectare. Due to the access afforded to the villagers via JFM

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Theory & Policy 23

and the positive actions of the Protection Committee, many of the NTFPs have reemerged, revitalizing an entire econ-omy. In 1998, about 20 tons of NTFPS worth 144,959 rupees (approximately $32,441.73 in current U.S. dollars) were extracted from the forest, allowing vil-lages to obtain higher standards of liv-ing. So far, the JFM program has been both successful and cost-effective. In the village of Behroonguda alone, the total cost (including village patrolling, forest department salaries, silvicultural treatments, and other expenses) of the program is $5,574.52, while the total benefits (including additional wages for forestry employees, NTFP sales, and the sale of poles from thinning) amount to $14,288.95 per year. Thus, in this small village alone the net gain from the policy of JFM is in excess of $8,714.43 per year. When such a cost-effective policy is im-plemented on a national scale and prop-erly applied to other Indian villages and communities, the total net gain to social welfare per year will greatly increase.

Case Study 2: ChinaAs China continues along its double-digit growth trajectory, policymakers must decide the optimal balance be-tween economic growth, increased so-cial welfare, and the sustainable use of resources. In a statement made in 2007, China’s State Forestry Administration spokesperson Mr. Cao Qingyao stated that “[under the current national forest policy,] China’s forests are expected to cover nearly one-quarter of its land mass by 2020 and the country does not fore-see any major problems in meeting its paper and timber needs. In fact, China’s forestry coverage rate has risen from 8.6 percent to 18.2 percent in the past 58 years…and has planted 53.3 million hec-

tares of forestland, more than any other country in the world.” While the cur-rent expansion rate of forest resources in China may sound highly optimistic, these figures should be examined with caution. It is essential to remember that China is in a unique position of resource usage due to its population and cur-rent economic growth. Despite forestry coverage of approximately 175 million hectares, ranking it fifth in the world for forest coverage, and a standing tim-ber stock of 12.5 billion square meters, China is still considered forest-deficient. This is because, apart from China’s growing population, which intensifies the stress placed on the country’s natural lack of forest resources, another source of tension is the country’s rapid economic growth. China’s GDP growth in the last two decades has had significant negative effects on its forest resources. Domesti-cally, China is now experiencing a num-ber of serious social and environmental crises related to the overexploitation of its forests. Facing the ecological conse-quences of the overexploitation of for-est resources and the growing pressures from “the demand side for products to be created in a sustainable manner,” the Chinese government has drastically re-oriented its forest policy since the 1980s, moving from a timber-production strat-egy to an ecosystem conservation and resource restoration strategy. For these reasons, China has introduced the Six Key Forest Projects (SKFP) and new pol-icies to “expand its forest growing and manufacturing base, improve degraded land, and provide more sustainable live-lihoods for millions of forestry-depend-ent communities.” Perhaps the most important provi-sions of the SKFP are the Natural For-est Protection Program (NFPP) and the Conversion of Cropland to Forest Pro-gram (CCFP), both of which can be la-beled as devolution agendas. In these programs, village committees, rather than a centralized bureau, undertake much of the decision-making. Commit-tees are active in deciding when and where to establish forest plantations on their collective land and what species to plant. In many cases, the committees are also able to enter into contracts that lease their land to either villagers or out-

siders to reforest in exchange for profit. In terms of the CCFP program, the gov-ernment has taken the initiative to pro-vide farmers and households with the necessary stipends, tax cuts, and seeds needed to replant the land as the com-munity leaders deem appropriate. What is crucial to note is that these village committees are able to make their own regulations that adapt national policy to local conditions. Currently, the SKFP is widely regard-ed as an effective plan by which to refor-est China. Under the NFPP, 95 million hectares of forestland have come under effective protection. In addition, the gov-ernment has successfully reforested five million hectares of barren land, banned logging in natural forests, and reduced timber harvesting from 18.24 million in 1997 to 11.26 million square meters in 2005. Similarly, under CCFP, the country has successfully converted 18 million hectares of unnecessary croplands (cre-ated during the “Great Leap Forward”) back to forestlands. In total, approxi-mately 120 million hectares of forest, or 12.5 percent of China’s land area, are now protected within 1,699 Wildlife and Forest Reserves. It is both necessary and instructive at this point to assess whether SKFP has been efficient. In other words, do the monetary benefits of restricting logging, timber harvesting, and reforestation ex-tend beyond the costs of implementing the SKFP? In terms of the NFPP, while it is difficult to assign a value to the eco-nomic losses accrued to China due to the ban in logging and timber harvest-ing in many areas, we can state with certainty that it affects the present eco-nomic growth of the country negatively. Beyond the economic loss, the ban has also contributed to the displacement of approximately 670,000 forestry workers with $300 million in unpaid salaries. In an effort to assist the workers, the gov-ernment has become burdened with stipends paid to unemployed forestry workers. Upon combining all of the eco-nomic impacts, the grand total cost to the government in establishing the SKFP is $85 billion, in addition to the amount spent on stipends and other social wel-fare programs for displaced workers. On the other hand, the banning of


24 Theory & Policy

Residents of Behroonguda, a small village in India, collectively

prepared themselves for change by forming a forest protection

organization to address conflict.

logging and timber harvesting has de-creased pollution and soil erosion prob-lems, while creating a booming national forest tourism industry which has pro-vided the country with 1.6 million jobs and $300 billion in revenue. Thus, while China has decreased its economic ben-efits by restricting its use of resources, it has created a very valuable tour-ism industry that will increase overall net social benefit in the years to come. However, it is necessary to remember that such costs of stipends are typically one-time costs and were used to initiate the program and help farmers switch from crops to reforestation. On the other hand, China has built a strong tourism industry on top of its reforestation pro-gram that brings in revenue of approxi-mately $300 billion yearly. China also now effectively manages 12.5 percent of its landmass under Wildlife and Forest Reserves. On the basis of the large increases in protected forest resources over the last three decades as well as the cost-benefits analysis of the NFPP and CCFP pro-grams, the SKFP program is relatively efficient and cost-effective. Neverthe-less, even effective and efficient pro-grams have certain flaws. In terms of China’s SKFP program, there are still is-sues, like illegal logging, that the central government is struggling to address. Both illegal logging and fuel wood gath-ering are the result of a failure to enforce the NFPP in certain areas of the country. However, the overall NFPP program still seems to be the best current solu-tion, as the amount of illegal activity as-sociated with the program is limited and the NFPP minimizes the cost of state regulation and enforcement through its “collective management” foundation, where village committees are responsi-ble for preventing the illegal logging un-dertaken by members of their villages.

ConclusionIt is clear from the above case studies that a highly localized regulatory ap-proach similar to that advocated by Os-trom has indeed been an effective means to regulate deforestation and ensure sustainable forest industry practices. The locally focused programs of JFM in India and SKFP in China have been suc-

cessful for two primary reasons. First, the localized approach has allowed the federal government of each nation to cater most effectively to local needs and tailor its policies so as to provide local communities with the ability to achieve the greatest level of productiv-ity while utilizing their forest and local resources to full capacity. Such locally minded policy formulation has played a key role in achieving many of the eco-nomic welfare benefits presented in the

above case studies. Second, focusing on a more local, albeit federally organized, subsidized, and supported enforcement mechanism has proven highly success-ful, as well. Local community members not only have more at stake in protect-ing their surrounding forest reserves but also have more localized and spe-cialized knowledge, applicable skill sets, and the ability to utilize social pres-sure (similar to the means explained by Ostrom and her co-authors) to induce more effective compliance. It is evident that, at least with respect to particular commons problems, namely those that are more amenable to local community management, Ostrom’s local adaptive governance methods are highly appli-cable and her proposal should at the very least be taken into consideration by federal authorities aiming to construct efficient and cost-effective regulatory policies. Nevertheless, it is also important to keep in mind the role played by the federal governments of India and China in overseeing the localized systems of regulation. Although the enforcement was highly localized and the policies catered to specific community needs, the authority was still delegated in a top-down manner and the policy was nevertheless centrally administered. We believe that with large nations such as

India and China, but especially within the context of the entire global commu-nity, a top-down (and hence somewhat centralized) approach is vital to the sustainable collective management of all of the world’s reserves of a particu-lar common resource. Although efforts have been made to date , and with some success, to develop international bodies that collectively determine appropriate deforestation levels for particular na-tions as well as effective international enforcement policies, the need for great-er participation and consensus remains a key next step for the international community to undertake. In order to achieve truly sustainable timber indus-try practices and limit deforestation (as well as other commons-related harms), an effective localized enforcement re-gime must be coupled with a strong centralized authority. Such an authority should certainly tailor its policies to best meet local needs and make the most ef-ficient use of local resources. Through this ability to set the most effective and welfare-maximizing poli-cies, the centralized authority would also be able to achieve sustainability and regulatory success on a global scale in a way that local institutions cannot due to the lack of both comprehensive information and even private and com-munal benefit incentives. A centralized structure is most economically efficient chiefly because it has the ability to craft effective international policies as well as to serve as an agent of ultimate legal en-forcement; such an authority provides local communities with the assistance, incentives, and local governing power that they require to effectively carry out a system of localized adaptive govern-ance. Thus, as seen by the analyses of the forest commons in China and In-dia as discussed in this paper, Ostrom’s theory of local adaptive governance ap-pears vindicated, especially since modi-fied versions have proven successful. In order to mitigate similar commons problems elsewhere in the world, it would behoove policymakers around the world to pay closer attention to this theory of environmental management, as it would prove enormously beneficial to the goal of sustainable economic de-velopment.

Fall 2010

Theory & Policy 25


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